Chapter 2 - Evaluating a

Firm’s Financial
Performance

 2005, Pearson Prentice

Hall
 Why we need for ratio analysis?
 To evaluate the firm’s financial performance
for the usage of the owners (investors),
managers and lenders of the firm.

 This is referring to:

 Principle 7
 Principle 5
 Principle 1
 Principle 7: Manager won’t work for the
owner unless its in the best interest to do so.

Stockholders need to have information

that can be used to monitor the managers
action.
 Principle 5: Competitive market make it
hard to exceptionally profitable investment.

 The notion of the rate of return is a primary

issue in knowing whether management is
creating value.

 Ratio: Profitability Ratios.

 Principle 1: The risk-return tradeoff; we
won’t take additional risk unless we expect to be
compensated with additional return.

 To see how management chooses to

finance the business which will affect the
company’s risk and as a result in the rate
of return.

 Ratio: Leverage and Profitability Ratios.

 Financial Ratio Analysis

 Are our decisions

maximizing
shareholder
wealth?
We will want to answer
questions about the firm’s
Current ratio Debt Ratio
Leverage Ratios
Liquidity Ratios (Financing
Asid Test Decision) Times interest
Ratio earned
Average
collection Net profit
period margin

Inventories Gross profit

Activity turnover margin
(Efficient Use Profitablity
of Asset) Total asset ratios
Operating
turnover profit margin
Fixed asset Return on
turnover equity
 Financial Ratios
 Tools that help us determine the financial
health of a company.
 We can compare a company’s financial
ratios with its ratios in previous years
(trend analysis).
 We can compare a company’s financial
ratios with those of its industry known as
industry average or industry norm
(comparative analysis).
 Example:
CyberDragon Corporation
 CyberDragon’s Balance Sheet
Assets: RM Liabilities & Equity: RM
Cash 2,000 Accounts payable 9,000
Marketable securities 1,900 Notes payable 8,300
Accounts receivable 10,100 Accrued taxes payable 3,200
Inventories 20,500 Other current liabilities 4, 000
Total current assets 34,500 Total current liabilities 24,500
Plant and equipment 45,000 Long-term debt (bonds) 25,000
Tools and equipment 25,000 Total liabilities 49,500
Total fixed assets 70,000 Common stock 13,000
Total assets 104,500 Paid in capital 20,000
Retained earnings 22,000
Total stockholders' equity 55,000
Total liabilities & equity 104,500
Sales (all credit) CyberDragon’s RM 120,000
Cost of Goods Sold (80,000)
Gross Profit
Income Statement 40,000
Operating Expenses:
Selling (6,600)
General & Administrative (5,000)
Total Operating Expenses (11,600)
Earnings before interest and taxes (EBIT) 28,400
Interest charges:
Interest on bank notes: (800)
Interest on bonds: (2,400)
Total Interest charges (3,200)
Earnings before taxes (EBT) 25,200
Taxes (assume 40%) (10,000)
Net Income 15,200
 1. Liquidity Ratios

 Do we have enough liquid assets

to meet approaching obligations?
 Liquidity Ratios
 Liquidity of a business can be defined as
“its ability to meet maturing debt
obligations”

 Referring to short-term debt.

 That is, does or will the firm have the

resources to pay creditors when the debt
comes due?
 1. Current Ratio

= current assets
current liabilities
EXAMPLE :
RM 34,500
RM 24,500 = 1.41 times
 Comment on single ratio:
 Current ratio = 1.41 times.

 The firm is liquid because the ratio is more

than 1. This indicates that the firm is able to
pay short term debt when it comes due.

 For every RM1.00 of current liabilities, the

firm has RM1. 41 to be ready for a payment.
Comment on Comparative Analysis
If the average current ratio for the
industry is 2.4, is this good or not?
CyberDragon Industry Average

Current ratio 1.41 times 2.40 times

The firm is less liquid than industry average.

This indicates that the ability the pay short
term debt is lower.
2. Acid Test Ratio (Quick Ratio)

= current assets - inventories

current liabilities

EXAMPLE :
50,190 - 27,530 = 0.89 times
25,523
 Comment on single ratio:
 Acid test ratio = 0.89 times.

 The firm is actually not liquid because the

ratio is less than 1. This indicates that there is a
greater chance that the firm will unable to
pay creditors when payments are due.

 For every RM1.00 of current liabilities, the

firm only has RM0.89 to be ready for a
payment.
Comment on Comparative Analysis
Suppose the industry average is 0.92 times.
What does this tell us?
CyberDragon Industry Average

Acid test ratio 0.89 times 0.92 times

The firm is still less liquid than industry

average. This indicates that the ability the pay
short term debt is lower.
 2. Activity Ratios

 To see how efficient the firm in

using and managing their assets to
generate sales.
 i : Average Collection Period

= accounts receivable
daily credit sales
or
= accounts receivable X 360
credit sales
EXAMPLE :
18,320 = 59.3 days
112,760/365
 Comment on single ratio:
 ACP = 59.3 days

 The firm is taking about 59 days to collect

the firm’s receivables. This indicates that the
firm is quite efficient in managing their
receivables.
Comment on Comparative Analysis
If the industry average is 47 days,
what does this tell us?
CyberDragon Industry Average

ACP 59.3 days 47 days

The firm is taking longer period to collect the firm’s
receivables than the industry average.

This indicates that the firm is slower in the collection and

not being careful in its collection policies. The firm may not
managing receivables effectively.
ii : Inventory Turnover

= Cost of goods sold

Inventory
or
= Sales
Inventory

85,300
27,530 = 3.10 times
 Comment on Comparative Analysis
CyberDragon Industry Average

Inventory 3.1 times 3.9 times

Turnover

 CyberDragon turns their inventory over 3.1 times

per year.
 The firm’s inventory turnover is slightly lower
than industry average. This indicates that the firm
is slightly less efficient in managing their
Low inventory turnover:

The firm may have too much

inventory, which is expensive
because:
 Inventory takes up costly
warehouse space.
 Some items may become spoiled
or obsolete.
iii : Total Asset Turnover

= sales
total assets

112,760 = 1.38 times

81,890
 Comment on Comparative Analysis
CyberDragon Industry Average

 Total Asset 1.38 times 1.82 times

Turnover

 The industry average is 1.82 times.

 The firm’s total asset turnover is lower than
industry average. This indicates that the firm is less
efficient in using their assets to generate sales.
iv : Fixed Assets Turnover

= sales
fixed assets

112,760
31,700 = 3.56 times
 Comment on Comparative Analysis
CyberDragon Industry Average

 Fixed Assets 3.56 times 4.6 times

Turnover

 The firm’s fixed assets turnover is very much

lower than industry average. This indicates that
the firm is less efficient in using their fixed assets
to generate sales.
 3. Leverage Ratios
(financing decisions)

 Measure the impact of using debt

capital to finance assets.
 Firms use debt to lever (increase)
returns on common equity.
 i: Debt Ratio

= total debt
total assets

47,523 = 58%
81,890
 i: Debt Ratio

47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?

Can leverage make the firm more

profitable?
Can leverage make the firm riskier?
 Comment on Comparative Analysis
CyberDragon Industry Average

 Debt ratio 58 % 47 %

 The firm’s debt ratio is higher than industry

average. This indicates that the firm uses more
debt to finance their assets. The firm is taking
higher risk.
 ii: Times Interest Earned

= operating income
interest expense
Operating income
= Earnings before interest and taxes
(EBIT)
ii: Times Interest Earned

= operating income
interest expense
or
= EBIT
interest expense
11,520
3,160 = 3.65 times
 Comment on Comparative Analysis
CyberDragon Industry Average

 TIE 3.65 times 6.7 times

 The firm’s times interest earned is lower than

industry average. This indicates that the ability of
the firm to pay interest is lower.
 3. Profitability Ratios

 Measure how efficiently the

firm’s assets and capital to
generate profits.
 i. Net profit margin

= Net profit RM 15 200 = 12.67%

Sales RM 120 000

Net Profit = Net income = EAT

(EAT : Earnings After Tax)
ii. Gross profit margin

= Gross profit
Sales
iii. Operating profit margin

= Operating profit
Sales
 iv. Return on Equity

How well are the firm’s managers

maximizing shareholder wealth?
 What is CyberDragon’s
Return on Equity (ROE)?

= net income
common equity

5,016
34,367 = 14.6%
 What is CyberDragon’s
Return on Equity (ROE)?

5,016
34,367 = 14.6%

The industry average is 17.54%.

Is this what we would expect,
given the firm’s leverage?
 Conclusion:

 Even though CyberDragon has

higher leverage than the industry
average, they are much less
efficient, and therefore, less
profitable. The firm needs to
figure out how to squeeze more
sales dollars out of its assets.
 Limitations of ratio analysis
 It is sometimes difficult to understand the
industry category.

 Industry averages are only approximations.

 Differences in accounting practices will lead to

differences in computed ratios.

 Industry averages may not provide a desirable

target ratio.
 Seasonality effects.

 A single ratio does not provide sufficient

information.

 Inflation distorted.

 Etc.