chapter 4 financial performance

8/11/2019 Chapter 4 Financial Performance

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Chapter 4 - Evaluating

Financial Performance Financial Analysisprocess of assessing

financial condition of a firm

Principal analytic tool is the financial

ratio

Understand ratios and what they mean


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Ratio Analysis

Identify firms strengths and weaknesses

Comparison of the firm over time or with

other firms

Industry averagesbenchmarks

Robert Morris Associates, Dun & Bradstreet

Four types of ratios: liquidity, efficiency,leverage and profitability


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Ratios and Major Questions

How liquid is the firm?

Are adequate operating profits being

generated?

How is the firm financing its assets?

Are shareholders receiving an adequate

return?


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How Liquid is the Firm?

Liquidityability to meet maturingobligations

Enough resources to pay when due? How do liquid assets compare with debt?

Compare cash and assets to be converted to

cash with debt due in same period Can firm convert receivables/inventories to

cash on timely basis? How quick or long?


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Liquidity

Current ratioconventional wisdom says2:1 but there is the lettuce problem.

Acid test or quick ratio(CA - Inv)/ CL Collection periodhow many days to

collect receivables = AR / DCrS = say 20

Turnoverhow many times are AR rolledover during a year? = CS/AR = say 18 X

By most of these measures, McD less liquid


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Collection Period & Turnover

Measure the same thing are reciprocals

365 days = 17.9 X 365 Days = 20.4days

20.4 days 17.9 X

McD not good at collections (20 days vs. 7)

Are longer credit terms good or bad?

Competitive necessity or weak management ?

Receivables aginggood footnote


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Inventory Turnover

Turnover Ratio = Cost of Goods Sold

(Times per year) Inventory

Why COGS? Need cost-based numbersin numerator and denominator

If less liquid, greater chance to be unable

to pay on time. McDexcellent inventory management

(87 times a year versus 35)


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Cash Conversion Cycle

To reduce working capital, speed up

collections, turn inventory faster, slow

disbursements

Sum of days required to collect + days in

inventory - Days of Payable Outstanding

DPO = Accounts Payable = say 29

COGS / 365


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Operating ProfitsAdequate?

Text tells us to use operating profits

GP ignores marketing exp; NP includes

financing effects OIROIOperating Income Return on

Investmentop profits relative to assets

OIROI = Operating Income

Total Assets

McD generates more income per $ of assets


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OIROI

Separate OIROI into its two pieces:

OIROI = OPM * TAT

15.4% = 23.4% * .66

Operating Profit Margin = Op. Income

Sales Managements effectiveness in keeping

costs in line with sales; McD = very good


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Total Asset Turnover

TAT = Sales = .66

Total Assets

Amount of sales generated by $1 of assets

Higher turnover better; good use of asset

McDweak $0.66 in sales per $ of assets Wheres the problem? Check

components


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Total Asset Turnover

McD very weak. But why?

Turnover McDonalds Peers

Receivables 17.9 X = Bad 56

Inventory 87 Good 35 Fixed Assets .84 Bad 3.2


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OIROI Summary

OIROI = Operating Inc. * Sales

Sales Total Assets

McD effectively keeps costs and operatingexpenses low, but is not particularly good in

managing its assets

Overall, they are doing better than the competitors

OIROI = 15. 4% versus 11.6%


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How Does Firm Finance Assets?

What percentage of assets are financed by debt

and how much by equity?

Debt includes all liabilities, both short andlong-term

Debt Ratio = Total Debt

Total Assets

McD uses significantly less debt (54 vs 69%)


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Times Interest Earned

TIEhow much operating income is availableto meet interest expense? Or, how many timesis it covering annual interest?

TIE = Operating Income = 7.5 Times

Interest Expense

McDno problem in paying int. Op. Inc. couldfall to 1/7thof current level and still pay (1/7.5)


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Adequate Returns?

Are stockholders receiving an adequatereturn on their investment? Is it attractive

compared to other companies?

Return on Com Equity = Net Income

Common EquityEquity = PV+ P-I + RE but no preferred stock

McDprofitability fully offsets low leverage


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What Can We Say About McD

Its liquidity is average even with low

receivable turnover; good on inventory

OIROI is good;good profitability offsets

low asset turnover

Uses less debt than competitors

Good Return on Equity; uses less debt

but this offset by greater profitability.


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Limitations With Ratios

Difficult to identify industry categories

No exact peers

Averages are only approximates Accounting principles differ

Ratios can be too high or too low

Industry averages include stars anddogs

However, ratios are still useful tools


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Unmentioned Problems

Old firm versus new

Have assets been depreciated?

Window dressing Actions to make good at year end

Role of revolvers

Some ratios make you look good, othersmake look bad

Overalllook at several combinations

chapter 4 financial performance

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