Evaluating Financial Performance

The Key Questions:

1. Does the firm have the ability to meet maturing financial obligations?

2. Does management do a good job at generating operating profits on the firm’s assets?

3. How is the firm financed?

4. Do the owners’ receive a good rate of return on their equity capital (return on equity)?

Ability to Meet Maturing Obligations

Balance sheet perspectiveCurrent ratio = current assets ÷ current debt

Quick ratio = (cash + accts receiv) ÷ current debt

Asset flow perspective:

Accts receivableturnover

= sales ÷ accts receivables

Inventoryturnover

= cost of goods sold ÷ inventories

Evaluating a Firm’s Operating Profitability

Is management doing a good job at generating profitability on the firm’s

assets?

The answer is based on one and only one ratio:

Why is the OROA high or low relative to competition????

But once we answer this question, we do not stop. We want to know:

Operating Operating Income

return on assets Total Assets=

To answer this second question,we look at the two pieces of OROA:

OROA = OperatingProfit margin

XTotal asset turnover

or more completely,

SalesTotal Assets

OROA =Operating profits

SalesX

The first piece is the operating profit margin:

OROA =Operating Profits

SalesX

Sales

Total Assets

Use a Common Sized Income Statement to

understand the operating margin

For example, IRM, Inc. compared to a peer company:

IRM, Inc. Peer Co.

Sales $400100% 100%

Cost of goods sold 240 60% 50%

Gross profits $160 40% 50%

Operating expenses:

Selling & marketing $48 12% 12%

General & admin 24 6% 11%

Depreciation expense 32 8% 7%

Total operating expenses $104 26% 30%

Operating income $56 14% 18%

gross profitmargin

operatingprofit margin

So the margins tell us:

How well we are managing the income statement!!!!The four “drivers” are:

1. The selling price for each product.2. The cost of manufacturing or acquiring the firm’s

products or services.3. The ability to control general and administrative

expenses.4. The ability to control the expenses in marketing

and distributing a firms product.

The second piece is the total asset turnover:

OROA =Operating profits

SalesX

SalesTotal assets

To know how efficiently we are using the firm’s assets (the balance sheet), we need two pieces of information:

1. A common-sized balance sheet to know the relative size of each asset in the balance sheet

2. The turnover ratios that tell us specifically how we are managing:– Accounts receivables: accounts receivable

turnover

– Inventories: inventory turnover

– Fixed assets: fixed asset turnover

(sales ÷ net fixed assets)

For example, IRM’s balance sheet: IRM, Inc. Peer Co.

Cash $20 10% 5%Accounts receivables 40 20% 26%Inventories 60 30% 25%Total current assets $120 60% 56%Net fixed assets 80 40% 44%Total assets $200 100% 100%

Accounts payable $30 15% 10%Short-term note 14 7% 15%Total current debt $44 22% 25%

Long-term debt 36 18% 43%Total debt $80 40% 68%Equity 120 60% 32%Total debt and equity $200 100% 100%

So:• OROA tells if management is generating

adequate operating profits on the assets!

• To determine why OROA is high or low, we look at the two components of OROA:

Operating profitsSales

andSales

Total Assets

Income StatementManagement

Efficiency of Asset Utilization

How does the firm finance its assets?

Balance sheet perspective:

Debt ratio = total debt ÷ total assets

Income statement perspective:

Times interestearned =

operatingincome

interestexpense

÷

Owner’s Rate of Return(return on equity)

Return onequity =

netincome

÷total equityinvestment

Total common equity = all of the equity, including retained earnings

What causes ROE to be high or low?

• High operating return on assets (OROA) produces a high return on equity (ROI), and vv.

• High debt causes ROE to be high IF OROA is higher than the firm’s interest rate on debt

• BUT high debt causes ROE to be low if OROA is lower than the firm’s interest rate on debt!!

• See an example.

Let’s Practice

Use the Dumas and Lakhani, Inc. financials to evaluate the firm’s performancew!