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TOPIC 4

EVALUATING FINANCIAL PERFORMANCE

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1. How easy is it for us to pay our bills?

2. How easy is it for us to pay our bills if our inventory is not very liquid?

3. Are we carrying the right amount of inventory?

4. Are we collecting our accounts receivable as fast as we should?

5. Do we have the right amount of debt?

6. Are we earning enough profit?

7. How is our stock price?

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What are the five major categories of ratios, and what questions do they answer?

Liquidity: Can we make required payments?

Asset management: right amount of assets vs. sales?

Debt management: Right mix of debt and equity?

Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?

Market value: Do investors like what they see as reflected in P/E and M/B ratios?

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FOR EACH RATIO YOU SHOULD KNOW:

1. THE “PROBLEM”

2. DEFINITION OF THE RATIO

3. RATIONALE FOR THE RATIO

4. HOW TO EVALUATE

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LIQUIDITY RATIOS

1. CURRENT RATIO

Current assets / current liabilities

2. QUICK RATIO

Current assets – inventory / current liabilities

When would this ratio be used?

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Comments on current ratio

2004 2003 2002 Ind.

Currentratio

2.34x 1.20x 2.30x 2.70x

Expected to improve but still below the industry average.

Liquidity position is weak.

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ASSET MANAGEMENT RATIOS

1. INVENTORY TURNOVER

Sales / Inventory Do we want this ratio to be as high as possible?

2. AR TURNOVER (DAYS SALES OUTSTANDING)

Accounts receivable / sales per day Do we want this ratio to be as low as possible?

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Fixed asset and total asset turnover

FA turnover = Sales / Net fixed assets

TA turnover = Sales / Total assets

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What is the inventory turnover vs. the industry average?

2004 2003 2002 Ind.

InventoryTurnover

4.1x 4.70x 4.8x 6.1x

Inv. turnover = Sales / Inventories= $7,036 / $1,716= 4.10x

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Appraisal of DSO

2004 2003 2002 Ind.

DSO 45.6 38.2 37.4 32.0

The company collects on sales too slowly, and is getting worse.

The company has a poor credit policy.

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DEBT RATIOS

1. THE DEBT RATIO (amount of debt)

Total debt / Total assets

2. TIMES INTEREST EARNED (ability toservice the debt)

EBIT / Annual Interest

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PROFITABILITY RATIOS

1. PROFIT MARGIN

Net Income / Sales

2. RETURN ON ASSETS

Net Income / assets

3. RETURN ON EQUITY

Net Income / equity

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MARKET VALUE RATIOS

1. P/E RATIO

2. MARKET/BOOK RATIOMarket value of the stock per sharedivided bybook value of the stock per share

Book value is total equity on the balancesheet divided by the number of shares outstanding

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DUPONT ANALYSIS

RETURN PROFIT ASSETON ASSETS = MARGIN X TURNOVER

ROA = NI/S X S/A

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The Du Pont systemAlso can be expressed as:

ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) Focuses on:

Expense control (PM) Asset utilization (TATO) Debt utilization (Eq. Mult.)

Shows how these factors combine to determine ROE.

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EXTENDED DUPONT EQUATION

RETURN RETURN EQUITYON EQUITY = ON ASSETS X MULTIPLIER

NI/E = NI/S X S/A X A/E

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Extended DuPont equation: Breaking down Return on equity

ROE = (Profit margin) x (TA turnover) x (Equity multiplier)

= 3.6% x 2 x 1.8

= 13.0%

PM TA TO EM ROE

2001 2.6% 2.3 2.2 13.3%

2002 -2.7% 2.1 5.8 -32.5%

2003E 3.6% 2.0 1.8 13.0%

Ind. 3.5% 2.6 2.0 18.2%

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Appraising profitability with the return on assets and return on equity

2004 2003 2002 Ind.

ROA 7.3% -5.6% 6.0% 9.1%

ROE 13.0%-

32.5%13.3% 18.2%

Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed.

Wide variations in ROE illustrate the effect that leverage can have on profitability.

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Why are ratios useful? Ratios standardize numbers and

facilitate comparisons. Ratios are used to highlight

weaknesses and strengths.

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NON-FINANCIAL ASPECTS OF COMPANY EVALUATION

1. Number of customers, suppliers, products

2. Amount of oversees business

3. Competition

4. Laws and regulations

5. Management

(Possible problem of “double counting.”

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PROBLEMS OR LIMITATIONS OFRATIO ANALYSIS

1. Determining the industry.2. Accounting practices differ.3. Industry average may not be

appropriate.4. Ratios may be misleading (for

example, high current ratio)5. Seasonal changes