How Can We Assess and Explain Financial Performance?

Financial Ratio Analysis

How can published financial statements be used to assess

financial performance?

Financial Ratio Types

• Market Value

• Profitability

• Asset Activity

• Leverage

• Liquidity

Market Value Ratios

• Examples: Market-to-Book; Price-Earnings

• Questions: How do securities markets value the company’s assets? Earnings?

Profitability Ratios

• Examples: Return on assets, equity, invested capital; gross, net profit margin

• Questions: How profitable is the company per dollar invested in the business; per dollar of sales?

Asset Activity Ratios

• Examples: asset turnover, average collection period, inventory conversion period, payables deferral period

• Questions: How efficiently does the company use its assets? How long does it take assets or liabilities to turn into cash?

Leverage Ratios

• Examples: Debt/assets; Debt/equity; Interest coverage

• Questions: How much of a burden does debt pose relative to assets, equity or cash flow? How risky is the company?

Liquidity Ratios

• Examples: Current ratio, quick ratio, interval measure

• Questions: How easily can the company meet its immediate cash requirements? How risky is the company?

Financial Ratios Relative to What?

• By themselves, financial ratios have no meaning. We need to compare to:

– Past data for the same company– Data for similar companies (e.g., same

industry)– Other ratios (i.e., DuPont ratios, Cash

Conversion Cycle)

Does One Trend Coincide with Another?

A Good Source of Company Ratios

www.investor.reuters.com

                                                    

Dell and Gateway: Margin Trends

2005 2004 2003 2002 2001 2000 1999 1998 1997

Dell

Gross Margin 18.6 18.2 17.9 17.7 20.2 20.7 22.5 22.1 21.5

Net Margin 6.6 6.4 6 4 6.8 6.6 8 7.7 6.7

Gateway

Gross Margin 9.1 13.6 13.6 14.1 21.4 20.5 18.3 17.1 18.6

Net margin 0.5 -15.1 -7.1 -17.4 2.5 4.8 4.5 1.7 5

Dell, Gateway and Computer Hardware

Dell Gateway Industry

Gross Margin 18.6 9.1 31.1

Net Margin 6.6 0.5 7.2

Asset Turnover 2.4 2.1 1.5

Inventory Turnover 91.6 16.4 45

Rec. Turnover 12.6 11.9 8.6

ROIC 40.8 3.2 19.6

ROE 58.4 44.4 31.9

Quick Ratio 0.9 0.8 1.3

Mkt/Book 13.6 3.7 6.9

DuPont Ratios

Net Income x Sales x Assets = Net Income

Sales Assets Equity Equity

Net profit X Asset x Equity = ROE

margin turnover multiplier

DuPont Analysis: Selected Companies

ROE S/A NI/S A/E

Burlington Northern Santa Fe 0.138 0.128 0.337 3.219

Citicorp 0.165 0.102 0.114 14.121

Consolidated Edison 0.113 0.495 0.098 2.340

Merck 0.375 0.943 0.195 2.038

Safeway 0.334 3.203 0.025 4.209

Wal-Mart Stores 0.198 2.776 0.030 2.384

THE CASH CONVERSION CYCLE DAYS SALES IN INVENTORY DAYS SALES IN RECEIVABLES INVENTORY/(COGS/DAY) RECEIVABLES/(SALES/DAY) INVENTORIES SALES SUPPLIERS PAID CASH RECEIVED PURCHASED BOOKED IN CASH FOR SALES PAYABLES/((COGS+SG&A)/DAY) DAYS SALES IN PAYABLES CASH CONVERSION CYCLE

Cash Conversion Cycle: Selected Companies

Company Inv. Conv.Ave. Coll.

Op. CyclePay. Def.

Cash Conv.

Hewlett-Packard

89.8 65.1 154.9 65.9 89

Merck 70 42.7 112.7 66 46.7

Boeing 74.1 22 96.1 54.4 41.7

Wal-Mart Stores

64.4 2.8 67.2 37.4 29.8

Safeway 33.9 2.8 36.7 35.3 1.4

American Airlines

15.1 24.7 39.8 70.9 -31.1

McDonald's 3.9 7.1 11 62.2 -51.2