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Chapter 4 Evaluating Financial Performance.ppt

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					      Chapter 4 - Evaluating
      Financial Performance
• Financial Analysis – process of assessing
  financial condition of a firm

• Principal analytic tool is the financial
  ratio

• Understand ratios and what they mean
                                              1
            Ratio Analysis
• Identify firm’s strengths and weaknesses
  – Comparison of the firm over time or with
    other firms
• Industry averages – benchmarks
  – Robert Morris Associates, Dun & Bradstreet
• Four types of ratios: liquidity, efficiency,
  leverage and profitability

                                                 2
  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?


                                           3
      How Liquid is the Firm?
• Liquidity – ability to meet maturing
  obligations
• 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?
                                                4
               Liquidity
• Current ratio – conventional wisdom says
  2:1 but there is “the lettuce problem”.
• Acid test or quick ratio – (CA - Inv)/ CL
• Collection period – how many days to
  collect receivables = AR / DCrS = say 20
• Turnover – how many times are AR rolled
  over during a year? = CS/AR = say 18 X
• By most of these measures, McD less liquid
                                           5
 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 aging – good footnote
                                               6
        Inventory Turnover
• Turnover Ratio = Cost of Goods Sold
  (Times per year)           Inventory
• Why COGS? Need cost-based numbers
  in numerator and denominator
• If less liquid, greater chance to be unable
  to pay on time.
• McD – excellent inventory management
  (87 times a year versus 35)
                                                7
     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

                                              8
Operating Profits – Adequate?
• Text tells us to use operating profits
  – GP ignores marketing exp; NP includes
    financing effects
• OIROI – Operating Income Return on
  Investment – op profits relative to assets
  OIROI = Operating Income
            Total Assets
McD generates more income per $ of assets
                                               9
                OIROI
• Separate OIROI into its two pieces:
         OIROI = OPM * TAT
            15.4% = 23.4% * .66
• Operating Profit Margin = Op. Income
                                 Sales
• Management’s effectiveness in keeping
  costs in line with sales; McD = very good
                                          10
         Total Asset Turnover
• TAT       =         Sales        = .66
                   Total Assets
•   Amount of sales generated by $1 of assets
•   Higher turnover better; good use of asset
•   McD – weak $0.66 in sales per $ of assets
•   Where’s the problem? Check
    components
                                            11
        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

                                           12
            OIROI Summary
• OIROI     = Operating Inc. *         Sales
                      Sales            Total Assets
• McD effectively keeps costs and operating
  expenses low, but is not particularly good in
  managing its assets

Overall, they are doing better than the competitors –
 OIROI = 15. 4% versus 11.6%

                                                      13
How Does Firm Finance Assets?
• What percentage of assets are financed by debt
  and how much by equity?
   – Debt includes all liabilities, both short and
     long-term
   Debt Ratio     =       Total Debt
                         Total Assets

• McD uses significantly less debt (54 vs 69%)
                                                     14
       Times Interest Earned
• TIE – how much operating income is available
  to meet interest expense? Or, how many times
  is it covering annual interest?

• TIE =      Operating Income =        7.5 Times
             Interest Expense

McD – no problem in paying int. Op. Inc. could
 fall to 1/7th of current level and still pay (1/7.5)
                                                        15
         Adequate Returns?
• Are stockholders receiving an adequate
  return on their investment? Is it attractive
  compared to other companies?

Return on Com Equity = Net Income
                          Common Equity
Equity = PV+ P-I + RE but no preferred stock
McD – profitability fully offsets low leverage
                                                 16
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.

                                              17
      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 and
  dogs”
• However, ratios are still useful tools
                                              18
     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, others
  make look bad
  • Overall – look at several combinations
                                             19

				
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