Chapter 4 - Evaluating Financial Performance

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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

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Ratio Analysis

• Identify firms 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

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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?

• 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?

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Liquidity

• Current ratio conventional wisdom says 21 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

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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 aging good footnote

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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)

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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 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

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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
• McD weak 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 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

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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 and
  long-term
• Debt Ratio Total Debt
• Total Assets
• McD uses significantly less debt (54 vs 69)

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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)

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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

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What Can We Say About McD

• Its liquidity is average even with low receivable
  turnover good on inventory
• OIROI is goodgood 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 and dogs
• 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, others make look
  bad
• Overall look at several combinations