Evaluating Financial Performance

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Evaluating Financial Performance
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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 firms assets?
3. How is the firm financed?
4. Do the owners receive a good rate of return on
   their equity capital (return on equity)?

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Ability to Meet Maturing Obligations

• Balance sheet perspective
• Current ratio current assets current debt
• Quick ratio (cash accts receiv) current
  debt
• Asset flow perspective

Accts receivable turnover
sales accts receivables
Inventory turnover
cost of goods sold inventories
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Evaluating a Firms Operating ProfitabilityIs
management doing a good job at generating
profitability on the firms assets?
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The answer is based on one and only one ratio
But once we answer this question, we do not stop.
We want to know
Why is the OROA high or low relative to competition????
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To answer this second question,we look at the two
pieces of OROA
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The first piece is the operating profit margin
Use a Common Sized Income Statement to understand
the operating margin
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• For example, IRM, Inc. compared to a peer
  company
• IRM, Inc. Peer Co.
• Sales 400 100 100
• 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 profit margin
operating profit margin
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So the margins tell us

• How well we are managing the income
  statement!!!!
• The four drivers are
• The selling price for each product.
• The cost of manufacturing or acquiring the firms
  products or services.
• The ability to control general and administrative
  expenses.
• The ability to control the expenses in marketing
  and distributing a firms product.

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The second piece is the total asset turnover
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• To know how efficiently we are using the firms
  assets (the balance sheet), we need two pieces
  of information
• A common-sized balance sheet to know the relative
  size of each asset in the balance sheet
• 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)

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For example, IRMs 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

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• 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

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How does the firm finance its assets?

• Balance sheet perspective
• Debt ratio total debt total assets
• Income statement perspective

Times interest earned
operating income
interest expense


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Owners Rate of Return(return on equity)
Return on equity
net income
total equity investment


Total common equity all of the equity,
including retained earnings
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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 firms interest rate on debt
• BUT high debt causes ROE to be low if OROA is
  lower than the firms interest rate on debt!!
• See an example.

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Lets Practice

• Use the Dumas and Lakhani, Inc. financials to
  evaluate the firms performancew!