Chapter 3 Evaluating Financial Performance

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Chapter 3Evaluating Financial Performance
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I. Basic Financial Statements

• Basic Financial Statements
• 1. Income Statement
• 2. Balance Sheet

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1. The Income Statement

• The statement of profit or loss for the period is
  comprised of net revenues less expenses for the
  period.

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• Table 3.1 Income Statement - Jamin for the Year
  ending Dec.31,95
• Sales 830,200
• Cost of Goods Sold 539,750
• Gross Profit on sales 290,450
• Operating Expenses
• Selling expenses 90,750
• General and Administrative expenses 71,800
• Depreciation 28,200
• Total Operating Expenses 190,750
• Operating Income 99,700
• Interest Expense 20,000
• Earnings before tax 79,700
• Income Tax 17,390
• Net Income 62,310

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• Table 3.1 Income Statement - Jamin for the Year
  ending Dec.31,95
• (cont.)
• Net Income 62,310
• Common Stock Dividend 15,000
• Change in retained earnings 47,310

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2. Balance Sheet

• A statement of financial position at a particular
  date. The form of the statement follows the
  balance sheet equation
• Total assets Total Liabilities Owners equity

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• Table 3.2 Balance Sheet - Jamin, December 31,
  1994 and 1995
• Assets 1994 1995 Change
• Current Assets
• Cash 39,000 44,000 5,000
• Accounts Receivable 70,500 78,000 7,500
• Inventories 177,000
  211,400 34,400
• Other Current Assets 13,500 13,800 300
• Total Current Assets 300,000
  347,200 47,200
• Fixed Assets
• Gross Plant and Equipment 759,000
  838,000 79,000
• Accumulated Depreciation (355,000)
  (383,200) (28,200)
• Net Plant and Equipment 404,000
  454,800 50,800
• Land 70,000 70,000
  0
• Total Fixed Assets
  474,000 524,800
  50,800
• Patents
  30,000 55,000
  25,000
• Total Assets
  804,000 927,000
  123,000

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• Table 3.2 Balance Sheet - Jamin, December 31,
  1994 and 1995
• Liabilities and Equity 1994 1995 Change
• Current Liabilities
• Accounts payable 60,810 76,110 15,300
• Income Tax payable 12,000
  17,390 5,390
• Accrued wages and salaries 3,400
  3,900 500
• Interest payable 2,000
  2,500 500
• Total current liabilities 78,210
  99,900 21,690
• Long-term notes payable
  146,000 200,000
  54,000
• Total Liabilities
  224,210 299,900
  75,690
• Common Stock (par valuepaid-in) 300,000
  300,000 0
• Retained Earnings
  279,790 327,100
  47,310
• Total Stockholders equity 579,790
  627,100 47,310
• Total Lia. and Equity 804,000
  927,000 123,000

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II. The Cash Flow Statement

• The statement of cash flow enumerates the cash
  receipts and cash disbursements for a specified
  interval of time (usually one year)
• Three main areas
• Cash Flow from Operations
• Cash Flow from Investments
• Cash Flow from Financing
• Two sources of data
• Balance Sheet 94 and 95
• Income Statement 95

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• Table 3-3 Cash Flow Statement Jamin for the year
  Ending Dec.31, 1995
• Cash flows from Operations
• Cash inflows received from customers
• Net Sales 830,200
• Less Change in Accounts Receivable (7,500)
• Cash Inflows received 822,700
• Cash Paid to suppliers
• Cost of Goods sold (539,750)
• Plus Change in inventory (34,400)
• Less Change in accounts payable 15,300
• Cash paid to suppliers (558,850)

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• Table 3-3 Cash Flow Statement Jamin for the year
  Ending Dec.31, 1995
• Other Operating Cash outflows and interest
  payments
• Marketing Expenses (90,750)
• General and Administrative expenses (71,800)
• Less Change in Accrued expenses 500
• Interest expense (20,000)
• Less Change in interest payable 500
• Other operating cash outflows and int. payments
  (181,550)
• Cash Tax payments
• Provisions for taxes in the income
  statement (17,390)
• Less Change in accrued taxes 5,390
• Cash Tax Payments
  (12,000)
• Total Cash Flows from Operations 70,300

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• Table 3-3 Cash Flow Statement Jamin for the year
  Ending Dec.31, 1995
• Cash Flows from Investment Activities
• Purchase of Fixed assets (Gross) (79,000)
• Purchase of other current assets (300)
• Purchase of patents (25,000)
• Net Cash Flows from Investment
  (104,300)
• Cash Flows from Financing Activities
• Proceeds from long-term debt 54,000
• Common Stock Dividends (15,000)
• Net cash Flows from Financing 39,000
• Total Cash Flows (change in Cash in Balance
  Sheet) 5,000

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• Table 3-4 Indirect Method to calculate Cash Flow
  From Operations
• Net Income 62,310
• Add(deduct) to reconcile net income to net cash
  flow
• Depreciation expense 28,200
• Less
• Increase in accounts receivable (7,500)
• Increase in inventories (34,400)
• Plus
• Increase in accounts payable 15,300
• Increase in accrued wages 500
• Increased in accrued taxes 5,390
• Increase in interest payable 500
• Cash Flows from Operations 70,300

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III. Financial Ratio Analysis

• to identify some strengths and weaknesses of a
  company.
• 1. Trend Analysis or time-series analysis
• - examine the ratios across time to see trends
• 2. Cross-sectional analysis
• - compare the firms ratios with those of other
  firms.

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• Four Groups of Ratios
• 1. Liquidity How liquid is the firm?
• 2. Operating Profitability Is management
  generating adequate operating profits on the
  firms asset?
• 3. Financing How is the firm financing its
  assets?
• 4. Profitability Are the owners (stockholders)
  receiving an adequate return on their investment?

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Question 1How Liquid is the Firm?

• ability to meet maturing debt
• Two ways
• 1. look at assets that are relatively liquid in
  nature (current asset) and compare to the amount
  of debt doming due in the near term (current
  liability)
• 2. look at how quickly the firms liquid assets
  are being converted into cash.

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• Approach I
• 1. Current ratio Current assets
• Current Liabilities
• Jamin 347,200 3.48
  Industry 2.70
• 99,900
• 2. Acid-test ratio current assets -
  inventories
• current liabilities
• Jamin 347,200 - 211,400 1.36
  1.25
• 99,900
• Both ratios suggest that Jamin is more liquid,
  Current Ratio suggests more liquidity than Jamin.

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• Approach II
• 3.1 Average Collection Period Accounts
  Receivable
• daily credit sales
• how long it takes the company to collect the
  receivables
• Jamin 78,000 34.30 Industry 35
• 830,200 / 365
• reasonably liquid

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• 3.2 Accounts Receivable turnover credit
  sales
• accounts receivable
• 365 / ACR
• Jamin 830,200 10.64 Industry 10.4
• 78,000

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• 4. Inventory Turnover Cost of goods sold
• Inventory
• Jamin 539,750 2.55 4.00
• 211,400
• Jamin can generate only 2.55 in sales (at cost)
  for every 1 of inventory, compared to 4 in
  sales (at cost) for the average firm.
• a significant problem for Jamin
• excessive inventory gt obsolete

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Question 2 Is Management Generating Adequate
Operating Profits on the Firms Assets?

• to know whether the profits are sufficient
  relative to the assets being invested.
• how we measure profit gross profits, operating
  profits,or net income.

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• 5. Operating Income Return on Investment
• Operating Income
• Total Assets
• Jamin 99,700 10.76
  Industry 13.2
• 927,000
• Jamin is not generating as much income on 1 of
  assets as are similar firms.
• Why?

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• OIROI Operating profit Margin Total
  Asset Turnover
• Operating Income Sales
• Sales Total Assets
• Operating Income Sales - CGS - AdminSelling
  Expense
• Sales Sales
• Driving forces of Operating Income
• 1. The number of units of product sold
• 2. The average selling price for each product
  unit
• 3. The cost of manufacturing or acquiring the
  firms product
• 4. The ability to control general and
  administrative expenses
• 5. The ability to control expenses in marketing
  and distributing the firms product

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• Total Asset Turnover Sales
• Total Assets
• how efficiently management is using the firms
  assets to generate sales
• Jamin Industry
• OPM 99,700 12.01 11
• 830,200
• TAT 830,200 0.896 1.20
• 927,000
• OIROR 12.01 0.896 10.76 11
  1.20 13.2

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• Jamin OIROI 12.01 0.896 10.76
  
• Industry OIROI 11 1.20 13.2
• Jamin is competitive in keeping costs and
  expenses in line with sales
• However, the firm is not using its assets
  efficiently. ( which assets??)

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• Jamin Industry
• A/R Turnover sales
• A/R
• 830,200 10.64 10.4
• 78,000
• Inventory Turnover CGS
• Inv
• 539,750 2.55 4.00
• 211,400
• Fixed Asset Turnover Sales
• Net F.A.
• 830,200 1.58 2.50
• 524,800

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• Excessive inventories
• too large an investment in fixed assets for the
  sales being produced.
• the consequence is a lower operating income
  return on investment.

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Question 3 How is the Firm Financing Its Assets?

• use of Debt VS Equity
• 6. Debt Ratio Total Liability / Total Assets
• - how many percentage the firm finances with
  debt
• Jamin 299,900 / 927,000 32 40
• Jamin uses less debt than the average.

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• 7. Times Interest Earned Ratio Operating
  Income / Interest
• how many times we are earning our interest.
• Jamin 99,700 / 20,000 4.99 4.00
• no problem
• rough measure because this ratio uses income to
  pay interest not cash, and it does not talk about
  the principal repayment.

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Question 4 Are the Owners (Stockholders)
Receiving an Adequate Return on Their Investment?

• to know if the earnings available to the firms
  owners or common equity investors is attractive
  when compared to the returns of owners of similar
  companies in the same industry.
• Return on Equity Net Income / Common Equity
• (Common Equity includes Par, Paid-in, R/E)
• Jamin 62,310 / 627,100 9.94
  12.5
• the owners of Jamin are receiving a ROE less
  than average. Why?

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• Why?
• 1. Profit ????
• 2. Debt ????? / Equity ?????

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• Example
• Firm A Firm B
• Total Assets 1,000 1,000
• Debt (10 interest rate) 0 600
• Equity 1,000 400

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• Example Firm A Firm B
• Good period
• Operating Income (OIROI 14) 140 140
• Interest expense (10) 0
  60
• Net Profit 140 80
• ROE 140 /1000 14 80/400 20
• Bad period
• Operating Income (OIROI 14) 60 60
• Interest expense (10) 0
  60
• Net Profit 60 0
• ROE 60 / 1000 6 0/400 0

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• Use of Debt (Financial Leverage)
• may increase ROE
• and at the same time, increase risk
• The other way to find ROE
• ROE OIROI (OIROI - I)debt / equity
• Firm Bs ROE 14 (14 - 10) 600/400
  20

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IV. Du Pont Analysis

• Return on Equity NI
• TE
• NI Sales TA
• Sales TA TE
• NPM TAT Equity Multiplier
• ROA EM
• ROA 1 / (1- TL/TA) ROA 1 /
  (1-DR)
• TA TA ____1____ 1 /
  (1 - TL/TA) 1 / (1-DR)
• TE TA - TL (TA-TL)/TA

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• ROE NI 62,310 9.94
  VS 12.5
• TE 627,100
• Why?
• ROE NPM TAT EM NI Sale TA
• Sale TA TE
• NI Sale 1
• Sale TA 1 - DR
• 62,310 830,200 1
  .
• 830,200 927,000 1 -
  (299,900/927,000)
• 7.51 0.896 0.6765 VS Ind
  6.25 1.2 1.67
• 9.94 12.5

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• ROE NPM TAT EM
• Jamin ROE 7.51 0.896 0.6765
  9.94
• Ind ROE 6.25 1.2 1.67
  12.5
• 1. Increase sales without a disproportionate
  increase in costs and expense
• 2. reduce the firsts costs of goods sold or
  operating expenses
• 3. Increase sales relative to the asset, too
  much inventory and fixed asset then try to reduce
• 4. Increase the use of debt relative to equity,
  but only to the extent that does not jeopardize
  the firms financial well-being.

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V. Limitations of Ratio Analysis

• 1. Difficult to identify industry
• 2. Published industry averages are only
  approximations
• 3. Different Accounting Practices
• 4. Financial ratios can be too high or too low.
• 5. An industry average may not provide a
  desirable target ratio or norm.
• 6. Seasonality in operations