EVALUATING FINANCIAL PERFORMANCE Financial Management Program Management Department

EVALUATING FINANCIAL PERFORMANCE Financial Management Program Management Department Faculty of Economic Petra Christian University Surabaya, 2009

Learning Objectives Understand important financial performance measures and their uses, by life cycle stage Describe how financial ratios are used to monitor a venture performance Identify specific cash burn rate measures and liquidity ratios and explain how they are calculated and used by the entrepreneur Identify and describe the use and value of conversion period ratios to the entrepreneur

Learning Objectives Identify specific leverage ratios and explain their use by lenders and creditors Identify and describe measures of profitability and efficiency that are important to the entrepreneur and equity investors Describe limitations when using financial ratios

User of Financial Performance Measures by Life Cycle Stage Type of Financing Financial Ratios & Measures Users of Financial Ratios & Measures Development & startup stage Seed financing & startup financing Cash burn rates and liquidity ratios Conversion period ratios Entrepreneur Business angels Venture capitalists (VCs) Survival stage First round financing Cash burn, liquidity, & conversion ratios Leverage ratios Profitability & efficiency ratios Entrepreneur, angels, VCs, Commercial banks Rapid growth stage Second round, mezzanine, & liquidity stage financing Leverage ratios Profitability & efficiency ratios Entrepreneur, angels, VCs, Commercial banks Investment bankers

Using Financial Ratios Financial ratios relationships between two or more financial variables or between financial variables and time Trend analysis examination of a venture’s performance over time

Using Financial Ratios Cross-sectional analysis comparison of a venture’s performance against an-other firm at the same point in time Industry comparables analysis comparison of a venture’s performance against the average performance of other firms in the same industry

Income Statement 2007 Net sales Cost of goods sold Gross profit Administrative expenses Marketing expenses Research & development Depreciation EBIT Interest expense Income before taxes Income taxes (30% rate) Net income 438. 000 285. 000 153. 000 45. 000 32. 000 20. 000 14. 000 42. 000 12. 000 30. 000 9. 000 21. 000 2008 575. 000 380. 000 195. 000 65. 000 39. 000 27. 000 17. 000 47. 000 20. 000 27. 000 8. 000 19. 000

Balance Sheets ASSETS Cash & marketable securities Receivables Inventories Total current assets Gross plant & equipment Less: accumulated depreciation Net plant & equipment Total assets Liabilities and Equity Payables Short term bank loan Accrued liabilities Total current liabilities Long term debt Owners’ equity Total Liabilities & equity 2006 2007 2008 10. 000 60. 000 70. 000 140. 000 205. 000 28. 000 177. 000 317. 000 10. 000 75. 000 95. 000 180. 000 205. 000 42. 000 163. 000 343. 000 5. 000 105. 000 140. 000 255. 000 59. 000 196. 000 446. 000 47. 000 40. 000 8. 000 95. 000 100. 000 122. 000 317. 000 57. 000 44. 000 9. 000 110. . 000 90. 000 143. 000 343. 000 84. 000 110. 000 204. 000 80. 000 162. 000 446. 000

Statements of Cash Flow Cash flow from operating activities Net income + depreciation - Increase in Receivables - increase in Inventories + increase in payables + increase in accrued liabilities Net cash flow from operations Cash flow from investing activities -Increase in gross equipment Net cash flow from investing activities Cash flow from financing activities + increase in short-term bank loan -Decrease in long term debt Net cash flow from financing Net change excluding cash account Beginning cash and marketable 2007 2008 21. 000 14. 000 -15. 000 -25. 000 10. 000 1. 000 6. 000 19. 000 17. 000 -30. 000 -45. 000 27. 000 1. 000 -11. 000 0 0 -50. 000 4. 000 -10. 000 -6. 000 0 10. 000 66. 000 -10. 000 56. 000 -5. 000 10. 000 5. 000

Cash Burn Rates and Liquidity Ratios Cash burn Cash a venture expends on its operating and financing expenses and its investments in assets Cash burn rate Cash burn for a fixed period of time, typically a month Cash burn = income statement-based operating, interest, and tax expenses liabilities) + increase in inventories - (changes in payables and accrued + capital expenditures

Measuring Venture Cash Burn and Build Amounts and Rates Cash build Net sales less the increase in receivables = net sales – increase in receivables Cash Build Rate Cash build for a fixed period of time, typically a month Net cash burn When cash burn exceeds cash build in a specified time period = cash burn – cash build Net cash burn rate Net cash burn for a fixed period of time, typically a month

Traditional Measures of Liquidity Ratios that indicate the ability to pay short-term liabilities when they come due Current Ratio Quick Ratio Net Working Capital (NWC) to Total Assets Ratio = average current assets - average inventories = average current assets : average current - Average current assets liabilities average current liabilities : average total assets

Conversion Period Ratios Conversion period ratios • Ratios that indicate the average time it takes in days to convert certain current asset and current liability accounts into cash Operating cycle • Time it takes to purchase required materials, assemble, and sell the product plus the time needed to collect receivables if the sales are on credit Cash conversion cycle • Sum of the inventory-to-sale conversion period and the sale-tocash conversion period less the purchase-to-payment conversion period

Operating Cycle Cash Materials Receivables (Credit Sales) Work-in-progress Finished Goods

Measuring Conversion Times Inventory-to-sale Conversion Period • Average inventories/(Cost of goods sold/365) Sale-to-cash Conversion Period • Average receivables/(net sales/365) Purchase-to-payment Conversion Period • (Average payables + average accrued liabilities)/(COGS/365) Cash Conversion Cycle • Inventory to sale Conversion Period + sale to cash conversion period – purchase to payment conversion period

Leverage Ratios Leverage ratios Ratios that indicate the extent to which the venture has used debt and its ability to repay its debt Loan principal amount obligations Dollar amount borrowed from a lender Interest Dollar amount paid on the loan to a lender as compensation for making the loan

Measuring Financial Leverage Total-debt-to-total-assets ratio = average total debt/average total assets Equity multiplier = average total assets/average owners’ equity Debt-to-equity ratio assets) = total debt to total assets/(1 -total debts to total Current liabilities to total debt ratio = average current liabilities/average total debt Interest = EBITDA/interest Fixed charges coverage = EBITDA + lease payment/(interest + lease payments + [debt repayments/(1 - tax rate)]

Profitability and Efficiency Ratios that indicate how efficiently a venture controls its expenses and uses its assets Income statement measures of profitability Gross profit margin = (net sales – COGS)/net sales Operating profit margin = EBIT/net sales Net profit margin = net profit/net sales NOPAT margin = EBIT(1 - tax rate)/net sales

Efficiency and Return Measures Sales-to-Total-Assets Ratio = net sales/ average total assets Operating Return on Assets = EBIT/average total assets Return on Assets (ROA) = net profit/average total assets = net profit/net sales x net sales/average total assets Return on Equity (ROE) = net income/average owners equity = net profit margin x asset turnover x equity multiplier

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