Ch 5

Chapter 5: Evaluating Operating and Financial Performance Chapter 5 EVALUATING OPERATING AND FINANCIAL PERFORMANCE

DISCUSSION QUESTIONS AND ANSWERS 1.

Identify the types of financing typically used during each life cycle stage of the successful entrepreneurial venture. Refer to Figure 5.1. Development and Startup Stages: Type of Financing: Seed and startup financing Survival Stage: Type of Financing: First-round financing Rapid-Growth Stage: Type of Financing: Second-round, mezzanine, and liquidity-stage

2.

Describe the types of financial ratios and other financial performance measures that are used during a venture’s successful life cycle. Who are the users of financial performance measures? Refer to Figure 5.1. Development and Startup Stages: Financial Ratios and Measures: Cash burn rates and liquidity ratios Conversion period ratios Users of Financial Ratios and Measures: Entrepreneur Business angels Venture capitalists (VCs) Survival Stage: Financial Ratios and Measures: Cash burn, liquidity, and conversion ratios Leverage ratios Profitability and efficiency ratios Users of Financial Ratios and Measures: Entrepreneur, angels, and VCs Commercial banks Rapid-Growth Stage: Financial Ratios and Measures: Leverage ratios Profitability and efficiency ratios

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Chapter 5: Evaluating Operating and Financial Performance Users of Financial Ratios and Measures: Entrepreneur, angels, and VCs Commercial banks Investment bankers

3.

What are financial ratios and why are they useful? Financial ratios are measurements that show relationships between two or more financial variables.

4.

What are the three types of comparisons that can be made when conducting ratio analyses? The three types of comparison that can be made with ratio analysis are trend analysis, cross-sectional analysis, and industry comparables (benchmark) analysis.

5.

What are the meanings of the terms “cash build” and “cash burn”? How do we calculate net cash burn rates? Cash build is the amount the firm receives on its sales calculated by net sales less the change in receivables. Cash burn is the amount of cash a firm uses on its operating and financing expenses and on its investments in assets.

6.

How is the current ratio calculated and what does it measure? How does the quick ratio differ from the current ratio? The firm’s current ratio is calculated by dividing the current assets by the current liabilities. This ratio measures the firm’s ability to pay off its short term debt in the near term. The quick ratio differs in that it leaves out inventory in calibrating current assets.

7.

Describe how a firm’s net working capital (NWC) is measured and how the NWC-to-total- assets ratio is calculated. What does this ratio measure? Net working capital is measured by subtracting current liabilities from current assets. NWC-to-totalassets ratio is calculated by dividing NWC by the firm’s total assets (or average total assets). This calculation measures liquidity of the firm with a higher percentage indicating a greater liquidity.

8.

What is the meaning of leverage ratios? What are typical ratios used for relating total debt to a venture’s assets and/or its equity? Leverage ratios indicate the extent to which the venture is in debt and its ability to repay its debt obligations. Typical ratios used are the total-debt-to-total-assets-ratio, debt-to-equity-ratio, and the equity multiplier.

9.

What is the importance of the relationship between a venture’s current liabilities and its total debt? The portion of total debt that is “current” represents those liabilities that will come due within the next year. The percentage of debt held in current liabilities is a reasonable glimpse of the venture’s reliance on debt soon requiring an outlay of cash. Ventures with higher percentages are more likely to need to restructure their liabilities in the near future.

Chapter 5: Evaluating Operating and Financial Performance 10.

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Describe the two types of “coverage” ratios that are typically calculated when trying to assess a venture’s ability to meet its interest payments and other financing-related obligations? The two types of coverage ratios used are the interest coverage ratio and the fixed charges coverage ratio. The interest coverage ratio measures the venture’s ability to pay its annual interest liability and is calculated by dividing EBITDA by the annual interest payment. The fixed charges ratio measures the venture’s ability to cover interest and fixed charges. It is calculated by dividing the sum of the

venture’s EBITDA and lease payments by the sum of interest payments, rental or lease payments, and the before-tax cost of debt repayments. 11.

What are four measures used to indicate how efficiently the venture is in generating profits on its sales? Describe how each measure is calculated. The four ratios used are gross profit margin, operating profit margin, net profit margin, and NOPAT margin. Gross profit margin is calculated by dividing the gross profit by the venture’s net sales. Operating profit margin is calculated by dividing earnings before interest and taxes (EBIT), by the venture’s net sales. Net profit margin is calculated by dividing net income (or net profit) by net sales. NOPAT margin is calculated by: (EBIT x (1 minus the tax rate))/net sales.

12.

Identify and describe four efficiency/return ratios that combine data from both the income statement and the balance sheet. The four ratios are sales-to-total-assets, operating return on assets, return on assets, and return on equity. Sales-to-total-assets is net sales divided by average total assets. Operating return on assets is EBIT divided by average total assets. Return on assets is net profit divided by average total assets. Return on equity is net income (or net profit) divided by average owners’ equity.

13.

Identify and describe the two components of the ROA model both in terms of what financial dimensions they measure and how they are calculated. The two components of the ROA model are the net profit margin and the sales-to-total-assets ratio. Net profit margin measures the amount of sales that become net profit and is calculated by dividing net income by sales. Sales-to-total-assets measures the how much the firm generates in sales with one dollar of assets. It is calculated by dividing net sales by the firm’s average assets.

14.

What are the three ratio components of the ROE model? How is each calculated and what financial dimensions do they measure? The three ratio components of the ROE model are the net profit margin (net profit/sales), asset turnover (net sales/average total assets), and the equity multiplier (average total assets/average equity). Net profit margin measures profitability of sales. Asset turnover measures how well asset are utilized in the production of sales. The equity multiplier measures how the firm scales its assets on a base of equity (through liabilities and debt).

15.

Indicate some of the concerns or cautions that need to be considered when conducting ratio analysis.

. When conducting ratio analysis, it is important to compare “apples to apples” by consistent use of the same inputs to the ratios (e.g. annual sales or quarterly sales). It is also important to understand that certain ratios may simultaneously indicate undesirable and desirable aspects of the venture’s

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Chapter 5: Evaluating Operating and Financial Performance strategy and risk position. For example, an efficient use of trade credit can be interpreted as advantageous use of inexpensive credit or as the assumption of a large amount of short-term financial risk (low current and quick ratios).

16. From the Headlines – The Lovely Touch in Raising Cupcake Dough: You have been retained as a consultant for Lovely Touch and tasked with assessing the financial viability of their commercial ventures. What types of financial ratios would you enlist in your report to Lovely Touch? Answers will vary: To fund growth internally, profitability (or contribution) will be important, as will be the efficient use of limited capital. Useful ratios would include Gross Profit Margins, Net Profit Margins, Sales-to-Assets Ratios, Return on Assets, and many others.

EXERCISES/PROBLEMS AND ANSWERS Note: for readers who were introduced to financial statements for the first time in Chapter 4, you may want to first work the “Supplemental Exercises/Problems” presented at the end of Chapters 1, 2, and 3 which were intended for readers who had a previous understanding of financial statements. 2. [Liquidity and Financial Leverage Ratios] Refer to the Salza Technology Corporation in Problem 1. A. Using average balance sheet account data, calculate the (a) current ratio, (b) quick ratio, (c) total-debt-to-total-assets ratio, and (d) the interest coverage ratio for 2016. Using average account balances: (a) Current ratio: Average current assets/Average current liabilities = (($240 + $300)/2) + (($60 + $95)/2) = $270/$77.50 = 3.48 times (b) Quick ratio: (Average current assets – Average inventories)/Average current liabilities = (($240 + $300)/2 - ($151 + $204)/2)/($60 + $95)/2 = ($270 - $177.50)/$77.50 = $92.50/$77.50 = 1.19 times (c) Total-debt-to-total-assets ratio: Average total debt/Average total assets = (($60 + $95)/2 + ($15 + 15)/2)/($345 + $465)/2 = ($77.50 + $15)/$405 = $92.50/$405 = 22.84% (d) Interest coverage ratio: Average EBITDA/Average interest EBITDA = Net sales – Cost of goods sold – Operating expenses 2015: $375 - $225 - $46 = $104 2016: $450 - $270 - $46 = $134 Interest coverage ratio = (($104 + $134)/2)/(($4 + $4)/2) = ($238/2)/($8/2) = $119/$4 = 29.75 times

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B. Repeat the ratio calculations requested in Part A separately for 2015 and 2016 using year-end balance sheet account data. What changes, if any, have occurred in terms of liquidity and financial leverage? (a) Current ratio: 2015: $240/$60 = 4.00 times 2016: $300/$95 = 3.16 times The current ratio declined but still exceeded 3.0 times in 2016. (b) Quick ratio: 2015: ($240 - $151)/$60 = $89/$60 = 1.48 times 2016: ($300 - $204)/$95 = $96/$95 = 1.01 times The quick ratio declined to just slightly above 1.0 in 2016. Liquidity has gotten poorer. (c) Total-debt-to-total-assets ratio: 2015: ($60 + $15)/$345 = $75/$345 = .2174 = 21.74% 2016: ($95 + $15)/$465 = $110/$465 = .2366 = 22.66% Total debt as a percentage of total assets increased in 2016 by less than one percentage point. (d) Interest coverage ratio: 2015: ($375 - $225 - $46)/$4 = $104/$4 = 26.00 times 2016: ($450 - $270 - $46)/$4 = $134/$4 = 33.50 times Interest coverage increased in 2016 to above 30.0 times. The firm uses a small amount of financial leverage (primarily from current liabilities) and maintains a very high interest coverage ratio. 4. [Financial Ratios] Use the financial statements data for the Bike-With-Us Corporation provided in Problem 3 to make the following calculations. A. Calculate the operating return on assets. Operating return on assets = EBIT/Assets = $30,000/$131,000 = 22.90% B. Determine the effective interest rate paid on the long-term debt. Effective interest rate = Interest/Long-term debt = $5,000/$50,000 = 10.00% C. Calculate the NOPAT margin. How does this compare with the results for the net profit margin? Did the owners benefit from the use of interest-bearing long-term debt? Tax Rate = Taxes/EBT = $6,000/$25,000 = 24.00% NOPAT Margin = [(EBIT)(1 – tax rate)]/Net Sales = [$30,000(1 - .24)]/$325,000 = $22,800/$325,000 = 7.02%

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Chapter 5: Evaluating Operating and Financial Performance The Net Profit Margin was lower at 5.85% Since the Operating Return on Assets (22.90%) was higher than the Effective Interest Rate (10.00%), the firm benefited from having interest-bearing long-term debt.

5. [Cash Burn and Build] Following are two years of income statements and balance sheets for the Munich Exports Corporation. MUNICH EXPORTS CORPORATION Balance Sheet Cash Accounts Receivables Inventories Total Current Assets Fixed Assets, Net Total Assets

2015 $50,000 200,000 450,000 700,000 300,000 $1,000,000

2016 $50,000 300,000 570,000 920,000 380,000 $1,300,000

Accounts Payable Accruals Bank Loan Total Current Liabilities Long-Term Debt Common Stock ($.05 par) Additional Paid-in-Capital Retained Earnings Total Liab. & Equity

130,000 50,000 90,000 270,000 400,000 50,000 200,000 80,000 $1,000,000

$180,000 70,000 90,000 340,000 550,000 50,000 200,000 160,000 $1,300,000

Income Statement Net Sales Cost of Goods Sold Gross Profit Marketing General & Administrative Depreciation EBIT Interest Earnings Before Taxes Income Taxes (40% rate) Net Income

2015 2016 $1,300,000 $1,600,000 780,000 960,000 520,000 640,000 130,000 160,000 150,000 150,000 40,000 55,000 200,000 275,000 45,000 55,000 155,000 220,000 62,000 88,000 $93,000 $132,000

A. Calculate the cash build, cash burn, and net cash burn or build for Munich Exports in 2016. Cash Build = Net Sales – Increase in Receivables = $1,600,000 – ($300,000 - $200,000) = $1,500,000

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Cash Burn = Income Statement-Based Operating, Interest, and Tax Expenses + Increase in Inventories – (Changes in Payables + Accrued Liabilities) + Capital Expenditures Operating Expenses = Cost of Goods Sold + Marketing + General and Administrative = $960,000 + $160,000 + $150,000 = $1,270,000 Other Cash Expenses = Interest + Taxes = $55,000 + $88,000 = $143,000 Increase in Inventories = ($570,000 - $450,000) = $120,000 Changes in Payables and Accrued Liabilities = [($180,000 - $130,000) + ($70,000 $50,000)] = $70,000 Capital Expenditures or Change in Gross Fixed Assets = Change in Net Fixed Assets plus Depreciation = ($380,000 - $300,000) + $55,000 = $135,000 Cash Burn = $1,270,000 + $143,000 + $120,000 - $70,000 + $135,000 = $1,598,000 Net Cash Burn = Cash Burn – Cash Build = $1,598,000 - $1,500,000 = $98,000 B. Assume that 2017 will be a repeat of 2016. If your answer in Part A resulted in a net cash burn position, calculate the net cash burn monthly rate and indicate the number of months remaining “until out of cash.” If your answer in Part A resulted in a net cash build position, calculate the net cash build monthly rate and indicate the expected cash balance at the end of 2017. $98,000/12 = $8,166.67 Cash balance at end of 2008 = $50,000 $50,000/$8,166.67 = 6.12 months (remaining “until out of cash”) 6. [Liquidity Ratios and Cash Burn or Build] The Castillo Products Company was started in 2014. The company manufactures components for personal decision assistant (PDA) products and for other hand-held electronic products. A difficult operating year 2015 was followed by a profitable 2016. However, the founders (Cindy and Rob Castillo) are still concerned about the venture’s liquidity position and the amount of cash being used to operate the firm. Following are income statements and balance sheets for the Castillo Products Company for 2015 and 2016. CASTILLO PRODUCTS COMPANY Income Statement Net Sales

Cost of Goods Sold Gross Profit Marketing General & Administrative Depreciation EBIT Interest

$900,000 540,000 360,000 90,000 250,000 40,000 -20,000

2015 2016 $1,500,000 900,000 600,000 150,000 250,000 40,000 160,000 45,000 60,000

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Chapter 5: Evaluating Operating and Financial Performance Earnings Before Taxes Income Taxes Net Income (Loss)

-65,000 0 -$65,000

100,000 25,000 $75,000

Balance Sheet 2015 Cash $50,000 Accounts Receivables 200,000 Inventories 400,000 Total Current Assets 650,000 Gross Fixed Assets 450,000 Accumulated Depreciation -100,000 Net Fixed Assets 350,000 Total Assets $1,000,000

2016 $20,000 280,000 500,000 800,000 540,000 -140,000 400,000 $1,200,000

Accounts Payable $130,000 Accruals 50,000 Bank Loan 90,000 Total Current Liabilities 270,000 Long-Term Debt 300,000 Common Stock ($.05 par) 150,000 Additional Paid-in-Capital 200,000 Retained Earnings 80,000 Total Liab. & Equity $1,000,000

$160,000 70,000 100,000 330,000 400,000 150,000 200,000 120,000 $1,200,000

A. Use year-end data to calculate the current ratio, the quick ratio, and the net working capital (NWC) to total assets ratio for 2015 and 2016 for the Castillo Company. What changes occurred? Current Ratio = Current Asset/Current Liabilities Year 2015: $650,000/$270,000 = 2.41 Year 2016: $800,000/$330,000 = 2.42 Quick Ratio = (CA - Inventories)/CL Year 2015: ($650,000 - $400,000)/$270,000 = 0.93 Year 2016: ($800,000 - $500,000)/$330,000 = 0.91 NWC to Total Assets Ratio = (CA - CL)/Assets Year 2015: ($650,000 - $270,000)/$1,000,000 = 0.38 Year 2016: ($800,000 - $330,000)/$1,200,000 = 0.39 B. Use Castillo’s complete income statement data and the changes in balance sheet items between 2015 and 2016 to determine the firm’s cash build and cash burn for 2016. Did Castillo have a net cash build or net cash burn for 2016? Cash Build = Sales – Change in Accounts Receivable = $1,500,000 - $80,000 = $1,420,000

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Cash Burn

= Inventory-Related Purchases + Administrative Expenses + Marketing Expenses + Interest Expense - (Change in Accrued Liabilities + Change in Payables) + Capital Investments + Taxes = ($900,000 + + $250,000 + $150,000 + $60,000 + $25,000 + $100,000 - ($20,000 + $30,000) + $90,000 = $1,525,000 Net Cash Burn or Build = Cash Build – Cash Burn = $1,420,000 - $1,525,000 = -$105,000 = $105,000 Cash Burn C. Convert the annual cash build and cash burn amounts calculated in Part B to monthly cash build and cash burn rates. Also indicate the amount of the net monthly cash build or cash burn rate. Monthly Cash Burn Rate Less: Monthly Cash Build Rate Monthly Net Cash Burn Rate

$1,525,000 12 -$1,420,000 12 $105,000 12

$127,083.33 -$118,333.33 $8,750.00

7. [ROA Model and Expenses Related to Sales] Use the financial statements data for the Castillo Products presented in Problem 6. A. Calculate the net profit margin in 2015 and 2016 and the sales-to-total-assets ratio using yearend data for each of the two years. Net profit margin 2015: -$65,000/$900,000 = -7.22% Net profit margin 2016: $75,000/$1,500,000 = 5.00% Sales-to-total-assets 2015: $900,000/$1,000,000 = .900 Sales-to-total-assets 2016: $1,500,000/$1,200,000 = 1.250 B. Use your calculations from Part A to determine the rate of return on assets in each of the two years for the Castillo Products. Rate of return on assets 2015: -7.22% x .900 = -6.50% Rate of return on assets 2016: 5.00% x 1.250 = 6.25% C. Calculate the percentage growth in net sales from 2015 to 2016. Compare this with the percentage change in total assets for the same period. Percentage growth in net sales: ($1,500,000 - $900,000)/$900,000 = 66.67% Percentage change in total assets: ($1,200,000 - $1,000,000)/$1,000,000 = 20.00% D. Express each expense item as a percentage of net sales for both 2015 and 2016. Describe what happened that allowed Castillo Products to move from a loss to a profit between the two years. Net sales

2015 100.00%

2016 100.00%

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Chapter 5: Evaluating Operating and Financial Performance Cost of goods sold Gross profit Marketing General & administrative Depreciation EBIT Interest Earnings before taxes Income taxes Net income (loss)

60.00 40.00 10.00 27.78 4.44 -2.22

60.00 40.00 10.00 16.67 2.67 10.67 5.00

-7.22 0.00 -7.22%

4.00 6.67 1.67 5.00%

The decline in general and administrative expenses as a percentage of sales (i.e., the spreading of fixed costs) was the major contributor to Castillo becoming profitable. The decline in depreciation expenses and in interest expenses as percentages of sales also contributed to the move to profitability. However, increased taxes on profits reduced some of the profitability gains.