Chapter 5

Evaluating Operating and

Financial Performance

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Chapter 5: Learning Objectives
• Understand important operating and financial performance measures and
their users by life cycle stage
• Describe how financial ratios are used to monitor a venture’s performance
• Identify specific cash burn rate measures and liquidity ratios and explain how
they are calculated and used by the entrepreneur
• 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 how comparable industry data are used
• Describe limitations when using financial ratios

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Financial Measure by Life Cycle

FIGURE 5.1 Measures of Operating and Financial Performance by Life Cycle

Stage and User

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Financial Ratio & Analysis

Financial Ratios:
show the relationship between two or more financial variables
Trend Analysis:
used to examine a venture’s performance over time
Cross-sectional Analysis:
used to compare a venture’s performance against another firm at the same point
in time
Industry Comparables Analysis:
used to compare a venture’s performance against the average performance in
the same industry

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MPC Income Statements

Table 5.1 MPC Income Statements for Years Ended 2018 and 2019
2018 2019
Net sales $438,000 $575,000
−Cost of goods sold −285,000 −380,000
Gross profit 153,000 195,000
−Administrative expenses −45,000 −65,000
−Marketing expenses −32,000 −39,000
−Research and development −20,000 −27,000
−Depreciation − 14,000 −17,000
EBIT 42,000 47,000
−Interest expense − 12,000 −20,000
Income before taxes 30,000 27,000
−Income taxes (30% rate) −9,000 −8,000
Net income $ 21,000 $ 19,000

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MPC Balance Sheets
Table 5.2 MPC Balance Sheets for Years Ended 2017, 2018 and 2019
2017 2018 2019
Assets
Cash and marketable securities $ 10,000 $ 10,000 $ 5,000
Receivables 60,000 75,000 105,000
Inventories 70,000 95,000 140,000
Total current assets 140,000 180,000 250,000
Gross plant and equipment 205,000 205,000 255,000
Less: accumulated depreciation −28,000 −42,000 −59,000
Net plant and equipment 177,000 163,000 196,000
Total assets $317,000 $343,000 $446,000
Liabilities and Equity
Payables 47,000 57,000 84,000
Short-term bank loan 40,000 44,000 110,000
Accrued liabilities 8,000 9,000 10,000
Total current liabilities 95,000 110,000 204,000
Long-term debt 100,000 90,000 80,000
Owners’ equity 122,000 143,000 162,000
Total liabilities and equity $317,000 $343,000 $446,000
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MPC Statements Of Cash Flow
Table 5.1 MPC Income Statements for Years Ended 2018 and 2019
2018 2019
Cash Flow from Operating Activities
Net Income $21,000 $19,000
+ Depreciation 14,000 17,000
− Increase in receivables −15,000 −30,000
− Increase in inventories −25,000 −45,000
+ Increase in payables 10,000 27,000
+ Increase in accrued liabilities 1,000 1,000
Net Cash Flow from Operations 6,000 −11,000
Cash Flow from Investing Activities
− Increase in gross equipment 0 −50,000
Net Cash Flow from Investing Activities 0 −50,000
Cash Flow from Financing Activities
+ Increase in short-term bank loan 4,000 66,000
− Decrease in long-term debt −10,000 −10,000
Net Cash Flow from Financing −6,000 56,000
Net Change Excluding Cash Account 0 −5,000
Beginning Cash and Marketable Securities 10,000 10,000
Ending Cash and Marketable Securities $10,000 $ 5,000
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Cash Burn

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

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Cash Burn / Build / Burn Rate (1 of 2)

Cash Burn =
Inventory-related expenses + Admin expenses + Marketing expenses + R&D
expense + Interest expenses + Change in prepaid expenses − (Change in accrued
liabilities + Change in payables) + Capital investment + Taxes
MPC for 2016:
Cash burn = 425,000 + 65,000 + 39,000 + 27,000 + 20,000 + 0 − (1,000 + 27,000) +
50,000 + 8,000 = 606,000
Note 425,000 = 380,000 (COGS) + 45,000 (Change in Inv.)

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Cash Burn / Build / Burn Rate (2 of 2)

Cash Build = Net sales − Change in receivables

MPC for 2016:
Cash build = 575,000 − 30,000 = 545,000
Cash Build Rate:
Cash build for a fixed period of time, typically a month
Net Cash Burn = Cash burn − Cash build
= 606,000 − 545,000 = 61,000

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Liquidity Ratios (1 of 3)

Indicate the ability to pay short-term liabilities when they come due
Current Ratio:
= Average Current Assets Average Current Liabilities

=
( 250,000 + 180,000 ) 2
( 204,000 + 110,000 ) 2
= 1.37 times

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Liquidity Ratios (2 of 3)

Liquid assets:
sum of a venture’s cash and marketable securities plus its receivables
Quick Ratio:

Average Current Assets - Average Inventories

=
Average Current Liabilities

=
( 250,000 + 180,000 ) 2 - (140,000 + 95,000 ) 2
( 204,000 + 110,000 ) 2
= 0.62 times

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Liquidity Ratios (3 of 3)

Net working capital (NWC):

current assets minus current liabilities
NWC -to-Total-Assets Ratio:
Average Current Assets - Average Current Liabilities
=
Average Total Assets

=
( 250,000 + 180,000 ) 2 - ( 204,000 + 110,000 ) 2
( 446,000 + 343,000 ) 2
= 0.147 or 14.7%

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MPC Burn Rates & Liquidity Ratios

Table 5.4 MPC Burn Rates & Liquidity Ratios for 2018 and 2019
RATE OR RATIO 2018 2019 CHANGE %CHANGE
Cash burn 417,000 606,000 +189,000 +45.3
Monthly cash burn 34,750 50,500 +15,750 +45.3
Cash build 423,000 545,000 +122,000 +28.8
Monthly cash build 35,250 45,417 +10,167 +28.8
Net cash burn −6,000 61,000 +67,000 N/A
Monthly net cash burn rate −500 5,083 +5583 N/A
Year-end months of cash N/A 0.98 N/A N/A
Current ratio 1.56 1.37 −0.19 −12.2
Quick ratio 76 0.62 −0.14 −18.4
NWC-to-total-assets ratio 0.174 0.147 −0.027 −15.5

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Leverage Ratios

Leverage Ratio:
indicates the extent to which the venture is in debt and its ability to repay its debt
obligations
Loan Principal Amount:
dollar amount borrowed from a lender
Interest:
dollar amount paid on the loan to a lender as compensation for making the loan

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Measuring Financial Leverage (1 of 5)

Total-Debt-to-Total-Asset Ratio:

= Average Total Debt Average Total Assets

=
( 204,000 + 110,000 ) 2 + ( 80,000 + 90,000 ) 2
( 446,000 + 343,000 ) 2
= 0.6134 or 61.34%

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Measuring Financial Leverage (2 of 5)

Equity Multiplier:
= Average Total Assets Average Owners' Equity

=
( 446,000 + 343,000 ) 2
(162,000 + 143,000 ) 2
= 2.587 times

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Measuring Financial Leverage (3 of 5)

Current-Liabilities-to-Total-Debt Ratio:
= Average Current Liabilities Average Total Debt

=
( 204,000 + 110,000 ) 2
( 284,000 + 200,000 ) 2
= 0.6488 or 64.88%

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Measuring Financial Leverage (4 of 5)

Interest Coverage Ratio:

= EBITDA Interest
47,000 + 17,000
=
20,000
= 3.20 times

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Measuring Financial Leverage (5 of 5)

Fixed-Charge Coverage:

EBITDA + Lease Payments

=
Interest + Lease Payments + éëDebt Repayments (1 - T ) ùû
64,000 + 0
=
20,000 + 0 + éë10,000 (1 - 0.30 ) ùû
= 1.87 times

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MPC Leverage Ratio Performance

Table 5.5 MPC Leverage Ratio Performance

LEVERAGE RATIO 2018 2019 IMPACT ON LEVERAGE RISK
Total debt/total assets 59.8% 61.3% Increase
Equity multiplier 2.491 2.587 Increase
Current liabilities/total debt 52.9% 64.9% Increase
Interest coverage 467 3.20 Increase
Fixed-charges coverage 2.13 1.87 Increase

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Profitability & Efficiency Ratios

Profitability Ratios:
indicate how efficiently a venture controls its expenses
Efficiency Ratios:
indicate how efficiently a venture uses its assets in producing sales

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Measuring Profitability & Efficiency (1 of 9)

Gross Profit Margin:

Net Sales - COGS
=
Net Sales
= 195,000 575,000
= 0.3391 or 33.91%

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Measuring Profitability & Efficiency (2 of 9)

Operating Profit Margin:

EBIT
=
Net Sales
= 47,000 575,000
= 0.0817 or 8.17%

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Measuring Profitability & Efficiency (3 of 9)

Net Profit Margin:

Net Profit
=
Net Sales
= 19,000 575,000
= 0.0330 or 3.30%

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Measuring Profitability & Efficiency (4 of 9)

Interest Tax Shield:

proportion of a venture’s interest payment paid by the government because
interest is deductible before taxes are paid
NOPAT Margin:
EBIT (1 - Tax Rate )
=
Net Sales
47,000 (1 - 0.30 )
=
575,000
= 0.0572 or 5.72%

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Measuring Profitability & Efficiency (5 of 9)

Sales-to-Total-Assets Ratio:
Net Sales
=
Average Total Assets
575,000
=
( 446,000 + 343,000 ) 2
= 1.458 times

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Measuring Profitability & Efficiency (6 of 9)

Return on Total Assets (ROA):

Net profit
=
Average Total Assets
19,000
=
( 446,000 + 343,000 ) 2
= 0.048 or 4.8%

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Measuring Profitability & Efficiency (7 of 9)

ROA Model:
the decomposition of ROA into the product of the net profit margin and the sales-
to-total-assets ratio
ROA = (Net Profit Sales ) ´ (Net Sales Average Total Assets )
= (19,000 575,000 ) ´ ( 575,000 ( 446,000 + 343,000 ) 2 )
= 0.0330 ´ 1.458 = 0.048 or 4.8%

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Measuring Profitability & Efficiency (8 of 9)

Return on Equity (ROE):

Net Income
=
Average Owners' Equity
19,000
=
(162,000 + 143,000 ) 2
= 0.1246 or 12.46% (or 12.5% rounded)

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Measuring Profitability & Efficiency (9 of 9)

ROE Model:
the decomposition of ROE into the product of the net profit margin, sales-to-total-
assets ratio, and equity multiplier
ROE = (Net Profit Sales ) ´ (Net Sales Average Total Assets ) ´ ( Average Total Assets Average Equity )
= 3.3% ´ 1.46% ´ 2.59% = 12.5%

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MPC Profitability & Efficiency Performance

Table 5.6 MPC’s Profitably, Efficiency, and Return Measures

INDICATED IMPACT ON
RATIO 2018 2019
PROFITABILITY/EFFICIENCY
Gross profit margin 34.93% 33.91% Lower
Operating profit margin 9.59% 8.17% Lower
Net profit margin 4.79% 3.30% Lower
NOPAT margin 6.71% 5.12% Lower
Sales to total assets 1.327 1.458 Higher
Operating ROA 12.73% 11.91% Lower
ROA 6.36% 4.82% Lower
Return on owners’ equity 15.85% 12.46% Lower

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MPC Industry Comparables Analysis

Table 5.7 MPC Industry Comparables Analysis

2019 2019 INDUSTRY AVERAGE COMPARISON WITH INDUSTRY
Liquidity Ratios
Current ratio 1.37 1.80 Lower
Quick ratio 0.62 0.80 Lower
Leverage Ratios
Total debt to total assets 61.3% 60.0% Higher
Interest coverage 3.20 4.00 Lower
Profitability Ratios
Gross profit margin 33.91% 35.00% Lower
Operating profit margin 8.17% 10.00% Lower
Net profit margin 3.30% 4.50% Lower
NOPAT margin 5.72% 6.00% Lower
Efficiency and Return Ratios
Sales to total assets 1.458 1.500 Lower
Operating ROA 11.91% 15.00% Lower
ROA 4.82% 6.30% Lower
Return on equity 12.46% 15.00% Lower

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