The vote, taken by five School of Business Promotion Committee members and the candidate’s representative revealed 3 votes

in favor and 3 votes against the ca

Dear Dean Gillett,

Evaluating Financial Health

Dr. C. Bulent Aybar

Professor of International Finance
 SciTronics Balance Sheets 2005-2008
SciTronics Consolidated Balance Sheet December 31, 2005-2008

2005 2006 2007 2008

Cash 9,000 10,000 15,000 18,000
Accounts receivable 42,000 53,000 61,000 66,000
Inventories 21,000 28,000 30,000 29,000
Other current assets 10,000 13,000 21,000 20,000
Total current assets 82,000 104,000 127,000 133,000
Net property & equipment 9,000 12,000 13,000 18,000
Other 2,000 2,000 6,000 8,000
Total assets 93,000 118,000 146,000 159,000
Notes payable 3,000 18,000 8,000 10,000
Accounts payable 5,000 6,000 7,000 6,000
Accrued expenses 10,000 13,000 21,000 28,000
Other current liabilities 3,000 3,000 4,000 4,000
Total current liabilities 21,000 40,000 40,000 48,000
Long-term senior debt 10,000 9,000 8,000 7,000
Subordinated convertible debt 20,000 20,000
Other liabilities 1,000 3,000 7,000 9,000
Owners’ equity 61,000 66,000 71,000 85,000
Treasury stock -10,000
Owners’ equity 61,000 66,000 71,000 75,000
Total liabilities and equity 93,000 118,000 146,000 159,000
 SciTronics Income Statements

SciTronics Inc. Consolidated Income Statements 2005-2008 ($ in thousands)

2004 2005 2006 2007 2008

Sales 115,000 147,000 171,000 205,000 244,000
Cost of goods sold 43,000 50,000 63,000 74,000
Gross margin 104,000 121,000 142,000 170,000
Research & development 15,000 20,000 26,000 28,000
Selling, general & 79,000 92,000 106,000 116,000
administrative expenses
Operating income 10,000 9,000 10,000 26,000
Interest expense 1,000 2,000 2,000 2,000
Profit before tax 9,000 7,000 8,000 24,000
Income tax 4,000 2,000 3,000 10,000
Net income 5,000 5,000 5,000 14,000
 Evaluating Sales growth SciTronics

Sales Growth

2005 2006 2007 2008

27.83% 16.33% 19.88% 19.02%

Compounded Growth Rate over 2005-2008 period

20.69%
[S(2008)/S(2004)]^(1/4) -1

Industury Comparison:
CAGR Low High
9 Large companies 9.50% 5.00% 15.30%
10 Mid size companies 12.00% 4.50% 31.80%
SciTronics 20.70% 16.33% 27.83%

SciTronics’ organic sales growth looks excellent. Its 4 year CAGR is

20.69%. The company ranked #3 in a sample of 19 medical device
companies in terms of the rate of sales growth. Is sales growth a good sign?
 Starting Point

• The starting point for a systematic analysis of a firm's

performance is its return on equity (ROE), defined as:
ROE=Net income/ Equity
• ROE is a comprehensive indicator of a firm's performance
because it provides an indication of how well managers are
employing the funds invested by the firm's shareholders to
generate returns.
• On average over long periods, large publicly traded firms in
the U.S. generate ROEs in the range of 11% to 13%

© Dr. C. Bulent Aybar

 Profitability

2005 2006 2007 2008

Gross Profit Margin (Gross Profit/Net Sales) 70.75% 70.76% 69.27% 69.67%
Operating Profit Margin (EBIT/Net Sales) 6.80% 5.26% 4.88% 10.66%
Net Profit Margin (Net Income/Net Sales) 3.40% 2.92% 2.44% 5.74%
Tax Rate (Taxes/EBT) 44.44% 28.57% 37.50% 41.67%
EBIT 10,000 9,000 10,000 26,000
EBIAT=NOPAT=EBITx(1-T) 5,556 6,429 6,250 15,167
Interest Bearing Debt 13,000 27,000 36,000 37,000
Equity 61,000 66,000 71,000 75,000
Invested Capital 74,000 93,000 107,000 112,000
ROIC=EBIAT/Invested Capital=NOPAT/IC 7.51% 6.91% 5.84% 13.54%
ROE (Net Income/Equity) 8.20% 7.58% 7.04% 18.67%

There are a number of measures of profitability. A very common indicator is ROE as it

measures the return on shareholders’ investment. SciTronics ROE was almost doubled
from 2005 to 2008. What did drive its ROE?
Its gross margin did not change much, there is a slight decline in it. However, its
operating margin improved substantially ! This is largely attributable to reduction in
sales and administrative expenses.
 Asset Turnover and Efficiency

• Asset turnover is the second driver of a company's return on

equity.
• Since firms invest considerable resources in their assets,
using them productively is critical to overall profitability.
• A detailed analysis of asset turnover allows the analyst to
evaluate the effectiveness of a firm's investment
management.
• There are two primary areas of asset management:
– working capital management and
– management of long-term assets.

© Dr. C. Bulent Aybar

 Efficiency (Activity Ratios)

Activity Ratios
Total Asset Turnover (Net Sales/Total Assets) 1.58 1.45 1.40 1.53
Average Collection Period (AR/Daily Credit Sales) 104 113 109 99
Inventor Turnover (COGS/Inventory) 2.05 1.79 2.10 2.55
Days Goods in Inventory (365/Inventory Turnover) 178 204 174 143
Days Goods in Inventory (Inventory/Daily Purchases) 178 204 174 143
Fixed Asset Turnover (Net Sales/Fixed Assets) 16.3 14.3 15.8 13.6
Accounts Payable Period (AP/Daily Credit Purchases) 42.4 43.8 40.6 29.6
Cash Conversion Cycle (DGI+ACP-APP) 240 274 242 212

What is striking here is the low inventory turnover and long collection period. SciTronics
cash conversion cycle is too long. In 2005, it took 240 days to turn cash back to cash! There
has been some improvement in 2008 with some improvements in ACP and Inventory
turnover! While these are good signs, it is important to verify that calculations are based on
consistent accounting data.
 Leverage

• Financial leverage enables a firm to have an asset base larger than its
equity.
• Financial leverage increases a firm's ROE as long as the cost of the
liabilities is less than the return on investments.
• In this respect, it is important to distinguish between interest-bearing
liabilities such as notes payable, other forms of short-term debt and long-
term debt, which carry an explicit interest charge, and other forms of
liabilities.
• Some firms carry large cash balances or investments in marketable
securities. These balances reduce a firm's net debt because conceptually
the firm can pay down its debt using its cash and short-term investments.

© Dr. C. Bulent Aybar

 Leverage Ratios

Leverage Ratios
Total Assets/Owner's Equity (Equity 1.52 1.79 2.06 2.12
Multiplier)
Total Liabilities/Total Assets 0.34 0.44 0.51 0.53
Total Debt Ratio at 0.15 0.23 0.30 0.32
Market=Debt/Debt+MVE
TIE=EBIT/Interest 10 4.5 5 13
Accounts Payable/COGS 11.63% 12.00% 11.11% 8.11%

Times Burden Covered= EBIT/(Interest + Principal/(1-T))

MVE=$175,000,000
 Liquidity Ratios

Liquidity Ratios
Current Ratio=Current Assets/Current 3.90 2.60 3.18 2.77
Liabilities
Quick Ratio=Current Assets-Inventory/Current 2.90 1.90 2.43 2.17
Liab.

These ratios measure the company’s ability to meet its current liabilities. While a
high ratio is desired, they should be looked at carefully. A high current or quick
ratio is not always sign of good health. In SciTronics case, there is some
deterioration in the liquidity ratios. These may be attributable to better
receivables and inventory management which reduces the investment in working
capital. Alternatively longer payment periods may lead to higher A/P which
reduces the liquidity ratios. While Receivables and inventories declined as a
percentage of assets, the culprit is the increase in the accrued expenses in 2008.
 Profitability Revisited

2005 2006 2007 2008

Net Profit Margin (NI/Sales) 3.40% 2.92% 2.44% 5.74%
Asset Utilization Efficiency (Sales/TA) 1.58 1.45 1.40 1.53
Financial Leverage (TA/Owner's Equity) 1.52 1.79 2.06 2.12
ROE=(NI/Sales)x(Sales/TA)x(TA/Owner's Equity) 8.20% 7.58% 7.04% 18.67%

• The DuPont analysis suggest that the improvement in ROE is attributable to

improvements in profit margin and leverage as compared to 2005.
• A combination of margin improvement and leverage increased the ROE for
the firm.
• Did leverage increase company’s risk? If we judge risk of insolvency by
using interest coverage ratio, that is not the case. However, it is clear that a
dramatic decline in EBIT may increase the insolvency risk for the company.
 Is ROE a Reliable Financial Yardstick?

• Is ROE forward looking?

– Not really! It is also an indicator based on one year’s earnings! Therefore it
cannot be a reliable guide for multi period financial decisions!!
• Does ROE say anything about the risk taken to generate it?
– Not much!! Unless we look at it deeper, ROE conceals the risk taken to
generate it. Therefore may not be used to make direct comparisons among
companies!!
• A Risk Neutral Indicator of Performance is ROIC!
– ROIC=EBIT(1-T)/Invested Capital =NOPAT/Invested Capital
– ROICBT= EBIT/Invested Capital
– Invested Capital=Interest Bearing Debt + Owner’s Equity
• ROE has also a value problem. Investors do not pay the book value of
equity to earn the ROE! They pay the market price of equity!
© Dr. C. Bulent Aybar
 The Earnings Yield

• Earnings Yield=Net Income/ Market Value of Equity

– Earnings Yield per share  EPS/Price per Share or simply EPS/P
• Turning the Earnings Yield on its head produces the P/E ratio:
– Price Earning Ratio=Price per Share/Earnings per Share
• P/E ratio depends principally on two things:
– Future earnings prospects
– Risk associated with those earnings
• P/E ratio rises with increased earnings prospects, and falls with
increasing risk!
• In general P/E ratio tells little about a company’s current financial
performance but it does indicate what investors believe about its future
prospects.
© Dr. C. Bulent Aybar
Market to Book Value of Equity vs. Return on Equity for 80 Large Corporations
• Try to match the five following types of companies with their corresponding balance sheets
and financial ratios as shown in the next slide:
– Electric utility
– Japanese automobile manufacturer
– Discount general merchandise retailer
– Automated test equipment/systems company
– Upscale apparel retailer

• In doing the exercise, consider the operating and competitive characteristics of the industry
and their implications for
– the collection period;
– inventory turnover;
– the amount of plant and equipment;
– the profit margins and profitability; and
– the appropriate financing structure.

• Then identify which one of the five sets of balance sheets and financial ratios best match
your expectations, given the difficult economic conditions in 2009.

© Dr. C. Bulent Aybar

 Unidentified Industries
Balance Sheet Percentages A B C D E
Cash 1.50% 14.40% 12.10% 13.30% 11.00%
Receivables 4.60% 3.80% 30.90% 39.80% 11.80%
Inventories 1.80% 24.60% 13.70% 4.70% 16.70%
Other current assets 2.00% 4.30% 5.00% 3.80% 10.00%
Property and equipment (net) 74.50% 49.60% 34.10% 22.10% 20.30%
Other assets 15.60% 3.40% 4.30% 16.30% 30.20%
Total assets 100.00% 100.10% 100.10% 100.00% 100.00%
Notes payable 5.30% 0.40% 5.40% 18.20% 1.40%
Accounts payable 2.10% 24.80% 11.00% 8.30% 8.80%
Other current liabilities 5.90% 17.00% 14.20% 8.70% 16.50%
Long-term debt 33.60% 10.00% 34.30% 23.10% 21.70%
Other liabilities 26.30% 2.20% 11.20% 5.60% 2.00%
Owners’ equity 26.80% 45.60% 23.90% 36.10% 49.60%
Total 100.00% 100.00% 100.00% 100.00% 100.00%
Selected Ratios
Net profit/net sales 10.30% 1.50% 5.10% 1.30% -5.80%
Return on capital 6.80% 9.20% 12.00% 0.90% -3.10%
Return on equity 12.50% 10.50% 28.10% 2.20% -7.60%
Sales/total assets 0.32 3.25 1.31 0.63 0.65
Collection period (days) 52 4 86 232 43
Days of inventory 43 32 62 31 147
Sales/net property & equipment 0.43 6.7 3.8 2.9 3.6
Total assets/equity 3.73 2.19 4.19 2.79 2.01
Total liabilities/total assets 0.73 0.54 0.76 0.66 0.5
Interest-bearing debt/total capital 59.00% 19.00% 62.00% 53.00% 32.00%
Times interest earned Current assets/current liabilities 3.2 16 6 4.4 NM
Current Assets/Current Liabilities 0.67 1.11 2.01 1.22 1.85