Chapter 3: Evaluating Financial Performance Kmart vs. Wal-Mart

Objectives Calculate financial ratios to evaluate the financial health of a company. Apply DuPont analysis in evaluating a firm’s financial performance. Explain the limitations of ratio analysis.

Relevant Principles Principle 7: Agency relationships, managers won’t work for the owners unless its in their best interest to do so. Principle 5: Competitive markets make it hard to find exceptionally profitable investments. Principle 1: The risk-return trade-off – we won’t take more risk unless we expect higher returns.

How to use Financial Ratios? Compare across time for an individual firm. Trend Analysis. Compare to an industry average. Industry Analysis. Compare to a dominant competitor in the same industry. Comparison Analysis. We will conduct trend analysis for both Kmart & Wal-Mart and compare the ratios of the two companies.

4 Key Questions to Answer with Ratio Analysis How liquid is the firm? Is management generating adequate operating profits on the firm’s assets? How is the firm financing its assets? Are the stockholders receiving an adequate return on their investment?

How liquid is the firm? Measuring Liquidity Approach 1: comparing liquid assets to short-term debt. Current Ratio = Current Assets/Current Liabilities Acid-test Ratio = (Current Assets – Inventory)/Current Liabilities

How liquid is the firm? Measuring Liquidity Approach 2: How easily can other current assets be converted into cash. Average Collection Period = Accounts Receivable/Daily (Credit) Sales Accounts Receivable/(Sales/365) Accounts Receivable Turnover = (Credit) Sales/Accounts Receivable Inventory Turnover = Cost of Goods Sold/Inventory

Kmart and Wal-Mart’s Liquidity Ratios

Is management generating adequate operating profits on the firm’s assets? Operating Return on Investment (OIROI) Operating Income/Total Assets, also: Operating Profit Margin x Total Asset Turnover Operating Profit Margin = Operating Income/Sales Operating Income = Pre-Tax Income plus interest expense, or Pre-tax income minus interest, non-op Total Asset Turnover = Sales/Total Assets Affected by Accounts Receivable Turnover, Inventory Turnover, Fixed Asset Turnover Fixed Asset Turnover = Sales/Net Fixed Assets; Net Fixed Assets = Property, Plant, Equip, NET

Kmart & Wal-Mart’s Operating Profitability Ratios

How is the firm financing its assets? Debt Ratio = Total Liabilities/Total Assets Times-Interest-Earned = Operating Income/Interest Expense Operating Income = Pre-Tax Income plus interest expense, or Pre-tax income minus interest, non-op (int exp for Kmart)

Kmart & Wal-Mart’s Financing Ratios

Are the stockholders receiving an adequate return on their investment? Return On Common Equity Net Income Available to Common Stockholders(including EI&DO)/Total Common Equity Total Common Equity = Total Shareholders’ Equity – Preferred Stock

Kmart & Wal-Mart’s Return on Equity

DuPont Analysis of Return on Common Equity (ROE) Breaks down company performance into operational and financing components. ROE = (Net Profit Margin x Total Asset Turnover)/(1-Debt Ratio), where Net Profit Margin = Net Income(available to common stockholders including EI&DO)/Sales Total Asset Turnover = Sales/Total Assets Debt Ratio = Total Liabilities/Total Assets Net Profit Margin x Total Asset Turnover = Return on Assets, which are the operating components. 1/(1-Debt Ratio) = measures impact of financial leverage

ROE = How does Leverage work? Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000. ROE = (ignore taxes for this example)

ROE = =15% 15,000 100,000 How does Leverage work? Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000. ROE = =15% 15,000 100,000

ROE = How does Leverage work? Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000. ROE =

ROE = = 15,000 - 4,000 50,000 How does Leverage work? Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000. ROE = = 15,000 - 4,000 50,000

ROE = = 22% 15,000 - 4,000 50,000 How does Leverage work? Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000. ROE = = 22% 15,000 - 4,000 50,000

Kmart & Wal-Mart’s DuPont Analysis

Caveats of Ratio Analysis Different Accounting Practices. Sometimes hard to pick an industry for comparison. Seasonality in Operations.