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

2. 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.

3. 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.

4. 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.

5. 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?

6. 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

7. 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

8. Kmart and Wal-Mart’s Liquidity Ratios

9. 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

10. Kmart & Wal-Mart’s Operating Profitability Ratios

11. 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)

12. Kmart & Wal-Mart’s Financing Ratios

13. 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

14. Kmart & Wal-Mart’s Return on Equity

15. 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

16. 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)

17. 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

18. 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 =

19. 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
50,000

20. 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 = = %
15, ,000
50,000

21. Kmart & Wal-Mart’s DuPont Analysis

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