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

Question 1: How Liquid is the Firm?

Approach 1: 2001 2000 1999 1998 1997Current Ratio 2.01 2.00 2.12 2.28 2.15Acid-test (Quick) Ratio 0.32 0.26 0.35 0.34 0.38Approach 2:Average Collection Period 0 0 0 0 0Accounts Receivable Turnover #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!Inventory Turnover 4.63 3.96 4.03 3.95 3.84

Question 1: How Liquid is the Firm?

Approach 1: 2001 2000 1999 1998 1997Current Ratio 0.92 0.94 1.26 1.34 1.64Acid-test (Quick) Ratio 0.18 0.18 0.24 0.20 0.19Approach 2:Average Collection Period 3.34 2.93 2.93 2.99 2.90Accounts Receivable Turnover 109.33 124.39 124.52 122.23 125.65Inventory Turnover 7.01 6.55 6.37 5.66 5.25

Kmart

Wal-Mart

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

Question 2: Is Management Generating Adequate Operating Profits on the Firm's Assets?

2001 2000 1999 1998 1997OIROI Component 1: Oper Profit Margin -0.1% 3.6% 3.2% 2.4% 2.5%OIROI Component 2 : Total Asset Turnover 2.53 2.38 2.38 2.37 2.20Oper. Income Return On Investmt (OIROI) -0.3% 8.6% 7.7% 5.8% 5.5%Accounts Receivable Turnover #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!Inventory Turnover 4.63 3.96 4.03 3.95 3.84Fixed Asset Turvover 5.65 5.60 5.69 5.88 5.48

Question 2: Is Management Generating Adequate Operating Profits on the Firm's Assets?

2001 2000 1999 1998 1997OIROI Component 1: Oper Profit Margin 5.9% 6.1% 5.8% 5.5% 5.4%OIROI Component 2 : Total Asset Turnover 2.474 2.371 2.784 2.629 2.681Oper. Income Return On Investmt (OIROI) 14.7% 14.4% 16.2% 14.3% 14.4%Accounts Receivable Turnover 109.33 124.39 124.52 122.23 125.65Inventory Turnover 7.01 6.55 6.37 5.66 5.25Fixed Asset Turvover 4.72 4.64 5.36 5.05 5.22

Kmart

Wal-Mart

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

Question 3: How is the Firm Financing Its Assets?

2001 2000 1999 1998 1997Debt Ratio 58.4% 58.3% 57.8% 52.7% 57.5%Times-Interest-Earned Ratio -0.16 4.64 3.72 2.15 1.73

Question 3: How is the Firm Financing Its Assets?

2001 2000 1999 1998 1997Debt Ratio 59.9% 63.3% 57.8% 59.2% 56.7%Times-Interest-Earned Ratio 8.36 9.89 10.19 8.29 6.77

Kmart

Wal-Mart

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

Question 4: Are the Owners Receiving an Adequate Return on Their Investment?

2001 2000 1999 1998 1997Return on Common Equity -3.8% 6.4% 8.7% 4.6% -4.3%Question 4: Are the Owners Receiving an Adequate Return on Their Investment?

2001 2000 1999 1998 1997Return on Common Equity 20.1% 20.8% 21.0% 19.1% 17.8%

Kmart

Wal-Mart

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

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)

How does Leverage work?

Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000.

ROE = =15%15,000100,000

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 =

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 - 4,00050,000

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 - 4,00050,000

Kmart & Wal-Mart’s DuPont Analysis

ROE Components: 2001 2000 1999 1998 1997Net Profit Margin -0.6% 1.1% 1.5% 0.8% -0.7%

Total Asset Turnover 2.53 2.38 2.38 2.37 2.20Return on Assets -1.6% 2.7% 3.7% 1.8% -1.5%

1 - Debt Ratio 0.42 0.42 0.42 0.47 0.43Return On Equity -3.8% 6.4% 8.7% 3.9% -3.6%

ROE Components: 2001 2000 1999 1998 1997Net Profit Margin 3.3% 3.2% 3.2% 3.0% 2.9%

Total Asset Turnover 2.47 2.37 2.78 2.63 2.68 Return on Assets 8.1% 7.6% 8.9% 7.8% 7.7%

1 - Debt Ratio 0.40 0.37 0.42 0.41 0.43 Return On Equity 20.1% 20.8% 21.0% 19.1% 17.8%

Kmart

Wal-Mart

Caveats of Ratio Analysis

Different Accounting Practices. Sometimes hard to pick an industry for

comparison. Seasonality in Operations.