Chapter 3: Evaluating Financial Performance

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 minusinterest, 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. 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. 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. 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. 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

20. 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

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.