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?
Kmart
Approach 1: 2001 2000 1999 1998 1997
Current Ratio 2.01 2.00 2.12 2.28 2.15
Acid-test (Quick) Ratio 0.32 0.26 0.35 0.34 0.38
Approach 2:
Average Collection Period 0 0 0 0 0
Accounts 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?

Wal-Mart
Approach 1: 2001 2000 1999 1998 1997
Current Ratio 0.92 0.94 1.26 1.34 1.64
Acid-test (Quick) Ratio 0.18 0.18 0.24 0.20 0.19
Approach 2:
Average Collection Period 3.34 2.93 2.93 2.99 2.90
Accounts Receivable Turnover 109.33 124.39 124.52 122.23 125.65
Inventory Turnover 7.01 6.55 6.37 5.66 5.25
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?
Kmart
2001 2000 1999 1998 1997
OIROI 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 2.20
Oper. 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 3.84
Fixed 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?

Wal-Mart
2001 2000 1999 1998 1997
OIROI 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 2.681
Oper. Income Return On Investmt (OIROI) 14.7% 14.4% 16.2% 14.3% 14.4%
Accounts Receivable Turnover 109.33 124.39 124.52 122.23 125.65
Inventory Turnover 7.01 6.55 6.37 5.66 5.25
Fixed Asset Turvover 4.72 4.64 5.36 5.05 5.22
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?
Kmart
2001 2000 1999 1998 1997
Debt 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?

Wal-Mart
2001 2000 1999 1998 1997
Debt 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
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?

Kmart
2001 2000 1999 1998 1997
Return 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?
Wal-Mart
2001 2000 1999 1998 1997
Return on Common Equity 20.1% 20.8% 21.0% 19.1% 17.8%
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 = 15,000 =15%

100,000
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 - 4,000 =
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 = 22%
50,000
Kmart & Wal-Mart’s DuPont
Analysis
Kmart
ROE Components: 2001 2000 1999 1998 1997
Net Profit Margin -0.6% 1.1% 1.5% 0.8% -0.7%
Total Asset Turnover 2.53 2.38 2.38 2.37 2.20
Return on Assets -1.6% 2.7% 3.7% 1.8% -1.5%
1 - Debt Ratio 0.42 0.42 0.42 0.47 0.43
Return On Equity -3.8% 6.4% 8.7% 3.9% -3.6%

Wal-Mart
ROE Components: 2001 2000 1999 1998 1997
Net 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%
Caveats of Ratio Analysis
 Different Accounting Practices.
 Sometimes hard to pick an industry for
comparison.
 Seasonality in Operations.