Chapter 3: Evaluating Financial Performance

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Chapter 3 Evaluating Financial Performance

• Kmart vs. Wal-Mart

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Objectives

• Calculate financial ratios to evaluate the
  financial health of a company.
• Apply DuPont analysis in evaluating a firms
  financial performance.
• Explain the limitations of ratio analysis.

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Relevant Principles

• Principle 7 Agency relationships, managers wont
  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 wont
  take more risk unless we expect higher returns.

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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.

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4 Key Questions to Answer with Ratio Analysis

• How liquid is the firm?
• Is management generating adequate operating
  profits on the firms assets?
• How is the firm financing its assets?
• Are the stockholders receiving an adequate return
  on their investment?

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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

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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

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Kmart and Wal-Marts Liquidity Ratios
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Is management generating adequate operating
profits on the firms 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

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Kmart Wal-Marts Operating Profitability Ratios
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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)

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Kmart Wal-Marts Financing Ratios
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Are the stockholders receiving an adequate return
on their investment?

• Return On Common Equity
• Net Income Available to Common Stockholders(includ
  ing EIDO)/Total Common Equity
• Total Common Equity Total Shareholders Equity
  Preferred Stock

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Kmart Wal-Marts Return on Equity
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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 EIDO)/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

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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)

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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
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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

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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
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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
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Kmart Wal-Marts DuPont Analysis
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Caveats of Ratio Analysis

• Different Accounting Practices.
• Sometimes hard to pick an industry for
  comparison.
• Seasonality in Operations.