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
firms financial performance.
Explain the limitations of ratio analysis.

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.

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 firms 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-Marts Liquidity

Ratios
Question 1: How Liquid is the Firm?
Approach 1:
Current Ratio
Acid-test (Quick) Ratio
Approach 2:
Average Collection Period
Accounts Receivable Turnover
Inventory Turnover

2001
2.01
0.32

2000
2.00
0.26

Kmart
1999
2.12
0.35

#DIV/0!
4.63

#DIV/0!
3.96

#DIV/0!
4.03

#DIV/0!
3.95

#DIV/0!
3.84

Wal-Mart
2000
1999
0.94
1.26
0.18
0.24

1998
1.34
0.20

1997
1.64
0.19

2.99
122.23
5.66

2.90
125.65
5.25

1998
2.28
0.34

1997
2.15
0.38

Question 1: How Liquid is the Firm?

Approach 1:
Current Ratio
Acid-test (Quick) Ratio
Approach 2:
Average Collection Period
Accounts Receivable Turnover
Inventory Turnover

2001
0.92
0.18
3.34
109.33
7.01

2.93
124.39
6.55

2.93
124.52
6.37

Is management generating adequate

operating profits on the firms assets?

Operating Return on Investment (OIROI)

Operating Profit Margin = Operating Income/Sales

Operating Income/Total Assets, also:

Operating Profit Margin x Total Asset Turnover
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-Marts 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-Marts Financing

Ratios
Question 3: How is the Firm Financing Its Assets?

Debt Ratio
Times-Interest-Earned Ratio

2001
58.4%
-0.16

Kmart
2000
1999
58.3%
57.8%
4.64
3.72

1998
52.7%
2.15

1997
57.5%
1.73

Wal-Mart
2000
1999
63.3%
57.8%
9.89
10.19

1998
59.2%
8.29

1997
56.7%
6.77

Question 3: How is the Firm Financing Its Assets?

Debt Ratio
Times-Interest-Earned Ratio

2001
59.9%
8.36

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-Marts Return on

Equity
Question 4: Are the Owners Receiving an Adequate Return on Their Investment?
Kmart
2001
2000
1999
1998
Return on Common Equity
-3.8%
6.4%
8.7%
4.6%
Question 4: Are the Owners Receiving an Adequate Return on Their Investment?
Wal-Mart
2001
2000
1999
1998
Return on Common Equity
20.1% 20.8% 21.0% 19.1%

1997
-4.3%

1997
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 equityfinanced 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 equityfinanced 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 =
50,000

22%

Kmart & Wal-Marts DuPont

Analysis
ROE Components:
Net Profit Margin
Total Asset Turnover
Return on Assets
1 - Debt Ratio
Return On Equity

ROE Components:
Net Profit Margin
Total Asset Turnover
Return on Assets
1 - Debt Ratio
Return On Equity

2001
-0.6%
2.53
-1.6%
0.42
-3.8%

2001
3.3%
2.47
8.1%
0.40
20.1%

2000
1.1%
2.38
2.7%
0.42
6.4%

Kmart
1999
1.5%
2.38
3.7%
0.42
8.7%

1998
0.8%
2.37
1.8%
0.47
3.9%

1997
-0.7%
2.20
-1.5%
0.43
-3.6%

2000
3.2%
2.37
7.6%
0.37
20.8%

Wal-Mart
1999
3.2%
2.78
8.9%
0.42
21.0%

1998
3.0%
2.63
7.8%
0.41
19.1%

1997
2.9%
2.68
7.7%
0.43
17.8%

Caveats of Ratio Analysis

Different Accounting Practices.

Sometimes hard to pick an industry for
comparison.
Seasonality in Operations.