# Chapter 3_ Evaluating Financial Performance - College of Business

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Chapter 3: Evaluating
Financial Performance
Kmart vs. Wal-Mart
Objectives
n   Calculate financial ratios to evaluate the
financial health of a company.
n   Apply DuPont analysis in evaluating a
firm’s financial performance.
n   Explain the limitations of ratio analysis.
Relevant Principles
n   Principle 7: Agency relationships, managers
won’t work for the owners unless its in their best
interest to do so.
n   Principle 5: Competitive markets make it hard to
find exceptionally profitable investments.
n   Principle 1: The risk-return trade-off – we won’t
take more risk unless we expect higher returns.
How to use Financial Ratios?
n   Compare across time for an individual firm.
Trend Analysis.
n   Compare to an industry average. Industry
Analysis.
n   Compare to a dominant competitor in the same
industry. Comparison Analysis.
n   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
n   How liquid is the firm?
operating profits on the firm’s assets?
n   How is the firm financing its assets?
n   Are the stockholders receiving an
How liquid is the firm?
n   Measuring Liquidity Approach 1:
comparing liquid assets to short-term debt.

n   Current Ratio = Current Assets/Current
Liabilities
n   Acid-test Ratio = (Current Assets –
Inventory)/Current Liabilities
How liquid is the firm?
n   Measuring Liquidity Approach 2: How easily can
other current assets be converted into cash.
n   Average Collection Period = Accounts
Receivable/Daily (Credit) Sales
n   Accounts Receivable/(Sales/365)
n   Accounts Receivable Turnover = (Credit)
Sales/Accounts Receivable
n   Inventory Turnover = Cost of Goods Sold/Inventory
Kmart and Wal-Mart’s Liquidity
Ratios
operating profits on the firm’s assets?
n   Operating Return on Investment (OIROI)
n   Operating Income/Total Assets, also:
n   Operating Profit Margin x Total Asset Turnover
n   Operating Profit Margin = Operating Income/Sales
n   Operating Income = Pre-Tax Income plus interest
expense, or Pre-tax income minus interest, non-op
n   Total Asset Turnover = Sales/Total Assets
n   Affected by Accounts Receivable Turnover, Inventory
Turnover, Fixed Asset Turnover
n   Fixed Asset Turnover = Sales/Net Fixed Assets; Net
Fixed Assets = Property, Plant, Equip, NET
Kmart & Wal-Mart’s Operating
Profitability Ratios
How is the firm financing its
assets?
n   Debt Ratio = Total Liabilities/Total Assets
n   Times-Interest-Earned = Operating
Income/Interest Expense
n   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
Are the stockholders receiving an

n   Return On Common Equity
n   Net Income Available to Common
Stockholders(including EI&DO)/Total
Common Equity
n   Total Common Equity = Total Shareholders’
Equity – Preferred Stock
Kmart & Wal-Mart’s Return on
Equity
DuPont Analysis of Return on
Common Equity (ROE)
n   Breaks down company performance into
operational and financing components.
n   ROE = (Net Profit Margin x Total Asset
Turnover)/(1-Debt Ratio), where
n   Net Profit Margin = Net Income(available to common
stockholders including EI&DO)/Sales
n   Total Asset Turnover = Sales/Total Assets
n   Debt Ratio = Total Liabilities/Total Assets
n   Net Profit Margin x Total Asset Turnover = Return
on Assets, which are the operating components.
n   1/(1-Debt Ratio) = measures impact of financial
leverage
How does Leverage work?

n   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?

n   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?

n   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?

n   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?

n   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
Caveats of Ratio Analysis
n   Different Accounting Practices.
n   Sometimes hard to pick an industry for
comparison.
n   Seasonality in Operations.

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 views: 0 posted: 7/9/2013 language: English pages: 22