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?
n   Is management generating adequate
    operating profits on the firm’s assets?
n   How is the firm financing its assets?
n   Are the stockholders receiving an
    adequate return on their investment?
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
Is management generating adequate
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
adequate return on their investment?

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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posted:7/9/2013
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