Problem Set #1: CASE STUDY: Ratio Analysis.
Introduction
The case method simulates a real business situation, putting you in a senior management
position with a given business scenario. You must identify the major issues or problems,
analyze and evaluate the situation, presents alternatives, and make recommendations and
develop implementation plans. The internal situation analysis normally requires financial
analysis. Based on available financial information, you assess the firm’s financial
performance, assess its strengths and weaknesses, and provide suggestions for future
planning. A common approach is to calculate various ratios using major items from the
firm’s balance sheet, income statement, and stock market data. Ratio analysis is a
powerful means to evaluate the firm’s financial position and help understand the overall
picture of the firm. This analysis can be more effectively performed with the use of
Microsoft Excel, spreadsheet software including many useful features to facilitate and
simplify the work.
The financial analysis can be made on a historical basis and also by comparing similar
firms in the industries. The former method is based on a trend analysis to evaluate the
firm’s present ratios in comparison with those of previous years to find the direction that
the firm is moving toward and evaluate the effectiveness of its past strategy. The latter
method is based on cross-sectional analysis to determine the firm’s performance relative
to its major competitors and the industry average. Since trend analysis has been discussed
in other section (see problem sets for Economics 2020 and Mathematics 3010), the focus
of this section is the cross-sectional analysis and the evaluation of the firm based on its
relative position in the industry.
Mathematics
Ratio Analysis
In general ratio analysis is based on the evaluation of four types of ratios:: (1) current
ratios, which measure the firm’s ability to fulfill its short-term debt obligations, (2)
leverage ratios, which measure the level of the firm’s borrowing and its debt-serving
ability based on its earnings prospect, (3) activity ratios, which measure the efficiency
level of the firm in utilizing the assets for business operations, (4) profitability ratios,
which measure the firm’s earnings capacity.
The major ratios in these categories are as follows.
I.
Liquidity Ratios
1. Current ratio
Current . Assets
Current . Liabilities
Measures the extent to which the firm’s short-term debts are covered by its cash
and the assets that can be converted to cash in the near future.
2. Quick ratio
Current . Assets  Inventory
Current . Liabilities
A measure of a firm’s ability to pay its short-term debt without relying on the
sales of its inventory
II.
Leverage Ratios
3. Debt to assets ratio
Total. Debts
Total. Assets
An indication of the extent to which the business is financed by the borrowed
funds.
4. Debt to equity ratio
Total. Debts
Owner ' s. Equity
An alternative measure of the firm’s debt using, comparing the fund financed by
debts and that provided by the owner.
5. Time interest earned
Case Study: Ratio Analysis by Scott Liu
Income. before. Taxes  Interest
Interest . Ch arg es
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A multiple of earnings available to pay interest costs and the interest cost, which
measures the level of comfort for the firm to serve its interest obligations based on
its earnings prospect.
6. Fixed charge coverage
Income. before. Taxes.&. Interest  Lease
Lease. Ch arg es
An alternative measure with the purpose similar to Time Interest Earned, showing
the firm’s capacity to serve its debt obligations plus fixed obligation charges.
III.
Activity Ratios
7. Inventory turnover
Sales
Inventory
Based on a comparison with the industry average, it shows whether the firm has
excess inventory stock or inadequate inventory.
8. Total asset turnover
Sales
Total. Assets
It shows the relation between sales and the assets employed to generate the sales,
which measures the efficiency of business operations.
9. Account receivable turnover
Sales
Account . Re ivable
Based on a comparison of sales with the credit granted to generate the sales, it
shows the average length of time to collect the credit.
IV.
Profitability Ratios
10. Gross profit margin
Sales  Cost . of . Goods. Sold
Sales
A measure of the margin to cover operation costs and yield profits.
11. Net profit margin
Net . Income
Sales
Reflecting the profit per dollar of sales.
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Net . Income
Total. Assets
12. Return on total assets
A measure of the profit generated from each dollar of fund employed for business
operations.
Net . Income
Owner ' s. Equity
13. Return on equity
A measure of the profit earned by the owner for each of his/her dollar invested in
the business.
V.
Du Pont Analysis
Du Pont Analysis provides another perspective on how combined activities and financial
leverage determined the profitability of the firm.
Net . Income
Sales
×
Sales
Total. Assets
=
Net . Income
.
Total. Assets
Consequently,
Net profit margin × Total asset turnover = Return on assets.
Furthermore,
Total. Debts
Net . Income
Net . Income
× (1 +
) =
.
Total. Assets
Owner ' s. Equity
Owner ' s. Equity
In other words,
Return on Assets × ( 1 + Debt-Equity Ratio) =
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Return on Equity.
4
Excel
Next, we will construct a spreadsheet to analyze Wal-Mart Stores, Inc. as an example of
ratio analysis. The firm’s 1997 and 1996 income statements and balance sheet are
presented in Table 1 and Table 2, respectively.
Table 1. Wal-Mart Store, Inc.: Income Statement for years ending January 31
(millions of dollars)
For years ending January 31, 1998
Revenues
Costs and Expenses:
Cost of sales
Operating, selling and admin expenses
Interest Costs:
Debt
Capital leases
Total Costs and Expenses
Income Before Income Taxes
Provision for Income Taxes
1997
119,299
106,178
93,438
9,358
83,510
16,946
555
229
113,580
629
216
101,301
5,719
2,115
4,877
1,794
Net Income
$ 3,582
$ 3,110
______________________________________________________________________________
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Table 2. Wal-Mart Store, Inc.: Balance Sheets (millions of dollars)
For years ending January 31, 1998
1997
Assets
Current Assets:
Cash and cash equivalents
Receivables
Inventories
Prepaid expenses and other
Total Current Assets
$ 1,447
976
16,497
432
19,352
$ 883
845
15,897
368
17,993
Property, Plant and Equipment, net
Property under Capital Lease, net
Other Assets and Deferred Charges
Total Assets
21,469
2,137
2,426
$45,384
18,333
1,991
1,287
$39,604
Liabilities and Shareholders' Equity
Current Liabilities:
Total Current Liabilities
14,460
10,957
Long-Term Debt
Long-Term Obligations Under Capital Leases
Deferred Income Taxes and Other
Minority Interest
Total Long-term Liabilities
7,191
2,483
809
1,938
12,421
7,709
2,307
463
1,025
11,504
Shareholders' Equity
Common stock ($.10 par value; 2,241 and 2,285
issued and outstanding in 1998 and 1997)
Capital in excess of par value
Retained earnings
Foreign currency translation adjustment
Total Shareholders' Equity
224
585
18,167
(473)
18,503
228
547
16,768
(400)
17,143
Total Liabilities and Shareholders' Equity
$45,384
$39,604
_____________________________________________________________________________
Spreadsheet Construction
These financial data are used to construct financial statements in the Excel worksheet.
The example income statement and balance sheet have been created and shown in the
next figure. Create the same Excel spreadsheet using your computer.
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A
1
Wal-Mart Stores, Inc.
2
3
4
CONSOLIDATED INCOME STATEMENTS
5
6
7
8
9
10
11
12
13
14
15
Revenues
Costs and Expenses:
Cost of sales
Operating, selling and admin expenses
Interest Costs:
Debt
Capital leases
Total Costs and Expenses
Income Before Income Taxes
Provision for Income Taxes
Net Income
B
C
1998
1997
119,299
106,178
93,438
9,358
83,510
16,946
555
229
113,580
5,719
2,115
$3,582
629
216
101,301
4,877
1,794
$3,110
1998
1997
$1,447
976
16,497
432
19,352
21,469
2,137
2,426
$45,384
$883
845
15,897
368
17,993
18,333
1,991
1,287
$39,604
14,460
7,191
2,483
809
1,938
12,421
10,957
7,709
2,307
463
1,025
11,504
224
585
18,167
-473
18,503
$45,384
228
547
16,768
-400
17,143
$39,604
D
E
F
(Amounts in millions except per share data)
Fiscal years ended January 31,
16
17
Wal-Mart Stores, Inc.
18
19
20
CONSOLIDATED BALANCE SHEETS
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
Assets
Current Assets:
Cash and cash equivalents
Receivables
Inventories
Prepaid expenses and other
Total Current Assets
Property, Plant and Equipment, net
Property under Capital Lease, net
Other Assets and Deferred Charges
Total Assets
(Amounts in millions)
January 31,
Liabilities and Shareholders' Equity
Total Current Liabilities
Long-term Debt
Long-term Obligations Under Capital Leases
Deferred Income Taxes and Other
Minority Interest
Total Long-term Liabilities
Shareholders' Equity:
Common Stocks
Capital in excess of par value
Retained earnings
Foreign currency translation adjustment
Total Shareholders' Equity
Total Liabilities and Shareholders' Equity
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Next, we can get Excel to calculate ratios for us by inputting formulas into relevant cells.
The following table shows the results with ratios between cells I4 and J22 calculated by
the computer automatically. You may type exactly the same information into these cells
of the Excel spreadsheet except cells between I4 and J22.
D
E
F
G
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
Major Ratios
Liquidity Ratios
Current Ratio
Quick Ratio
1998
1.34
0.20
1997
1.64
0.19
Leverage Ratios
Debts-Asset Ratio
Debts-Equity Ratio
Time Interest Covered
Fixed Charge Covered
0.59
1.45
11.30
8.29
0.57
1.31
8.75
6.77
Activity Ratios
Inventory Turnover
Assets Turnover
A/R Turnover
7.23
2.63
122.23
6.68
2.68
125.65
18
19
20
21
22
23
Profitability Ratios
Gross Profit Margin
Net Profit Margin
Return on Assets
Return on Equity
21.68%
3.00%
7.89%
19.36%
21.35%
2.93%
7.85%
18.14%
HI
I
1
24
Then in cell F4, type: “=B27/B34”, and then the Enter key;
in cell F5, type: “(B27-B25)/B34”, and the Enter key;
in cell F8, type “(B46-B45)/B46”, and then the Enter key;
in cell F9, type “(B46-B45)/B45”, and then the Enter key;
in cell F10, type “(B13+B10+B11)/B10”, and then the Enter key;
in cell F11, type “(B13+B10+B11)/(B10+B11)”, and then the Enter key;
in cell F14, type “B5/B25”, and then the Enter key;
in cell F15, type “B5/B31”, and then the Enter key;
in cell F16, type “B5/B24”, and then the Enter key;
in cell F19, type “(B5-B7)/B5”, and then the Enter key;
in cell F20, type “B15/B5”, and then the Enter key;
in cell F21, type “B15/B31”, and then the Enter key;
in cell F22, type “B15/B45”, and then the Enter key.
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For the ratios in 1996 (the fiscal years ending January 31, 1997), you only need to copy
the formula in cells F4:F22 to cells G4:G22. Immediately you will see the ratios are
calculated for 1996 data as well.
Du Pont Analysis is further presented as follows. To get your own results, you first type
he table as follows except the cells showing ratios.
D
26
27
28
29
30
31
32
33
34
E
F
G
H
I
J
X
X
X
Assets Turnover
2.63
2.68
Du Pont Analysis
1997
1996
Return on Asset =
7.89%
7.85%
N Profit Margin
=
3.00%
=
2.93%
1997
1996
Return on Equity =
19.36%
18.14%
Return on Asset X
=
7.89% X
=
7.85% X
(1 + Debt-Equity Ratio)
2.45
2.31
35
36
Then in cell G29, type: “=F20”, and then the Enter key;
in cell I29, type: “=F15”, and then the Enter key;
in cell E29, type: “=G29*I29”, then the Enter key;
in cell G30, type: “=G20”, and then the Enter key;
in cell I30, type: “=G15”, and then the Enter key;
in cell E30, type: “=G30*I30”, then the Enter key;
in cell G33, type: “=E29”, and then the Enter key;
in cell I33, type: “=(1+F9)”, and then the Enter key;
in cell E33, type: “=G33*I33”, and then the Enter key;
in cell G34, type: “=E30”, and then the Enter key;
in cell I34, type: “=(1+G9)”, and then the Enter key;
in cell E34, type: “=G34*I34”, and then the Enter key.
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Business Application
The last two sections provide a brief introduction of major ratios and the use of Excel to
calculate them. These ratios are firm specific, but also determined by the industry nature
and economic environment. Therefore, a more meaningful way to undertake analysis is to
compare a company’s ratios with those of its major competitor or the industrial average.
To help you perform ratio analysis with focus on real application, we have put on the
Application Pack web site (iris.nyit.edu/appack) an Excel template designed to simplify the
ratio analysis process. To use this template, you need to have a computer with Internet
access. Then what you need is only to follow the instructions and collect financial data
and enter them into the computer. As a result, all the ratios will be available to you
automatically. The demonstration of this ratio analysis is based on 1998 financial
statements of Wal-Mart and Kmart, two major competitors in the mass retail industry.
First, go to the web site, iris.nyit.edu/~apsom, and download the Excel Tool Analysis
template. Then load the Excel program and open the Excel file “Tool-Analysis.”
Selecting “Source” tab at the bottom of the screen to select this worksheet if you are not
yet in it. Following the steps, first click the Hyperlink to connect you to relevant web
sites to get the companies’ accounting data from 1998’s10K reports filed with SEC.
Based on the data retrieved from these web sites, you can prepare the simplified income
statements and balance sheets of these two companies as follows.
1998 Income Statement
(Amount in million)
Kmart
Wal-Mart
Sales
Cost of good sold
Gross margin
Selling, general and admin expenses
Other expenses
Interest expense
Other fixed charges
Income before taxes
Taxes
Others
Net income
$ 33,674
2 6,319
7,355
6,245
19
293
0
4798
230
50
$ 518
$ 139,208
108,725
30,483
22,363
0
529
268
7323
2740
153
$ 4,430
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1998 Balance Sheet
Kmart
(Amount in million)
Cash and equivalent
Account Receivables
Inventory
Other current assets
Total current assets
Property and equipment, net
Other fixed assets
Wal-Mart
710
0
6,536
584
7,830
5914
422
$ 1,879
1,118
17,076
0
21,132
23,674
5,190
$ 14,166
$ 49,996
$ 3691
1538
2958
5979
16,762
9,607
2,515
21,112
Total Liabilities and Shareholders’ Equity $ 14,166
$ 49,996
Total Assets
Current liabilities
Long-term liabilities
Other long-term obligations
Shareholders’ equity
Next you may click “Report” tab at the bottom of the screen to select the template for
presenting the financial statements in the spreadsheet.
A macro has been written to facilitate you to enter data to present financial statements.
What you need to do is to click the Another Company button to initiate the macro and
follow the instruction to enter the required data. After you complete the input, the balance
sheets and income statements of two companies will be presented to you. If you have a
clear idea on the structure of financial statements and want to build the statements by
yourself, you may also enter the data to their corresponding cells directly, which should
generate the same results.
After you have completed the creation of financial statements, the ratios have already
being prepared for you. You need to select the “Ratios” tab at the bottom of the screen,
which will lead you to the third spreadsheet. The major ratios and Du Pont analysis
results have been prepared for the companies. Thus you can save yourself from the
tedious calculation and focus on analysis of the content.
Interpretations
A brief look at these ratios suggests that Wal-Mart is in a much better financial situation
than Kmart. In 1998, the return on equity was 21% for Wal-Mart, while it was only 8.7%
for Kmart. Why Wal-Mart can achieve a much better performance than Kmart, and what
is the key to its success? To have a more conclusive answer, we of course need further
research on various aspects of firm operations and strategies. However, these ratios have
already give us some indications.
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First, there are similarities between two companies. Both have almost identical capital
structure, with debt representing 58% of total investment. However, because of its better
profitability, Wal-Mart has the fixed cost coverage ratio equal to 10.2, which is much
better than Kmart’s ratio of 3.72. While Kmart covers its fixed charges by a low margin
of safety, the company may face difficulties if it wants to borrowing additional funds. In
terms of liquidity ratios, Kmart seems to be more liquid and have the cash ready to pay
for its short-term debts.
The turnover ratios usually reflect the firm’s efficiency in utilizing assets employed in
business operations. However, they may also have limitations. For example, Wal-Mart
has a lower fixed assets turnover ratio, which probably is due to its expansions in the
more recent period. As fixed assets are expressed in the balance sheet on a historical cost
basis, the new facilities will to have a higher value in comparison with the old facilities,
which thus has an unfavorable effect on the new firm’s fixed assets turnover ratios. On
the other hand, the inventory turnover is presented on a more comparable basis. It
indicates that Wal-Mart is more efficient in generating sales from its inventory carried in
comparison with Kmart (8.15 vs. 5.15). Overall, Wal-Mart has total assets turnover
slightly better than that of Kmart (2.784 vs. 2.38).
The Du Pont analysis helps identify the main source of different performance levels.
There is not much difference between these two companies in terms of total assets
turnover. How, Wal-Mart’s 3.18% net profit margin is twice as much as Kmart’s
(1.54%), which lead to a major difference on return on assets (8.88% vs. 3.66%). Notice
that both have markup representing as low as 20 percent of retail prices, which is
relatively low and indicate that they are discount retailers and seek to make profit on
volume. However, Wal-Mart has a better control of operation cost, or gains from
economies of scale, which lead to a better net profit margin. This difference is multiplied
given financial leverage is used in business operations.
Notice the error message “#DIV/0!” in cell H16. It is due to a zero value shown in Kmart’s
account receivable. Due to its nature of business, the retailer generally does not carry a
significant amount of account receivable. For Kmart’s case, that account has a zero
balance, which results in an error message as the computer in executing the formula in
the cell is asked to do a division with a zero in the denominator. If another company has
non-zero value in its account receivable, then an appropriate number will appear in that
cell.
Overall, Wal-Mart is a solid company with better financial performance. The analysis
above is purely based on the presentation of financial statements. Additional information
will be needed to have a more thorough study of the firm. More information can be
further found from various sources, including the analyst report provided by Moody,
Standard and Poor, Business Week, and Fortune. Additional web sites where you may
find useful information are listed at the end of this case study.
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The printout of spread sheet “Source” from file “Tool-Analysis”
Look Up Company Information in the Website W
Step One
Click the Hyperlink button (the globe) to connect you
to Yahoo Finance-Company Search =>
Step Two
Type the company's name in the search box and click Search
Step Three
If the search result shows the company, click Quote to get the current
stock price information and general trend. Click the Back button.
Step Four
Click Profile to get the company's brief information.
Step Five
Click Historical Quote Data to get the past stock price data. You may
specify the period, and daily or weekly or monthly of the data required,
and then click Get Historical Data. Click the Back button.
Step Six
Click Raw SEC Filings and 10K file to get the company's 10-K report
filed with SEC, which includes all the financial statements.
Remark
Any time, you may click File, Save As command to save the data in a
separate file. You may also copy part of text and/or data to another
file by moving the cursor to the start of the paragraph, holding the
left mouse button, dragging the selection to the end of the paragraph,
releasing the button, click Edit, Copy, and making the file which you
intend to copy to an active file and click Edit, Paste.
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The printout of spreadsheet “Report” from file “Tool-Analysis”
A comparative analysis for fiscal year of 1988
Comparative Balance Sheets
Kmart
Comparative Income
Statements
Wal-Mart
ASSETS
Cash
Receivables
Inventory
Other C. Assets
Total C. Assets
710
0
6,536
584
7,830
1879
1118
17076
1059
21132
Net Plant+Equipmt
Other Assets
5,914
422
23674
5190
14,166
49996
Total Assets
LIABILITIES
C-Liabilities
L/T Liabilities
Total Liabilities
3,691
4,496
8,187
16762
12122
28884
Total Revenue
Cost of Goods Sold
Profit Margin
Kmart
Wal-Mart
33,674 139208
26,319 108725
7,355
30483
EXPENSES
Operating Expenses
Other Expenses
Interest Expenses
Other Fixed Charges
Total Expenses
6,245
19
293
0
6,557
22363
0
529
268
23160
Income before Taxes
798
7323
Income Taxes
Other Interests
230
50
2740
153
Net Income
518
4430
EQUITY
Stockholders' Equity
5,979
21112
Total Liability+Equity
14,166
49996
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The printout of spreadsheet “Ratios” from file “Tool-Analysis”
Ratio Analysis
1
2
LIQUIDITY RATIOS
Current Ratio = Current Assets/Current Liability
Quick Ratio = (C. Assets - Inventory)/C. Liabilities
3
4
5
LEVERAGE RATIOS
Debt to assets ratio = Total debts/Total assets
Debt to equity ratio = Total debt/Total equity
Fixed Charge Covd =(Income bf Tax+Interst+Lease)/Int+Lease
6
7
8
9
ACTIVITY RATIOS
Inventory turnover = Sales/Inventory
Total assets turnover = Sales/Total assets
Fixed assets turnover = Sales/Fixed assets
Account receivable turnover = Sales/Acct Receivable
10
11
12
13
PROFITABILITY RATIOS
Gross profit margin = (Sales - Cost of goods sold)/Sales
Net profit margin = Net income/Sales
Return on total assets = Net income/Total assets
Return on stockholders equity = Net income/equity
Kmart
Wal-Mart
2.121
1.261
0.351
0.242
0.58
1.37
3.72
0.58
1.37
10.19
5.15
2.38
5.31
#DIV/0!
8.15
2.78
4.82
124.52
21.84%
1.54%
3.66%
8.66%
21.90%
3.18%
8.86%
20.98%
Du Pont Analysis
Return on Assets =
3.66%
8.86%
Net Profit Margin
=
1.54%
=
3.18%
8.66%
20.98%
Return on Assets
=
3.66%
=
8.86%
Kmart
Wal-Mart
Return on Equity =
Kmart
Wal-Mart
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X
X
X
Assets Turnover
2.377
2.784
X ( 1 + Debt-Equity Ratio )
X
2.369
X
2.368
15
Additional Websites:
http://www.pathfinder.com/fortune/fortune500/
http://www.moodys.com/
http://www.nytimes.com/library/financial/glossary/bfglosa.htm
http://wal-mart.com
http://www.kmart.com
http://dir.yahoo.com/Business_and_Economy/Companies/Retailers/Wal_Mart_Stores__Inc_/
http://www.spglobal.com/index.html
http://biz.yahoo.com/fin/l/w/wmt.html
http://www.wsrn.com/
http://www.lib.umich.edu/libhome/Documents.center/stecind.html
http://www.rpi.edu/~holmec/finrat.html#under
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Additional Problems:
1.
2.
Research Problem
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