Chapter 3: Evaluating
Financial Performance
Kmart vs. Wal-Mart
Objectives
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

Calculate financial ratios to evaluate the
financial health of a company.
Apply DuPont analysis in evaluating a
firm’s financial performance.
Explain the limitations of ratio analysis.
Relevant Principles

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Principle 7: Agency relationships, managers
won’t 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 won’t
take more risk unless we expect higher returns.
How to use Financial Ratios?
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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
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How liquid is the firm?
Is management generating adequate
operating profits on the firm’s 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

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Accounts Receivable/(Sales/365)
Accounts Receivable Turnover = (Credit)
Sales/Accounts Receivable
Inventory Turnover = Cost of Goods Sold/Inventory
Kmart and Wal-Mart’s 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
0
0
0
0
0
#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 firm’s assets?

Operating Return on Investment (OIROI)
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Operating Profit Margin = Operating Income/Sales
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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-Mart’s 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?
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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-Mart’s 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-Mart’s 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)
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Breaks down company performance into
operational and financing components.
ROE = (Net Profit Margin x Total Asset
Turnover)/(1-Debt Ratio), where
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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-Mart’s 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

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Different Accounting Practices.
Sometimes hard to pick an industry for
comparison.
Seasonality in Operations.