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Introduction to FA-3909 and Problem Set #1: CASE STUDY: Ratio ...

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Introduction to FA-3909 and Problem Set #1: CASE STUDY: Ratio ...

1. 1. 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.
2. 2. 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 Current . Assets 1. Current ratio 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. Current . Assets − Inventory 2. Quick ratio 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 Total. Debts 3. Debt to assets ratio Total. Assets An indication of the extent to which the business is financed by the borrowed funds. Total. Debts 4. Debt to equity ratio Owner ' s. Equity An alternative measure of the firm’s debt using, comparing the fund financed by debts and that provided by the owner. Income. before. Taxes + Interest 5. Time interest earned Interest . Ch arg es Case Study: Ratio Analysis by Scott Liu version 06/02/10 2
3. 3. 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. Income. before. Taxes.& . Interest + Lease 6. Fixed charge coverage 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 Sales 7. Inventory turnover Inventory Based on a comparison with the industry average, it shows whether the firm has excess inventory stock or inadequate inventory. Sales 8. Total asset turnover Total. Assets It shows the relation between sales and the assets employed to generate the sales, which measures the efficiency of business operations. Sales 9. Account receivable turnover 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 Sales − Cost . of . Goods. Sold 10. Gross profit margin Sales A measure of the margin to cover operation costs and yield profits. Net . Income 11. Net profit margin Sales Reflecting the profit per dollar of sales. Case Study: Ratio Analysis by Scott Liu version 06/02/10 3
4. 4. Net . Income 12. Return on total assets Total. Assets A measure of the profit generated from each dollar of fund employed for business operations. Net . Income 13. Return on equity Owner ' s. 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 Net . Income × = . Sales Total. Assets Total. Assets Consequently, Net profit margin × Total asset turnover = Return on assets. Furthermore, Net . Income Total. Debts Net . Income × (1 + ) = . Total. Assets Owner ' s. Equity Owner ' s. Equity In other words, Return on Assets × ( 1 + Debt-Equity Ratio) = Return on Equity. Case Study: Ratio Analysis by Scott Liu version 06/02/10 4
5. 5. 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 1997 Revenues 119,299 106,178 Costs and Expenses: Cost of sales 93,438 83,510 Operating, selling and admin expenses 9,358 16,946 Interest Costs: Debt 555 629 Capital leases 229 216 Total Costs and Expenses 113,580 101,301 Income Before Income Taxes 5,719 4,877 Provision for Income Taxes 2,115 1,794 Net Income \$ 3,582 \$ 3,110 ______________________________________________________________________________ Case Study: Ratio Analysis by Scott Liu version 06/02/10 5
6. 6. 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 \$ 1,447 \$ 883 Receivables 976 845 Inventories 16,497 15,897 Prepaid expenses and other 432 368 Total Current Assets 19,352 17,993 Property, Plant and Equipment, net 21,469 18,333 Property under Capital Lease, net 2,137 1,991 Other Assets and Deferred Charges 2,426 1,287 Total Assets \$45,384 \$39,604 Liabilities and Shareholders' Equity Current Liabilities: Total Current Liabilities 14,460 10,957 Long-Term Debt 7,191 7,709 Long-Term Obligations Under Capital Leases 2,483 2,307 Deferred Income Taxes and Other 809 463 Minority Interest 1,938 1,025 Total Long-term Liabilities 12,421 11,504 Shareholders' Equity Common stock (\$.10 par value; 2,241 and 2,285 issued and outstanding in 1998 and 1997) 224 228 Capital in excess of par value 585 547 Retained earnings 18,167 16,768 Foreign currency translation adjustment (473) (400) Total Shareholders' Equity 18,503 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. Case Study: Ratio Analysis by Scott Liu version 06/02/10 6
7. 7. A B C D E F 1 Wal-Mart Stores, Inc. 2 CONSOLIDATED INCOME STATEMENTS 3 (Amounts in millions except per share data) 4 Fiscal years ended January 31, 1998 1997 5 Revenues 119,299 106,178 6 Costs and Expenses: 7 Cost of sales 93,438 83,510 8 Operating, selling and admin expenses 9,358 16,946 9 Interest Costs: 10 Debt 555 629 11 Capital leases 229 216 12 Total Costs and Expenses 113,580 101,301 13 Income Before Income Taxes 5,719 4,877 14 Provision for Income Taxes 2,115 1,794 15 Net Income \$3,582 \$3,110 16 17 Wal-Mart Stores, Inc. 18 CONSOLIDATED BALANCE SHEETS 19 (Amounts in millions) 20 January 31, 1998 1997 21 Assets 22 Current Assets: 23 Cash and cash equivalents \$1,447 \$883 24 Receivables 976 845 25 Inventories 16,497 15,897 26 Prepaid expenses and other 432 368 27 Total Current Assets 19,352 17,993 28 Property, Plant and Equipment, net 21,469 18,333 29 Property under Capital Lease, net 2,137 1,991 30 Other Assets and Deferred Charges 2,426 1,287 31 Total Assets \$45,384 \$39,604 32 33 Liabilities and Shareholders' Equity 34 Total Current Liabilities 14,460 10,957 35 Long-term Debt 7,191 7,709 36 Long-term Obligations Under Capital Leases 2,483 2,307 37 Deferred Income Taxes and Other 809 463 38 Minority Interest 1,938 1,025 39 Total Long-term Liabilities 12,421 11,504 40 Shareholders' Equity: 41 Common Stocks 224 228 42 Capital in excess of par value 585 547 43 Retained earnings 18,167 16,768 44 Foreign currency translation adjustment -473 -400 45 Total Shareholders' Equity 18,503 17,143 46 Total Liabilities and Shareholders' Equity \$45,384 \$39,604 Case Study: Ratio Analysis by Scott Liu version 06/02/10 7
8. 8. 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 HI I 1 2 Major Ratios 3 Liquidity Ratios 1998 1997 4 Current Ratio 1.34 1.64 5 Quick Ratio 0.20 0.19 6 7 Leverage Ratios 8 Debts-Asset Ratio 0.59 0.57 9 Debts-Equity Ratio 1.45 1.31 10 Time Interest Covered 11.30 8.75 11 Fixed Charge Covered 8.29 6.77 12 13 Activity Ratios 14 Inventory Turnover 7.23 6.68 15 Assets Turnover 2.63 2.68 16 A/R Turnover 122.23 125.65 17 18 Profitability Ratios 19 Gross Profit Margin 21.68% 21.35% 20 Net Profit Margin 3.00% 2.93% 21 Return on Assets 7.89% 7.85% 22 Return on Equity 19.36% 18.14% 23 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. Case Study: Ratio Analysis by Scott Liu version 06/02/10 8
9. 9. 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 E F G H I J 26 Du Pont Analysis 27 28 Return on Asset = N Profit Margin X Assets Turnover 29 1997 7.89% = 3.00% X 2.63 30 1996 7.85% = 2.93% X 2.68 31 32 Return on Equity = Return on Asset X (1 + Debt-Equity Ratio) 33 1997 19.36% = 7.89% X 2.45 34 1996 18.14% = 7.85% X 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. Case Study: Ratio Analysis by Scott Liu version 06/02/10 9