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

  • 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 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
  • 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
  • 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
  • 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
  • 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
  • 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
  • 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
  • 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
  • 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 $ 33,674 $ 139,208 Cost of good sold 2 6,319 108,725 Gross margin 7,355 30,483 Selling, general and admin expenses 6,245 22,363 Other expenses 19 0 Interest expense 293 529 Other fixed charges 0 268 Income before taxes 4798 7323 Taxes 230 2740 Others 50 153 Net income $ 518 $ 4,430 Case Study: Ratio Analysis by Scott Liu version 06/02/10 10
  • 1998 Balance Sheet (Amount in million) Kmart Wal-Mart Cash and equivalent 710 $ 1,879 Account Receivables 0 1,118 Inventory 6,536 17,076 Other current assets 584 0 Total current assets 7,830 21,132 Property and equipment, net 5914 23,674 Other fixed assets 422 5,190 Total Assets $ 14,166 $ 49,996 Current liabilities $ 3691 16,762 Long-term liabilities 1538 9,607 Other long-term obligations 2958 2,515 Shareholders’ equity 5979 21,112 Total Liabilities and Shareholders’ Equity $ 14,166 $ 49,996 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. Case Study: Ratio Analysis by Scott Liu version 06/02/10 11
  • 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. Case Study: Ratio Analysis by Scott Liu version 06/02/10 12
  • 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. Case Study: Ratio Analysis by Scott Liu version 06/02/10 13
  • The printout of spreadsheet “Report” from file “Tool-Analysis” A comparative analysis for fiscal year of 1988 Comparative Balance Sheets Comparative Income Statements Kmart Wal-Mart Kmart Wal-Mart ASSETS Total Revenue 33,674 139208 Cash 710 1879 Cost of Goods Sold 26,319 108725 Receivables 0 1118 Profit Margin 7,355 30483 Inventory 6,536 17076 Other C. Assets 584 1059 EXPENSES Total C. Assets 7,830 21132 Operating Expenses 6,245 22363 Other Expenses 19 0 Net Plant+Equipmt 5,914 23674 Interest Expenses 293 529 Other Assets 422 5190 Other Fixed Charges 0 268 Total Expenses 6,557 23160 Total Assets 14,166 49996 Income before Taxes 798 7323 LIABILITIES C-Liabilities 3,691 16762 Income Taxes 230 2740 L/T Liabilities 4,496 12122 Other Interests 50 153 Total Liabilities 8,187 28884 Net Income 518 4430 EQUITY Stockholders' Equity 5,979 21112 Total Liability+Equity 14,166 49996 Case Study: Ratio Analysis by Scott Liu version 06/02/10 14
  • The printout of spreadsheet “Ratios” from file “Tool-Analysis” Ratio Analysis LIQUIDITY RATIOS Kmart Wal-Mart 1 Current Ratio = Current Assets/Current Liability 2.121 1.261 2 Quick Ratio = (C. Assets - Inventory)/C. Liabilities 0.351 0.242 LEVERAGE RATIOS 3 Debt to assets ratio = Total debts/Total assets 0.58 0.58 4 Debt to equity ratio = Total debt/Total equity 1.37 1.37 5 Fixed Charge Covd =(Income bf Tax+Interst+Lease)/Int+Lease 3.72 10.19 ACTIVITY RATIOS 6 Inventory turnover = Sales/Inventory 5.15 8.15 7 Total assets turnover = Sales/Total assets 2.38 2.78 8 Fixed assets turnover = Sales/Fixed assets 5.31 4.82 9 Account receivable turnover = Sales/Acct Receivable #DIV/0! 124.52 PROFITABILITY RATIOS 10 Gross profit margin = (Sales - Cost of goods sold)/Sales 21.84% 21.90% 11 Net profit margin = Net income/Sales 1.54% 3.18% 12 Return on total assets = Net income/Total assets 3.66% 8.86% 13 Return on stockholders equity = Net income/equity 8.66% 20.98% Du Pont Analysis Return on Assets = Net Profit Margin X Assets Turnover Kmart 3.66% = 1.54% X 2.377 Wal-Mart 8.86% = 3.18% X 2.784 Return on Equity = Return on Assets X ( 1 + Debt-Equity Ratio ) Kmart 8.66% = 3.66% X 2.369 Wal-Mart 20.98% = 8.86% X 2.368 Case Study: Ratio Analysis by Scott Liu version 06/02/10 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 Case Study: Ratio Analysis by Scott Liu version 06/02/10 16
  • Additional Problems: 1. 2. Research Problem Case Study: Ratio Analysis by Scott Liu version 06/02/10 17