Using ratio analysis to evaluate Financial PerformancePresentation Transcript
Using ratio analysis to evaluate financialperformance21st FEBRUARY 2013Authoring Faculty: Wilbert Frank. MBA (Certified Hotel Administrator)Sponsoring School: International Hospitality Academy (IHA)Total Learning Time: 3 to 4 Hours
Course FocusDescriptionSuccess in business depends first on anorganization’s ability to analyze its financialstanding. By carefully analyzing financialperformance, an organization can identifyopportunities and make adjustments to improveperformance at the department, unit, ororganizational level.In this course, you will learn to use several ratio-analysis instruments to assess financial performanceso that the organization can then design andimplement initiatives for increased productivity andprofitabilityCourse ObjectivesCalculate financial ratios to evaluate the financialhealth of a company.Apply DuPont analysis in evaluating a firm’s financialperformance.Explain the limitations of ratio analysis.
Relevant PrinciplesPrinciple 7: Agency relationships,managers won’t work for the ownersunless its in their best interest to do so.Principle 5: Competitive markets makeit hard to find exceptionally profitableinvestments.Principle 1: The risk-return trade-off – wewon’t take more risk unless we expecthigher returns.
How to use Financial Ratios?Compare across time for an individual firm. TrendAnalysis.Compare to an industry average. Industry Analysis.Compare to a dominant competitor in the sameindustry. 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 RatioAnalysis1. How liquid is the firm?2. Is management generatingadequate operating profits on thefirm’s assets?3. How is the firm financing its assets?4. Are the stockholders receiving anadequate return on theirinvestment?
How liquid is the firm?• Measuring Liquidity Approach 1: comparingliquid assets to short-term debt.• Current Ratio = Current Assets/CurrentLiabilities• Acid-test Ratio = (Current Assets –Inventory)/Current Liabilities
How liquid is the firm?• Measuring Liquidity Approach 2: How easily canother current assets be converted into cash.– Average Collection Period = Accounts Receivable/Daily(Credit) Sales• Accounts Receivable/(Sales/365)– Accounts Receivable Turnover = (Credit) Sales/AccountsReceivable– Inventory Turnover = Cost of Goods Sold/Inventory
Kmart and Wal-Mart’s Liquidity RatiosQuestion 1: How Liquid is the Firm?Approach 1: 2001 2000 1999 1998 1997Current Ratio 2.01 2.00 2.12 2.28 2.15Acid-test (Quick) Ratio 0.32 0.26 0.35 0.34 0.38Approach 2:Average Collection Period 0 0 0 0 0Accounts Receivable Turnover #DIV/0! #DIV/0! #DIV/0! #DIV/0! #DIV/0!Inventory Turnover 4.63 3.96 4.03 3.95 3.84Question 1: How Liquid is the Firm?Approach 1: 2001 2000 1999 1998 1997Current Ratio 0.92 0.94 1.26 1.34 1.64Acid-test (Quick) Ratio 0.18 0.18 0.24 0.20 0.19Approach 2:Average Collection Period 3.34 2.93 2.93 2.99 2.90Accounts Receivable Turnover 109.33 124.39 124.52 122.23 125.65Inventory Turnover 7.01 6.55 6.37 5.66 5.25KmartWal-Mart
Is management generating adequateoperating profits on the firm’s assets?•Operating Return on Investment(OIROI)–Operating Income/Total Assets,also:–Operating Profit Margin x TotalAsset Turnover•Operating Profit Margin = OperatingIncome/Sales–Operating Income = Pre-TaxIncome plus interest expense, orPre-tax income minus interest, non-op•Total Asset Turnover = Sales/TotalAssets–Affected by Accounts ReceivableTurnover, Inventory Turnover, FixedAsset Turnover–Fixed Asset Turnover = Sales/NetFixed Assets; Net Fixed Assets =Property, Plant, Equip, NET
How is the firm financing its assets?• Debt Ratio = Total Liabilities/TotalAssets• Times-Interest-Earned =Operating Income/InterestExpense– Operating Income = Pre-TaxIncome plus interest expense,or Pre-tax income minusinterest, non-op
Kmart & Wal-Mart’s Financing RatiosQuestion 3: How is the Firm Financing Its Assets?2001 2000 1999 1998 1997Debt Ratio 58.4% 58.3% 57.8% 52.7% 57.5%Times-Interest-Earned Ratio -0.16 4.64 3.72 2.15 1.73Question 3: How is the Firm Financing Its Assets?2001 2000 1999 1998 1997Debt Ratio 59.9% 63.3% 57.8% 59.2% 56.7%Times-Interest-Earned Ratio 8.36 9.89 10.19 8.29 6.77KmartWal-Mart
Are the stockholders receiving an adequatereturn on their investment? Return On Common Equity Net Income Available to Common Stockholders(includingEI&DO)/Total Common Equity Total Common Equity = Total Shareholders’ Equity – PreferredStock
Kmart & Wal-Mart’s Return on EquityQuestion 4: Are the Owners Receiving an Adequate Return on Their Investment?2001 2000 1999 1998 1997Return on Common Equity -3.8% 6.4% 8.7% 4.6% -4.3%Question 4: Are the Owners Receiving an Adequate Return on Their Investment?2001 2000 1999 1998 1997Return on Common Equity 20.1% 20.8% 21.0% 19.1% 17.8%KmartWal-Mart
DuPont Analysis of Return on CommonEquity (ROE)• Breaks down companyperformance into operational andfinancing components.• ROE = (Net Profit Margin x TotalAsset Turnover)/(1-Debt Ratio),where– Net Profit Margin = NetIncome(available to commonstockholders includingEI&DO)/Sales– Total Asset Turnover = Sales/TotalAssets– Debt Ratio = TotalLiabilities/Total Assets• Net Profit Margin x Total AssetTurnover = Return on Assets, whichare the operating components.• 1/(1-Debt Ratio) = measures impactof financial leverage
How does Leverage work?• Suppose we have an all equity-financedfirm worth $100,000. Its earnings thisyear total $15,000.ROE =(ignore taxes for this example)
How does Leverage work?• Suppose we have an all equity-financedfirm worth $100,000. Its earnings thisyear total $15,000.ROE = =15%15,000100,000
How does Leverage work?• Suppose the same $100,000 firm isfinanced with half equity, and half 8% debt(bonds). Earnings are still $15,000.ROE =
How does Leverage work?• Suppose the same $100,000 firm isfinanced with half equity, and half 8% debt(bonds). Earnings are still $15,000.ROE = =15,000 - 4,00050,000
How does Leverage work?• Suppose the same $100,000 firm isfinanced with half equity, and half 8% debt(bonds). Earnings are still $15,000.ROE = = 22%15,000 - 4,00050,000