Chapter 17 Financial Statement Analysis

Topics Covered  Financial Ratios  DuPont System  Using Financial ratios  Measuring Company Performance  The Role of Financial Ratios

Ratio Analysis  Examines firm’s management of various facets of the company’s business through its financial statements.  Scales balance sheet and income statement information for easy comparison across time or to other companies.

Two common approaches  Trend Analysis - looks at changes in one company’s ratios over time.  Comparison or Industry Analysis - compares company’s ratios against a similar company or against industry- wide ratios.  We will look at both with Coca-Cola and Pepsi.

Areas Examined by Ratio Analysis  Leverage - measures the use of financial leverage (debt) and its impact  Liquidity - measures the ability to meet short-term obligations  Efficiency - measures the ability to contain the growth of assets, and the ability to effectly utilize assets  Profitability - measures the profitability of various segments of a company

Leverage Ratios

Leverage Ratios calculation notes for Target & Wal-Mart  Given our Financial Statement (B/S and I/S) formatting from OneSource/Multitex: Long-term debt = Total long-term debt from the B/S, which includes long-term borrowing and capital lease obligations. Equity = Total Equity from B/S EBIT = Operating income + Interest Expense from I/S Depreciation expense was listed on Target’s I/S, but had to find Wal-Mart’s depreciation by the annual change in accumulated depreciation from B/S.

Target & Walmart’s Leverage Ratios Target Long-term debt ratio Debt-equity ratio Total debt ratio Times interest Earned Cash coverage ratio Walmart Long-term debt ratio Debt-equity ratio Total debt ratio Times interest Earned Cash coverage ratio

Best Leverage Management?

Liquidity Ratios

Liquidity Ratios calculation notes for Target & Wal-Mart  Given our Financial Statement (B/S and I/S) formatting from OneSource/Multitex: Net working capital = total current assets – total current liabilities Cash and marketable securities are in one account (cash and short-term investments)

Target & Walmart’s Liquidity Ratios Target NWC to assets Current ratio Quick ratio Cash ratio Walmart NWC to assets Current ratio Quick ratio Cash ratio

Best Liquidity Management?

Efficiency Ratios

Efficiency Ratios calculation notes for Target & Wal-Mart  Given our Financial Statement (B/S and I/S) formatting from OneSource/Multitex: Sales = Total Revenue from I/S Cost of Goods Sold = Cost of Revenue, Total from I/S Average “whatever asset” = (beginning+ ending amounts from B/S)/2 Average Daily Sales or Cost of Goods Sold = Amount form I/S divided by 365

Target & Walmart’s Efficiency Ratios Target Total asset turnover Average collection period Inventory turnover Days' sales in inventories Walmart Total asset turnover Average collection period Inventory turnover Days' sales in inventories

Best Efficiency Management?

Profitability Ratios

Profitability Ratios calculation notes for Target & Wal-Mart  Given our Financial Statement (B/S and I/S) formatting from OneSource/Multitex: Dividend information listed below the I/S: Gross dividends = total annual dividends. Also can find EPS and Dividends per share here. Earnings = Net Income from I/S

Target & Walmart’s Profitability Ratios Target Net profit margin3.8%3.4% Operating profit margin5.1%4.6% Return on assets8.5%8.4%9.2%9.4% Return on equity19.1%19.0%20.4% Payout ratio13.2%14.8%15.3%16.7% Plowback ratio86.8%85.2%84.7%83.3% Growth in equity from plowback16.6%16.2%17.3%17.0% Walmart Net profit margin3.3%3.0%3.3%3.2% Operating profit margin3.6% 3.9%3.8% Return on assets10.1%9.7%10.1%10.6% Return on equity21.6%20.1%22.0%22.9% Payout ratio16.5%18.7%17.0%16.6% Plowback ratio83.5%81.3%83.0%83.4% Growth in equity from plowback18.0%16.3%18.3%19.1%

Best Profitability Management?

The DuPont System  A breakdown of ROE and ROA into component ratios

The DuPont System asset turnover Operating profit margin

The DuPont System leverage ratio asset turnover Operating profit margin debt burden

The DuPont System: Simplification of ROE  The last two terms of the 4-part DuPont equation for ROE, operating profit margin and debt burden, can be simplified to one term, net profit margin.  Net profit margin = Net Income/Sales  Also assets/equity can be written in terms of the total debt ratio.

Target vs. Walmart Du Pont System Target Asset turnover Operating profit margin5.1%4.6% ROA8.5%8.4%9.2%9.4% Leverage ratio Asset turnover Operating profit margin5.1%4.6% Debt burden ROE19.1%19.0%20.4% Walmart Asset turnover Operating profit margin3.6% 3.9%3.8% ROA10.1%9.7%10.1%10.6% Leverage ratio Asset turnover Operating profit margin3.6% 3.9%3.8% Debt burden ROE21.6%20.1%22.0%22.9%

Final Du Pont System comments  When a firm uses no debt financing, the leverage term = 1 and ROE = ROA.  Using more financial leverage will increase ROE when the return on new assets (investment) exceeds the interest rate on the new debt.

MVA & Economic Profit A gauge of how much value management added for the year. Depends upon managerial decisions and stock market forces. Market Value Added = The difference between the market value of common stock and its book value

MVA for Target and Wal-Mart Target Wal- Mart Stock Price Stock Price # of Shares # of Shares MV of Equity MV of Equity 209,026264,375249,873 Total BV Eq Total BV Eq MVA 16,07730,91026,080 MVA 169,689229,273218,530 MV/BV MV/BV

Residual Income & EVA Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital. Residual Income or EVA = Net Dollar return after deducting the cost of capital © EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

EVA for Target and Wal-Mart  From Stern-Stewart ( EVA/MVA ranking in millions of dollars.  Target 2002 EVA: MVA rank: EVA: MVA rank: 92  Wal-Mart 2002 EVA: 2, MVA rank: EVA: 2, MVA rank: 6