Conduct a Financial assessment on a typical organization of your choice. Attempt to obtain a copy of their balance sheet, income statement, and any other pertinent information you can obtain. If obtaining the information becomes a difficult challenge, t

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Foundations of Finance

Tenth Edition

Chapter 4

Evaluating a Firm’s Financial Performance

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Learning Objectives

4.1 Explain the purpose and importance of financial analysis.

4.2 Calculate and use a comprehensive set of measurements to evaluate a company’s performance.

4.3 Describe the limitations of financial ratio analysis.

The Purpose of Financial Analysis

Financial analysis using ratios

A popular way to analyze the financial statements is by computing ratios. A ratio is a relationship between two numbers, e.g., a given ratio of A:B = 30:10 means A is 3 times B.

A ratio by itself may have no meaning. Hence, a given ratio is compared to

ratios from previous years

ratios of other firms or leaders in the same industry

See Figure 4.1 for a financial analysis example.

Figure 4.1 Financial Statement Data by Industry Norms for Software Publishers

Uses of Financial Ratios: Within the Firm (1 of 3)

Identify deficiencies in a firm’s performance and take corrective action.

Evaluate employee performance and determine incentive compensation.

Compare the financial performance of the firm’s different divisions.

Uses of Financial Ratios: Within the Firm (2 of 3)

Prepare, at both firm and division levels, financial projections.

Understand the financial performance of the firm’s competitors.

Evaluate the financial condition of a major supplier.

Uses of Financial Ratios: Within the Firm (3 of 3)

Financial ratios are used by

Lenders in deciding whether or not to lend to a company.

Credit-rating agencies in determining a firm’s credit worthiness.

Investors (shareholders and bondholders) in deciding whether or not to invest in a company.

Major suppliers in deciding to whether or not to extend credit to a company or in designing the specific credit terms.

Measuring Key Financial Relationships

Question 1: How Liquid Is the Firm? Can It Pay Its Bills?

A liquid asset is one that can be converted quickly and routinely into cash at the current market price.

Liquidity measures the firm’s ability to pay its bills on time. It indicates the ease with which noncash assets can be converted to cash to meet the financial obligations.

How Liquid Is the Firm?

Liquidity is measured by two approaches:

Comparing the firm’s current assets and current liabilities

Examining the firm’s ability to convert accounts receivables and inventory into cash on a timely basis

Measuring Liquidity: Perspective 1

Compare a firm’s current assets with current liabilities using:

Current Ratio

Acid Test or Quick Ratio

Table 4.1 Walmart Income Statement for the Year Ending January 31, 2018 (expressed in millions, except per share data) (1 of 2)

Sales	$ 500,343
Cost of goods sold	(373,396)
Gross profit	$ 126,947
Operating expenses:	Blank
Selling, general and administrative expenses	$ (95,981)
Depreciation expenses	(10,529)
Total operating expenses	$(106,510)
Operating income (earning before interest and taxes)	$ 20,437
Interest expense	(2,178)
Non-operating losses	(3,136)
Earnings before taxes (taxable income)	$ 15,123
Income taxes	(5,261)
Net income (earnings available to common shareholders)	$ 9,862

Table 4.1 Walmart Income Statement for the Year Ending January 31, 2018 (expressed in millions, except per share data) (2 of 2)

Additional information:	Blank
Number of shares outstanding (millions)	3,007
Earnings per share	$ 3.28
Dividends paid to stockholders	$ 6,124
Dividends per share	$ 2.04

Table 4.2 Walmart’s Balance Sheet for the Year Ending January 31, 2018 (expressed in millions) (1 of 2)

Cash and cash equivalents	$ 6,756
Accounts receivable	5,614
Inventories	43,783
Prepaid expenses and other current assets	3,511
Total current assets	$ 59,664
Gross plant and equipment	$202,298
Less accumulated depreciation	(87,480)
Net plant and equipment	$114,818
Goodwill and other intangible assets	30,040
Total assets	$ 204,522

Table 4.2 Walmart’s Balance Sheet for the Year Ending January 31, 2018 (expressed in millions) (2 of 2)

Liabilities and Equity	Blank
Accounts payable	$ 46,510
Accrued liabilities	24,031
Short-term notes	9,662
Total current liabilities	$ 80,203
Long-term debt	45,179
Total debt	$125,382
Stockholders' equity	Blank
Common stock (par value)	$ 295
Paid-in capital	2,648
Retained earnings	76,197
Total equity	$ 79,140
Total liabilities and equity	$ 204,522

Current Ratio

Current ratio compares a firm’s current assets to its current liabilities.

Walmart has $0.74 in current assets for every $1 in current liabilities. Walmart’s liquidity is slightly less than that of Target, which has a current ratio of 0.95.

Acid Test or Quick Ratio

Quick ratio compares cash and current assets (minus inventory) that can be converted into cash during the year with the liabilities that should be paid within the year.

Walmart has 15 cents in quick assets for every $1 in current debt. Walmart is slightly less liquid than Target, which has 20 cents for every $1 in current debt.

Measuring Liquidity: Perspective 2

Measures a firm’s ability to convert accounts receivable and inventory into cash:

Days in Receivables or Average Collection Period

Inventory Turnover

Days in Receivables (Average Collection Period)

How long does it take to collect the firm’s receivables?

Walmart (at 10.24 days) is slightly slower than Target (at 9.56 days) in collecting accounts receivable.

Accounts Receivable Turnover

How many times are the accounts receivable “rolled-over” each year?

The conclusion is the same — Walmart (35.65X) is slightly slower than Target (38X) in collecting accounts receivable.

Days in Inventory

How long is the inventory held before being sold?

Walmart carries inventory for a shorter time (42.80 days) than Target (61.81 days).

Inventory Turnover

How many times are the firm’s inventories sold and replaced during the year?

The conclusion is the same—Walmart moves inventory much quicker (8.53X) than Target (5.91X).

Question 2: Are the Firm’s Managers Generating Adequate Operating Profits from the Company’s Assets?

This question focuses on the profitability of the assets in which the firm has invested. We consider the following ratios to answer the question:

Operating Return on Assets

Operating Profit Margin

Total Asset Turnover

Fixed Assets Turnover

Figure 4.2 Walmart Operating Profits Resulting from Asset Investments

Operating Return on Assets (ORA)

O R A indicates the level of operating profits relative to the firm’s total assets.

Thus Walmart managers are generating 10 cents of operating profit for every $1 of assets, which is less than Target (11.1%).

Disaggregation of Operating Return on Assets

Calculated as follows:

Managing Operations: Operating Profit Margin (O P M)

O P M examines how effective the company is in managing its cost of goods sold and operating expenses that determine the operating profit.

Target managers are better than Walmart in managing the cost of goods sold and operating expenses, as the Operating Profit Margin for Target is 6.0% compared to Walmart at 4.1%.

Managing Assets: Total Asset Turnover

This ratio measures how efficiently a firm is using its assets in generating sales.

Walmart is generating $2.45 cents in sales for every $1 invested in assets, which is higher than Target (1.84X).

Managing Assets: Fixed Asset Turnover

Examines efficiency in generating sales from investment in “fixed assets.”

Walmart generates $4.36 in sales for every $1 invested in fixed assets, which is much higher than Target (2.87X).

Figure 4.3 Analysis of Walmart’s Operating Return on Assets

Question 3: How Is the Firm Financing Its Assets?

Here we examine the question: Does the firm finance its assets by debt or equity or both? We use the following two ratios to answer the question:

Debt Ratio

Times Interest Earned

Debt Ratio

This ratio indicates the percentage of the firm’s assets that are financed by debt (implying that the balance is financed by equity).

Walmart finances 61% of its assets by debt and 39% by equity compared to Target financing 70% of its assets by debt.

Times Interest Earned (1 of 2)

This ratio indicates the amount of operating income available to service interest payments.

Walmart’s operating income is 9 times the annual interest expense and higher than Target (6.47X) due to its relatively higher operating profits.

Times Interest Earned (2 of 2)

Note

Interest is not paid with income but with cash.

Oftentimes, firms are required to repay part of the principal annually.

Thus, times interest earned is only a crude measure of the firm’s capacity to service its debt.

Question 4: Are the Firm’s Managers Providing a Good Return on the Capital Provided by the Company’s Shareholders?

This is analyzed by computing the firm’s accounting return on common stockholder’s investment or return on equity (R O E).

Note: Common equity includes both common stock and retained earnings.

Return On Equity (ROE)

Owners of Walmart are receiving a 12.5% return compared to Target’s 25%.

One of the reasons for lower ROE is the lower operating return on assets (10.0% for Walmart v. 11.1% for Target).

A lower return on the firm’s assets will always result in a lower return on equity and vice versa.

Also, Walmart uses less debt (61% for Walmart v. 70% for Target).

Higher debt translates to higher ROE under favorable business conditions.

Figure 4.4 Return on Equity Relationships for the Walmart Company

Question 5: Are the Firm’s Managers Creating Shareholder Value?

We can use two approaches to answer this question:

Market value ratios (P/E)

Economic Value Added (E V A)

These ratios indicate what investors think of management’s past performance and future prospects.

Price/Earnings Ratio

Measures how much investors are willing to pay for $1 of reported earnings.

Investors are willing pay more for Walmart for every dollar of earnings per share compared to Target ($26.22 for Walmart versus $14.07 for Target).

Price/Book Ratio

Compares the market value of a share of stock to the book value per share of the reported equity on the balance sheet.

A ratio greater than 1 indicates that the shares are more valuable than what the shareholders originally paid. The Walmart ratio of 3.27X is lower than Target ratio of 3.53X, suggesting that Target is perceived as having better growth prospects relative to its risk.

Summary of Ratios