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Interpretation of key figures in financial analysis

Term Paper 2008 34 Pages

Business economics - Accounting and Taxes

Excerpt

Table of Contents

Executive Summary

List of Tables

List of Abbreviations

1 Introduction

2 Examples from the Retail Industry
2.1 Wal-Mart Stores Inc
2.2 Target Corp

3 Key Figures in Financial Analysis
3.1 Leverage Ratios
3.1.1 Debt Ratio
3.1.2 Debt-Equity Ratio
3.1.3 Times-Interest-Earned
3.2 Liquidity Ratios
3.2.1 Current Ratio
3.2.2 Quick Ratio
3.2.3 Cash Ratio
3.3 Efficiency Ratios
3.3.1 Sales-To-Assets Ratio
3.3.2 Days in Inventory
3.3.3 Average Collection Period
3.4 Profitability Ratios
3.4.1 Net Profit Margin
3.4.2 Return on Assets (ROA)
3.4.3 Return on Equity (ROE)
3.4.4 Payout Ratio
3.5 The Dupont System

4 Conclusion

Bibliography

Appendices

Balance Sheet Wal-Mart Stores Inc

Income Statement Wal-Mart Stores Inc

Balance Sheet Target Corp

Income Statement Target Corp

ITM-Checklist

List of Tables

Table 1: Debt Ratios for Wal-Mart and Target

Table 2: Debt-Equity Ratios for Wal-Mart and Target

Table 3: Times-Interest-Earned Ratios for Wal-Mart and Target

Table 4: Current Ratios for Wal-Mart and Target

Table 5: Quick Ratios for Wal-Mart and Target

Table 6: Cash Ratios for Wal-Mart and Target

Table 7: Sales-To-Assets Ratios for Wal-Mart and Target

Table 8: Days in Inventory Ratios for Wal-Mart and Target

Table 9: Average Collection Periods for Wal-Mart and Target

Table 10: Net Profit Margins for Wal-Mart and Target

Table 11: Return on Assets for Wal-Mart and Target

Table 12: Return on Equity for Wal-Mart and Target

Table 13: Payout Ratios for Wal-Mart and Target

List of Abbreviations

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1 Introduction

In 2005, 2007 and 2008, Wal-Mart was the largest company worldwide as announced in the Fortune 500 global index, which is an annually created list of the 500 top-selling companies worldwide and published by the US economic Fortune magazine. Therefore, investors as well as creditors watch closely, how Wal-Mart is developing to either possibly anticipate future earnings or to limit risks when allowing credits respectively.

Financial ratios will help both, investors and creditors to evaluate and forecast Wal- Mart’s financial position and to ask the right questions to conclude the underlying factors driving ratios. Therefore, different financial ratios examining leverage, liquidity, efficiency and profitability will be presented in this paper applying them to Wal-Mart and confronting them to its most important competitor in the US, Target, which was ranked on place 31 in the Fortune 500 global index of in 2008 (Global 500, 2008). The financial ratios of both companies, Wal-Mart and Target are additionally confronted to ratios of the retail industry.

2 Examples from the Retail Industry

“The health of the US economy depends heavily on retail trade“ (Asaeda 2007), as in 2006, retail trade contributed 30 % of US gross domestic product (GDP) (Asaeda 2007). The retail industry combines different business models, amongst others discount stores, whose financial ratios will be regarded within this paper for the two most important companies Wal-Mart Stores Inc. and Target Corp. within this segment.

When giving industry comparisons within this paper, the ratios of Wal-Mart and Target are additionally confronted with the ratios of the retail industry. While ratios of Wal-Mart and Target have been calculated by the author from the financial statements of both companies that are furthermore added in the appendices, comparative values for the year 2005 from the retail industries have been extracted from Brealey et al. 2008, p. 801.

2.1 Wal-Mart Stores Inc.

Wal-Mart Stores Inc. was founded in 1945, is based in Bentonville, Arkansas and runs retail stores in a variety of formats worldwide. The company's segment offers general merchandise, including nondurable goods, like apparel, books, shoes, electronics, furnishings, small appliances, automotive accessories, cellular phones and cellular service plan contracts, pharmaceuticals, jewelry, and opticals as well as grocery merchandise and financial services and products, and photo processing services. It serves in supercenters, discount stores, and neighborhood markets in the United States, as well as through walmart.com. Its Sam's Club segment provides hardgoods, softgoods, institutional-size grocery items, and selected private-label items through warehouse membership clubs in the United States, as well as through samsclub.com (McGraw-Hill Companies, 2008).

The company's International segment includes various formats of retail stores and restaurants, including combination discount and grocery stores, supercenters, Sam's Clubs, hypermarkets, supermarkets, cash-n-carry stores, neighborhood markets, department stores, and general merchandise stores (McGraw-Hill Companies, 2008).

As of January 31, 2008, Wal-Mart operated 971 discount stores, 2,447 supercenters, 132 neighborhood markets, and 591 Sam's Clubs in the United States; and 21 units in Argentina, 313 in Brazil, 305 in Canada, 149 in Costa Rica, 70 in El Salvador, 145 in Guatemala, 47 in Honduras, 394 in Japan, 1,023 in Mexico, 46 in Nicaragua, 54 in Puerto Rico, and 352 in the United Kingdom, as well as 202 stores through joint ventures in China (McGraw-Hill Companies, 2008).

Therefore, Wal-Mart Stores Inc. has a huge share of the retailing business, not only in the US. It is the world’s largest retailer, engaged 2.1 million employees in 2008 (Schoewe 2008) and had domestic revenues from retail stores of $ 272.3 billion in the fiscal year ended January 2007, which made up about 2.1 % of US GDP (Asaeda 2007).

When being asked, Wal-Mart customers name low prices as the most important reason for shopping there, which reflects its advertisement slogan "Low prices, always" that was used from 1962 until 2006 (Barbaro 2007). Wal-Mart’s customer’s income lies with $ 35,000 below the US average. Analysts recently estimated that more than 20 % of Wal-Mart’s costumers do not have a bank account, which is twice the national rate (Thierney 2005).

2.2 Target Corp.

Target Corp., which was founded in 1902 and is headquartered in Minneapolis, Minnesota, employed 366,000 full-time employees in 2008 (Scovanner 2008) and operates large-format general merchandise and food discount stores under the brand names of `Target' and `SuperTarget' in the United States. The company's stores offer an assortment of general merchandise, including consumables and commodities; electronics, entertainment, sporting goods, and toys; apparel and accessories; and home furnishings and decor, as well as a line of food items. It also sells merchandise under private-label as well as licensed brands (McGraw-Hill Companies, 2008).

As of February 2, 2008, Target Corp. operated 1,381 Target stores and 210 SuperTarget stores within the US. It also operates an integrated online business, Target.com.

Compared to Wal-Mart, Target is considered an upscale discounter, which is not necessarily contradicting. Its stores’ atmospheres and product varieties are more upscale than those of other discounters. Therefore, the prices are higher, merchandise is stylish, and layout is roomy with wide aisles. Standard & Poor’s, for example, believes that Target seeks a wealthier clientele than other discounters, like Wal-Mart do. Target’s customers’ median household income is $ 58,000, and about 43 % have a college degree (Asaeda 2007).

3 Key Figures in Financial Analysis

Financial analysis means the appraisal of a company’s financial condition. It can either be conducted by the company itself (internal financial analysis) to allocate information for top management’s decisions or by external analysts like current or future shareholders, creditors as well as competitors, unions and employees, who are mainly interested in a company’s financial condition (external financial analysis). Financial analysis is primarily an analysis of the annual financial statements like the balance sheet, the income statement as well as for a corporation an appendix and the management report (Perridon & Steiner 2007, p. 536).

Ratio analysis shows a company’s overall financial condition. It helps investors and analysts to examine whether the company is in well financial shape compared to competitors and the industry or whether it is in the risk of insolvency. Investors use ratios to ascertain a company’s performance and growth. Hence, poor financial ratios will lead to higher financing costs, as good ratio]s will investors lead to provide the company with money at sound financing costs. Banks use financial ratios to decide about allowing credit and its amount to a company. Creditors become concerned when a company does not generate enough money to periodically pay the interest on outstanding debts. They also worry about companies which are too heavy in debt (Groppelli & Nikbakht 2006, p. 457).

The value of financial ratios depends on their skillful application and interpretation. Beyond the internal operating activities that influence a company’s financial ratios, analysts must be conscious about the effects of economic events, industry factors, management policies, and accounting methods (Wild et al. 2003, p. 31).

Therefore, ratios must be interpreted with care because factors influencing the numerator can correlate with those affecting the denominator. For instance, companies can progress the ratio of operating cost to sales by reducing costs that stimulate sales (e.g. research and development). However, decreases in these types of costs will probably yield long-term declines in sales or market share. Therefore, an apparently short-term improvement in profitability can damage a company’s future prospects. Several ratios have significant variables in common with other ratios. Consequently, it is not necessary to compute all possible ratios to analyze a situation. Financial ratios are thus not relevant in isolation. Instead, they should be interpreted in comparison with prior ratios, predetermined standards, and ratios of competitors and the same branch or industry as well as over time (Brealey & Myers 2008, p. 792, Perridon & Steiner 2007, p. 537, Wild et al. 2003, p. 31).

Within the following chapters, due to limited space within this assignment, certain ratios were selected and analyzed from a large variety of possible financial ratios regarding a company’s leverage, liquidity, efficiency and profitability, whereby market ratios shall not be explained within this assignment.

3.1 Leverage Ratios

Firms are financed by some combination of debt and equity. The right capital structure for a company will depend on tax policy, whereby high corporate rates favor debt, high personal tax rates favor equity as well as on bankruptcy costs, and on overall corporate risk.

To increase earnings, companies use financial leverage. Excessive debt confines management’s initiative and flexibility for following profitable opportunities. Creditors prefer increased equity capital as protection against losses from difficulties. Lowering equity capital as a proportionate share of a company’s financing, decreases creditor’s protection against loss and consequently increase credit risk (Wild et al. 2003, p. 538).

A main motivation for a company to finance its business activities by debt is its potential for lower costs, because from a shareholder’s perspective, debt is less expensive than financing by equity for at least two reasons:

- Interest on most debt is set and, provided interest is less than the return earned from debt financing, the excess return benefits equity investors.
- Interest is a tax-deductible cost whereas dividends are not (Wild et al. 2003, p. 539).

Company’s bankers and bondholders follow the interest, that the company does not borrow too much money. Therefore, concrete scrutiny is undertaken by the lenders to ensure the company’s debt stays within realistic limits (Brealey et al. 2008, p. 793). Thus, leverage ratios give an idea about the company’s methods of financing. They also measure the company’s capability to meet financial obligations.

The central problem in measurement and interpretation of leverage ratios is that assets and equity are typically measured in terms of the book value in the firm's financial statements. This figure, however, often has very little to do with the market value of the firm, or the value that creditors could receive when the firm was liquidated (Brealey et al. 2008, p. 793).

Next to the following presented ratios, investors and lenders might also consider the long-term debt to net working capital ratio to evaluate a company’s ability to meet financial obligations, which will not be conducted within this assignment due to limited space.

3.1.1 Debt Ratio

Financial leverage can be measured by relating long-term debt with total long-term capital. Because long-term lease contracts also lead the company to set of fixed payments, these obligations are also included into long-term debt (Brealey et al. 2008, p. 793).

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Since debt ratios can be defined in different ways, analysts should ask how the presented ratio has been calculated (Brealey et al. 2008, p. 794).

Table 1: Debt Ratios for Wal-Mart and Target

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Since debt ratios can be defined in different ways, analysts should ask how the presented ratio has been calculated (Brealey et al. 2008, p. 794).

Table 1 demonstrates Wal-Mart’s and Target’s debt ratios throughout the years 2004 to 2008. It can be seen, that Target has a constantly higher debt ratio than Wal-Mart.

Scott (2000, p. 141) argues that a low debt ratio indicates a conservative way of financing and the opportunities for future loans without risks.

3.1.2 Debt-Equity Ratio

This ratio indicates the relative proportion of equity and debt used to finance a company’s assets.

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The debt-equity ratio is watched carefully by investors and creditors. Banks are interested in this ratio, because a high relation of debt to equity might endanger the payback of borrowed money. Often, analysts look at the debt-equity ratio to determine the organization’s ability to generate new funds from the capital market. Therefore, a company with considerable debt is often thought to have little new-financing capacity.

It is recommended to watch this ratio additionally over several years, because a mature payment can make a difference in the company‘s solvency.

Since variations in calculating both, the debt ratio as well as the debt-to-equity ratio may occur, investors should ask for the formula (Stickney & Weil, 2005, p. 211).

Table 2: Debt-Equity Ratios for Wal-Mart and Target

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Table 2 shows Wal-Mart’s and Target’s debt-equity ratios in the years 2004 to 2008. Throughout the years, Wal-Mart’s debt-equity ratios are considerably lower than Target’s, which means that Wal-Mart has taken fewer debts in relation to equity than

Target. Again, a lower ratio is assumed to be better, because of increased opportunities for getting future loans. Wild et al. (2003, p. 545) argue that the higher the proportion of debt, the bigger the fixed charges of interest and debt repayment, and the larger the probability of insolvency during episodes of decreasing earnings.

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Details

Pages
34
Year
2008
ISBN (eBook)
9783640162673
ISBN (Book)
9783640164202
File size
1 MB
Language
English
Catalog Number
v114941
Institution / College
University of Applied Sciences Berlin
Grade
1,3
Tags
Interpretation Financial Management Ratio analysis

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Title: Interpretation of key figures in financial analysis