Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the

Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the

ratios of other firms in the industry since these other firms are in a similar line of business and face some of the same market pressures—for example, competition in the input and output markets—as the firm we are evaluating.

But finding the appropriate comparable firms is difficult for many large firms that have operations spanning many different lines of business. For example, in 2001, the Walt Disney Company reported the following: 5

Dollar Amounts, in Millions, with the Percentage of the Total in [ ]

Segment

Revenues

Operating Income Assets

Media networks

[46.58%] Theme parks and resorts

[26.02%] Studio entertainment

[15.14%] Consumer product

5 The Walt Disney Company 2001 Annual Report.

Financial Ratio Analysis

EXHIBIT 22.3 Wal-Mart Stores Balance Sheet for Fiscal Years 2001 and 2000

Period Ending Jan 31, 2002 Jan 31, 2001

Assets Current Assets

Cash and cash equivalents $2,161 $2,054 Net receivables

2,000 1,768 Inventory

22,614 21,442 Other current assets

1,471 1,291 Total current assets

$28,246 $26,555 Long-Term Assets Property plant and equipment

$45,750 $40,934 Goodwill

8,595 9,059 Other assets

860 1,582 Total assets

$83,451 $78,130 Current Liabilities

Payables and accrued expenses $24,134 $22,288 Short-term and current long term debt

3,148 6,661 Total current liabilities

$27,282 $28,949 Long-Term Liabilities Long-term debt

$18,732 $15,655 Deferred long-term liability charges

1,128 1,043 Minority interest

1,207 1,140 Total liabilities

$48,349 $46,787 Stockholders Equity Common atock

$445 $447 Retained earnings

34,441 30,169 Capital surplus

1,484 1,411 Other stockholder equity

(1,268) (684) Total stockholder equity

$35,102 $31,343 Total liabilities and equity

FINANCIAL STATEMENT ANALYSIS

EXHIBIT 22.4 Wal-Mart Stores Income Statement for 2001 and 2000 Fiscal Years

Period Ending: Jan 31, 2002 Jan 31, 2001

Total Revenue $219,812 $193,295 Cost of Revenue

171,562 150,255 Gross Profit

$48,250 $43,040 Selling General and Administrative Expenses

36,173 31,550 Earnings Before Interest and Taxes

$12,077 $11,490 Interest Expense

1,326 1,374 Income Before Tax

$10,751 $10,116 Income Tax Expense

3,897 3,692 Minority Interest

(183) (129) Net Income

EXHIBIT 22.5 Selected Financial Ratios for Wal-Mart Stores for 2001 and 2000

Return Basic earning power

$12,077/$83,451 = 14.47% $16,490/$78,130 = 21.11% Return on assets

$6,671/$83,451 = 7.9% $6,295/$78,130 = 8.06% Return on equity

$6,671/$35,102 = 19.00% $6,295/$31,343 = 20.03% Liquidity

Current ratio $28,246/$27,282 = 1.04 times $26.555/$28,949 = 0.92 times Quick ratio

$5,628 /$27,282 = 0.21 times $5,113/$28,949 =0.18 times Profitability

Gross profit margin $48,250/$219,812 = 21.95% $43,040/$193,295 = 22.27% Operating profit margin $12,877/$219,812 = 5.86%

$11,490/$193,295 = 5.94% Net profit margin

$6,671/$219,812 = 3.03% $6,295/$193,295 = 3.26% Activity

Inventory turnover $171,562/$22,618 = 7.59 times $150,255/$21,442 = 7.01 times Total asset turnover

$219,812/$83,451 = 2.63 times $193,295/$78,130 = 2.47 times Financial leverage

Total debt-to-assets $48,319/$83,451 = 58.90% $46,787/$78,130 = 59.88% Total debt-to-equity

$48,319/35,102 = 1.38 times $46,787/$31,343 = 1.49 times Interest coverage

$12,077/$1,326 = 9.11 times $11,490/$1,374 = 8.36 times

Financial Ratio Analysis

In what industry do we classify the Walt Disney Company? Media net- works, where it has invested almost 50% of its assets but derives only 38% of its revenues? Studio entertainment, where it derives 24% of its revenues and invests only 15% of its assets? What are the comparable companies? It is not always clear. In the case of Disney, there are no companies with the same mix of lines of business, so we end up compar- ing it with similar companies, such as AOL Time Warner, that are in the same lines of business—amusements and film entertainment (i.e., cre- ative contents)—but with different revenue, income, and asset mixes.

Suppose we find a comparable firm or set of firms. The average ratios of these comparable firms do not necessarily constitute a good bench- mark. Finding that a firm is about average is not necessarily the same as saying that it is doing well. A better comparison may be with those firms that are in similar lines of business and are also the industry’s leaders.

Selecting and Interpreting Ratios It is difficult to say whether a comparison is good or bad. Suppose we

find a firm has a current ratio greater than the industry leaders. This could mean the firm is more liquid than the others and there is less risk that it cannot meet its near-term obligations. But it may also mean that the company is tying up its assets in low- or no-earning assets, which reduces its profitability.

Because ratios cannot be viewed in isolation, we need to look at sev- eral different characteristics of a firm at the same time in order to make judgments regarding its operating performance and financial condition. Statistical models have been developed that incorporate several aspects of a firm’s operating performance and financial conditions at the same time in order to make assessments of a firm’s creditworthiness. With the help of computers, these models enable us to translate financial ratios into meaningful measures.

Another issue of interpretation is the appropriateness of particular ratios to the firm. Consider an electric utility whose sole line of business is generating electricity. The only inventory that such a utility has on hand will be nuts, bolts, and a few spare parts—which do not amount to much. Calculating an inventory turnover doesn’t make sense for this type of firm—and any attempts to do so will result in an absurd inven- tory turnover, perhaps over 2,000 times! The selection of ratios must make sense for the firm being analyzed.

Still another issue is trying to make sense out of ratios that are out of reasonable bounds. Suppose a firm has a negative book value of equity—it can happen. If we calculate its total debt-to-assets ratio, we get a value greater than 1.0, meaning that more than 100% of the firm’s

FINANCIAL STATEMENT ANALYSIS

assets are financed with debt. In this case, some other ratio—say, total debt-to-market-value of equity—should be used instead.