Term Paper on "Corporate Finance Project"

Term Paper 10 pages (3222 words) Sources: 1+

[EXCERPT] . . . .

Corporate Finance Project

Wal-Mart is the world's largest retailer. They company operates primarily in the discount retail industry, competing with a cost leadership strategy. The company is also active in a number of export markets, the most important being Mexico, Canada, China and the United Kingdom. The company also competes in the warehouse club segment of the retailing industry, where its Sam's Club brand trails Costco in market share and revenue. Wal-Mart is only the world's second-largest online retailer behind Amazon.com. The company become successful based on its strengths in logistics and in purchasing. Wal-Mart uses its bargaining power and economies of scale in order to drive down its prices to consumers, and uses this a source of competitive advantage. This paper will focus on a financial analysis of Wal-Mart, using data for the past two fiscal years (2011 and 2010). This analysis will result in a determination of whether or not to lend to Wal-Mart. The figures used in this report come from the 2011 Wal-Mart Annual Report, unless otherwise specified.

Liquidity Analysis

The liquidity analysis is the most important form of analysis for a potential creditor. The liquidity analysis is a means by which the creditor can ascertain the likelihood of default (Loth, 2011). Favorable liquidity ratios indicate that the company is likely to be in a position to repay its debts. The current ratio is computed as the current assets / current liabilities. The current ratio for Wal-Mart as of FY2011 is 0.88, and for FY 2010 it was 0.86. This is lower than the RMA figures, which indicate that a figure below 1.0 is "worst." There is a caveat to this, however, in that the current assets contains inventory. Wal-Mart's business model encourages rapid inventory turnover. It uses a just-in-time ordering system that keeps inventory levels to a minimum. The RMA statistic is based on "all other general merchandise stores," which includes non-discount retailers that will traditionally have a much higher inventory level than firms competing in the discount space.

In order to discount the affect of bloated inventory levels on the RMA statistics, the quick ratio should be used as well. For Wal-Mart, the quick ratio is 0.26 and for the previous year was 0.28. The quick ratio would put Wal-Mart closer to the "average" category based on the RMA statistics. Thus while the current ratio is the most popular means of understanding a firm's liquidity and on this measure Wal-Mart looks to have poor liquidity, when the business model is taken into account, Wal-Mart's liquidity looks better.

Continuing with the liquidity analysis, there are several measures of managerial efficiency. The first of these is a reflection of accounts receivables turnover, as measured in days. This measure tells the story of how fast the firm converts on the credit sales it makes. Firms with a lower number of days' turnover have a more efficient receivables turnover and this leads to a shorter cash conversion cycle. For a creditor, it is important that the company to which you are lending has a short cash conversion cycle, as this reduces the risk of default. The longer receivables are held, the greater the likelihood of default on those receivables. The formula for receivables turnover is 365 / (sales/avg turnover). For Wal-Mart is FY2011, the accounts receivable turned over is 4 days. The RMA standard is 3 days for "average." According to this measure, then, Wal-Mart falls near the industry average in terms of receivables turnover.

Inventory turnover is a similar measure to receivables turnover and it also has an impact on the cash conversion cycle. This measure is important for retailers in particular because they often have a significant portion of their assets tied up in inventory. Inventory can become dated, so a rapid inventory turnover is a sign that the business is operating well and that the company has good inventory management. The formula for inventory turnover is 365 / (COGS/avg inventory). For FY2011 at Wal-Mart, the inventory turnover was 30 days. The RMA for inventory turnover is 38 days for "best." This puts Wal-Mart better than the best for the industry with respect to inventory turnover. It also supports the earlier contention that Wal-Mart's system of managing inventory levels, suppressing the levels, made the quick ratio a more relevant indicator of liquidity than the current ratio.

While the receivables and inventory turnover ratios can be used to analyze the company's cash conversion cycle, it is also important to analyze the payables turnover ratio as well. For creditors, this is particularly important. Companies that have cash flow problems will often extend their payables as far as they can in order to stretch their outbound cash conversion cycle. Thus, a large payables turnover in days can indicate that the company is experiencing some financial distress. The payables turnover is calculated as the cost of 365 / (sales / avg payables). For Wal-Mart in FY2011, the payables turnover was 37 days. The RMA for payables turnover holds that 34 days is average, indicating that Wal-Mart's payables turnover is around average for the industry.

The final liquidity ratio to be studied is the times interest earned. This is a measure of how many times over the course of a year the firm is able to earn its interest obligations. For a creditor, this measure is important. The more times per year the company earns its obligations, the less likely it is to default or have a cash crunch that delays either the interest payment or the principle repayment. The times interest earned is calculated as EBIT/interest. For Wal-Mart for FY 2011, the times interest earned was 12.75 times, which equates to once every 28 days. The RMA for this metric is than 10.8 times is "best," meaning that Wal-Mart outperformed the industry best in this measure. The firm's business model that emphasizes a short cash conversion cycle allows it to make its interest obligations for the year in a single month.

Asset Analysis

The asset analysis reflects the firm's capital structure, that is to say the degree to which the firm finances its activities through debt and equity. In general, firms seek to strike a balance between the relatively low cost of debt and the relatively high risk that debt obligations represent. Debt obligations represent a drag on the firm's cash flow. This is especially true of obligations that are superordinate. As a lender, a new loan may be subordinate to existing loans. In that situation, the amount of those loans as a percentage of the firm's worth is an important measure. The debt/worth ratio provides an indicator of the firm's capital structure. For Wal-Mart, the debt/worth ratio in FY2011 was 1.53. The RMA for this metric is that 1.4 is average. This means that Wal-Mart has a slightly higher degree of leverage than the average firm in the industry. There could be a number of explanations for this. The company could be deliberately acting to lower its cost of capital, or it could be seeking new funds to finance its expansion. In Wal-Mart's situation, the cash flow statement provides some insight. The company's largest cash outflow was to purchase company stock, and its second-greatest source of financing was from the issuance of debt. The stock repurchases will increase the market value of the company's stock but will lower the book value of the stock by retiring it. The number of shares outstanding has been steadily declining. The company added debt in the past year, as the debt issuance was used in part to finance operations but also to finance the stock repurchases.

Profitability Analysis

Profitability analysis is important for creditors because it provides insight into the company's operations. The more profitable the company is, the lower the risk of default. There are exceptions, such as if profitability is driven by unusual events like major asset sales, but for the most part the more profitable a firm is, the better credit they should be. The first major profitability ratio is the pre-tax ROE. This is calculated as the pre-tax income / net worth. This ratio is an indicator of how the return that the firm's shareholders earn on their investment. For Wal-Mart, for FY2011, the pre-tax ROE was 33%. The RMA on this metric holds that 30.7% is "best," indicating that Wal-Mart is outperforming the industry best with respect to its ROE.

The second profitability ratio is the pre-tax ROA, or return on assets. This is an indicator of how well the firm converts its assets into profit. It is therefore a measure of asset utilization and the higher the ROA number the better the company is using its asset base. The formula for pre-tax ROA is the pre-tax profit / total assets. For Wal-Mart, for FY 2011, the pre-tax ROA was 13%. The RMA on this metric holds that 13.6% is "best," indicating the Wal-Mart's ROA is in the vicinity of the industry ideal.

The third profitability ratio is the sales/net fixed assets. This ratio indicates how well a… READ MORE

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