Corporate finance principles and applications

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 company converts its fixed assets (as opposed to current assets like inventory) into sales. This is a particularly useful metric for retailers, because the fixed assets are typically the stores and land. The greater the degree to which the retailer can convert the stores and land to sales, the implication is that the retailer is a superior merchandiser. For Wal-Mart, the sales/net fixed assets ratio is 3.25. The RMA for this metric holds that 7.3 is "worst." This indicates that Wal-Mart is doing a relatively poor job by industry standards of converting its fixed assets (buildings and land) into sales.

The fourth profitability ratio is the sales/total assets. This metric takes the sales/net fixed assets ratio and adds back the other forms of assets. The value of this ratio to the creditor is that it provides an indication of the degree to which the firm converts all of its assets into sales. This is also similar to the ROA, except that it focuses on sales rather than profits. For Wal-Mart in FY2011, the sales/total assets ratio was 2.33. The RMA for this metric holds that 1.7 is "worst" and 2.9 is "average." Wal-Mart again underperforms the industry in this measure. This ratio is influenced by the high net fixed assets, but indicates that compared to its industry peers, Wal-Mart is not converting its assets into sales very well. That the company does convert assets into profits (pre-tax ROA) indicates that the company is very profitable in its endeavors and this makes up for the low degree of sales to assets.

The ratio analysis reveals a few things about Wal-Mart. In most categories, the company is either exceeding the industry standards ("best") or is operating around the industry average. For the most part, Wal-Mart operates at a very high level. The one aspect of the ratio analysis that is cause for concern is the ability of the company to convert assets to revenues. However, as Wal-Mart does a good job of converting assets to profits, this is not a major cause for concern.

The company has good liquidity ratios.. While the current ratio is not considered to be good, the company's liquidity looks fine when considering the other ratios in balance. The business model emphasizing low levels of inventory is partially to blame for the poor current ratio, and Wal-Mart has operated at this ratio for a couple of years without seeming too concerned about it. The company's receivables and inventories turnover ratios are strong compared with the industry . With such a short cash conversion cycle, Wal-Mart appears to have strong liquidity and is a low default risk. The company earns in EBIT its annual interest expense every month.

Wal-Mart appears to be comfortable with its current capital structure. The company is adding to its long-term liabilities, probably because of the low interest rate environment. Some of the proceeds from this lending are being used for stock buybacks, which improve the market value of the company's stock. These buybacks also reduce the common shares outstanding and the book value of the firm's equity. These moves to increase leverage are deliberate on the part of management, indicating that any increase in the company's debt is something that it desires.

Wal-Mart may not convert assets to revenue, but it converts both assets and equity to profit better than its industry peers. This indicates that the company is profitable. It has good control over its cost structure. That Wal-Mart has a formula for profitability is a good indication of both its financial and operational health. In general, the company's indicators are strong relative to the industry and this indicates that Wal-Mart is a relatively low default risk.

Cash Flow Analysis

Wal-Mart has two main sources of inbound cash flow. The most significant source is income from continuing operations. Most of what Wal-Mart does is financed by its profits. The other significant cash inflow last year came from the issuance of debt. The company issued $11.396 billion in debt, while retiring just $4.080 billion. This escalation in leverage is a deliberate action on the part of management to alter the firm's capital structure. Depreciation being added back from the income statement was the third-largest "source" of funding, although the point is that depreciation is not an actual cash flow. The fourth-largest source was the change in the accounts payable. Wal-Mart stretched its payables in order to finance some operations, but its payables turnover is still rated as average. These inbound cash flows are normal. Wal-Mart used a combination of equity (cash flow from operations) and debt financing for its operations last year. The company increased its long-term borrowing, but not unduly so.

The outbound cash flows are not unusual. The largest outbound cash flow item was the purchase of company stock. This is something that companies will often do at times when their stock price is depressed. The buyback increases the market value of the stock by increasing its scarcity on the markets. By propping up the share price, the company is improving the returns to the shareholders. The second-largest cash outflow was for payments for property and equipment. This is not surprising given the size of Wal-Mart's fixed asset base. The company is also expanding rapidly in a number of key emerging markets. This category of spending is typically considered an investment that should yield future improvements in income. Dividends paid is the third outbound cash category. This is a normal business activity, and helps to increase the return to the shareholders. The fourth-largest category of outbound cash flow is the payment of long-term debt. This is also normal. Some of this debt was rolled into new borrowings, which again is quite normal.

There is nothing unusual about the cash flow statement for Wal-Mart. The shift in capital structure that the company is undertaking is not surprising given the low interest rate environment and the volatility of the stock markets. Wal-Mart is able to build shareholder value while lowering its cost of capital. The company is continuing to invest, which given the profitability of its operations is quite desirable.

Recommendation and Conclusion

The bank should lend to Wal-Mart. The company is the largest retailer in the world, and its metrics are generally solid. The high-volume, low-margin business model is somewhat risky but the company does not have an irresponsible amount of debt. The pros of lending to Wal-Mart rest on the low risk of default. The company has a high times interest earned ratio and a short cash conversion cycle. The company's current ratio is not of serious concern, especially given its low inventory levels. Wal-Mart is also a profitable company and appears to have strong operating efficiency as well, to help maintain cash flow.