Ratio Analysis



KMART CORPORATION

HISTORICAL ANALYSIS

FIN 6425

March 10, 2000

Debbie Hilderbrandt

Joyce Hinrichs

David Holton

Index

Note: All dollar values used in this analysis in relation to the financial statements are in millions unless otherwise noted.

Section Pages

Historical Analysis 1-36

Appendix 37

Table 1 – Income Statement 1

Table 2 - Balance Sheet 2

Table 3 – Cash Flow Statement 3

Table 4 – Common-size Income Statement 4

Table 5 – Common-size Balance Sheet 5

Table 6 – Financial Ratios 6

Table 7 – Other Key Ratios 7

RMA Industry Data

Bibliography

Introduction

Attention Kmart shoppers, all 180 million of you! Kmart Corporation is the second largest discount retailer in the nation and third largest general merchandise retailer. Kmart’s primary lines of business are name brand and private label general merchandise with approximately 2,161 stores, including 100 Super Kmart Centers. Kmart has a retail presence in all 50 states, Puerto Rico, the U.S. Virgin Islands, and Guam. Kmart owns 110 stores and leases approximately 2,051 stores. Kmart’s primary competitors from the discount retail sector include Wal-mart, Target, Shopko and Costco. From the department store sector, J.C Penny and Sears are the main competitors. The primary factors in maintaining a competitive advantage are price, quality, service, product mix and convenience.

Kmart stores are generally one-floor, freestanding units ranging from 40,000 to 180,000 square feet. Kmart’s diversification into specialty retailing brought it close to bankruptcy in 1995. Restructuring efforts have resulted in the conversion of many older stores into the Big Kmart format featuring grocery sections, brighter décor and an expanded selection of merchandise. These stores feature an expanded selection of merchandise including private labels such as Martha Stewart, Sesame Street, Jaclyn Smith and Kathy Ireland. In addition, new marketing concepts featuring the TV celebrities Rosie O’Donnell and Penny Marshall are seen in almost every Kmart commercial.

The Super Kmart center is a new store prototype for the discount retailer that features a full assortment of groceries as well as a broad selection of general merchandise and apparel found at traditional Kmart stores. The offerings include fresh and frozen food, bakery and meats. There are also one-stop conveniences such as video rental, hair salons, florists, banking, and one-hour photo processing. The Super Kmart centers are open 24 hours a day and seven days a week. There were 102 Super Kmart centers as of 1998.

Prior to 1996, Kmart had diversified into specialty retailing and international operations in Mexico, Canada and Singapore, which nearly put them on the brink of bankruptcy. During late 1995 and into 1996, they began a company wide restructuring that included the divestiture of these international operations. Additionally, in 1997 Kmart discontinued operations of several subsidiaries including: Building Square, Border Group, OfficeMax, Sport’s Authority, Thrifty Payless Holdings, Inc. Coles Myer, Ltd. and Furr’s/Bishops, Inc.

An additional part of the restructuring effort involved the availability of a private label Kmart Credit Card to credit worthy customers. The credit card is offered though Beneficial National Bank USA who now owns the accounts receivables and under the terms of the purchase agreement, retains all of the credit risk associated with the credit card.

Kmart over the last few years have been restructuring their organization and as a result has become the second largest discount retailer in the nation. This restructuring has not been without financial cost in their performance. Kmart’s performance over the 1996-1998 period will be examined in detail in the remaining sections of the paper.

Financial ratios are calculated from income statements and balance sheets to evaluate Kmart’s management of assets to produce revenue. The ratios were compared to industry averages cited from the Robert Morris Associates (RMA) for the year 1998. Kmart, Wal-Mart, and Target have captured 80% of the discount retail market share. Consequently, the upper quartile should be used to analyze Kmart’s financial position. However, RMA common size numbers generate the median ratios. Therefore, this analysis uses the median ratios to ensue proper comparison to the industry numbers. Where RMA data was not available, median peer comparisons from Wal-Mart, Target, Shopko, Ames and Costco were used provided by Bank of America Retail Peer Analysis for 1998. The remainder of the paper will examine these financial ratios to provide a benchmark and trend analysis for Kmart for the fiscal years 1996-1998. (Note: See Appendix for Tables 1-7 for financial statements and ratio calculations).

Ratio Analysis

Liquidity Ratios

Liquidity ratios measure a firm’s ability to meet its financial obligations. The overall health of a firm has traditionally been measured by these ratios. The usefulness of liquidity ratios is now changing as more companies are holding fewer current assets to generate revenue. These ratios are still a good measure for this industry because the discount retail industry does rely on a large amount of current assets to generate revenue. The meaning of high and low ratios are judged based on the relevant industry norms.

Current Ratio

Current Ratio = Total Current Assets

Total Current Liabilities

Items in this table represent percentages of total assets.

|Account |1996 |1997 |1998 |RMA |

|Cash & Equivalents |2.88% |3.67% |5.01% |14.3% |

|Merchandise Inventories |45.11 |46.96 |46.14 |36 |

|Other Current Assets |6.91 |4.51 |4.12 |.8 |

|Total Current Assets |54.9% |55.14% |55.27% |53.60% |

|Current Maturities of Long-term debt |1.09% |.58% |.54% |2% |

|Trade Accounts Payable |14.06 |14.18 |14.45 |17.3 |

|Accrued Payroll & Other Liabilities |9.09 |7.85 |9.59 |7.9 |

|Taxes other than income taxes |.97 |1.54 |1.47 |N/A |

|Total Current Liabilities |25.21% |24.15% |26.06% |33.8% |

|Current Ratio |2.15 |2.28 |2.12 |1.6 |

The current ratio is a measure of total current assets to total current liabilities. This indicates a firm’s ability to meet its current obligations with cash, inventories or other liquid current assets. A high ratio usually indicates that a firm is better able to meet liability obligations.

Benchmark:

Kmart’s current ratio is 27% above the industry norm. It appears that Kmart is in a better position to meet its obligations than the industry. The company’s common sized statements relative to the industry can explain this relation to the industry. Current assets are 3% greater than the industry; while the current liabilities are 23% lower than the industry. Thus, the current ratio is greater than the industry.

A closer look into the elements of the ratio indicates a heavy reliance on inventory, which is 28% above the industry norm. The company also has in comparison to the industry low cash balances (64% less). Kmart’s current assets are 3% greater than the industry. The most significant feature of current liabilities is trade accounts payable at 16% less than the industry. In addition, current maturities of long term debt of accrued payroll are less then the industry in relative common-size figures. Thus, the current liabilities of Kmart are 23% lower than the industry. Although Kmart is carrying significantly less current liabilities it is also carry much less cash and much more inventory than the industry.

However, Kmart’s cash management appears to be adequate even with the stated lower cash balances. In reviewing the cash flow statement, net cash after operations was a positive $2,011M for fiscal year end 1998. Kmart had adequate cash flow coverage to pay their current maturities of long term debt, interest expense and income tax expense. Kmart’s net capital expenditures of $1,113M were also covered by cash flow. Kmart’s remaining cash balance was $710M for the year 1998. However, it is important to note that net cash flow operations had been on a 52% decline for the three year period 1996-1998. In addition, Kmart has a revolving credit agreement of $2.5 billion that provides Kmart the continued flexibility in their cash management practices.

Taking into consideration both common size and cash flow statements it appears that inventory management may be the primary problem. As seen later in the inventory ratios, Kmart holds above the average norm of inventory resulting in their higher costs of goods sold. In order to better evaluate Kmart’s liquidity, the quick ratio will be reviewed below.

Trend:

The current ratio over the last three years has remained stable due to the stability of the current assets and current liabilities as a percentage of total assets. Current assets grew 1% while current liabilities grew 2% over the entire period and thus, the 1998 ratio is somewhat less than the 1996 ratio.

Quick Ratio

Quick Ratio = Cash and Equivalents - Inventory

Total Current Liabilities

|Account |1996 |1997 |1998 |RMA |

|Cash & Equivalents |2.88% |3.67% |5.01% |14.03% |

|Trade Accounts receivable |0 |0 |0 |2.5 |

|Other Current Assets |6.91 |4.51 |4.12 |.8 |

|Total Current Assets less inventory |9.72% |8.18% |9.13% |17.6% |

|Current Maturities of Long-term debt |1.09% |.58% |.54% |2.0% |

|Trade Accounts Payable |14.06 |14.18 |14.45 |17.3 |

|Accrued Payroll & Other Liabilities |9.09 |7.85 |9.59 |7.9 |

|Taxes other than income taxes |.97 |1.54 |1.47 |N/A |

|Total Current Liabilities |25.21% |24.15% |26.06% |33.8% |

|Quick Ratio |.38 |.34 |.35 |.4 |

The quick ratio is considered a more accurate measure of a firm’s ability to meet its current liabilities. In calculating this ratio, inventory is subtracted from the total current assets because it is the most commonly inflated and least liquid current asset.

Benchmark:

Kmart’s quick ratio of .35 relative to the industry ratio of .4 indicates that the company is reliant on inventory to meet its obligations. Kmart’s current assets minus inventory is 9.13% of total assets in comparison to the industries 17.6%. This reliance upon inventory to meet current obligation is usually a bad situation. Kmart’s lower quick ratio compared to the industry can be further explained by the fact that Kmart’s inventory represents 83% of its current assets, which is significantly higher than the industry average of 67%.

The current liabilities are lower than the industry and have been discussed previously in the current ratio. While, the current liabilities is only 23% less than the industry, the current assets minus inventory is 48% is less than the industry. Consequently, the quick ratio is less than the industry by 12.5%.

Trend:

The quick ratio over the last three years overall has remained stable due to the stability of the current assets and current liabilities as a percentage of total assets. However, with a 6% drop in current assets minus inventory and a 2% increase in current liabilities, the ratio has slightly declined over the three year period. In addition to liquidity ratios, asset management ratios will highlight the company’s strengths and weaknesses.

Management Ratios

Sales Receivable Ratio

Sales / Receivable = Net Sales

Trade Receivables

This ratio measures the number of times receivables turn over in a year relative to sales. This determines the time between a sale and actual collection. The credit terms and quality of receivables can be measured using this ratio relative to the industry. Another way to view this ratio is in the number of days the receivable remains on the company’s books. This ratio will be discussed with the Days in Accounts Receivable ratio below.

Days Receivable Ratio

Days Receivables = 365

Sales/ Receivables Ratio

Day’s Receivables ratio tells how many days on average it takes to collect on sales. If this number is high, it indicates that there are some accounts that are aging and may never be collected. It may also indicate loose credit policies and poor collection processes. In some extreme cases, it can reveal poor internal controls and processes in accounting such as cash collection and reconcilement of accounts. Kmart does not carry any account receivable due to the sale of their credit card to Beneficial National Bank USA. According to the terms of the sale, Beneficial retains all credit risk for credit card receivables. Because of Kmart’s zero trade receivables these ratios are not relevant to our analysis other than to note that Kmart is atypical of their peers.

Inventory Growth

|Account |1996 |1997 |1998 |RMA |

|Inventory percent to total assets |44.48% |46.96% |46.14% |36.00% |

|Inventory |$6,354M |$6,367M |$6,536M |N/A |

|Inventory Growth |N/A |.20% |2.65% |N/A |

Inventory has remained relatively stable for the past three years. However, in comparison to the industry as seen in the above table, they are holding excessive inventory. Inventory days on hand (inventory turnover) is approximately 30 days (4.06x) greater than (less than) the industry average of 61 days (5.0) as seen below.

Cost of Sale Inventory Ratio

Cost of sales / Inventory = Cost of sales

Inventory

|Account |1996 |1997 |1998 |RMA |

|Cost of goods sold |77.58% |78.15% |78.16% |67.60% |

|Inventory |44.48% |46.96% |46.14% |36.00% |

|Cost of Sales/Inventory Ratio |3.84 |3.95 |4.06 |5.0 |

This ratio measures the number of times inventory is turned over during the year in terms of dollars. High and low turnover relative to the industry could mean either poor inventory management (high turnover) or poor utilization of related resources (low turnover).

Days Inventory Ratio (INVDOH)

Days Inventory = 365

Cost of Sales/Inventory

|Account |1996 |1997 |1998 |RMA |

|Turnover Ratio |3.84 |3.95 |4.03 |6.0 |

|(INVDOH) |95.09 |92.40 |90.64 |73 |

Inventory days on hand measures how long the company holds inventory before it is sold. Kmart’s 90.64 days is (18 days longer than the industry) shows a very serious problem that ripples through the entire company’ financial statements and operations. This ratio supports previous evidence that the company is experiencing inventory control and management problems.

Benchmark:

The cost of sales is 15% higher than the industry average; a significant difference that could be attributed to a poor distribution system, poor sales management and ineffective purchasing practices. Inventory is 28% above the industry average indicating Kmart may be experiencing inventory management problems. Since inventory exceeds the industry by a greater magnitude than cost of sales exceeds the industry, the cost of sales/inventory ratio is less than the industry and as a result inventory days on hand is greater than the industry average.

Trend:

Inventory days on hand has been declining due to a 7.9% growth in cost of sales versus a 2.9% growth in inventory over the 1996-1998 period.

Cost of Sales Payables Ratio

Cost of Sales / Payables = Cost of sales

Trade Payables

|Account |1996 |1997 |1998 |RMA |

|Cost of Sales |77.58% |78.15% |78.16% |67.60% |

|Accounts Payables – Trade |14.06% |14.18% |14.45% |17.30% |

|Cost of Sales Payable Turnover Ratio |12.14 |13.08 |12.86 |10.9 |

This measurement of liquidity measures the number of times account payables turnover in one year and can provide numerous insights into the operations of a company including how well they are working with vendors in its supply chain. A downward trend or a low ratio compared to industry standard may be indicative of cash flow problems or turmoil between the corporation and its suppliers.

Days Payable Ratio (APDOH)

APDOH = 365

Cost of Sales/Payables

|Account |1996 |1997 |1998 |RMA |

|Cost of Sales |77.58% |78.15% |78.16% |67.60% |

|Payable Turnover Ratio |12.14 |13.08 |12.86 |18.6 |

|APDOH |30.06 |27.91 |28.39 |33.0 |

The cost of sales/payable ratio is utilized to derive the number of days payable which provides a measurement of the length of time between the purchase on account and the time the account is settled. It is not uncommon for companies to take liberties with the payment of accounts, stretching the credit terms or riding their trade.

Benchmark:

Cost of sales is trending upwards to 78.16% in 1998 which is 16% above industry average. As seen in the accounts payable common size percentages, Kmart is holding approximately 16.5% lower on average than the industry standard. Since the cost of sales is greater than industry average and accounts payables are less than the industry average; cost of sales/payable ratio for Kmart is greater than the industry and accounts payable days on hand is less than the industry.

Trend:

Cost of sales has grown 7.9% over 1996-1998 while accounts payable increased 1.9% over the same period. As a result, the turnover got larger and the days got smaller over the three year period. Per notes to the 1998 financial statements, Kmart reported higher promotional and occupancy cost as a contributing factor for the increase in cost of sales. Because Kmart is paying their trade payables 4.61 days quicker than the industry Kmart is using approximately $319 more cash than they would if they were more in-line with the industry average of 33 days.

Kmart’s accounts payable days on hand are less than the industry average. They are paying an average of 14% faster, with an average of 29 days relative to the industries 33 days.

Operating Cycle

Accounts Receivable Days on Hand (ARDOH) + Inventory Days on Hand (INVDOH)

Cash Conversion Cycle

Accounts Receivable Days on Hand (ARDOH) + Inventory Days on Hand (INVDOH) – Accounts Payable Days on Hand (APDOH)

|Elements |1996 |1997 |1998 |RMA |

|ARDOH |0 |0 |0 |2 |

|INVDOH |95.09 |92.40 |90.64 |73 |

|APDOH |30.06 |27.91 |28.39 |33 |

|Operating Cycle |95.09 |92.40 |90.64 |75 |

|Cash Conversion Cycle |65.02 |64.49 |62.25 |42 |

Operating Cycle

The operating cycle is the time to acquire or to manufacture inventory, sell the product and collect the cash. The operating cycle is usually less than one year for most industries. As seen in the Kmart’s operating cycle of 90.64 days and the industry standard of 75 days, the discount retail industry is an example of a shorter operating cycle.

Benchmark:

Kmart’s operating cycle is 20.85% longer than the RMA industry average. The operating cycle for 1998 is 90.64 days in comparison to the industry of 75 days.

Trend:

Inventory days on hand has been declining due to a 7.9% growth in cost of sales versus a 2.9% growth in inventory over the 1996-1998 period which has caused the operating cycle days to improve the 4.68% as indicated above. As previously stated Kmart does not retain credit risk on their credit card receivables therefore ARDOH is zero.

Cash conversion cycle:

The amount of time expressed in number of days required to sell inventory and collect accounts receivable less the number of days credit is extended by suppliers.

Benchmark:

The cash conversion cycle is 48.21% longer than the RMA industry average. The cash conversion cycle for 1998 is 62.45 days in comparison to the industry of 42 days.

Trend:

With INVDOH declining at 5% and APDOH also declining at 6% for the period, the cash conversion cycle has decreased. The operating cycle is, as stated above is also longer than the industry having a 20.85% impact on the cash conversion cycle. Kmart’s accounts payable days on hand are less than the industry average. They paying an average of 14% faster to pay, with an average of 29 days relative to the industries 33 days. Kmart's cash conversion cycle has improved by 4.45% over the three year period 1996-1998, however still remaining 20.45 days longer than the industry.

Sales / Net Working Capital Ratio

Sales / Working Capital = Net sales

Net working capital

|Account |1996 |1997 |1998 |RMA |

|Net Sales |$31,437M |$32,193M |$33,674M |See note |

|Total Current Assets |54.13% |55.14% |55.27% |53.60% |

|Total Current Liabilities |25.21% |24.15% |26.06% |33.80% |

|Net Working Capital |28.92% |30.99% |29.21% |19.80% |

|Sales/Net Working Capital Ratio |7.61 |7.66 |8.14 |12.7 |

Note: RMA sales data was not input because it was not comparable to Kmart which is one of the top three retailers making up 80% of the discount retail market share.

This ratio provides a measurement of how well working capital, the difference between current assets and current liabilities, is being utilized within the organization. In essence this ratio tells us for every dollar of new working capital invested in 1998 $8.12 of sales were generates revenues compared to the industry $12.40 in sales. The long- term survival of an organization is partially dependent on how well it manages current operations. The firm must strategically plan for a targeted range of current assets and plan for their financing.

Benchmark:

The sales/net working capital ratio has tracked below the industry average for the past three years. The ratio has increased from 7.61x in 1996 to 8.14x in 1998 in comparison to 12.7x to the industry. Sales/net working capital ratio is 35.91% lower than the industry.

Current assets are slightly higher than the industry while current liabilities were 29% lower than the industry standard. As a result, Kmart’s sales to net working capital ratio is less than the industry. This disparity in current assets and current liabilities relative to the industry could indicate that financing of current assets may be taking place with long- term liabilities. As a result of Kmart’s net working capital is 48% greater than the industry. This large net working capital is driving the ratio down relative to the RMA industry average.

The working capital of the discount store industry can fluctuate due to seasonal levels net of trade accounts payable, profitability, and the level of store openings and closings. Kmart ended 1998 with an increase in its number of stores for the first time in five years. Kmart’s primary sources of working capital are cash flows from operations and borrowings under its credit facilities.

Trend:

Sales increased by 7%, while net working capital only increased by.2% for the 1996-1998 period, resulting in an increase in the sales/net working capital ratio.

Sales / Net Fixed Assets

|Account |1996 |1997 |1998 |RMA |

|Net Sales |$31,437M |$32,183M |$33,674M |See note |

|Net Fixed Assets |34.4%/ $5,740M |40.2%/ $5,472M |40.4%/ $5,914M |37.5% |

|Net Sales/Net Fixed Assets Ratio |5.48 |5.88 |5.69 |8.5 |

Note: RMA sales data was not input because it was not comparable to Kmart which is one of the top three retailers making up 80% of the discount retail market share.

This ratio shows the effectiveness of the use of fixed assets in a business to produce sales. There is not a serious distortion in the yearly ratios from year to year, which represents fixed assets not being largely depreciated or fixed assets are being replaced/added at the same rate as depreciation. Surprisingly, the intense use of labor in this form of business has not affected or distorted the ratios from year to year. When compared to the industry the ratio is considerably low. This may be the result of an over investment of its fixed assets or a large amount of leasehold improvements. Since leasehold improvements can only be depreciated on a straight-line basis and not at an accelerated basis. If Kmart held a large percentage of leasehold improvements versus the percentage of buildings, the net fixed assets would be larger than their peers attributing to the discrepancy in the ratio.

Care must be taken when using this ratio to compare other firms. Inflation may have caused the values of some of the older assets to be seriously understated. Older assets may have also been depreciated by a greater amount. The result of such a comparison is that an older firm who acquired its assets years ago at lower prices may have a higher turnover ratio of fixed assets. In addition, firms using an accelerated depreciation versus a straight-line method would have a higher turnover ratio.

Benchmark:

Net fixed assets are 40.4% to total assets while the industry is only 37.5%. Because of Kmart’s reliance on net fixed assets relative to the industry, the net sales/net fixed assets ratio is 33.06% lower than the industry.

Kmart leases 95% of all their facilities while the peers in the industry own the majority of their facilities. It appears that due to this ownership difference, the peers in the industry are able to depreciate their fixed assets on an accelerated depreciation method versus the straight-line amortization on leasehold improvements used by Kmart. As a result, Kmart’s net fixed assets are higher than the industry as previously stated above. Refer to above Net Fixed Assets/Tangible Net Worth ratio for further details regarding Net fixed Assets.

Trend:

Sales increased by 7% while net fixed assets increased by 3.9% over the three year period. As a result, sales/total net fixed assets has increased over the three year period. Sales increased faster than Kmart’s net fixed assets is again indicative of Kmart’s leasing rather than owning stores.

Net Sales / Total Assets

|Account |1996 |1997 |1998 |RMA |

|Net Sales |$31,437M |$32,183M |$33,674M |See note |

|Total Assets |$14,286M |$13,558M |$14,166M |See Note |

|Net Sales/Total Assets Ratio |2.20 |2.37 |2.38 |2.6 |

Note: RMA sales and assets data was not input because it was not comparable to Kmart which is one of the top three retailers making up 80% of the discount retail market share.

Again, this ratio is a measure of management's ability to utilize its assets, in this case all of its assets. It appears that Kmart is only able to generate $2.38 versus their industry peers generating $2.60 in sales for every $1 of assets. Thus, it appears that Kmart is somewhat less efficient. This ratio is slightly lower than the industry average due to the higher inventory and low cash balances. As stated above an effort should be made however to increase sales volume to improve the ratio. Another option for improvement would be to improve its current asset turnover by improving inventory management, which will improve its total asset turnover, thus improving the net sales-total asset ratio.

Benchmark:

The net sales/total assets ratio is 8.46% less than the industry average.

Trend:

Sales increased by 7% while net total assets decreased by 1% over the three year period. As a result, sales/total net fixed assets has increased over the three year period by 8.18%. With the new Big-K format, sales have increased with the introduction of new lines. In addition, total assets have decreased slightly due to the other assets listed on the financial statements. The notes to the financial statements did not include an explanation as to what is comprised in the other asset accounts, both short-term and long-term.

Coverage Ratios

Coverage ratios measure the ability to service debt from operations.

EBIT / Interest

EBIT/Interest = EBIT____

Interest

|Account/Item |1996 |1997 |1998 |RMA |

|Earnings Before Interest and Taxes |2.49% |2.43% |3.24% |5.5% |

|Interest |1.44% |1.13% |.87% |.5% |

|EBIT/Interest Ratio |1.73 |2.15 |3.72 |12.2 |

This ratio shows how well a firm is able to meet interest payments. In 1998, Kmart’s operating income would cover their interest cost 3.72 times relative to the industry norm of 12.2 times.

Benchmark:

The EBIT/Interest ratio is 3.72x in comparison to the industry average of 12.2x. Earnings before interest and taxes has tracked below the RMA average for the three-year period. In 1998, Kmart’s EBIT was at 3.24% versus the industry average of 5.5%. In addition, interest has decreased by 39.6% over the past three years. However, interest expense of .87% for 1998 remains above the industry standard of .5%. With EBIT significantly below the industry norm of interest near the norm, the coverage ratio is significantly below the RMA average of 12.2.

Trend:

EBIT increased 30% while interest decreased 39.6% over the 1996-1998 period. Therefore, TIE increased by 115%. This is further validated by total debt dropping from 57.5% to 50.5% of total assets.

Total Debt / EBIT

|Account |1996 |1997 |1998 |Median Peer Comparison|

|Total Liabilities |57.50% |52.68% |50.85% |N/A |

|EBIT |2.49% |2.43% |3.24% |N/A |

|Total Debt/EBIT Ratio |10.49 |9.15 |6.6 |4.3 |

Total debt to earning before interest and taxes indicates the amount of debt the company has it relates to the EBIT (operating income). For example, in 1996, Kmart had $10.49 of debt to every one dollar of EBIT, $9.15 and $6.60 for 1997 and 1998 respectively. In essence in 1998, it took $6.60 of debt to generate $1 of operating income. This ratio remains high in comparison to the median peer comparison.

Kmart’s improvement by continued reduction of total liabilities was due to the use of cash from operations to pay down their term debt, mortgage notes and medium term notes. This reduction of liabilities was offset by the issuance of Commercial Mortgage Pass Through Certificates (CMBS) mortgage loans, which are subject to interest and principal payments with a maturity date of February 2002. Total debt also includes a $2.5 billion revolving credit agreement; however, no outstandings were reported for 1996-1998. However, the revolving credit agreement allows Kmart to carry much lower cash balances than their peers.

Debt Service Coverage Ratio

|Account |1996 |1997 |1998 |

|Net Income |$(189M) |$298M |$568M |

|Depreciation |654 |660 |671 |

|Amortization |0 |0 |0 |

|Interest Expense |453 |363 |293 |

|Total Cash Available for Debt Service |$913M |$1,321M |$1,532M |

|CMLTD |$156 |$78 |$77 |

|Interest Expense |453 |363 |293 |

|TOTAL DEBT Service |$609M |$441M |$370M |

|Cash After Debt Service |$304M |$880M |$1,902M |

|Debt Service Coverage Ratio |1.49 |2.99 |4.14 |

Traditional Debt Service: Operating Income + Deprec .+ Amort .+ Interest Expense Current Maturity Long Term Debt + Interest Expense

Traditional debt service coverage is the measurement of a company’s ability to service its current maturities of long-term debt and interest owed on that debt. Kmart debt service coverage of 1.49,2.99 and 4.14 for fiscal years ending 96-98 respectively has improved for the last three years. This increase in the ratio is attributed to the large growth in net income of 213.08% and 108.03% coupled with the decrease in total debt service of 16%.

Kmart leases 2,051 of their facilities. The terms of the leases are 25 years with multiple five year renewal options the allows the company to extend the life of the lease up to 50 years beyond the initial term. The following ratios illustrates the companies ability to repay their debt taking rental expense or lease expense into consideration rather than the traditional debt service coverage ratio above.

EBITDAR / Interest Expense + Rental Expense

|Account |1996 |1997 |1998 |

|EBIT |$783M |$781M |$1,091M |

|Depreciation |654 |660 |671 |

|Amortization |0 |0 |0 |

|Rent/Lease Expense |442 |478 |524 |

|EBITDAR |$1,879M |$1,919M |$2,286M |

|Interest Expense |453 |363 |293 |

|Rental/Lease Expense |442 |478 |524 |

|TOTAL |$895M |$841M |$817M |

|EBITDAR/(Interest +Rent Expense) |2.10x |2.28x |2.80x |

This ratio represents the amount of coverage the company has in order to pay their interest expense and lease expense. This ratio is adding back non-cash expense of depreciation and amortization besides the cash expense of rent to calculate total EBITDAR. The continuing trend is a positive trend due to increased EBIT, EBITDAR and the decreased in total interest expense. The lower interest expense is due to the paydown of long term debt, is more than offsetting the increasing lease expense.

EBITR / Interest Expense + Rental Expense

|Account |1996 |1997 |1998 |Median for |

| | | | |Peers |

|Net Income |$783M |$781M |$1,091M |N/A |

|Rent/Lease Expense |442 |478 |524 |N/A |

|EBITR |$1,225M |$1,259M |$1,615M |N/A |

|Interest Expense |453 |363 |293 |N/A |

|Rental/Lease Expense |442 |478 |524 |N/A |

|TOTAL |$895M |$841M |$817M |N/A |

|EBITR/Interest +Rent Expense |1.37 |1.50 |1.98 |3.4 |

This ratio represents the amount of coverage the company has in order to pay their interest expense and lease expense. This ratio does not add back non-cash expenses as seen above. This ratio is also a standard industry ratio for discount retail stores. Although, Kmart’s ratio is trending towards a positive direction, in comparison to the median for the peers in the industry that include; Wal-mart, Dayton Hudson, Costco, Shopko and Ames, they are significantly lower. The median peer EBIT margin is approximately 3.9% versus Kmart’s 3.24% margin. The lower ratio in comparison to their peers is attributed to the lower EBIT margin. The peer analysis of the expense side of the ratio was not available for comparative purposes for this analysis.

Leverage Ratios

Leverage ratios measure the extent of the organization’s financing with debt. It is a measurement of the capacity and ability to meet long-term obligations. The leverage ratios compare the funds supplied by business owners with financing supplied by creditors. This debt financing involves risk associated with the payment of principal and interest. However, the firm may earn more on these investments than it pays in interest that results in the return of the owner’s capital being favorably leveraged. Debt financing also has the advantage of not diluting stockholder ownership.

Fixed / Worth

Fixed / Worth = Net fixed assets

Tangible net worth

|Account |1996 |1997 |1998 |RMA |

|Net Fixed Assets |40.18% |40.36% |41.75% |37.50% |

|Net worth |42.50% |47.32% |49.15% |48.0% |

|Less Intangible Assets |0 |0 |0 |0 |

|Tangible Net Worth |42.50% |47.32% |49.15% |48% |

|Fixed Assets/ TNW |0.95 |0.85 |0.85 |0.80 |

This shows to what extent the company has invested its capital into the fixed assets of plant and equipment. A smaller ratio shows a relatively small investment into these fixed assets, providing more liquidity for creditors. A higher number would indicate a greater risk to these creditors.

Kmart’s Fixed/Worth ratio is only slightly larger than the industry standard and may be attributed to the number of stores in the chain compared to the industry. Per notes to the financial statements Kmart’s fixed assets are comprised of 40% capital leases and leasehold improvements, and 48% is invested in furniture and fixtures. The concentration of fixed assets in furniture and fixtures is attributed to the investment in the Big Kmart stores, which require additional refrigeration equipment for the grocery section (The Pantry). As stated previously, Kmart leases 95% of their facilities also attributed to the higher fixed assets compared to the industry because the amortization method used for financial statement purposes is straight-line method over the estimated useful life of the assets.

Benchmark:

Net fixed assets are 11.3% greater than the RMA and tangible net worth is 2.4% greater than the RMA. Since net fixed assets exceed the industry average the fixed assets/total net worth is greater (.85) than the industry average (.80).

Trend:

The tangible net worth has shown an upward trend for the past few years with an increase of 15.65 % from 1996 to 1998. The net fixed assets during the same period has only increased by 3.9%. Since the total net worth increased faster than net fixed assets over the period, this ratio has declined.

Debt / Worth

Debt / Worth = Total Liabilities

Tangible Net Worth

|Account |1996 |1997 |1998 |RMA |

|Total Liabilities |57.5% |52.68% |50.85% |52.00% |

|Tangible Net Worth |42.5% |47.32% |49.15% |48.0% |

|Total Debt/TNW Ratio |1.35 |1.11 |1.03 |1.08 |

This ratio shows the capital contribution relationship between creditors and owners and is sometimes referred to as the degree of advantage. A highly leveraged firm will not have as much flexibility to borrow in the future as one with a higher debt/worth ratio. A higher ratio indicates that the corporation is utilizing a large amount of debt to finance its business operations on a daily basis. It would appear that Kmart is marginally below their peers in the usage of debt.

Benchmark:

Total liabilities are 2.2% lower than the RMA industry average and tangible net worth is 2.4% higher than the RMA average. As a result, Kmart’s debt/worth ratio of 1.03x similar to the 1.08x RMA average.

Trend:

As a result of total liabilities decreasing by 12% while net worth has increased by 16% over this period. Kmart’s debt/worth ratio has improved by 23.7% during the three year period 1996-1998.

The company has paid down their long-term notes with cash, but also issuing convertible preferred securities. These securities are convertible to 3.33 shares of Kmart stock. Kmart also has a $2.5 billion dollar Revolving Credit Agreement that was amended in 1997 with maturity extensions and reduced interest rate spreads. In 1998, the company believed that its current financing arrangements would be sufficient to meet their liquidity needs for operations and capital.

Profitability Ratios

Profitability ratios are a useful tool in the evaluation of management performance.

Net Income Growth Rate

|Account |1996 |1997 |1998 |

|Net Income |$(220)M |$249M |$518M |

|Net Income Growth Rate |61% |213.18% |108.03% |

Net income growth rate as seen in the table above improved significantly for years 96, 97 and 98. The loss in 1996 is attributed to a decrease of .9% in sales from the previous year which can be attributed to the sale of the Mexican and Canadian international operations. Kmart also closed 48 stores in 1996, which was offset partially by the opening of 21 new stores. In addition, FYE 1996 had one less week during fiscal year 1996 decreased sales. In addition Kmart at FYE 1996 reported a net loss of $451 from discontinued operations from the sales of the Builders Square subsidiary and also the sale of a portion of an investment in Thrifty Payless Holdings.

Net income for 1997 increased at a rate of 213.18%; primarily due to the opening of the Big Kmart stores, the introduction of the Martha Stewart lines, Sesame Street kids line and increased promotional activities. The net income increase was due to not only the sales increase but to expense control. However, most of the large percentage increase in net income was due to an 83% decrease in voluntary early retirement programs and a 91% decrease in interest expense. Sales increased by 2.37% for the FYE97. In addition, SG&A expenses decreased by .89% due to the sale of the international operations and management control of expenses by focusing on the core business lines.

Net income for 1998 increased a second year in a row with the growth of 108.03% over 1997. This increase in attributed to a 4.63% growth in sales for FYE98 from the new Big Kmart store concept, the Martha Stewart lines, Sesame Street kids line and private label Kathy Ireland line. In addition, SG&A expenses decreased by .52% for the year, again for the reasons stated in the preceding paragraph.

Although Kmart is reporting not only positive net income levels, but positive trends for the past two years, their gross margins are significantly lower than industry as stated above.

Margins

Gross Margin and Operating Margin

|Account |1996 |1997 |1998 |RMA |

|Net Sales |$31,437M |$32,183M |$33,67M |See Note |

|Less COGS |77.9 |77.6 |78.2 |67.6 |

|Gross Margin |22.42% |21.85% |21.84% |32.40% |

|Less Operating Expenses |23.3% |20.0% |19.4% |26.9% |

|Operating Margin |2.46% |2.78% |3.30% |5.50% |

Note: RMA sales data was not input because it was not comparable to Kmart which is one of the top three retailers making up 80% of the discount retail market share.

The Gross Margin and the Operating Margin both represent a company's ability to translate sales dollars into profit. These margins are calculated at different stages of measurement.

The gross margin is the relationship between sales and the cost of product sold. It is an accurate measurement in terms of the company's ability to control costs of goods sold. Consideration is given to the company's ability to pass unavoidable price increases to the customers. In most recent years, Kmart has remained consistent in its gross margin, but it is substantially lower than the industry standard as seen above. The lower gross margin can be attributed to Kmart's costs of goods sold being significantly higher than industry standards.

The operating profit margin measures overall operating efficiency. It incorporates all expenses associated with the operations of the business. Kmart has been successful at improving its operating margin due to controlling operating expenses. Operating expenses were 19.4% in comparison to 26.9% industry average. Although, the operating expenses were lower than industry, Kmart’s operating margin of 3.30x remains below industry average of 5.50x. This again can be attributed to costs of goods sold exceeding industry by 10.6%.

EBITDA / Revenue

|Account |1996 |1997 |1998 |Median Peer |

| | | | |Comparison |

|EBIT |$783M |$781M |$1,091M |N/A |

|Depreciation |654 |660 |671 |N/A |

|EBITDA |$1,437M |$1,441M |$1,762M |N/A |

|Revenue |$31,437 |$32,183 |$33,674 |N/A |

|EBITDA / Revenue |4.57 |4.48 |5.23 |6.0 |

The EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization to Revenue ratio has become a valuable barometer to a company's success. EBITDA is a measure of cash flow from the company’s operation. The assumption is that as EBITDA steadily improves, debt will be repaid and a company's balance sheet is acceptable and portrays a successfully run business. This ratio shows the raw earning power of the business.

Kmart has continued to improve this ratio and is .77 from meeting the "median peer comparison". This comparison is made up of the top six retailers in the industry. Contributions to Kmart's success in this ratio include better merchandising and improved inventory management. Consumers are attracted to this form of the retail industry, because of their value of brand names at discount prices.

% Profit Before Taxes / Tangible Net Worth

|Item |1996 |1997 |1998 |RMA |

|Earnings Before Taxes |1.05% |1.30% |2.37% |5.00% |

|Tangible Net Worth |42.5% |47.32% |49.15% |48% |

|% EBT/TNW Ratio |5.43% |6.52% |11.46% |31.9% |

EBIT divided by tangible net worth reflects the rate of return on tangible assets within an organization. When combined with other ratios, it can be a useful management tool but is more effective when compared to other ratios that provide a more detailed analysis. A high number is usually indicative of successful management but may be a false assumption if degree of capitalization and other factors are not considered.

Benchmark:

Kmart’s EBT is approximately 52.6% below industry average due to the higher COGS, which also resulted in lower gross and operating margins. The tangible net worth is 2.4% higher than the industry average. Consequently, Kmart’s %EBT/TNW is considerably lower than the industry average.

Trend:

Kmart’s EBT/TNW has improved by 111% for the three year period ending 1996-1998. This large growth has been due to EBT growing115% over the three year period 1996-1998 while TNW has only grown by 16%. However, as stated above Kmart is still well below the industry norm. The upward trend of this ratio may be partially due to the corporate goal to get themselves in the position of being able to direct large amounts of capital into new opportunities without add debt.

Profit Before Taxes / Total Assets

| Item |1996 |1997 |1998 |RMA |

|Earnings Before Taxes |1.05% |1.30% |2.37% |5.00% |

| |$330M |$418M |$798M | |

|Total Assets |$14,286M |$13,558M |$14,166M |N/A |

|% EBT/Total Assets Ratio |2.31% |3.08% |5.63% |12.3% |

Note: RMA asset data was not input because it was not comparable to Kmart which is one of the top three retailers making up 80% of the discount retail market share.

This ratio is a representation of management's ability to utilize the resources available. It expresses the ratio of pre-tax returns on total assets.

Benchmark:

Earning before taxes of 2.3% is considerable lower than the industry average. The low EBT is the major factor behind the EBT/Total Assets ratio being less than the industry. EBT is approximately 52.6% below industry average due to the higher COGS, which also resulted in lower gross and operating margins.

Trend:

Kmart’s EBT/Total Assets ratio is trending upward since 1996; earnings before taxes have increased over the 1996-1998 period by 142% while total assets decreased of 1%. As a result, EBT/Total Assets has been above the industry during this period.

Supplemental Key Industry Ratios

Same Store Sales

| |1997 |1998 |

|K-Mart |4.8x |4.8x |

|Wal-Mart |6.0 |9.0 |

|Dayton-Hudson (Target) |5.0 |6.1 |

|Median Peer Comparison |4.8 |6.5 |

Success with customers is measured by yearly sales gains. The Same Store Sales quantitative indicator is one of the most closely watched indicators. It is defined as the increase or decrease from the preceding year in sales at stores that have been open at least one year. New stores are excluded since first year openings are often spikes in the statistics for company’s sales history. The same store sales is an excellent barometer of basic demand. Trends in this factor give a better indication of the state of the business rather than a single month's number would. Kmart has had the same increase in sales for the last two years. Kmart’s same store sales has remained stagnant even though they have been opening new stores. This stable ratio has been because Kmart, although opening new stores, has also been closing stores at the same time in their effort to restructure the company.

Due to the lack of an upward trend in the rate of sales growth, management may need to reevaluate new store positions and locations, which can impact this data. The below median peer comparison also reflects stagnation in the growth of the company as well as slow profit when compared to the other major players in the retail industry.

Sales / Square Foot (millions)

| |1997 |1998 |

|K-Mart |$211M |$222(S)M |

|Wal-Mart |347 |371(G) |

|Dayton-Hudson (Target) |230 |244(S) |

|Median Peer Comparison |$216M |$221M |

(S) Designates sq. footage vs. (G) gross

The Sales to Square Foot ratio is a measurement of how efficient the retailer is using its assets. It gives credit to the designers/architects who design the buildings that house the retailers as well as to the management and marketing staff who control its product presentation. It indicates how effective space, in this case square footage for selling, is utilized. If the sales per square foot is low relative to other retailers in the same sector a problem may exist. Some of the factors contributing to this problem are the sales associate's performance, the customer base or the physical location of the business.

Kmart's numbers in this ratio are impressive in that they have demonstrated improvements and are presently slightly above the median peer comparison. It appears they are utilizing their assets effectively; however, their lack of growth overall in the market may be contributed to their lack of profitability from their product mix. Please note: the s referred to in the table above denotes selling space per square foot while the “G” represent gross square footage. For example: Kmart is reporting their selling per square footage, (only the space used to sell) versus Wal-mart is reporting their selling/square foot from their gross store square footage. The gross number is including non-selling space, which inflates Wal-mart numbers in the peer comparison.

Conclusion

The following table identifies key strengths and weaknesses identified through the historical analysis of Kmart.

|Strengths |Weaknesses |

|Cash: Kmart is maintaining positive net cash after operations to service|Cash: Cash balances are 64% less than the industry. In addition, |

|their debt. However, net cash after operations has declined 52% over the|net cash after operations has declined 52% over the three year |

|three year period 1996-1998. The cash position could be views as a |period 1996-1998. |

|strength or weakness. | |

|Kmart has a $2.5 billion revolving credit agreement. | |

|Accounts Payable: APDOH is 4.61 shorter than the industry average |Inventory: Kmart is carrying 28% above the inventory norm. INVDOH|

|resulting in Kmart paying 14% faster than the industry resulting in the |is 17.64 days longer than the industry resulting in a longer |

|use of cash of approximately $319. |operating and cash conversion cycles resulting in the use of cash |

| |of approximately $1,222. |

|EBIT/Interest: EBIT increased 30% while interest decreased 39.6% over the|Cost of Goods Sold: Cost of goods sold is 16% above the industry |

|1996-1998 period resulting TIE increasing by 115%. |average resulting in a lower gross margin of 21.84% in comparison |

| |to 32.40% industry average. In addition, the operating margin is |

| |affected by cost of goods sold at 3.30% versus the 5.50% industry |

| |average. |

|Sales Growth: Sales growth has improved 7.12% over the three year period |Sales/net working capital ratio: Sales/net working capital ratio is|

|1996-1997. |35.91% greater than the industry. It appears that Kmart is |

| |financing current assets with long-term debt. |

|%EBT/Total Assets: Earnings before taxes of 2.3% is considerable lower |Same store sales: Same store sales remained constant for 1997 and |

|than the industry average. The %EBT/Total Assets ratio is less than the |1998 and was lower (4.8x) than the industry 6.5x for 1998. |

|industry. EBT is approximately 52.6% below industry average due to the | |

|higher COGS which resulting in lower gross margins and operating margins.| |

|Earnings before taxes have increased over the 1996-1998 period by 142%. | |

|EBITR/ Interest Expense+Rent Expense: The median peer EBIT margin is |Sales/net fixed assets: Sales increased by 7% while net fixed |

|approximately 3.9% versus Kmart’s 3.24% margin. The lower ratio in |assets increased by 3.9% over the three year period. As a result, |

|comparison to their peers is attributed to the lower EBIT margin. |sales/total net fixed assets has increased over the three year |

| |period. |

|Income growth: Income grew 201% over the three year period. However, |Leases vs. Own: Kmart leases 2,051 and owns 110 of their |

|due to expenses associated with divesting subsidiaries, Kmart reported |facilities. |

|losses for fiscal year ended 1996. In addition, Kmart booked expenses | |

|for early retirement programs. | |

|Debt Service Coverage: Debt service coverage is 4.14x for 1998 versus | |

|2.99x. This increase in the ratio is attributed to the large growth in | |

|net income of 213.08% and 108.03% coupled with the decrease in total debt| |

|service of 16%. | |

Kmart’s income grew 201% over the past three years due to improved merchandise assortments and roll out of the Big-K format. Additionally, the absence of a $114M expense for voluntary early retirement was a contributing factor to the income growth. Although cash balances are significantly lower than the industry, Kmart appears to manage their cash position with reported positive net cash after operations for the past three years.

Kmart’s performance is trending upward for the past three years in comparison to 1995 when they were on the verge of bankruptcy. Sales have continued to increase an average 7.12% for the past three years. In addition, Kmart has reduced interest expense through debt restructuring and pay downs of long-term debt. Although Kmart is improving their debt structure, asset management practices could be improved.

Kmart’s primary weakness is their inventory management practices. As seen in the analysis and above table, inventory has slightly declined in the past year, however they are still above the industry average by 28%. In addition, cost of good sold is 16% higher than the industry. This has resulted in a higher INVDOH by 17.64 days greater than the industry resulting in an effect of $1,222M. Kmart’s management needs to focus on examining the problem in inventory management control. Inventory management is a critical aspect in the discount retail industry because it is their primary source of revenue generation. In addition, Kmart is paying their trade payables faster than the industry by 4.61 days resulting in a $319 use of cash.

Kmart leases 95% of their facilities. The remaining competitors in the industry own the majority of their facilities. Because of differences in depreciation methods of straight-line amortization (leases) and accelerated (owning the building), Kmart’s net fixed assets are higher than the industry. Kmart has signed 25 year leases with 5 year renewable options. It appears the new store opening are being bought, rather than leased, and are included in the 110 stores owned.

Kmart’s same store sales are also lower than the industry caused by recent store closings and openings. Kmart has closed many stores, while opening others utilizing the Super K centers. As a result, Kmart’s ratio has been biased down since the new stores are not included in the ratio. This discount retail industry ratio subtracts out the current year sales of the new stores to determine same store sales. This ratio ensures that new store opening do not inflate store sales figures each year. Therefore, this ratio is a critical part of historical analysis for the discount retail industry.

This historical analysis provides a financial overview of the companies performance over the past three years 1996-1998. The main strengths and weaknesses of Kmart are identified in the above table, which were validated in the ratio analysis throughout the paper. The fourth stage of this industry analysis project will provide projections for the next three year period.

We expect Kmart to grow at approximately 6.5% increasing at a rate of 2% each year. This increase is expected due to the opening of the Big K format stores during the next three years. Cost of goods sold will continue to increase at the rate of sales also contributed from the opening of new stores for the next three years. Overall net income will increase due to the increase in sales, controlled SG&A expenses and the absence of loss of discontinued operations. The sale of all Kmart’s discontinued operations should be completed by the end of 2000.

Due to the sales increase and cost of goods sold and new store openings; inventory on the balance will increase at the rate of sales. The continued change of Kmart’s format into the Big-K layout will result in an increase in fixed assets contributed to the refrigeration equipment and expansion of facilities. Kmart has also entered into a new revolving credit agreement of $40.6MM for working capital will result in continued decreasing cash balances. Overall, Kmart is expected to continue to report positive results for the next three years. The main resources used in this paper were the 1996-1998 audited financial statements, RMA industry data and Bank of America Retail Peer Analysis.

APPENDIX

Financial Statements and Ratios

Bibliography

Laney, Janice. Bank of America Retail Peer Analysis, 1998. Pgs. 62-70.

Kmart Corporation. Audited Financial Statements, 1996-1998.

Robert Morris and Associates Industry Data., 1998. Pgs. 654-655.

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