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**Analyzing Financial Statements**

Chapter 14 Chapter 14: Analyzing Financial Statements.

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**Understanding The Business**

Economy-wide Factors Industry Factors Individual Company Factors In considering an investment decision in the stock of a corporation, potential investors should evaluate the company’s future income and growth potential on the basis of industry factors and economy-wide factors as well as individual company factors. Invest? No Yes

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**Understanding The Business**

Return on an equity security investment Dividends Increase in share price Investors provide resources, usually cash, to companies with the expectation of receiving more cash in return at some future time. Investors will receive future cash returns in the form of periodic dividends and from the sale of their ownership shares, hopefully at an increased share price. Investors

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**Explain how a company’s business strategy affects financial analysis.**

Learning Objectives Explain how a company’s business strategy affects financial analysis. LO1 Our first learning objective in Chapter 14 is to explain how a company’s business strategy affects financial analysis.

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**Understanding a Company’s Strategy**

I need to know the company’s policies on product differentiation, pricing, and cost control to make my financial analysis more meaningful. Successful investors must understand a company’s business strategy. Two strategies that can yield profitable results are product differentiation and operating cost advantages.

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**Understanding a Company’s Strategy**

Business Strategy Operating Decisions Transactions A company’s business strategy leads to operating decisions that are ultimately reflected in the company’s financial statements. Financial Statements

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**Discuss how analysts use financial statements.**

Learning Objectives Discuss how analysts use financial statements. LO2 Our second learning objective in Chapter 14 is to discuss how analysts use financial statements.

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**Financial Statement Analysis**

FINANCIAL STATEMENT USERS MANAGEMENT EXTERNAL DECISION MAKERS . . . uses accounting data to make product pricing and expansion decisions. . . . use accounting data for investment, credit, tax, and public policy decisions. Financial analysis is used by many people within the organization. Managers find financial analysis helpful as they make decisions concerning the operations of the business. External users of financial statements are also interested in the results of comprehensive financial analysis. Shareholders, creditors, and customers all want to learn as much as possible about the financial health of a company.

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**Financial Statement Analysis**

THREE TYPES OF FINANCIAL STATEMENT INFORMATION Past Performance Present Condition Future Performance Financial analysts evaluate past performance, present condition, and prospects for future performance. Income, sales volume, cash flows, return on investment, and earnings per share can be used to evaluate past performance. The present condition can be evaluated with an analysis of various balance sheet amounts. Past trends are often used to evaluate future prospects. We will look at a number of financial ratios in this chapter that provide insight into the past, present, and future. Income, sales volume, cash flows, return- on-investments, EPS. Assets, debt, inventory, various ratios. Sales and earnings trends are good indicators of future performance.

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**Financial Statement Analysis**

Financial statement analysis is based on comparisons. Time series analysis Comparison with similar companies Examines a single company to identify trends over time. Part I In order to compare companies or to assess the status of a single company, analysts use several different forms of analysis. Time series analysis examines a single company’s financial performance over time. Part II When we complete our analysis it is essential to compare the results we obtained to those of our competitors, other companies in our same industry, and general financial market guidelines

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**Financial Statement Analysis**

Financial statement analysis is based on comparisons. Time series analysis Comparison with similar companies Financial results are often affected by industry factors and economy-wide factors. By comparing one company’s financial performance with other companies in the same line of business, in the same time period, we get an indication of the relative performance of the companies. Provides insights concerning a company’s relative performance. Company A Company B

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**Ratio and Percentage Analyses**

Ratio analysis, or percentage analysis, is used to express the proportionate relationship between two different amounts. Analysts use trend percentages, component percentages, and ratios to perform assessments of a company’s performance. Let’s look at how each of these tools can be used.

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**Compute and interpret component percentages.**

Learning Objectives Compute and interpret component percentages. LO3 Our third learning objective in Chapter 14 is to compute and interpret component percentages.

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**Component Percentages**

Express each item on a particular statement as a percentage of a single base amount. Total assets on the balance sheet Net sales on the income statement Component percentages express all items on a financial statement in terms of one component of that statement. For the income statement we generally express all items as a percent of net sales revenue. For the balance sheet we generally express all items as a percent of total assets Let’s see how this works using Home Depot’s Income Statements for 2003 and

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**Component Percentages**

The comparative income statements of Home Depot for 2004 and 2003 appear on the next slide. Prepare component percentage income statements where net sales equal 100%. The comparative income statements of Home Depot for 2004 and 2003 appear on the next slide. Let’s prepare component percentage income statements for both years where net sales equal 100%. Home Depot

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**Component Percentages**

We will express all line-items on the income statement as a percent of total sales. We begin by setting total sales equal to 100 percent.

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**Component Percentages**

2004 Cost ÷ 2004 Sales Let’s begin the calculation by determining the cost of merchandise sold percentage. For 2004, divide cost of merchandise sold of $44,236,000,000 by net sales of $64,816,000,000 and multiply by 100 percent. For 2004, cost of merchandise sold was 68.2 percent of net sales. Before moving to the next slide, calculate the component percentages for the other line items on the income statements.

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**Component Percentages**

Here you see the component percentages for each line item on the income statement for both 2004 and Although the percentages are relatively stable from 2003 to 2004, some differences can be seen. For more meaningful trend analysis, component percentages for several years should be computed and plotted over time. An interesting comparative analysis would involve comparing Home Depot’s component percentages with those of its principal competitor, Lowe’s.

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**Now, let’s look at some commonly used ratios.**

Ratios are mathematical expressions of relationships between items. Ratios can be used to compare past performance to present performance or to compare one company with another company.

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**The 2004 and 2003 balance sheets for Home Depot are presented next.**

Commonly Used Ratios The 2004 and 2003 balance sheets for Home Depot are presented next. We will be referring to these financial statements throughout the ratio analyses. The 2004 and 2003 balance sheets for Home Depot are presented on the next two slides. We will be referring to the balance sheets as well as the income statement throughout the ratio analyses. Home Depot

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**Comparative Statements**

On your screen, you see the asset section of Home Depot’s balance sheets for both 2004 and 2003. Continued

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**Comparative Statements**

On this screen, you see the liabilities and equity sections of Home Depot’s balance sheets for both 2004 and 2003.

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**Compute and interpret profitability ratios.**

Learning Objectives Compute and interpret profitability ratios. LO4 Our fourth learning objective in Chapter 14 is to compute and interpret profitability ratios.

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**Tests of Profitability**

Profitability is a primary measure of the overall success of a company. Now, let’s look at the profitability ratios for Home Depot for 2004. Profitability is a primary measure of the overall success of a company. Now, let’s look at the profitability ratios for Home Depot for 2004. Home Depot

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**This measure indicates how much income was earned for every dollar**

Return on Equity Net Income Average Owners’ Equity Return on Equity = Return on Equity $4,304 ($22,407 + $19,802) ÷ 2 = = 20.4% Return on equity measures how well the company employed the owners’ investments to earn income. This ratio is calculated by dividing net income by average owners’ equity. Home Depot’s 2004 income is $4,304,000,000. Ending owners’ equity for 2004 is $22,407,000,000, and ending owners’ equity for 2003 is $19,802,000,000, When the income is divided by the average owners’ equity, we see that the return on equity at Home Depot for 2004 is 20.4 percent. This measure indicates how much income was earned for every dollar invested by the owners.

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**Net Income + Interest Expense (net of tax)**

Return on Assets Return on Assets Net Income + Interest Expense (net of tax) Average Total Assets = Return on Assets $4,304 + ($62 × ( )) ($34,437 + $30,011) ÷ 2 = = % Corporate tax rate is 34%. We can also determine the return a company earns on its total assets. To calculate this ratio we divide net income plus interest expense (net of tax) by the average total assets for the period. Because creditors provide financing for a portion of the assets, we add interest expense to income in the numerator of the ratio. Home depot earned a return on its total assets of 13.5 percent. Please spend a few minutes going over the calculation of this ratio, especially the interest expense computation. Return on total assets measures how well assets have been employed by Home Depot. This ratio is generally considered the best overall measure of a company’s profitability.

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**Financial Leverage Percentage**

Return on Equity – Return on Assets = 6.9% = % – % Financial leverage is the advantage or disadvantage that occurs as the result of earning a return on equity that is different from the return on assets. Financial leverage is the advantage or disadvantage that occurs as the result of earning a return on equity that is different from the return on assets. Home Depot has positive financial leverage since the return on equity is higher than the return on assets. Positive financial leverage indicates that Home Depot has borrowed money at a low rate of interest and employed the borrowed funds at a higher rate of return.

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**Earnings per Share (EPS)**

Net Income Average Number of Shares of Common Stock Outstanding EPS = EPS $4,304 2,283 = = $1.88 Earnings per share is equal to net income less preferred stock dividends divided by the weighted-average number of common shares outstanding. The numerator of the equation is sometimes referred to as income available to common shareholders. Home Depot’s earnings per share for 2004 is $ Home Depot has no preferred stock dividends to subtract from income in the numerator. Earnings per share is one of the most widely quoted financial ratios. It is a measure of the company’s ability to produce income for each common share outstanding. Average number of shares outstanding is from Home Depot’s 2004 Income Statement. Earnings per share is probably the single most widely watched financial ratio.

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**Quality of Income Quality of Income**

Cash Flow from Operating Activities Net Income = Quality of income compares cash flow from operating activities to reported net income. A high net income compared to a low cash flow from operating activities indicates a lower quality of earnings. On your screen you see the cash flow from operating activities portion of Home Depot’s 2004 Statement of Cash Flows.

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**A ratio higher than 1 indicates high-quality earnings.**

Quality of Income Quality of Income Cash Flow from Operating Activities Net Income = Quality of Income $6,545 $4,304 = = Dividing Home Depot’s cash flow from operating activities by net income, we see that Home Depot’s quality of income is A quality of income ratio higher than 1 indicates high-quality earnings because each dollar of income is supported by more than one dollar of cash flow from operations. A ratio higher than 1 indicates high-quality earnings.

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Profit Margin Profit Margin Net Income Net Sales = = 6.6% Profit Margin $4,304 $64,816 = Profit margin tells us how effective the company is at producing bottom line net income. The ratio is determine by dividing net income by net sales. At Home Depot, after all expenses and taxes have been paid, the company was able to produce a profit margin of 6.6 percent in 2004. This ratio tells us the percentage of each sales dollar that is income.

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**Net Sales Revenue Average Net Fixed Assets**

Fixed Asset Turnover Fixed Asset Turnover Net Sales Revenue Average Net Fixed Assets = Fixed Asset Turnover $64,816 ($20,063 + $17,168) ÷ 2 = = 3.5 The fixed asset turnover ratio is equal to net sales revenue divided by average net fixed assets. By net fixed assets, we mean property, plant, and equipment, net of accumulated depreciation. To get the average amount we add the beginning and ending balances of net property, plant and equipment from the balance sheets, and divide by 2. At Home Depot, the fixed asset turnover ratio is 3.5 for The fixed asset turnover ratio is a measure of how effectively management is using the company’s investment in fixed assets to generate sales revenue. This ratio measures a company’s ability to generate sales given an investment in fixed assets.

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**Compute and interpret liquidity ratios.**

Learning Objectives Compute and interpret liquidity ratios. LO5 Our fifth learning objective in Chapter 14 is to compute and interpret liquidity ratios.

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**Now, let’s look at the liquidity ratios for Home Depot for 2004.**

Tests of Liquidity Tests of liquidity focus on the relationship between current assets and current liabilities. Now, let’s look at the liquidity ratios for Home Depot for 2004. Liquidity refers to a company’s ability to meet its currently maturing debts. Tests of liquidity focus on the relationship between current assets and current liabilities. Now, let’s look at the liquidity ratios for Home Depot for 2004. Home Depot

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**Cash + Cash Equivalents**

Cash Ratio Cash Ratio Cash + Cash Equivalents Current Liabilities = = 0.296 to 1 Cash Ratio $2,826 $9,554 The cash ratio is a measure of the adequacy of available cash to pay current liabilities. We compute the cash ratio by dividing the sum of cash and cash equivalents by current liabilities. At the 2004 balance sheet date, Home Depot’s cash ratio is 0.296, meaning Home Depot has slightly less than 30 cents in cash on hand for each dollar of current liabilities. While this number might seem alarming, Home Depot generates large amounts of cash from operations that will be available before cash payments are due. Managing cash flow is extremely important. Certainly the company must have sufficient cash to meet its obligations, but holding too much cash can lower the return on assets. This ratio measures the adequacy of available cash.

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**This ratio measures the ability of the company to pay current **

Current Ratio Current Ratio Current Assets Current Liabilities = Current Ratio $13,328 $9,554 = 1.39 to 1 Perhaps the most widely used measure of a company’s ability to pay current obligations is the current ratio. It is computed by dividing current assets by current liabilities. At Home Depot, the current ratio at the 2004 balance sheet date is This means that for every dollar of current liabilities, Home Depot has $1.39 of current assets to pay those obligations. It might be tempting to say that the higher this ratio becomes, the better off the company is. However, maintaining a very high current ratio restricts the amount that can be invested elsewhere in the business. For years the accepted standard for the current ratio was But with the ability to efficiently manage cash flows, most companies now maintain a current ratio somewhat less than 2.0. This ratio measures the ability of the company to pay current debts as they become due.

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**Quick Ratio (Acid Test)**

Quick Assets Current Liabilities = Quick Ratio $3,949 $9,554 = 0.41 to 1 Quick Ratio The quick ratio is a more stringent measure than the current ratio. We calculate this ratio by dividing quick assets by current liabilities. Quick assets include cash and cash equivalents, net receivables, and short-term investments. As you can see from looking back at Home Depot’s balance sheet, inventories are approximately three-fourths of current assets. Quick assets exclude inventories from the numerator. For that reason, Home Depot’s quick ratio of 0.41 at the 2004 balance sheet date is much lower than the current ratio. This ratio is like the current ratio but measures the company’s immediate ability to pay debts.

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**Average Net Receivables**

Receivable Turnover Net Credit Sales Average Net Receivables Receivable Turnover = Receivable Turnover $64,816 ($1,097 + $1,072) ÷ 2 = 60 Times = The receivable turnover ratio tells us the number of times per year a company can convert its accounts receivable into cash. For any company, the higher the turnover, the faster the cash collection on accounts receivable. We calculate receivable turnover by dividing net credit sales by average net receivables. This is yet another example of a ratio that contains and income measure in the numerator and a balance sheet measure in the denominator. Remember, in this type of ratio we always use an average amount in the denominator. At Home Depot, the receivable turnover for 2004 is 60 times. This means that, on average, the company collected its receivables 60 times per year. This ratio measures how quickly a company collects its accounts receivable.

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**Average Age of Receivables**

Days in Year Receivable Turnover Average Age of Receivables = = Days Average Age of Receivables = Average age of receivables is calculated by dividing 365 days by the receivable turnover ratio. This ratio measures the average number of days it takes to collect receivables. At Home Depot, the average age of receivables is only 6.1 days. This ratio measures the average number of days it takes to collect receivables.

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**This ratio measures how quickly the company sells its inventory.**

Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = Inventory Turnover $44,236 ($9,076 + $8,338) ÷ 2 = 5.1 Times = Like the receivable turnover ratio, we can also calculate the inventory turnover. The inventory turnover ratio measures the number of times inventory is sold and replaced during the year. Higher inventory turnover helps protect a company from obsolete inventory items. Inventory turnover is calculated by dividing cost of goods sold for the period by the average inventory. At Home depot, the inventory turnover for 2004 is 5.1 times, telling us that Home Depot sells and replaces its inventory about 5.1 times per year. This ratio measures how quickly the company sells its inventory.

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**Average Days’ Supply in Inventory**

Days in Year Inventory Turnover Average Days’ Supply in Inventory = = Days = Average Days’ Supply in Inventory Average days’ supply in inventory is calculated by dividing 365 days by the inventory turnover ratio. This ratio measures the average number of days it takes a company to sell its inventory. Throughout 2004, Home Depot averaged 71.6 days of inventory available for sale. This ratio measures the average number of days it takes to sell the inventory.

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**Accounts Payable Turnover**

Cost of Goods Sold Average Accounts Payable Accounts Payable Turnover = Accounts Payable Turnover $44,236 ($5,159 + $4,560) ÷ 2 = 9.1 Times = Like the inventory turnover ratio and the receivables turnover ratio, we can also calculate the accounts payable turnover ratio. The accounts payable turnover ratio measures the number of times purchases on account are paid each year. The accounts payable turnover ratio is calculated by dividing cost of goods sold for the period by the average accounts payable. At Home depot, the accounts payable turnover ratio for 2004 is 9.1 times, telling us that, on average, Home Depot pays the balance owed to its suppliers about 9.1 times per year. This ratio measures how quickly the company pays its accounts payable.

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**Average Age of Payables**

Days in Year Accounts Payable Turnover Average Age of Payables = = Days = Average Age of Payables Average age of payables is calculated by dividing 365 days by the accounts payable turnover ratio. This ratio measures the average number of days it takes a company to pay its suppliers. Throughout 2004, Home Depot averaged 40.1 days to pay its suppliers. This ratio measures the average number of days it takes to pay its suppliers.

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**Compute and interpret solvency ratios.**

Learning Objectives Compute and interpret solvency ratios. LO6 Our sixth learning objective in Chapter 14 is to compute and interpret solvency ratios.

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**Now, let’s look at the solvency ratios for Home Depot for 2004.**

Tests of Solvency Tests of solvency measure a company’s ability to meet its long-term obligations. Now, let’s look at the solvency ratios for Home Depot for 2004. Tests of solvency measure a company’s ability to meet its long-term obligations. Now, let’s look at the solvency ratios for Home Depot for 2004. Home Depot

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**This ratio indicates a margin of protection for creditors.**

Times Interest Earned Net Interest Income Tax Income Expense Expense Interest Expense Times Interest Earned = + $4, $ $2,539 $62 Times Interest Earned = = Times Times interest earned is a ratio that measures the ability of a company to meet its periodic interest payments. The ratio is calculated by dividing income before interest and taxes by interest expense for the period. Since interest expense is deducted before computing taxes and net income, we add both interest expense and income tax expense back to net income for the numerator of this ratio. In 2004, Home Depot earned 111 times the amount of its interest expense. This ratio indicates a margin of protection for creditors.

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Cash Coverage Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid = The cash coverage ratio compares the cash generated from operations to cash obligations. The ratio is calculated by dividing cash flow from operations before interest and taxes by the amount of interest paid. On your screen you see the cash flow from operating activities portion of Home Depot’s 2004 Statement of Cash Flows.

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Cash Coverage Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid = Cash Coverage = $6, $ $2,539 $70 = 131 In the numerator of this ratio, you see that we added interest paid and income tax expense to cash flow from operating activities to get cash flow from operating activities before interest and taxes. Also note that interest paid in the denominator is different from interest expense used in the times interest earned ratio. Home Depot generated nearly $131 dollars in cash for each dollar of interest paid in 2004. This ratio compares the cash generated with the cash obligations of the period.

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**Debt-to-Equity Ratio Total Liabilities Owners’ Equity**

= $12,030 $22,407 = = Debt-to-Equity Ratio The debt-to-equity ratio measures the amount of liabilities that exists for each $1 invested by the owners. We compute the ratio by dividing total liabilities by total owners’ equity. At the 2004 balance sheet date, Home Depot’s debt to equity ratio is 0.54, meaning the shareholders of Home Depot have provided almost twice as much of the company’s financing as the creditors. This ratio measures the amount of liabilities that exists for each $1 invested by the owners.

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**Compute and interpret market test ratios.**

Learning Objectives Compute and interpret market test ratios. LO7 Our seventh learning objective in Chapter 14 is to compute and interpret market test ratios.

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**Now, let’s look at the market tests for Home Depot for 2004.**

Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor. Now, let’s look at the market tests for Home Depot for 2004. Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor. Now, let’s look at the market tests for Home Depot for 2004. Home Depot

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**Price/Earnings (P/E) Ratio**

Current Market Price Per Share Earnings Per Share P/E Ratio = $40 $1.88 = 21 A recent price for Home Depot stock was $40 per share. The price/earnings ratio measures the relationship between the current market price of the stock and its earnings per share. Once we know the earnings per share of stock we can calculate the price-earnings ratio by dividing the current market price per share of the company’s stock by the price/earnings ratio. Using a recent price of $40 per share for Home Depot’s common stock, we divide by the 2004 earnings per share of $1.88 to obtain a price earnings ratio of We conclude that Home Depot’s common stock is selling in the market place for 21 times its earnings for 2004. This ratio measures the relationship between the current market price of the stock and its earnings per share.

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Dividend Yield Ratio Dividend Yield Dividends Per Share Market Price Per Share = Dividend Yield $0.27 $40 = = % Home Depot paid dividends of $.27 per share when the market price was $40 per share. Investors are interested in the amount of income that they will receive in the form of dividends. One comparison that investors make is based on dividend yield. To determine the dividend yield ratio we divide the annual dividend per share by the market price per share of the company’s common stock. During 2004, Home Depot paid dividends of $0.27 per common share of stock outstanding. Dividing $0.27 by the share price of $40 dollars, we find that Home Depot’s dividend yield is 0.68 percent. This ratio is often used to compare the dividend-paying performance of different investment alternatives.

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Interpreting Ratios Ratios may be interpreted by comparison with ratios of other companies or with industry average ratios. Ratios may vary because of the company’s industry characteristics, nature of operations, size, and accounting policies. We gain the most insight from financial ratios if they are compared to Ratios of other companies in the same line of business. Ratios from the same company over time. Industry average ratios. Care must be exercised when comparing ratios. Ratios may be computed differently by different companies. Earnings per share is the only ratio whose computation has been standardized by the accounting profession. In addition, different companies use different accounting practices that have an impact on ratios. For example, the choice of first-in, first-out inventory cost flow assumptions versus last-in, first-out inventory cost flow assumptions will produce different financial statement results.

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**Other Financial Information**

In addition to financial ratios, special factors might affect company analysis: Rapid growth. Uneconomical expansion. Subjective factors. Often we must look beyond financial ratios to find the information needed to evaluate companies. For example, financial ratios may indicate rapid growth in sales and earnings which is almost always considered favorable. However, if the rapid growth is due to uneconomical expansion that cannot be sustained, the rapid growth may not be an indication of a successful business model for the long term. Financial statements do not measure all of the attributes of a business that are necessary for success. For example, financial statements do not measure the value of human capital. The most valuable assets at many companies are the skilled work force and the talented management team. These assets are not reported in the financial statements. They are examples of subjective factors that financial analysts must consider in addition to financial statement analysis in order to properly evaluate a company.

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Efficient Markets A securities market in which prices fully reflect available information is called an efficient market. In an efficient market, a company’s stock reacts quickly when new, relevant information is released about the company. A securities market in which prices fully reflect available information is called an efficient market. In an efficient market, a company’s stock reacts quickly when new, relevant information is released about the company. Relevant information includes financial statement information as well as frequent press releases concerning the current operations of a business.

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End of Chapter 14 End of Chapter 14.

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