 # Analyzing Financial Statements 9/01/03

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Analyzing Financial Statements 9/01/03
Chapter 14 Analyzing Financial Statements 9/01/03

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.

THREE TYPES OF FINANCIAL STATEMENT INFORMATION Past Performance Present Condition Future Performance Income, sales volume, cash flows, return- on-investments, EPS. Assets, debt, inventory, various ratios. Sales and earnings trends are good indicators of future performance.

Return on an equity security investment Dividends Increase in share price Investors

Economy-wide Factors Industry Factors Individual Company Factors Invest? No Yes

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.

Fundamental Strategies
Product differentiation: unique features, quality, I.e., Lexus Cost advantage: lower costs, better efficiency, lower prices, I.e., Honda What is Home Depot’s Strategy? Are they successful with it?

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.

Financial Statement Analysis
Financial statement analysis is based on comparisons. Time series analysis Comparison with similar companies Company A Company B Provides insights concerning a company’s relative performance.

Ratio and Percentage Analyses
Ratio analysis, or percentage analysis, is used to express the proportionate relationship between two different amounts.

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 Example
The comparative income statements of Home Depot 2001 and 2000 appear on the next slide. Prepare component percentage income statements where net sales equal 100%. Home Depot

Component Percentages

Component Percentages
2001 Cost ÷ 2001 Sales

Component Percentages

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

The 2001 and 2000 balance sheets for Home Depot are presented next.
Commonly Used Ratios The 2001 and 2000 balance sheets for Home Depot are presented next. We will be referring to these financial statements throughout the ratio analyses. Home Depot

Comparative Statements
Continued

Comparative Statements

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 2001. Home Depot

This measure indicates how much income was earned for every dollar
Return on Equity Income Average Owners’ Equity Return on Equity = Return on Equity \$2,581 (\$15,004 + \$12,341) ÷ 2 = = 18.9% This measure indicates how much income was earned for every dollar invested by the owners. Lowes ratio 15.9; ROT 15%+

Return on Assets Return on Assets
Income + Interest Expense (net of tax) Average Total Assets = Return on Assets \$2,581 + (\$21 ×( )) (\$21,385 + \$17,081) ÷ 2 = = % Corporate tax rate is 34 percent. This ratio is generally considered the best overall measure of a company’s profitability. Lowes ratio 9.1%; ROT 10%+

Financial Leverage Financial Leverage
Return on Equity – Return on Assets = 5.4% = % – % 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. Lowes 6.8%.

Earnings per Share (EPS)
Income Average Number of Shares of Common Stock Outstanding EPS = EPS \$2,581 (2, ,304) ÷ 2 = = \$1.11 Earnings per share is probably the single most widely watched financial ratio.

Quality of Income Quality of Income
Cash Flow from Operating Activities Net Income =

Quality of Income Quality of Income
Cash Flow from Operating Activities Net Income = Quality of Income \$2,796 \$2,581 = = A ratio higher than 1 indicates higher-quality earnings. No significant non-cash earnings. Cash from Current Assets/Liabilities balanced. ROT >1.0

This ratio describes a company’s ability to earn income from sales.
Profit Margin Profit Margin Income (before Extraordinary Items) Net Sales = = 5.6% Profit Margin \$2,581 \$45,738 = This ratio describes a company’s ability to earn income from sales. Lowes 4.3%; ROT >10%

Net Sales Revenue Average Net Fixed Assets
Fixed Asset Turnover Fixed Asset Turnover Net Sales Revenue Average Net Fixed Assets = Fixed Asset Turnover \$45,738 (\$13,068 + \$10,227) ÷ 2 = = 3.9 This ratio measures a company’s ability to generate sales given an investment in fixed assets. Lowes ratio 3.1; ROT > 1.0

Total Asset Turnover Ratio
Total Asset = Net Sales Revenue Turnover Average Total Assets Home Depot = \$45,738 (\$21,385 + \$17,081) / 2 = 2.38 Lowes = 1.86

Now, let’s look at the liquidity ratios for Home Depot for 2001.
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 2001. Home Depot

Cash + Cash Equivalents
Cash Ratio Cash Ratio Cash + Cash Equivalents Current Liabilities = = 0.04 : 1 Cash Ratio \$167 \$4,385 This ratio measures the adequacy of available cash. Lowes ratio 0.15

Current Ratio Current Ratio Current Assets Current Liabilities =
\$7,777 \$4,385 = 1.77 : 1 This ratio measures the ability of the company to pay current debts as they become due. ROT 2.0 to 1

Quick Ratio (Acid Test) (Excludes inventory & other curr. Assets)
Quick Assets Current Liabilities = Quick Ratio \$1,012 \$4,385 = .23 : 1 Quick Ratio This ratio is like the current ratio but measures the company’s immediate ability to pay debts.

Receivable Turnover(per year)
Net Credit Sales Average Net Trade Receivables Receivable Turnover = Receivable Turnover \$45,738 (\$835 + \$587) ÷ 2 = 64 times = This ratio measures how quickly a company collects its accounts receivable.

Average Age of Receivables(DSO)
Days in Year Receivable Turnover Average Age of Receivables = = days 365 64 Average Age of Receivables = This ratio measures the average number of days it takes to collect receivables. ROT 45 to 60 days. Why is HD so low? Lots of Cash Sales.

This ratio measures how quickly the company sells its inventory.
Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = Inventory Turnover \$32,057 (\$6,556 + \$5,489) ÷ 2 = 5.3 times = This ratio measures how quickly the company sells its inventory. Lowes ratio 4.4 times ROT 4.0 times or better.

Average Days’ Supply in Inventory
Days in Year Inventory Turnover Average Days’ Supply in Inventory = = days = Average Days’ Supply in Inventory This ratio measures the average number of days it takes to sell the inventory. Lowes days 83.

Tests of Solvency and Equity Position
Tests of solvency measure a company’s ability to meet its obligations. Now, let’s look at the solvency ratios for Home Depot for 2001. Home Depot

This ratio indicates a margin of protection for creditors.
Times Interest Earned Net Interest Income Tax Income Expense Expense Interest Expense Times Interest Earned = + \$2, \$ \$1,636 \$21 Times Interest Earned = = 202 This ratio indicates a margin of protection for creditors. ROT 7 times or better.

Cash Coverage Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid =

Cash Coverage Cash Coverage
Cash Flow from Operating Activities Before Interest and Taxes Interest Paid = Cash Coverage = \$2, \$ \$1,386 \$16 = This ratio compares the cash generated with the cash obligations of the period.

Debt/Equity Ratio Total Liabilities Owners’ Equity Debt/Equity Ratio =
\$6,381 \$15,004 = Debt/Equity Ratio = This ratio measures the amount of liabilities that exists for each \$1 invested by the owners. Lowes ratio ROT >1.00.

Total Debt Ratio Debt Ratio = Total Debt Total Assets
Home Depot = \$6,381 = 29.8% \$21,385 ROT > 50%

Now, let’s look at the market tests for Home Depot for 2001.
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 2001. Home Depot

Price/Earnings (P/E) Ratio
Current Market Price Per Share Earnings Per Share P/E Ratio = \$35 \$1.11 = A recent price for Home Depot stock was \$35 per share. This ratio measures the relationship between the current market price of the stock and its earnings per share. Lowes p/e ratio 14; ROT 20+

Other Analytical Considerations
In addition to financial ratios, special factors might affect company analysis: Rapid growth. Uneconomical expansion. Subjective factors.

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.

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.

End of Chapter 14 Ratios Ratios Ratios Ratios Ratios