1. Analyzing Financial Statements Chapter 13 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

2. Economy-wide Factors Industry Factors Individual Company Factors Lend? Sell on credit? Invest? Invest?Invest? NoYes Understanding The Business

3. McGraw-Hill/Irwin Slide 3 Analyzing Financial Statements  Dollar and percentage changes on statements (Horizontal Analysis)  Common-size statements (Vertical Analysis)  Ratios Analytical techniques used to examine relationships among financial statement items

4. Horizontal Analysis Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

5. McGraw-Hill/Irwin Slide 5 Horizontal Analysis ($11,500 ÷ $23,500) × 100% = 48.9% $12,000 – $23,500 = $(11,500)

6. McGraw-Hill/Irwin Slide 6 Horizontal Analysis

7. McGraw-Hill/Irwin Slide 7 Horizontal Analysis

8. Common-Size Statements In balance sheets, all items usually are expressed as a percentage of total assets. In income statements as a percentage of sales.

9. McGraw-Hill/Irwin Slide 9 Common-Size Statements Sales Sales is usually the base and is expressed as 100%.

10. McGraw-Hill/Irwin Slide 10 Common-Size Statements

11. 14-11 COMMONLY USED RATIOS

12. 14-12 Commonly Used Ratios The 2012 and 2011 financial statements for Home Depot are in the text on pages 644-47. The calculation of the ratios following is based on them. The 2012 and 2011 financial statements for Home Depot are in the text on pages 644-47. The calculation of the ratios following is based on them. Home Depot

13. 14-13 Tests of Profitability ─ Return on Assets Return on Assets Net Income + Interest Expense (net of tax) Average Total Assets = Return on Assets $3,883 + ($606 × (1 -.34)) ($40,518 + $40,125) ÷ 2 = = 10.6% This ratio measures how well assets have been employed by the business. Many analysts consider this ratio as the best overall measure of a company’s profitability. Assume the corporate tax rate is 34%.

14. 14-14 TESTS OF PROFITABILITY ─ FINANCIAL LEVERAGE PERCENTAGE Financial Leverage Percentage Return on Equity – Return on Assets = 10.5% = 21.1% – 10.6% 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.

15. 14-15 Financial Leverage Financial leverage Financial leverage involves acquiring assets with borrowed funds. Return on investment in assets > Interest rate on borrowed funds Positive financial leverage = Return on investment in assets < Interest rate on borrowed funds Negative financial leverage =

16. 14-16 Tests of Profitability ─ Earnings per Share (EPS) EPS $3,883 1,562 == $2.49 Earnings per share is probably the single most widely watched financial ratio. Average number of shares based on the number of shares at the beginning and end of the year. Net Income* Average Number of Shares Outstanding for the Period EPS = *If there are preferred dividends, the amount is subtracted from net income.

17. 14-17 Tests of Profitability ─ Quality of Income A ratio higher than 1 indicates high-quality earnings. Quality of Income Cash Flow from Operating Activities Net Income = $6,651 $3,883 = 1.71 Home Depot’s Quality of Income

18. 14-18 Tests of Profitability ─ Profit Margin This ratio tells us the percentage of each sales dollar, on average, that represents income. Profit Margin Net Income Net Sales Revenue = = 5.5% Profit Margin $3,883 $70,395 =

19. 14-19 Tests of Profitability ─ Profit Margin This ratio tells us the percentage of each sales dollar, on average, that represents income. Profit Margin Net Income Net Sales Revenue = = 5.5% Profit Margin $3,883 $70,395 =

20. 14-20 Tests of Profitability ─ Fixed Asset Turnover Fixed Asset Turnover $70,395 ($24,448 + $25,060) ÷ 2 == 2.84 Fixed Asset Turnover Net Sales Revenue Average Net Fixed Assets = This ratio measures a company’s ability to generate sales given an investment in fixed assets.

21. 14-21 Tests of Liquidity ─ Current Ratio Current Ratio Current Assets Current Liabilities = Current Ratio $14,520 $9,376 = =1.55 to 1 This ratio measures the ability of the company to pay current debts as they become due. This ratio measures the ability of the company to pay current debts as they become due.

22. 14-22 Tests of Liquidity ─ Receivable Turnover Net Credit Sales Average Net Receivables Receivable Turnover = $70,395 ($1,245 + $1,085) ÷ 2 = 60.4 Times = This ratio measures how quickly a company collects its accounts receivable.

23. 14-23 Tests of Liquidity ─ Average Age of Receivables Days in Year Receivable Turnover Average Age of Receivables = = 6.0 Days 365 60.4 Average Age of Receivables = This ratio measures the average number of days it takes to collect receivables.

24. 14-24 Tests of Liquidity ─ Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = $46,133 ($10,325 + $10,625) ÷ 2 = 4.4 Times = This ratio measures how quickly the company sells its inventory.

25. 14-25 Tests of Liquidity ─ Average Days’ Supply in Inventory Days in Year Inventory Turnover Average Days’ Supply in Inventory == 83 Days 365 4.4 = Average Days’ Supply in Inventory This ratio measures the average number of days it takes to sell the inventory.

26. 14-26 Tests of Liquidity ─ Accounts Payable Turnover Ratio Cost of Goods Sold Average Accounts Payable Accounts Payable Turnover = This ratio measures how quickly the company pays its accounts payable. $46,133 ($4,856 + $4,717) ÷ 2 = 9.6 Times = Accounts Payable Turnover

27. 14-27 This ratio indicates a margin of protection for creditors. Tests of Solvency ─ Times Interest Earned Net Interest Income Tax Income Expense Expense Interest Expense Times Interest Earned = ++ $3,883 + $606 + $2,185 $606 Times Interest Earned = = 11.0 Times Tests of solvency measure a company’s ability to meet its long-term obligations.

28. 14-28 Tests of Solvency ─ Debt-to-Equity Ratio This ratio measures the amount of liabilities that exists for each $1 invested by the owners. $22,620 $17,898 = 1.26= Debt-to-Equity Ratio Total Liabilities Stockholders’ Equity Debt-to-Equity Ratio =

29. 14-29 Market Tests ─ Dividend Yield Ratio Dividend Yield Dividends Per Share Market Price Per Share = Dividend Yield $1.16 $60 = = 1.9% This ratio is often used to compare the dividend-paying performance of different investment alternatives. Home Depot paid dividends of $1.16 per share when the market price was $60 per share.

30. 14-30 Tests of Profitability ─ Total Asset TO Asset TO Sales Average Total Assets = Asset TO $70,395 ($40,518 + $40,125) ÷ 2 = = 1.75X This ratio measures how well assets have been used to generate sales. Assume s all sales are on credit.

31. 14-31 Tests of Profitability ─ Gross Profit% This ratio tells us the percentage of each sales dollar, on average, that is available to cover all of the other expenses of the business after paying for the cost of the products sold. Gross Profit % Gross Profit Net Sales = = 34.5% Gross Profit % $24,262 $70,395 =

32. 14-32 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. 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.

33. 14-33 Limitations of Ratio Analysis Analysts should look beyond the ratios. Economic factors Industry trends Changes within the company Technological changes Consumer tastes

34. 14-34 Other Financial Information In addition to financial ratios, special factors might affect company analysis: Rapid growth. Uneconomical expansion. Subjective factors. 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.

35. © 2008 The McGraw-Hill Companies, Inc. End of Chapter 13