Analyzing Financial Statements Chapter 14 Chapter 14: Analyzing Financial Statements McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Understanding The Business Individual Company Factors Industry Factors Economy-wide 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

Understanding The Business Return on an equity security investment Dividends Increase in share price Investors invest resources in 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

Understanding a Company’s Strategy I need to know if the company is trying to earn a high rate of return through product differentiation or cost differentiation. Business Strategy Successful investors must understand a company’s business strategy. Two strategies that can yield profitable results are product differentiation and cost differentiation. A company’s business strategy leads to operating decisions that determine transactions and are ultimately reflected in the company’s financial statements. Operating Decisions Transactions Financial Statements

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. In order to compare companies or to assess the status of a single company, analysts use two different forms of analysis. Time series analysis examines a single company’s financial performance over time. It is also important to compare the company with those of other companies in the same industry. 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.

Component Percentages Express each item on a particular statement as a percentage of a single base amount. Net sales on the income statement Total assets on the balance sheet 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 The comparative income statements of Home Depot for 2007, 2008, and 2009 appear on the next slide. Let’s prepare component percentage income statements for each year where net sales equal 100%. The comparative income statements of Home Depot for 2007, 2008, and 2009 appear on the next slide. Prepare component percentage income statements where net sales equal 100%.

Net Sales will be set to 100% and all other components will be expressed as a percentage of Net Sales. First, we will look at the 2009 year. We will set net sales to 100% and express all other line-items on the income statement as a percentage of net sales.

2009 Cost of Sales ÷ 2009 Net Sales 2009 Gross Profit ÷ 2009 Net Sales Net Sales will be set to 100% and all other components will be expressed as a percentage of Net Sales. 2009 Cost of Sales ÷ 2009 Net Sales $47,298 ÷ $71,288 = .664 or 66.4% 2009 Gross Profit ÷ 2009 Net Sales $23,990 ÷ $71,288 = .336 or 33.6% 2009 Selling, G&A ÷ 2009 Net Sales $17,846 ÷ $71,288 = .250 or 25.0% Next, we determine the cost of sales as a percentage of net sales. For 2009, divide cost of sales of $47,298 by net sales of $71,288 and multiply by 100 percent. For 2009, cost of sales was 66.4 percent of net sales. We repeat the process for Gross Profit and Selling, General, and Administrative expenses to determine that Gross Profit was 33.6% of Net Sales and that Selling, General, and Administrative expenses were 25% of Net Sales.

Component Percentages Remember that component percentages express all items on a financial statement in terms of one component of that statement. For the income statement we expressed all items as a percent of net sales revenue. The comparative income statements of Home Depot for 2009, 2008, and 2007 show that the cost of merchandise sold has remained constant at 66.4% over the three year period, while selling, general and administrative costs have increased each year.

The 2009 and 2008 balance sheets for Home Depot are presented next. Commonly Used Ratios The 2009 and 2008 balance sheets for Home Depot are presented next. We will be referring to these financial statements throughout the ratio analyses. The 2009 and 2008 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

On this slide, you see the asset section of Home Depot’s balance sheets for both 2009 and 2008.

On this screen, you see the liabilities and stockholders’ equity sections of Home Depot’s balance sheets for both 2009 and 2008.

Test of Profitability ─ Return on Equity Profitability is a primary measure of the overall success of a company. Net Income Average Stockholders’ Equity Return on Equity = Return on Equity $2,260 ($17,777 + $17,714) ÷ 2 = = 12.7% 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 stockholders’ equity. Home Depot’s 2009 income is $2,260 million. Ending stockholders’ equity for 2009 is $17,777 and ending owners’ equity for 2008 is $17,714. When the income is divided by the average stockholders’ equity, we see that the return on equity at Home Depot for 2009 is 12.7 percent. This measure indicates how much income was earned for every dollar invested by the owners.

Test of Profitability ─ Return on Assets Net Income + Interest Expense (net of tax) Average Total Assets = Return on Assets $2,260 + ($624 × (1 - .34)) ($41,164 + $44,324) ÷ 2 = = 6.3% Assume the corporate tax rate is 34%. Return on total assets measures how well assets have been employed by the business. 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 6.3 percent. Please spend a few minutes going over the calculation of this ratio, especially the interest expense computation. Many analysts consider this ratio as the best overall measure of a company’s profitability.

Test of Profitability ─ Financial Leverage Percentage Return on Equity – Return on Assets = 6.4% = 12.7% – 6.3% 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.

Test of Profitability ─ Earnings per Share (EPS) Net Income* Average Number of Shares Outstanding for the Period EPS = *If there are preferred dividends, the amount is subtracted from net income. EPS $2,260 (1,696 + 1,690) ÷ 2 = = $1.34 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. 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. Home Depot’s earnings per share for 2009 is $1.34. Home Depot has no preferred stock dividends to subtract from income in the numerator. The average number of shares used in this computation is based on the beginning and ending number of shares for the year rather than the weighted-average number of shares reported in Home Depot’s income statement. Average number of shares based on the number of shares at the beginning and end of the year. Earnings per share is probably the single most widely watched financial ratio.

Test of Profitability ─ Quality of Income Cash Flow from Operating Activities Net Income = $5,528 $2,260 = 2.45 Home Depot’s Quality of Income Remember that in the cash flow from operating activities section of the cash flow statement there is a reconciliation of net earnings to net cash provided by operating activities. One method of evaluating the quality of a company’s earnings is to compare its reported earnings to its cash flows from operating activities, as shown in this ratio. Dividing Home Depot’s cash flow from operating activities by net income, we see that Home Depot’s quality of income is 2.45. 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.

Test of Profitability ─ Profit Margin Net Income Net Sales = = 3.2% Profit Margin $2,260 $71,288 = Profit margin tells us how effective the company is at producing bottom line net income. The ratio is determined 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 3.2 percent in 2009. This ratio tells us the percentage of each sales dollar that is income.

Test of Profitability ─ Fixed Asset Turnover Net Sales Revenue Average Net Fixed Assets = Fixed Asset Turnover $71,288 ($26,234 + $27,476) ÷ 2 = = 2.65 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. 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. At Home Depot, the fixed asset turnover ratio is 2.65 for 2009. This ratio measures a company’s ability to generate sales given an investment in fixed assets.

Tests of Liquidity ─ Cash Ratio Tests of liquidity focus on the relationship between current assets and current liabilities. Cash Ratio Cash + Cash Equivalents Current Liabilities = = 0.05 to 1 Cash Ratio $519 $11,153 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. 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 2009 balance sheet date, Home Depot’s cash ratio is 0.05, meaning Home Depot has slightly less than 5 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.

Tests of Liquidity ─ Current Ratio Current Assets Current Liabilities = Current Ratio $13,362 $11,153 = 1.20 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 2009 balance sheet date is 1.20. This means that for every dollar of current liabilities, Home Depot has $1.20 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 2.0. 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.

Tests of Liquidity ─ Quick Ratio (Acid Test) Quick Assets Current Liabilities = Quick Ratio $1,497 $11,153 = 0.13 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 0.13 at the 2009 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.

Tests of Liquidity ─ Receivable Turnover Net Credit Sales Average Net Receivables Receivable Turnover = Receivable Turnover $71,288 ($972 + $1,259) ÷ 2 = 63.9 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 an 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 2009 is 63.9 times. This means that, on average, the company collected its receivables 63.9 times per year. This ratio measures how quickly a company collects its accounts receivable.

Tests of Liquidity ─ Average Age of Receivables Days in Year Receivable Turnover Average Age of Receivables = = 5.7 Days 365 63.9 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 5.7 days. This ratio measures the average number of days it takes to collect receivables.

Tests of Liquidity ─ Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = Inventory Turnover $47,298 ($10,673 + $11,731) ÷ 2 = 4.2 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 2009 is 4.2 times, telling us that Home Depot sells and replaces its inventory about 4.2 times per year. This ratio measures how quickly the company sells its inventory.

Tests of Liquidity ─ Average Days’ Supply in Inventory Days in Year Inventory Turnover Average Days’ Supply in Inventory = = 86.9 Days 365 4.2 = 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 2009, Home Depot averaged 86.9 days of inventory available for sale. This ratio measures the average number of days it takes to sell the inventory.

Tests of Liquidity ─ Accounts Payable Turnover Cost of Goods Sold Average Accounts Payable Accounts Payable Turnover = $47,298 ($4,822 + $5,732) ÷ 2 = 9 Times = Accounts Payable Turnover 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 2009 is 9 times, telling us that, on average, Home Depot pays the balance owed to its suppliers about 9 times per year. This ratio measures how quickly the company pays its accounts payable.

Tests of Liquidity ─ Average Age of Payables Days in Year Accounts Payable Turnover Average Age of Payables = = 40.6 Days 365 9 = 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 2009, Home Depot averaged 40.6 days to pay its suppliers. This ratio measures the average number of days it takes to pay its suppliers.

Tests of Solvency ─ Times Interest Earned Tests of solvency measure a company’s ability to meet its long-term obligations. Net Interest Income Tax Income Expense Expense Interest Expense Times Interest Earned = + $2,260 + $624 + $1,278 $624 Times Interest Earned = = 6.7 Times Tests of solvency measure a company’s ability to meet its long-term obligations. 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 2009, Home Depot earned 6.7 times the amount of its interest expense. This ratio indicates a margin of protection for creditors.

Tests of Solvency ─ Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Paid Interest Paid = Cash Coverage = $5,528 + $622 + $1,225 $622 = 11.9 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 2009 Statement of Cash Flows. In the numerator of this ratio, you see that we added interest paid (not interest expense) and income tax paid (not income tax expense) to cash flow from operating activities to get cash flow from operating activities before interest and taxes. Note that interest paid used in this ratio is a different amount than interest expense used in the times interest earned ratio. Home Depot generated approximately $11.9 dollars in cash for each dollar of interest paid in 2009. This ratio compares the cash generated with the cash obligations of the period.

Tests of Solvency ─ Debt-to-Equity Ratio Total Liabilities Stockholders’ Equity Debt-to-Equity Ratio = $23,387 $17,777 = 1.32 = 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 stockholders’ equity. At the 2009 balance sheet date, Home Depot’s debt to equity ratio is 1.32, meaning the company’s creditors have provided more capital than the shareholders of Home Depot. This ratio measures the amount of liabilities that exists for each $1 invested by the owners.

Market Tests ─ Price/Earnings (P/E) Ratio Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor. P/E Ratio = Current Market Price Per Share Earnings Per Share A recent price for Home Depot stock was $26 per share. P/E Ratio = $26 $1.34 = 19.4 Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor. 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 $26 per share for Home Depot’s common stock, we divide by the 2009 earnings per share of $1.34 to obtain a price earnings ratio of 19.4. We conclude that Home Depot’s common stock is selling in the market place for 19.4 times its earnings for 2009. This ratio measures the relationship between the current market price of the stock and its earnings per share.

Market Tests ─ Dividend Yield Ratio Dividends Per Share Market Price Per Share = Dividend Yield $0.90 $26 = = 3.5 % Home Depot paid dividends of $.90 per share when the market price was $26 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 2009, Home Depot paid dividends of $0.90 per common share of stock outstanding. Dividing $0.90 by the share price of $26 dollars, we find that Home Depot’s dividend yield is 3.5 percent. This ratio is often used to compare the dividend-paying performance of different investment alternatives.

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.

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. 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. 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 End of chapter 14.