Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Analyzing Financial Statements Chapter 14

14-2 Economy-wide Factors Industry Factors Individual Company Factors Invest? NoYes Understanding The Business

14-3 Investors Dividends Increase in share price Return on an equity security investment Understanding The Business

14-4 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.

14-5 FINANCIAL STATEMENT USERS... uses accounting data to make product pricing and expansion decisions.... use accounting data for investment, credit, tax, and public policy decisions. EXTERNAL DECISION MAKERS MANAGEMENT Financial Statement Analysis

14-6 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. Financial Statement Analysis

14-7 Financial Statement Analysis Examines a single company to identify trends over time. Financial statement analysis is based on comparisons. Time series analysis Comparison with similar companies

14-8 Company A Company B Provides insights concerning a company’s relative performance. Financial Statement Analysis Financial statement analysis is based on comparisons. Comparison with similar companies Time series analysis

14-9 Ratio and Percentage Analyses Ratio analysis, or percentage analysis, is used to express the proportionate relationship between two different amounts.

14-10 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

14-11 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. Prepare component percentage income statements where net sales equal 100%. Home Depot

14-12 Component Percentages

Cost ÷ 2004 Sales Component Percentages

14-14 Component Percentages

14-15 Now, let’s look at some commonly used ratios.

14-16 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 next. We will be referring to these financial statements throughout the ratio analyses. Home Depot

14-17 Comparative Statements Continued

14-18 Comparative Statements

14-19 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 Profitability is a primary measure of the overall success of a company. Now, let’s look at the profitability ratios for Home Depot for Home Depot

14-20 Return on Equity $4,304 ($22,407 + $19,802) ÷ 2 = = 20.4% Net Income Average Owners’ Equity Return on Equity = This measure indicates how much income was earned for every dollar invested by the owners. This measure indicates how much income was earned for every dollar invested by the owners.

14-21 Return on Assets Net Income + Interest Expense (net of tax) Average Total Assets = Return on Assets $4,304 + ($62 × (1 -.34)) ($34,437 + $30,011) ÷ 2 = = 13.5% This ratio is generally considered one of the best overall measures of a company’s profitability. This ratio is generally considered one of the best overall measures of a company’s profitability. Corporate tax rate is 34%. Adding interest expense back to net income enables the return on assets to be compared for companies with different amounts of debt or over time for a single company that has changed its mix of debt and equity.

14-22 Financial Leverage Percentage Financial Leverage Return on Equity – Return on Assets= 6.9% = 20.4% – 13.5% 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.

14-23 Earnings per Share (EPS) Net Income Average Number of Shares of Common Stock Outstanding EPS= $4,304 2,283 == $1.88 Earnings per share is probably the single most widely watched financial ratio. Average number of shares outstanding is from Home Depot’s 2004 Income Statement.

14-24 Quality of Income Cash Flow from Operating Activities Net Income =

14-25 Quality of Income $6,545 $4,304 == 1.52 A ratio higher than 1 indicates high-quality earnings. Quality of Income Cash Flow from Operating Activities Net Income =

14-26 Profit Margin = 6.6% Profit Margin $4,304 $64,816 = This ratio tells us the percentage of each sales dollar that is income. Profit Margin Net Income Net Sales =

14-27 Fixed Asset Turnover $64,816 ($20,063 + $17,168) ÷ 2 == 3.5 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.

14-28 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 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 Home Depot

14-29 Cash Ratio Cash Ratio Cash + Cash Equivalents Current Liabilities ==0.296 to 1 Cash Ratio $2,826 $9,554 = This ratio measures the adequacy of available cash.

14-30 Current Ratio Current Ratio Current Assets Current Liabilities = Current Ratio $13,328 $9,554 = =1.39 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.

14-31 Quick Ratio (Acid Test) Quick Assets Current Liabilities = Quick Ratio $3,949 $9,554 =0.41 to 1= Quick Ratio Quick assets include Cash, Marketable Securities, Accounts Receivable and current Notes Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory.

14-32 Receivable Turnover Net Credit Sales Average Net Receivables Receivable Turnover = $64,816 ($1,097 + $1,072) ÷ 2 = 60 Times = This ratio measures how quickly a company collects its accounts receivable.

14-33 Average Age of Receivables Days in Year Receivable Turnover Average Age of Receivables = = 6.1 Days Average Age of Receivables = This ratio measures the average number of days it takes to collect receivables.

14-34 Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = $44,236 ($9,076 + $8,338) ÷ 2 = 5.1 Times = This ratio measures how quickly the company sells its inventory.

14-35 Average Days’ Supply in Inventory Days in Year Inventory Turnover Average Days’ Supply in Inventory == 71.6 Days = Average Days’ Supply in Inventory This ratio measures the average number of days it takes to sell the inventory.

14-36 Accounts Payable Turnover Cost of Goods Sold Average Accounts Payable Accounts Payable Turnover = $44,236 ($5,159 + $4,560) ÷ 2 = 9.1 Times = This ratio measures how quickly the company pays its accounts payable. Accounts Payable Turnover

14-37 Average Age of Payables Days in Year Accounts Payable Turnover Average Age of Payables = = 40.1 Days = This ratio measures the average number of days it takes to pay its suppliers. Average Age of Payables

14-38 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 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 Home Depot

14-39 This ratio indicates a margin of protection for creditors. Times Interest Earned Net Interest Income Tax Income Expense Expense Interest Expense Times Interest Earned = ++ $4,304 + $62 + $2,539 $62 Times Interest Earned = = 111 Times

14-40 Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid =

14-41 Cash Coverage = $6,545 + $70 + $2,539 $70 = 131 This ratio compares the cash generated with the cash obligations of the period. Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid = Cash Coverage

14-42 Debt-to-Equity Ratio Total Liabilities Owners’ Equity Debt-to-Equity Ratio = This ratio measures the amount of liabilities that exists for each $1 invested by the owners. $12,030 $22,407 = 0.54= Debt-to-Equity Ratio

14-43 Market Tests 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 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 Home Depot

14-44 Price/Earnings (P/E) Ratio P/E Ratio = Current Market Price Per Share Earnings Per Share P/E Ratio = $40 $1.88 = 21 This ratio measures the relationship between the current market price of the stock and its earnings per share. A recent price for Home Depot stock was $40 per share.

14-45 Dividend Yield Ratio Dividend Yield Dividends Per Share Market Price Per Share = Dividend Yield $0.27 $40 = = 0.68% This ratio is often used to compare the dividend-paying performance of different investment alternatives. Home Depot paid dividends of $.27 per share when the market price was $40 per share.

14-46 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.

14-47 Other Financial Information In addition to financial ratios, special factors might affect company analysis: Rapid growth. Uneconomical expansion. Subjective factors. In addition to financial ratios, special factors might affect company analysis: Rapid growth. Uneconomical expansion. Subjective factors.

14-48 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.