Analyzing Financial Statements Chapter 14 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Slide 2 McGraw-Hill/Irwin 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

Slide 3 McGraw-Hill/Irwin 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 Provides insights concerning a company’s relative performance.

Slide 4 McGraw-Hill/Irwin 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 The comparative income statements of Home Depot for 2007 and 2006 appear on the next slide. Prepare component percentage income statements where net sales equal 100%.

Slide 5 McGraw-Hill/Irwin

Slide 6 McGraw-Hill/Irwin Commonly Used Ratios The 2007 and 2006 balance sheets for Home Depot are presented next. We will be referring to these financial statements throughout the ratio analyses. The 2007 and 2006 balance sheets for Home Depot are presented next. We will be referring to these financial statements throughout the ratio analyses. Home Depot

Slide 7 McGraw-Hill/Irwin Continued

Slide 8 McGraw-Hill/Irwin

Slide 9 McGraw-Hill/Irwin Test of Profitability ─ Return on Equity Return on Equity $5,761 ($25,030 + $26,909) ÷ 2 = = 22.2% This measure indicates how much income was earned for every dollar invested by the owners. Profitability is a primary measure of the overall success of a company. Net Income Average Stockholders’ Equity Return on Equity =

Slide 10 McGraw-Hill/Irwin Test of Profitability ─ Earnings per Share (EPS) EPS $5,761 (1, ) ÷ 2 == $2.81 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.

Slide 11 McGraw-Hill/Irwin Tests of Liquidity ─ Current Ratio Current Ratio Current Assets Current Liabilities = Current Ratio $18,000 $12,931 = =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.

Slide 12 McGraw-Hill/Irwin Tests of Liquidity ─ Receivable Turnover Net Credit Sales Average Net Receivables Receivable Turnover = $90,837 ($3,223 + $2,396) ÷ 2 = 32.3 Times = This ratio measures how quickly a company collects its accounts receivable.

Slide 13 McGraw-Hill/Irwin 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 = ++ $5,761 + $392 + $3,547 $392 Times Interest Earned = = 24.7 Times Tests of solvency measure a company’s ability to meet its long-term obligations.

Slide 14 McGraw-Hill/Irwin Tests of Solvency ─ Debt-to-Equity Ratio This ratio measures the amount of liabilities that exists for each $1 invested by the owners. $27,233 $25,030 = 1.09= Debt-to-Equity Ratio Total Liabilities Stockholders’ Equity Debt-to-Equity Ratio =

Slide 15 McGraw-Hill/Irwin Market Tests ─ Price/Earnings (P/E) Ratio P/E Ratio = Current Market Price Per Share Earnings Per Share P/E Ratio = $34 $2.80 = 12.1 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 $34 per share. Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor.

Slide 16 McGraw-Hill/Irwin 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.