2 Understanding The Business FINANCIAL STATEMENT USERSMANAGEMENTEXTERNAL DECISIONMAKERS. . . uses accounting data to make product pricing and expansion decisions.. . . use accounting data for investment, credit, tax, and public policy decisions.
3 Understanding The Business THREE TYPES OF FINANCIAL STATEMENT INFORMATIONPast PerformancePresent ConditionFuture PerformanceIncome, sales volume, cash flows, return- on-investments, EPS.Assets, debt, inventory, various ratios.Sales and earnings trends are good indicators of future performance.
4 Understanding The Business Return on an equity security investmentDividendsIncrease in share priceInvestors
5 Understanding The Business Economy-wide FactorsIndustry FactorsIndividual Company FactorsInvest?NoYes
6 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.
7 Fundamental Strategies Product differentiation: unique features, quality, I.e., LexusCost advantage: lower costs, better efficiency, lower prices, I.e., HondaWhat is Home Depot’s Strategy?Are they successful with it?
8 Financial Statement Analysis Financial statement analysis is based on comparisons.Time series analysisComparison with similar companiesExamines a single company to identify trends over time.
9 Financial Statement Analysis Financial statement analysis is based on comparisons.Time series analysisComparison with similar companiesCompany ACompany BProvides insights concerning a company’s relative performance.
10 Ratio and Percentage Analyses Ratio analysis, or percentage analysis, is used to express the proportionate relationship between two different amounts.
11 Component Percentages Express each item on a particular statement as a percentage of a single base amount.Total assets on the balance sheetNet sales on the income statement
12 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
17 The 2001 and 2000 balance sheets for Home Depot are presented next. Commonly Used RatiosThe 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
20 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
21 This measure indicates how much income was earned for every dollar Return on EquityIncomeAverage Owners’ EquityReturn on Equity=Return on Equity$2,581($15,004 + $12,341) ÷ 2== 18.9%This measure indicates how muchincome was earned for every dollarinvested by the owners.Lowes ratio 15.9; ROT 15%+
22 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 consideredthe best overall measure of acompany’s profitability.Lowes ratio 9.1%; ROT 10%+
23 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%.
24 Earnings per Share (EPS) IncomeAverage Number of Shares of Common Stock OutstandingEPS=EPS$2,581(2, ,304) ÷ 2== $1.11Earnings per share is probably the single most widely watched financial ratio.
25 Quality of Income Quality of Income Cash Flow from Operating ActivitiesNet Income=
26 Quality of Income Quality of Income Cash Flow from Operating ActivitiesNet 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
27 This ratio describes a company’s ability to earn income from sales. Profit MarginProfitMarginIncome (before Extraordinary Items)Net Sales== 5.6%ProfitMargin$2,581$45,738=This ratio describes a company’s ability to earn income from sales.Lowes 4.3%; ROT >10%
28 Net Sales Revenue Average Net Fixed Assets Fixed Asset TurnoverFixed Asset TurnoverNet Sales Revenue Average Net Fixed Assets=Fixed Asset Turnover$45,738 ($13,068 + $10,227) ÷ 2== 3.9This ratio measures a company’s ability to generate sales given an investment in fixed assets.Lowes ratio 3.1; ROT > 1.0
29 Total Asset Turnover Ratio Total Asset = Net Sales RevenueTurnover Average Total AssetsHome Depot = $45,738($21,385 + $17,081) / 2= 2.38Lowes = 1.86
30 Now, let’s look at the liquidity ratios for Home Depot for 2001. Tests of LiquidityTests 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
31 Cash + Cash Equivalents Cash RatioCashRatioCash + Cash EquivalentsCurrent Liabilities==0.04 : 1CashRatio$167$4,385This ratio measures the adequacy of available cash.Lowes ratio 0.15
32 Current Ratio Current Ratio Current Assets Current Liabilities = $7,777$4,385=1.77 : 1This ratio measures the abilityof the company to pay currentdebts as they become due.ROT 2.0 to 1
33 Quick Ratio (Acid Test) (Excludes inventory & other curr. Assets) Quick AssetsCurrent Liabilities=QuickRatio$1,012$4,385=.23 : 1QuickRatioThis ratio is like the currentratio but measures the company’simmediate ability to pay debts.
34 Receivable Turnover(per year) Net Credit SalesAverage Net Trade ReceivablesReceivable Turnover=Receivable Turnover$45,738($835 + $587) ÷ 2= 64 times=This ratio measures how quickly a company collects its accounts receivable.
35 Average Age of Receivables(DSO) Days in YearReceivable TurnoverAverage Age of Receivables== days365 64Average 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 ofCash Sales.
36 This ratio measures how quickly the company sells its inventory. Inventory TurnoverCost of Goods SoldAverage InventoryInventory 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 timesROT 4.0 times or better.
37 Average Days’ Supply in Inventory Days in YearInventory TurnoverAverage Days’ Supply in Inventory== days=Average Days’ Supply in InventoryThis ratio measures the average number of days it takes to sell the inventory. Lowes days 83.
38 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
39 This ratio indicates a margin of protection for creditors. Times Interest EarnedNet Interest Income Tax Income Expense Expense Interest ExpenseTimes Interest Earned=+$2, $ $1,636 $21Times Interest Earned== 202This ratio indicates a margin of protection for creditors.ROT 7 times or better.
40 Cash CoverageCash CoverageCash Flow from Operating Activities Before Interest and Taxes Interest Paid=
41 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.
42 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.
43 Total Debt Ratio Debt Ratio = Total Debt Total Assets Home Depot = $6,381 = 29.8%$21,385ROT > 50%
44 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
45 Price/Earnings (P/E) Ratio Current Market Price Per Share Earnings Per ShareP/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+
46 Other Analytical Considerations In addition to financial ratios, special factors might affect company analysis:Rapid growth.Uneconomical expansion.Subjective factors.
47 Interpreting RatiosRatios 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.
48 Efficient MarketsA 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.
49 End of Chapter 14RatiosRatiosRatiosRatiosRatios