# Learning Objectives Understand the Business – LO1 Describe the purposes and uses of horizontal, vertical and ratio analyses. Study the accounting methods.

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Learning Objectives Understand the Business – LO1 Describe the purposes and uses of horizontal, vertical and ratio analyses. Study the accounting methods – LO2 Use horizontal (trend) analyses to recognize financial changes that unfold over time. – LO3 Use vertical (common-size) analyses to understand important relationships within financial statements. – LO4 Calculate financial ratios to assess profitability, liquidity, and solvency. Evaluate the results – LO5 Interpret the results of financial analyses. – LO6 Describe how analyses depend on key accounting decisions and concepts. Review the chapter 1© McGraw-Hill Ryerson. All rights reserved.

Interpreting Horizontal Analyses Horizontal analysis of The Home Depot’s balance sheet shows the company did not significantly grow or decline in 2009. Total assets decreased 0.7%. Horizontal analysis of The Home Depot’s income statement shows net sales fell by 7%, probably a result of the slowdown in the global economy. © McGraw-Hill Ryerson. All rights reserved.2 LO5

Vertical analysis for The Home Depot’s balance sheet shows the company has shifted from debt to equity. – Debt was 57% and equity 43% in 2008. – Debt was 53% and equity 47% in 2009. Vertical analysis of The Home Depot’s income statement shows Cost of Goods Sold and Operating Expenses are the important determinants of the company’s profitability. © McGraw-Hill Ryerson. All rights reserved.3 Interpreting Vertical Analyses LO5

Interpreting Ratio Analyses © McGraw-Hill Ryerson. All rights reserved.4 LO5 Profitability Ratios The Home Depot was able to cut costs enough to increase net income more than the decline of Net Sales Revenue. This allowed net profit margin to increase in 2009. The slight increase means The Home Depot made slightly more gross profit on each dollar of sales in 2009; possible due to higher selling prices or lower unit costs. 2. Gross Profit Percentage 1. Net Profit Margin

© McGraw-Hill Ryerson. All rights reserved.5 LO5 The asset turnover ratio suggest assets did not generate sales as efficiently in 2009 as in the previous year. 3. Asset Turnover The amount of sales generated by fixed assets decreased in 2009. This is unfavourable, but understandable because 2009 was a difficult year for retailers. In comparison, Rona (a competitor) had a better ratio of 5.53. 4. Fixed Asset Turnover The Home Depot’s ROE increased in part because of the increase in shareholders’ equity to finance debt repayment mentioned earlier. The Home Depot was able to cut operating expenses enough to increase net income, which increased ROE. 5. Return on Equity

© McGraw-Hill Ryerson. All rights reserved.6 LO5 The Home Depot’s ratio is much greater than 1.0, meaning operations are producing positive results. Most cash based business have high quality of income ratios because their sales are collected in cash immediately. 7. Quality of Income The P/E ratio increased slightly. In 2009 investors are willing to pay 17.3 times earning to buy one share. In comparison, Rona (a competitor) had a lower P/E ratio of 14.0. 8. Price/Earnings (P/E) Ratio EPS increased along with the increase in ROE. 6. Earnings per Share

© McGraw-Hill Ryerson. All rights reserved.7 LO5 Liquidity Ratios 9. Receivables Turnover This ratio is not meaningful for businesses that make most sales for cash like The Home Depot. Although the economy was weak in 2009, The Home Depot was able to maintain the inventory turnover and days to sell ratios. 10. Inventory Turnover The current ratio increased from 2008 to 2009. In this industry a current ratio greater than 1.0 is acceptable, The Home Depot’s current ratio appears strong. 11. Current Ratio The quick ratio also increased. In this industry a low quick ratio is common. 12. Quick Ratio

© McGraw-Hill Ryerson. All rights reserved.8 LO5 Solvency Ratios This ratio shows the proportion of total assets financed by creditors. The higher the ratio, the riskier the financing strategy. In 2009, The Home Depot relied less on creditors and more on shareholders. Times Interest Earned above 1.0 indicates that net income is sufficient to cover the company’s interest expense. The Home Depot’s ratio of 5.9 is more than enough to pay interest expense. 14. Times Interest Earned This ratio shows that The Home Depot was able to pay for all purchases of property, plant and equipment using cash generated from operating activities. 15. Capital Acquisitions Ratio 13. Debt to Assets

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