1. BSAD 221 Introductory Financial Accounting Donna Gunn, CA

2. 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. Understanding The Business

3. Economy-wide Factors Industry Factors Individual Company Factors Invest? NoYes The Investment Decision

4. Understanding a Company’s Strategy Business Strategy Operating Decisions Transactions Financial Statements

5. ROE Profit Driver Analysis ROE Net Profit Margin Asset Turnover Financial Leverage =×× Net Income Average Shareholders’ Equity Net Income Average Shareholders’ Equity Net Income Net Sales Net Income Net Sales Average Total Assets Net Sales Average Total Assets Average Shareholders’ Equity Average Total Assets Average Shareholders’ Equity ×× =

6. Profit Drivers and Business Strategy High-value or product-differentiation Rely on R&D and product promotion to convince customers of the superiority of your product. Low-Cost Rely on efficient management of accounts receivable, inventory and productive assets to produce high asset turnover.

7. Financial Statement Analysis Financial statement analysis is based on comparisons. Time series analysis Comparison with similar companies

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

9. 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

10. Component Percentages The comparative income statements of Home Depot for 2006 and 2005 appear on the next slide. Prepare component percentage income statements where net sales equal 100%.

12. 2007 Cost ÷ 2007 Sales

14. Continued Comparative Statements

16. Tests of Liquidity Tests of liquidity focus on the relationship between current assets and current liabilities. Common Liquidity Ratios: Current Ratio Quick Ratio Inventory Turnover Receivable Turnover Days’ Sales in Receivables

17. 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.

18. Quick Ratio (Acid Test) Quick Assets Current Liabilities = Quick Ratio $3,837 $12,931 =0.30 to 1= Quick Ratio This ratio is like the current ratio but measures the company’s immediate ability to pay debts.

19. Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = $61,054 ($11,401 + $12,822) ÷ 2 = 5.0x = This ratio measures how quickly the company sells its inventory.

20. Average Days’ Supply in Inventory Days in Year Inventory Turnover Average Days’ Supply in Inventory == 73 Days 365 5.0 = Average Days’ Supply in Inventory This ratio measures the average number of days it takes to sell the inventory.

21. Receivable Turnover Net Credit Sales Average Net Receivables Receivable Turnover = $90,837 ($2,396 + $3,223) ÷ 2 = 32.3 Times = This ratio measures how quickly a company collects its accounts receivable.

22. Days Sales in Receivables Average Net A/R One Days Sales Days Sales in Receivables = =11.3 Days ($2,396 + $3,223)÷2 $90,837÷ 365 = This ratio measures the average number of days it takes to collect receivables.

23. Average Age of Receivables Days in a Year Receivable Turnover Average Age of Receivables = = 11.3 Days 365 32.3 Average Age of Receivables = This ratio measures the average number of days it takes to collect receivables. Same as prior slide – just more common approach. This ratio measures the average number of days it takes to collect receivables. Same as prior slide – just more common approach.

24. Measuring Ability to Pay Long Term Debt Measure a company’s ability to meet its long- term obligations. Common Tests of Solvency: Debt to Equity Times Interest Earned

25. 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. $27,233 $25,030 = 1.09 (or 109%)= Debt-to- Equity Ratio

26. This ratio indicates a margin of protection for creditors. 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

27. Tests of Profitability Profitability is a primary measure of the overall success of a company Common Profitability Ratios: Return on Net Sales Return on Assets Return on Equity EPS Gross Margin

28. Return on Net Sales (AKA Profit Margin) = 6.3% $5,761 $90,837 = This ratio tells us the percentage of each sales dollar that is income. Return on Net Sales Net Income Net Sales =

29. Return on Assets Net Income + Interest Exp. (net of tax) Average Total Assets = Return on Assets $5,761 + ($392 × (1 -.38)) ($44,405 + $52,263) ÷ 2 = = 12.4% This ratio is generally considered the best overall measure of a company’s profitability. Corporate tax rate is 38%.

30. Return on Equity $5,761 ($26,909 + $25,030) ÷ 2 = = 22.2% Net Income –Pref. Dividends Average Common Equity Return on Equity = This measure indicates how much income was earned for every dollar invested by the common share owners.

31. Earnings per Share (EPS) Net Income Available to Common Shareholders Weighted-Average Number of Common Shares Outstanding EPS= $5,761 2,054 == $2.80 Earnings per share is probably the single most widely watched financial ratio. Average number of shares outstanding is from Home Depot’s 2006 Income Statement.

32. Gross Profit Margin = 32.8% Gross Profit Margin $90,837- 61,054 $90,837 = This ratio tells us the percentage of each sales dollar after we’ve paid for the cost of the product Gross Profit Margin Net Sales - COGS Net Sales =

33. Analyzing Shares as An Investment Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor. Common Market Tests: Price Earnings Ratio Dividend Yield Book Value per share of Common Stock

34. Price/Earnings (P/E) Ratio P/E Ratio = Current Market Price Per Share Earnings Per Share P/E Ratio = $43.95 $2.80 = 15.7 This ratio measures the relationship between the current market price of the stock and its earnings per share. A recent price for Home Depot common share was $43.95 per share.

35. Dividend Yield Ratio Dividend Yield Dividends Per Share Market Price Per Share = Dividend Yield $0.75 $43.95 = = 1.7% This ratio is often used to compare the dividend- paying performance of different investment alternatives. Home Depot paid dividends of $0.75 per share when the market price was $43.95 per share.

36. 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.

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

38. 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.