1. Analyzing Financial Statements
Chapter 14
Analyzing Financial Statements
Taken from:

2. Understanding The Business
FINANCIAL STATEMENT USERS
MANAGEMENT
EXTERNAL DECISION
MAKERS
. . . 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 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.

4. Understanding The Business
Return on an equity security investment
Dividends
Increase in share price
Investors

5. Understanding The Business
Economy-wide Factors
Industry Factors
Individual Company Factors
Invest? No
Yes

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

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

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

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

11. 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

12. Component Percentages

13. Component Percentages
2001 Cost ÷ 2001 Sales

14. Component Percentages

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

16. The 2001 and 2000 balance sheets for Home Depot are presented next.
Commonly Used Ratios
The 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

17. Comparative Statements
Continued

18. Comparative Statements

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 2001.
Home Depot

20. This measure indicates how much income was earned for every dollar
Return on Equity
Income
Average Owners’ Equity
Return on Equity =
Return on Equity
$2,581
($15,004 + $12,341) ÷ 2 =
= 18.9%
This measure indicates how much
income was earned for every dollar
invested by the owners.

21. 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 considered
the best overall measure of a
company’s profitability.

22. 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.

23. Earnings per Share (EPS)
Income
Average Number of Shares of Common Stock Outstanding
EPS =
EPS
$2,581
(2, ,304) ÷ 2 =
= $1.12
Earnings per share is probably the single most widely watched financial ratio.

24. Quality of Income Quality of Income
Cash Flow from Operating Activities
Net Income =

25. A ratio higher than 1 indicates higher-quality earnings.
Quality of Income
Quality of Income
Cash Flow from Operating Activities
Net Income =
Quality of Income
$2,796
$2,581 = =
A ratio higher than 1 indicates higher-quality earnings.

26. This ratio describes a company’s ability to earn income from sales.
Profit Margin
Profit
Margin
Income (before Extraordinary Items)
Net Sales =
= 5.6%
Profit
Margin
$2,581
$45,738 =
This ratio describes a company’s ability to earn income from sales.

27. Net Sales Revenue Average Net Fixed Assets
Fixed Asset Turnover
Fixed Asset Turnover
Net Sales Revenue Average Net Fixed Assets =
Fixed Asset Turnover
$45,738 ($13,068 + $10,227) ÷ 2 =
= 3.9
This ratio measures a company’s ability to generate sales given an investment in fixed assets.

28. Now, let’s look at the liquidity ratios for Home Depot for 2001.
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 2001.
Home Depot

29. Cash + Cash Equivalents
Cash Ratio
Cash
Ratio
Cash + Cash Equivalents
Current Liabilities = =
0.04 : 1
Cash
Ratio
$167
$4,385
This ratio measures the adequacy of available cash.

30. Current Ratio Current Ratio Current Assets Current Liabilities =
$7,777
$4,385 =
1.77 : 1
This ratio measures the ability
of the company to pay current
debts as they become due.

31. Quick Ratio (Acid Test)
Quick Assets
Current Liabilities =
Quick
Ratio
$1,012
$4,385 =
.23 : 1
Quick
Ratio
This ratio is like the current
ratio but measures the company’s
immediate ability to pay debts.

32. Receivable Turnover Net Credit Sales Receivable Turnover
Average Net Trade Receivables
Receivable Turnover =
Receivable Turnover
$45,738
($835 + $587) ÷ 2
= 64 times =
This ratio measures how quickly a company collects its accounts receivable.

33. Average Age of Receivables
Days in Year
Receivable Turnover
Average Age of Receivables =
= days
365 64
Average Age of Receivables =
This ratio measures the average number of days it takes to collect receivables.

34. This ratio measures how quickly the company sells its inventory.
Inventory Turnover
Cost of Goods Sold
Average Inventory
Inventory Turnover =
Inventory Turnover
$32,057
($6,556 + $5,489) ÷ 2
= 5.3 times =
This ratio measures how quickly the company sells its inventory.

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

36. 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

37. This ratio indicates a margin of protection for creditors.
Times Interest Earned
Net Interest Income Tax Income Expense Expense Interest Expense
Times Interest Earned = +
$2, $ $1,636 $21
Times Interest Earned =
= 202
This ratio indicates a margin of protection for creditors.

38. Cash Coverage
Cash Coverage
Cash Flow from Operating Activities Before Interest and Taxes Interest Paid =

39. 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.

40. 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.

41. 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

42. Price/Earnings (P/E) Ratio
Current Market Price Per Share Earnings Per Share
P/E Ratio =
$35 $1.12 =
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.

43. Dividend Yield Ratio Dividend Yield Dividends Per Share
Market Price Per Share =
Dividend
Yield
$0.16 $35 =
= %
Home Depot paid dividends of $.16 per share when the market price was $35 per share.
This ratio is often used to compare the dividend-paying performance of different investment alternatives.

44. Other Analytical Considerations
In addition to financial ratios, special factors might affect company analysis:
Rapid growth.
Uneconomical expansion.
Subjective factors.

45. 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.

46. 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.

47. End of Chapter 14
Ratios
Ratios
Ratios
Ratios
Ratios