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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
AnalyzingFinancial
Statements
Chapter 14
14-2
Economy-wideFactors
IndustryFactors
IndividualCompanyFactors
Invest?No Yes
Understanding The Business
14-3
Investors
DividendsIncrease inshare price
Return on an equitysecurity investment
Understanding The Business
14-4
Learning Objectives
Explain how a company’s businessstrategy affects financial analysis.
Explain how a company’s businessstrategy affects financial analysis.
14-5
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.
14-6
Understanding a Company’s Strategy
BusinessStrategy
OperatingDecisions
Transactions
FinancialStatements
14-7
Learning Objectives
Discuss how analysts use financial statements.Discuss how analysts use financial statements.
14-8
FINANCIAL STATEMENT USERS
. . . uses accounting data to make product pricing
and expansion decisions.
. . . use accounting data for investment, credit, tax, and public policy
decisions.
EXTERNAL DECISIONMAKERS
MANAGEMENT
Financial Statement Analysis
14-9
THREE TYPES OF FINANCIAL STATEMENT INFORMATION
PastPerformance
PresentCondition
FuturePerformance
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
14-10
Financial Statement Analysis
Examines a single company to identify
trends over time.
Financial statement analysisis based on comparisons.
Time seriesanalysis
Comparison with similar companies
14-11
Company A Company
B
Provides insightsconcerning a
company’s relativeperformance.
Financial Statement Analysis
Financial statement analysisis based on comparisons.
Comparison with similar companies
Time seriesanalysis
14-12
Ratio and Percentage Analyses
Ratio analysis, or percentage analysis, is used to express the
proportionate relationship between two different amounts.
14-13
Learning Objectives
Compute and interpret component percentages.
Compute and interpret component percentages.
14-14
Component Percentages
Express each item on a particular statement as a percentage of a single base amount.
Total assetson the balance
sheet
Net saleson the income
statement
14-15
Component Percentages
The comparative income statements of Home Depot for 2004 and 2003
appear on the next slide.
Prepare component percentage income statements where net sales equal
100%.
The comparative income statements of Home Depot for 2004 and 2003
appear on the next slide.
Prepare component percentage income statements where net sales equal
100%.
Home Depot
14-16
HOME DEPOTComparative Income Statements (Condensed)
Amounts in Millions Except Per Share Data2004 Percent 2003 Percent
Net Sales 64,816$ 100.0% 58,247$ 100.0% Cost of Merchandise Sold 44,236 40,139
Gross Profit 20,580 18,108 Operating Expenses 13,734 12,278
Operating Income 6,846 5,830 Interest and Investment Income 59 79 Interest Expense (62) (37)
Earnings Before Income Taxes 6,843 5,872 Income Taxes 2,539 2,208 Net Earnings 4,304$ 3,664$
Basic Earnings Per Share 1.88$ 1.57$ Weighted-Average Number of Common Shares Outstanding 2,283 2,336 Diluted Earnings Per Share 1.88$ 1.56$
Component Percentages
14-17
HOME DEPOTComparative Income Statements (Condensed)
Amounts in Millions Except Per Share Data2004 Percent 2003 Percent
Net Sales 64,816$ 100.0% 58,247$ 100.0% Cost of Merchandise Sold 44,236 68.2% 40,139
Gross Profit 20,580 18,108 Operating Expenses 13,734 12,278
Operating Income 6,846 5,830 Interest and Investment Income 59 79 Interest Expense (62) (37)
Earnings Before Income Taxes 6,843 5,872 Income Taxes 2,539 2,208 Net Earnings 4,304$ 3,664$
Basic Earnings Per Share 1.88$ 1.57$ Weighted-Average Number of Common Shares Outstanding 2,283 2,336 Diluted Earnings Per Share 1.88$ 1.56$
2004 Cost ÷ 2004 Sales
Component Percentages
14-18
Component PercentagesHOME DEPOT
Comparative Income Statements (Condensed)Amounts in Millions Except Per Share Data
2004 Percent 2003 Percent Net Sales 64,816$ 100.0% 58,247$ 100.0% Cost of Merchandise Sold 44,236 68.2% 40,139 68.9%
Gross Profit 20,580 31.8% 18,108 31.1% Operating Expenses 13,734 21.2% 12,278 21.1%
Operating Income 6,846 10.6% 5,830 10.0% Interest and Investment Income 59 0.1% 79 0.1% Interest Expense (62) -0.1% (37) -0.1%
Earnings Before Income Taxes 6,843 10.6% 5,872 10.1% Income Taxes 2,539 3.9% 2,208 3.8% Net Earnings 4,304$ 6.7% 3,664$ 6.3%
Basic Earnings Per Share 1.88$ 1.57$ Weighted-Average Number of Common Shares Outstanding 2,283 2,336 Diluted Earnings Per Share 1.88$ 1.56$
14-19
Now, let’s look at some
commonly used ratios.
14-20
Commonly Used Ratios
The 2004 and 2003 balance sheets for Home Depot are presented next.
We will be referring to these financial statements throughout the ratio
analyses.
The 2004 and 2003 balance sheets for Home Depot are presented next.
We will be referring to these financial statements throughout the ratio
analyses.
Home Depot
14-21
Comparative Statements
Continued
14-22
Comparative Statements
14-23
Learning Objectives
Compute and interpret profitability ratios.Compute and interpret profitability ratios.
14-24
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 2004.
Profitability is a primary measure of the overall success of a company.
Now, let’s look at the profitability ratios for Home Depot for 2004.
Home Depot
14-25
Return on Equity
Return on Equity $4,304
($22,407 + $19,802) ÷ 2= = 20.4%
Net Income
Average Owners’ EquityReturn on Equity =
This measure indicates how muchincome was earned for every dollar
invested by the owners.
This measure indicates how muchincome was earned for every dollar
invested by the owners.
14-26
Return on Assets
Return on
AssetsNet Income + Interest Expense (net of tax)
Average Total Assets=
Return on
Assets
$4,304 + ($62 × (1 - .34))
($34,437 + $30,011) ÷ 2= = 13.5%
This ratio is generally consideredthe best overall measure of a
company’s profitability.
This ratio is generally consideredthe best overall measure of a
company’s profitability.
Corporate tax rate is 34%.
14-27
Financial Leverage Percentage
Financial Leverage
Return on Equity – Return on Assets=
6.9% = 20.4% – 13.5%
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.
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.
14-28
Earnings per Share (EPS)
Net Income
Average Number of Shares ofCommon Stock Outstanding
EPS =
EPS $4,304
2,283= = $1.88
Earnings per share is probably the single most widely watched financial ratio.
Earnings per share is probably the single most widely watched financial ratio.
Average number of shares outstanding is from Home Depot’s 2004 Income Statement.
14-29
Quality of Income
Quality
of Income
Cash Flow from Operating Activities
Net Income
=
Cash Flow from Operating Activities
Net Income 4,304$ Add: Depreciation and Amortization 1,076
Decrease in Receivables, net 25 Increase in Accounts Payable 790 Increase in Deferred Revenue 279 Increase in Deferred Income Taxes 605 Other 186
Deduct: Increase in Merchandise Inventories (693) Decrease in Income Taxes Payable (27)
Cash Flow from Operating Activities 6,545$
14-30
Quality of Income
Quality
of Income
$6,545
$4,304
= = 1.52
A ratio higher than 1 indicates high-quality earnings.
A ratio higher than 1 indicates high-quality earnings.
Quality
of Income
Cash Flow from Operating Activities
Net Income
=
14-31
Profit Margin
= 6.6%Profit
Margin
$4,304
$64,816=
This ratio tells us the percentage of each sales
dollar that is income.
This ratio tells us the percentage of each sales
dollar that is income.
Profit
Margin
Net Income
Net Sales=
14-32
Fixed Asset Turnover
FixedAsset
Turnover
$64,816
($20,063 + $17,168) ÷ 2= = 3.5
FixedAsset
Turnover
Net Sales Revenue
Average Net Fixed Assets=
This ratio measures a company’s ability to generate sales given an
investment in fixed assets.
This ratio measures a company’s ability to generate sales given an
investment in fixed assets.
14-33
Learning Objectives
Compute and interpret liquidity ratios.Compute and interpret liquidity ratios.
14-34
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 2004.
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 2004.
Home Depot
14-35
Cash Ratio
Cash
Ratio
Cash + Cash Equivalents
Current Liabilities=
= 0.296 to 1Cash
Ratio
$2,826
$9,554=
This ratio measures theadequacy of available cash.
This ratio measures theadequacy of available cash.
14-36
Current Ratio
Current
Ratio
Current Assets
Current Liabilities=
Current
Ratio
$13,328
$9,554
= = 1.39 to 1
This ratio measures the abilityof the company to pay current
debts as they become due.
This ratio measures the abilityof the company to pay current
debts as they become due.
14-37
Quick Ratio (Acid Test)
Quick Assets
Current Liabilities=
Quick
Ratio
$3,949
$9,554= 0.41 to 1=
Quick
Ratio
This ratio is like the currentratio but measures the company’s
immediate ability to pay debts.
This ratio is like the currentratio but measures the company’s
immediate ability to pay debts.
Cash & Cash Equivalents 2,826$ Receivables, net 1,097 Short-term Investments 26 Quick Assets 3,949$
14-38
Receivable Turnover
Net Credit Sales
Average Net ReceivablesReceivable
Turnover=
Receivable
Turnover
$64,816
($1,097 + $1,072) ÷ 2= 60 Times=
This ratio measures how quickly a company collects its
accounts receivable.
This ratio measures how quickly a company collects its
accounts receivable.
14-39
Average Age of Receivables
Days in Year
Receivable Turnover
Average Age
of Receivables=
= 6.1 Days365
59.8Average Age
of Receivables=
This ratio measures the average number of days it takes to
collect receivables.
This ratio measures the average number of days it takes to
collect receivables.
14-40
Inventory Turnover
Cost of Goods Sold
Average Inventory
Inventory
Turnover=
Inventory
Turnover
$44,236
($9,076 + $8,338) ÷ 2= 5.1 Times=
This ratio measures how quickly the company sells its
inventory.
This ratio measures how quickly the company sells its
inventory.
14-41
Average Days’ Supply in Inventory
Days in Year
Inventory Turnover
Average Days’ Supply in Inventory
=
= 71.6 Days365
5.1=
Average Days’ Supply in Inventory
This ratio measures the average number of days it takes to sell the inventory.
This ratio measures the average number of days it takes to sell the inventory.
14-42
Accounts Payable Turnover
Cost of Goods Sold
Average Accounts Payable
Accounts Payable Turnover
=
$44,236
($5,159 + $4,560) ÷ 2= 9.1 Times=
This ratio measures how quickly the company pays its
accounts payable.
This ratio measures how quickly the company pays its
accounts payable.
Accounts Payable Turnover
14-43
Average Age of Payables
Days in Year
Accounts Payable TurnoverAverage Age of Payables
=
= 40.1 Days365
9.1=
This ratio measures the average number of days it takes to pay its suppliers.
This ratio measures the average number of days it takes to pay its suppliers.
Average Age of Payables
14-44
Learning Objectives
Compute and interpret solvency ratios.Compute and interpret solvency ratios.
14-45
Tests of Solvency
Tests of solvency measure a company’s ability to meet its long-term obligations.
Now, let’s look at the solvency ratios for Home Depot for 2004.
Tests of solvency measure a company’s ability to meet its long-term obligations.
Now, let’s look at the solvency ratios for Home Depot for 2004.
Home Depot
14-46
This ratio indicates a margin of protection for creditors.
This ratio indicates a margin of protection for creditors.
Times Interest Earned
Net Interest Income Tax
Income Expense Expense
Interest Expense
Times
Interest
Earned=
+ +
$4,304 + $62 + $2,539
$62
Times
Interest
Earned= = 111 Times
14-47
Cash Coverage
Cash
Coverage
Cash Flow from Operating Activities
Before Interest and Taxes
Interest Paid
=
Cash Flow from Operating Activities
Net Income 4,304$ Add: Depreciation and Amortization 1,076
Decrease in Receivables, net 25 Increase in Accounts Payable 790 Increase in Deferred Revenue 279 Increase in Deferred Income Taxes 605 Other 186
Deduct: Increase in Merchandise Inventories (693) Decrease in Income Taxes Payable (27)
Cash Flow from Operating Activities 6,545$
14-48
Cash
Coverage=
$6,545 + $70 + $2,539
$70 = 131
This ratio compares the cash generated with the cash obligations of the period.
This ratio compares the cash generated with the cash obligations of the period.
Cash interest paid 70$ Income tax expense 2,539
Cash
Coverage
Cash Flow from Operating Activities
Before Interest and Taxes
Interest Paid
=
Cash Coverage
14-49
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.
This ratio measures the amount of liabilities that exists for each $1
invested by the owners.
$12,030
$22,407= 0.54=
Debt-to-Equity
Ratio
14-50
Learning Objectives
Compute and interpret market test ratios.Compute and interpret market test ratios.
14-51
Market Tests
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 forHome Depot for 2004.
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 forHome Depot for 2004.
Home Depot
14-52
Price/Earnings (P/E) Ratio
P/E Ratio =Current Market Price Per Share
Earnings Per Share
P/E Ratio =$40
$1.88= 21
This ratio measures the relationship between the current market price of the
stock and its earnings per share.
This ratio measures the relationship between the current market price of the
stock and its earnings per share.
A recent price for Home Depotstock was $40 per share.
14-53
Dividend Yield Ratio
Dividend
Yield
Dividends Per Share
Market Price Per Share=
Dividend
Yield
$0.27
$40= = 0.68%
This ratio is often used to compare the dividend-paying performance of
different investment alternatives.
This ratio is often used to compare the dividend-paying performance of
different investment alternatives.
Home Depot paid dividends of $.27 per share when the market price was $40 per share.
Home Depot paid dividends of $.27 per share when the market price was $40 per share.
14-54
Interpreting Ratios
Ratios may be interpreted by comparisonwith ratios of other companies or with
industry average ratios.
Ratios may vary because of thecompany’s industry characteristics,
nature of operations, size, andaccounting policies.
Ratios may be interpreted by comparisonwith ratios of other companies or with
industry average ratios.
Ratios may vary because of thecompany’s industry characteristics,
nature of operations, size, andaccounting policies.
14-55
Other Financial Information
In addition to financial ratios, special factors might affect company analysis:
Rapid growth. Uneconomical expansion. Subjective factors.
In addition to financial ratios, special factors might affect company analysis:
Rapid growth. Uneconomical expansion. Subjective factors.
14-56
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.
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.
14-57
End of Chapter 14
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