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PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Analyzing Financial Statements

Chapter 14

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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IndustryFactors

IndividualCompanyFactors Economy-wide

Factors

Invest?No Yes

Understanding The Business

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Investors

DividendsIncrease inshare price

Return on an equity security investment

Understanding The Business

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Understanding a Company’s Strategy

BusinessStrategy Operating

DecisionsTransactions

FinancialStatements

I need to know if the company is trying to earn a high rate of return through product differentiation or cost differentiation.

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Financial Statement Analysis

Examines a single company to identify

trends over time.

Financial statement analysisis based on comparisons.

Time seriesanalysis

Comparison with similar companies

Provides insightsconcerning a

company’s relativeperformance.

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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

The comparative income statements of Home Depot for 2007, 2008, and 2009 appear on the next slide.

Prepare component percentage income statements where net sales equal 100%.

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Net Sales will be set to 100% and all other components will be

expressed as a percentage of Net

Sales.

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2009 Cost of Sales ÷ 2009 Net Sales$47,298 ÷ $71,288 = .664 or 66.4%

2009 Gross Profit ÷ 2009 Net Sales$23,990 ÷ $71,288 = .336 or 33.6%

2009 Selling, G&A ÷ 2009 Net Sales$17,846 ÷ $71,288 = .250 or 25.0%

Net Sales will be set to 100% and all other components will be

expressed as a percentage of Net

Sales.

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Component Percentages

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Commonly Used Ratios

The 2009 and 2008 balance sheets for Home Depot are presented next.

We will be referring to these financial statements throughout the ratio

analyses.

The 2009 and 2008 balance sheets for Home Depot are presented next.

We will be referring to these financial statements throughout the ratio

analyses.

Home Depot

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Test of Profitability ─ Return on Equity

Return on Equity $2,260

($17,777 + $17,714) ÷ 2= = 12.7%

Net Income

Average Stockholders’ EquityReturn on Equity =

This measure indicates how much income was earned for every dollar invested by the owners.This measure indicates how much income was earned for every dollar invested by the owners.

Profitability is a primary measure ofthe overall success of a company.

Profitability is a primary measure ofthe overall success of a company.

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Test of Profitability ─ Return on Assets

Return on

AssetsNet Income + Interest Expense (net of tax)

Average Total Assets=

Return on

Assets

$2,260 + ($624 × (1 - .34))

($41,164 + $44,324) ÷ 2= = 6.3%

Many analysts consider this ratio as the best overall measure of a company’s profitability.Many analysts consider this ratio as the best overall measure of a company’s profitability.

Assume the corporate tax rate is 34%.

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Test of Profitability ─ Financial Leverage Percentage

Financial Leverage

Return on Equity – Return on Assets=

6.4% = 12.7% – 6.3%

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.

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Test of Profitability ─ Earnings per Share (EPS)

EPS $2,260

(1,696 + 1,690) ÷ 2= = $1.34

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 based on the numberof shares at the beginning and end of the year.

Net Income* Average Number of Shares Outstanding for the Period

EPS =

*If there are preferred dividends, the amount is subtracted from net income.

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Test of Profitability ─ Quality of Income

A ratio higher than 1 indicates high-quality

earnings.

Quality

of Income

Cash Flow from Operating Activities

Net Income

=

$5,528

$2,260

= 2.45

Home Depot’s Quality of Income

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Test of Profitability ─ Profit Margin

= 3.2%Profit

Margin

$2,260

$71,288=

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=

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Test of Profitability ─ Fixed Asset Turnover

FixedAsset

Turnover

$71,288

($26,234 + $27,476) ÷ 2= = 2.65

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.

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Tests of Liquidity ─ Cash Ratio

Cash

Ratio

Cash + Cash Equivalents

Current Liabilities=

= 0.05 to 1Cash

Ratio

$519

$11,153=

This ratio measures theadequacy of available cash.

This ratio measures theadequacy of available cash.

Tests of liquidity focus on the relationship between current assets and current liabilities.

Tests of liquidity focus on the relationship between current assets and current liabilities.

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Tests of Liquidity ─ Current Ratio

Current

Ratio

Current Assets

Current Liabilities=

Current

Ratio

$13,362

$11,153

= = 1.20 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.

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Tests of Liquidity ─ Quick Ratio (Acid Test)

Quick Assets

Current Liabilities=

Quick

Ratio

$1,497

$11,153= 0.13 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 519$ Receivables, net 972 Short-term Investments 6 Quick Assets 1,497$

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Tests of Liquidity ─ Receivable Turnover

Net Credit Sales

Average Net ReceivablesReceivable

Turnover=

Receivable

Turnover

$71,288

($972 + $1,259) ÷ 2= 63.9 Times=

This ratio measures how quickly a company collects its

accounts receivable.

This ratio measures how quickly a company collects its

accounts receivable.

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Tests of Liquidity ─ Average Age of Receivables

Days in Year

Receivable Turnover

Average Age

of Receivables=

= 5.7 Days365

63.9Average 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.

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Tests of Liquidity ─ Inventory Turnover

Cost of Goods Sold

Average Inventory

Inventory

Turnover=

Inventory

Turnover

$47,298

($10,673 + $11,731) ÷ 2= 4.2 Times=

This ratio measures how quickly the company sells its inventory.

This ratio measures how quickly the company sells its inventory.

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Tests of Liquidity ─ Average Days’ Supply in Inventory

Days in Year

Inventory Turnover

Average Days’ Supply in Inventory

=

= 86.9 Days365

4.2=

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.

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Tests of Liquidity ─ Accounts Payable Turnover

Cost of Goods Sold

Average Accounts Payable

Accounts Payable Turnover

=

This ratio measures how quickly the company pays its accounts payable.This ratio measures how quickly the company pays its accounts payable.

$47,298

($4,822 + $5,732) ÷ 2= 9 Times=

Accounts Payable Turnover

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Tests of Liquidity ─ Average Age of Payables

Days in Year

Accounts Payable TurnoverAverage Age of Payables

=

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.

= 40.6 Days365

9=

Average Age of Payables

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This ratio indicates a margin of protection for creditors.

Tests of Solvency ─ Times Interest Earned

Net Interest Income Tax

Income Expense Expense

Interest Expense

Times

Interest

Earned=

+ +

$2,260 + $624 + $1,278

$624

Times

Interest

Earned= = 6.7 Times

Tests of solvency measure a company’sability to meet its long-term obligations.

Tests of solvency measure a company’sability to meet its long-term obligations.

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Cash

Coverage=

$5,528 + $622 + $1,225

$622 = 11.9

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 622$ Income tax paid 1,225

From Statement of Cash Flows

Cash

Coverage

Cash Flow from Operating Activities

Before Interest and Taxes Paid

Interest Paid

=

Tests of Solvency ─ Cash Coverage

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Tests of Solvency ─ 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.

$23,387

$17,777= 1.32=

Debt-to-Equity

Ratio

Total Liabilities

Stockholders’ Equity

Debt-to-Equity

Ratio=

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Market Tests ─ Price/Earnings (P/E) Ratio

P/E Ratio =Current Market Price Per Share

Earnings Per Share

P/E Ratio =$26

$1.34= 19.4

This ratio measures the relationship between the current market price of the stock and its earnings per share.

A recent price for Home Depot stock was $26 per share.

Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor.

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Market Tests ─ Dividend Yield Ratio

Dividend

Yield

Dividends Per Share

Market Price Per Share=

Dividend

Yield

$0.90

$26= = 3.5 %

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 $.90 per share when the market price was $26 per share.

Home Depot paid dividends of $.90 per share when the market price was $26 per share.

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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, andaccounting policies.

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, andaccounting policies.

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Other Financial Information

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

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.

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End of Chapter 14