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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