Libbychap014.ppt

Chapter 14

Analyzing Financial Statements

© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin

14-2

Understanding The Business

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


14-3

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.



14-4

Investors

DividendsIncrease inshare price

Return on an equitysecurity investment



14-5

Economy-wideFactors

IndustryFactors

IndividualCompanyFactors

Invest?No Yes



14-6

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.


14-7

Financial Statement Analysis

Examines a single company to identify

trends over time.

Financial statement analysisis based on comparisons.

Time seriesanalysis

Comparison with similar companies


14-8

Financial Statement Analysis

Company A Company

B

Provides insightsconcerning a

company’s relativeperformance.

Financial statement analysisis based on comparisons.

Time seriesanalysis

Comparison with similar companies


14-9

Ratio and Percentage Analyses Ratio analysis, or percentage analysis, is

used to express the proportionate relationship between two different

amounts.


14-10

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


14-11

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%.

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


14-12

Component PercentagesHOME DEPOT

Comparative Income Statements (Condensed)Amounts in Millions Except Per Share Data

2001 Percent 2000 Percent Net Sales 45,738$ 100.0% 38,434$ 100.0% Cost of merchandise sold 32,057 27,023 Gross profit 13,681 11,411 Operating expenses 9,490 7,603 Operating Income 4,191 3,808 Interest and Investment Income 47 37 Interest Expense 21 41 Earnings Before Income Taxes 4,217 3,804 Income Taxes 1,636 1,484 Net Earnings 2,581$ 2,320$

Basic Earnings Per Share 1.11$ 1.03$ Weighted-Average Number of Common Shares Outstanding 2,315 2,244 Diluted Earnings Per Share 1.10$ 1.00$


14-13

HOME DEPOTComparative Income Statements (Condensed)

Amounts in Millions Except Per Share Data2001 Percent 2000 Percent

Net Sales 45,738$ 100.0% 38,434$ 100.0% Cost of merchandise sold 32,057 70.1% 27,023 Gross profit 13,681 11,411 Operating expenses 9,490 7,603 Operating Income 4,191 3,808 Interest and Investment Income 47 37 Interest Expense 21 41 Earnings Before Income Taxes 4,217 3,804 Income Taxes 1,636 1,484 Net Earnings 2,581$ 2,320$


2001 Cost ÷ 2001 Sales



14-14

HOME DEPOTComparative Income Statements (Condensed)

Amounts in Millions Except Per Share Data2001 Percent 2000 Percent

Net Sales 45,738$ 100.0% 38,434$ 100.0% Cost of merchandise sold 32,057 70.1% 27,023 70.3% Gross profit 13,681 29.9% 11,411 29.7% Operating expenses 9,490 20.7% 7,603 19.8% Operating Income 4,191 9.2% 3,808 9.9% Interest and Investment Income 47 0.1% 37 0.1% Interest Expense 21 0.0% 41 0.1% Earnings Before Income Taxes 4,217 9.2% 3,804 9.9% Income Taxes 1,636 3.6% 1,484 3.9% Net Earnings 2,581$ 5.6% 2,320$ 6.0%




14-15Now, let’s

look at some commonly

used ratios.


14-16

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.

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


14-17

Comparative Statements

Continued


14-18

Comparative Statements


14-19

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.

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


14-20

Return on Equity

Return on Equity $2,581

($15,004 + $12,341) ÷ 2= = 18.9%

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



14-21

Return on Assets

Return on

AssetsIncome + Interest Expense (net of tax)

Average Total Assets=

Return on

Assets

$2,581 + ($21 ×(1 - .34))

($21,385 + $17,081) ÷ 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 percent.


14-22

Financial Leverage

Financial Leverage

Return on Equity – Return on Assets=

5.4% = 18.9% – 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.


14-23

Earnings per Share (EPS)

Income

Average Number of Shares ofCommon Stock Outstanding

EPS =

EPS $2,581

(2,324 + 2,304) ÷ 2= = $1.12

Earnings per share is probably the single most widely watched

financial ratio.

Earnings per share is probably the single most widely watched

financial ratio.


14-24

Quality of Income

Quality

of Income

Cash Flow from Operating Activities

Net Income

=


Net Income 2,581$ Add: Depreciation and Amortization 601

Increase in Current Liabilities 754 Increase in Income Taxes Payable 151 Other 30

Deduct: Increase in Receivables, net (246) Increase in Merchandise Inventories (1,075)

Cash Flow from Operating Activities 2,796$


14-25

Quality of Income

Quality

of Income


Net Income

=

Quality

of Income

$2,796

$2,581

= = 1.08

A ratio higher than 1 indicates higher-quality earnings.

A ratio higher than 1 indicates higher-quality earnings.


14-26

Profit Margin

= 5.6%Profit

Margin

$2,581

$45,738=

This ratio describes a company’s ability to earn

income from sales.

This ratio describes a company’s ability to earn

income from sales.

Profit

Margin

Income (before Extraordinary Items)

Net Sales=


14-27

Fixed Asset Turnover

FixedAsset

Turnover

$45,738

($13,068 + $10,227) ÷ 2= = 3.9

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.


14-28

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.

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


14-29

Cash Ratio

Cash

Ratio

Cash + Cash Equivalents

Current Liabilities=

= 0.04 : 1Cash

Ratio

$167

$4,385=

This ratio measures theadequacy of available cash.

This ratio measures theadequacy of available cash.


14-30

Current Ratio

Current

Ratio

Current Assets


Current

Ratio

$7,777

$4,385

= = 1.77 : 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.


14-31

Quick Ratio (Acid Test)

Quick Assets


Quick

Ratio

$1,012

$4,385= .23 : 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 167$ Receivables, net 835 Short-term Investments 10 Quick Assets 1,012$


14-32

Receivable Turnover

Net Credit Sales

Average Net Trade ReceivablesReceivable

Turnover=

Receivable

Turnover

$45,738

($835 + $587) ÷ 2= 64 times=

This ratio measures how quickly a company collects its

accounts receivable.

This ratio measures how quickly a company collects its

accounts receivable.


14-33

Average Age of Receivables

Days in Year

Receivable Turnover

Average Age

of Receivables=

= 5.7 days365

64Average 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.


14-34

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.

This ratio measures how quickly the company sells its inventory.


14-35

Average Days’ Supply in Inventory

Days in Year

Inventory Turnover


=

= 69 days365

5.3=


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.


14-36

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.

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


14-37

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=

+ +

$2,581 + $21 + $1,636

$21

Times

Interest

Earned= = 202


14-38

Cash Coverage

Cash

Coverage


Before Interest and Taxes

Interest Paid

=


Net Income 2,581$ Add: Depreciation and Amortization 601

Increase in Current Liabilities 754 Increase in Income Taxes Payable 151 Other 30

Deduct: Increase in Receivables, net (246) Increase in Merchandise Inventories (1,075)

Cash Flow from Operating Activities 2,796$


14-39

Cash Coverage

Cash

Coverage=

$2,796 + $16 + $1,386

$16 = 262

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

Coverage


Before Interest and Taxes

Interest Paid

=

Cash payments made for:Interest 16$ Income Taxes 1,386


14-40

Debt/Equity Ratio

Total Liabilities

Owners’ Equity

Debt/Equity

Ratio=

$6,381

$15,004= 0.43

Debt/Equity

Ratio=

This ratio measures the amount of liabilities that exists for each $1


This ratio measures the amount of liabilities that exists for each $1



14-41

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 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 forHome Depot for 2001.

Home Depot


14-42

Price/Earnings (P/E) Ratio

P/E Ratio =Current Market Price Per Share

Earnings Per Share

P/E Ratio =$35

$1.12= 31.3

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 $35 per share.


14-43

Dividend Yield Ratio

Dividend

Yield

Dividends Per Share

Market Price Per Share=

Dividend

Yield

$0.16

$35= = 0.46%

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 $.16 per share when the market price was $35 per share.

Home Depot paid dividends of $.16 per share when the market price was $35 per share.


14-44

Other Analytical Considerations

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.


14-45

Interpreting Ratios

Ratios may be interpreted by comparison with 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 comparison with ratios of other companies or with industry

average ratios.

Ratios may vary because of thecompany’s industry characteristics,

nature of operations, size, andaccounting policies.


14-46

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.


14-47

End of Chapter 14

Ratios

Ratios

Ratios Ratios

Ratios

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Economy & Finance

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