Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Analyzing Financial...

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