14-1 Financial Statement Analysis Chapter 14 Electronic Presentation by Douglas Cloud Pepperdine University

14-1

Financial Statement Analysis

Chapter 14

Electronic Presentation by Douglas Cloud

Pepperdine University

Electronic Presentation by Douglas Cloud

Pepperdine University

14-2

1. Construct and interpret horizontal and vertical analyses.

2. Calculate and interpret the rate earned on stockholders’ equity and the rate earned on total assets.

3. Analyze the rate earned on total assets by evaluating the profit margin and the asset efficiency of a business.Anal

Learning GoalsLearning GoalsLearning GoalsLearning Goals

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

ContinuedContinuedContinuedContinued

14-3

4. Determine and interpret leverage.5. Calculate and interpret shareholder ratios: earnings per share,

price-earnings ratio, and dividend yield.6. Summarize the uses and limitations of analytical measures.7. Describe the contents of corporate annual reports.

Learning GoalsLearning GoalsLearning GoalsLearning Goals

14-4

Your Need to Know Value investing is an attempt to discover stocks with

an intrinsic value that are greater than the stock prices.

In growth investing, the investor tries to identify companies that are growing sales and earnings through new products, markets, or opportunities.

Income investing is where investors purchase common stocks for their dividend stream.

Technical investing involves investors using technical analysis to find clues about future performance from past performance.

14-5

1Learning GoalLearning GoalLearning GoalLearning Goal

Construct and interpret horizontal and vertical analyses.

14-6

Horizontal AnalysisHorizontal AnalysisHorizontal AnalysisHorizontal Analysis

What is horizontal analysis?

What is horizontal analysis?

It’s an analysis of the percentage increases and decreases of related items

in comparative financial statements.

It’s an analysis of the percentage increases and decreases of related items

in comparative financial statements.

14-7HOME DEPOT

Comparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001

AssetsCurrent assets $10,361 $ 7,777 $2,584 33.2%Property and equipment, net 15,375 13,068 2,307 17.7Other assets 658 540 118 21.9Total assets $26,394 $21,385 $5,009 23.4

LiabilitiesCurrent liabilities $ 6,501 $ 4,385 $2,116 48.3Long-term debt, excluding current installment 1,250 1,545 (295) (19.1)Other long-term liabilities 372 256 116 45.3Deferred income taxes 189 195 (6) (3.1)Total long-term liabilities $ 1,811 $ 1,996 $ (185) (9.3)Total liabilities $ 8,312 $ 6,381 $1,931 30.3

Increase (Decrease) Feb. 3, 2002 Jan. 28, 2001 Amount Percent

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CondensedCondensed

The stockholders’ equity section is not displayed.The stockholders’ equity section is not displayed.The stockholders’ equity section is not displayed.The stockholders’ equity section is not displayed.

14-8HOME DEPOT





14-8

CondensedCondensed

Horizontal Analysis: Horizontal Analysis:

Difference $2,584

Base year $7,777= 33.2%

33.2%

14-9HOME DEPOT



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CondensedCondensed

33.2% AssetsCurrent assets $10,361 $ 7,777 $2,584 33.2%Property and equipment, net 15,375 13,068 2,307 17.7Other assets 658 540 118 21.9Total assets $26,394 $21,385 $5,009 23.4


17.733.2%


Difference $2,307

Base year $13,068= 17.7%

14-10HOME DEPOT



14-10

CondensedCondensed



14-11

HOME DEPOT INC. Income Statement (in millions)

For Periods Ended February 3, 2002 and January 28, 2001

Sales (net) $53,553 $45,738 $7,815Cost of merchandise sold 37,406 32,057 5,349 Gross profit $16,147 $13,681 $2,466 Selling and store operating exp. 10,280 8,655 1,625General and administrative exp. 935 835 100 Total operating expenses $11,215 $ 9,490 $1,725Income from operations $ 4,932 $ 4,191 $ 741Other income and expenses:

Interest and investment inc. 53 47 6 Interest expense (28) (21) (7)Income before income tax $ 4,957 $ 4,217 $ 740 Income taxes 1,913 1,636 277 Net income $ 3,044 $ 2,581 $ 463


Difference $7,815

Base year $45,738= 17.1%

17.1%

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Increase (Decrease) 2002 2001 Amount Percent

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Difference $5,349

Base year $32,057= 16.7

17.1%16.7

14-12


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17.1%16.7

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18.018.812.018.217.7

12.833.317.516.917.9

14-14

HOME DEPOT INC. Comparative Retained Earnings Statement (in millions)


Retained earnings, beginning $10,151 $ 7,941 $2,210Net income for the year 3,044 2,581 463Total $13,195 $10,522 $2,673Dividends:

On common stock 396 371 25Retained earnings, ending $12,799 $10,151 $2,648


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Difference $2,210

Base year $7,941= 27.8%

27.8%

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HOME DEPOT INC. Comparative Retained Earnings Statement (in millions)


Retained earnings, beginning $10,151 $ 7,941 $2,210Net income for the year 3,044 2,581 463Total $13,195 $10,522 $2,673Dividends:

On common stock 396 371 25Retained earnings, ending $12,799 $10,151 $2,648


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27.8%17.925.4

6.726.1

14-16

Vertical AnalysisVertical AnalysisVertical AnalysisVertical Analysis

A percentage analysis can be used to show the relationship of each component to a total

within a single statement.

A percentage analysis can be used to show the relationship of each component to a total

within a single statement.

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The total, or 100% item, on the balance sheet is

“total assets.”

The total, or 100% item, on the balance sheet is

“total assets.”

Vertical AnalysisVertical AnalysisVertical AnalysisVertical Analysis

14-1814-18

AssetsCurrent assets $10,361 $ 7,777Property and equipment, net 15,375 13,068Other assets 58 540Total assets $26,394 $21,385

LiabilitiesCurrent liabilities $ 6,501 $ 4,385Long-term liabilities 1,811 1,996Total liabilities $ 8,312 $ 6,381 Stockholders’ EquityCommon stock/paid-in capital $ 5,529 $ 4,926RE & accumulated comp. loss 12,553 10,078Total stockholders’ equity $18,082 $15,004Total liabilities and SE $26,394 $21,385

Total assets is 100.0%


100.0%

HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001

Feb. 3, 2002 Jan. 28, 2001 Amount Percent Amount Percent

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CondensedCondensed

14-19HOME DEPOT



14-19

CondensedCondensed



39.3%

100.0%

Vertical Analysis: Vertical Analysis:

Current assets $10,361

Total assets $26,394= 39.3%

14-20HOME DEPOT



14-20

CondensedCondensed



39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

14-21HOME DEPOT



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CondensedCondensed

39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

100.0%





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CondensedCondensed



39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

100.0%

36.4%


Current assets $7,777

Total assets $21,385= 36.4%


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14-23


CondensedCondensed



39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

100.0%

36.4%61.1

2.5


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20.5% 9.3 29.8%

23.0% 47.1 70.2%100.0%

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Sales (net) $53,553 100.0% $45,738 100.0%Cost of merchandise sold 37,406 32,057Gross profit $16,147 $13,681Selling and store operating exp. 10,280 8,655General and administrative exp. 935 835Total operating expenses $11,215 $ 9,490Income from operations $ 4,932 $ 4,191Other income and expenses:

Interest and investment inc. 53 47 Interest expense (28) (21) Income before income tax $ 4,957 $ 4,217Income taxes 1,913 1,636Net income $ 3,044 $ 2,581

14-24

Amount Percent Amount Percent

2002 2001

Net sales is 100.0%

Net sales is 100.0%

Net sales is 100.0%

Net sales is 100.0%

14-25





14-25


2002 2001


Cost of Merchandise Sold $32,057

Net Sales $45,738

= 70.1%

2001

70.1

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Cost of Merchandise Sold $37,406

Net Sales $53,553

= 69.9%

2002



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2002 2001

69.9 70.1

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14-27


2002 2001

69.9 29.9%

18.9% 1.8

20.7%9.2%

0.1 (0.1)

9.2% 3.6

5.6%

70.1

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14-28


2002 2001

70.1 30.1%

19.2% 1.7 20.9%

9.2%

0.1 (0.0)

9.3% 3.6

5.7%

29.9%18.9%

1.8 20.7%

9.2%

0.1 (0.1)

9.2% 3.6

5.6%

69.9

14-29





14-29


2002 2001

70.1 69.9 30.1%

19.2% 1.7 20.9%

9.2%

0.1 (0.0)

9.3% 3.6

5.7%

29.9%18.9%

1.8 20.7%

9.2%

0.1 (0.1)

9.2% 3.6

5.6%

14-30

Calculate and interpret the rate earned on stockholders’ equity and the rate earned on total assets.


14-31

Rate Earned on Rate Earned on Stockholders’ EquityStockholders’ Equity


The stockholder desires a return on his or her investment. One

measure of this return is the rate earned on stockholders’ equity.

The stockholder desires a return on his or her investment. One

measure of this return is the rate earned on stockholders’ equity.

14-32



Net income

Average stockholders’ equity

$3,044,000,000

($15,004,000,000 + $18,082,000,000)/2

= 18.4%

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Net income

Average stockholders’ equity

$1,023,000,000

($5,494,000,000 + $6,674,000,000)/2

= 16.8%

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Another ratio to measure the relative profitability of a firm is

rate earned on total assets.

Another ratio to measure the relative profitability of a firm is

rate earned on total assets.

Rate Earned on Total AssetsRate Earned on Total AssetsRate Earned on Total AssetsRate Earned on Total Assets

14-35


Net income

Average total assets

$3,044,000,000

($21,385,000,000 + $26,394,000,000)/2

= 12.8%

14-36


Net income

Average total assets

$1,023,000,000

($11,358,000,000 + $13,736,000,000)/2

= 8.1%

14-37

Comprehensive Comprehensive Profitability AnalysisProfitability Analysis


The exhibit on the next slide diagrams the comprehensive ratio

relationship that can be used to analyze the rate earned on

stockholders’ equity.

The exhibit on the next slide diagrams the comprehensive ratio

relationship that can be used to analyze the rate earned on

stockholders’ equity.

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The rate earned on stockholders’ equity is normally higher

than the rate earned on total assets when

a company uses debt, or leverage.

The rate earned on stockholders’ equity is normally higher

than the rate earned on total assets when

a company uses debt, or leverage.

14-40



Leverage FormulaLeverage Formula

Rate earned on stockholders’ equity =

Rate earned on total assets × leverage

Net incomeAverage Stockholders’ Equity

=

Net incomeAverage Total Assets

×Average Total Assets

Average Stockholders’ Equity

14-41

Analyze the rate earned on total assets by evaluating the profit margin and the asset efficiency of a business.


14-42


Profit Margin × Asset Turnover

Net Income

Net Sales

Net Sales

Average Total Assets×

14-43

14-44

Margin AnalysisMargin AnalysisMargin AnalysisMargin Analysis

Why is the profit margin of Home Depot over one

percentage point stronger than Lowe’s?

Why is the profit margin of Home Depot over one

percentage point stronger than Lowe’s?

14-45

Home Depot and Lowe’s Condensed Common-Size Income Statement For the Year Ended February 3 and February 1, 2002

Sales (net) 100.0% 100.0%Cost of merchandise sold 69.9 71.2Gross profit 30.1% 28.8%

Selling expenses 19.2% 18.3%Administrative expenses 1.7 2.4

Total operating expenses 20.9% 20.7%Income from operations 9.2% 8.1%Other income 0.1 0.0Interest expense (0.0) (0.8) Income before income taxes 9.3% 7.3%Income tax expense 3.6 2.7Net income 5.7% 4.6%

Home Depot Lowe’s

Home Depot Home Depot has a higher has a higher gross profit gross profit

percentage than percentage than Lowe’s.Lowe’s.

Home Depot Home Depot has a higher has a higher gross profit gross profit

percentage than percentage than Lowe’s.Lowe’s.

Although Home Depot pays Although Home Depot pays more income taxes more income taxes

(percentage-wise), the (percentage-wise), the overall profit percentage is overall profit percentage is

higher than Lowe’s.higher than Lowe’s.

Although Home Depot pays Although Home Depot pays more income taxes more income taxes

(percentage-wise), the (percentage-wise), the overall profit percentage is overall profit percentage is

higher than Lowe’s.higher than Lowe’s.

Home Depot’s Home Depot’s higher selling higher selling expenses are expenses are

somewhat somewhat offset by lower offset by lower administrative administrative

expenses.expenses.

Home Depot’s Home Depot’s higher selling higher selling expenses are expenses are

somewhat somewhat offset by lower offset by lower administrative administrative

expenses.expenses.

14-46

Asset EfficiencyAsset EfficiencyAsset EfficiencyAsset Efficiency

14-47

Accounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable Turnover

Net sales $53,553 $22,111Accounts receivable (net):

Beginning of year $ 835 $ 161End of year 820 166Total $ 1,755 $ 327

Average $ 878 $ 164

Home Depot Lowe’s

Accounts Receivable AnalysisAccounts Receivable Analysis

61.0 134.8 Net sales on account

Average accounts receivable

Net sales on account


(all dollar amounts in millions)

14-48

Accounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable Turnover

Net sales $53,553 $22,111Accounts receivable (net):

Beginning of year $ 835 $ 161End of year 820 166Total $ 1,755 $ 327

Average $ 878 $ 164

Home Depot Lowe’s





Average accounts receivable61.0 134.8

Use: To assess the efficiency in collecting receivables and in the management of credit.


(all amounts except ratios in millions)

14-49

Number of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in Receivables

Accounts receivable (net)end of year $920 $166

Net sales on account $53,553 $22,111Average daily sales on

on account (net sales ÷ 365) $147 $61


Accounts receivable, end of year

Average daily sales on account



Home Depot Lowe’s

6.3 2.7


14-50

Number of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in Receivables

Accounts receivable (net)end of year $920 $166

Net sales on account $53,553 $22,111Average daily sales on

on account (net sales ÷ 365) $147 $61






(all amounts except ratios in millions)

6.3 2.7



Home Depot Lowe’s

14-51

Inventory TurnoverInventory TurnoverInventory TurnoverInventory Turnover

Cost of merchandise sold $37,406 $15,743Inventories:

Beginning of year $ 6,556 $ 3,285End of year 6,725 3,611Total $13,281 $ 6,896

Average $ 6,641 $ 3,448

Inventory AnalysisInventory Analysis

Cost of merchandise sold

Average inventory


Average inventory

Home Depot Lowe’s

5.6 4.6


14-52

Inventory TurnoverInventory TurnoverInventory TurnoverInventory Turnover

Cost of merchandise sold $37,406 $15,743Inventories:

Beginning of year $ 6,556 $ 3,285End of year 6,725 3,611Total $13,281 $ 6,896

Average $ 6,641 $ 3,448



Average inventory


Average inventory

Home Depot Lowe’s

5.6 4.6

Use: To assess the efficiency in the management of inventory.



14-53

Number of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in Inventory

Inventories, end of year $6,725 $3,611Cost of merchandise sold $37,406 $15,743Average daily cost of

merchandise sold (COGS ÷ 365) $102 $43


Inventories, end of year

Average daily cost of goods sold



Home Depot Lowe’s


65.9 84.0

14-54

Number of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in Inventory

Inventories, end of year $6,725 $3,611Cost of merchandise sold $37,406 $15,743Average daily cost of

merchandise sold (COGS ÷ 365) $102 $43






Home Depot Lowe’s

65.9 84.0




14-55

Fixed Asset TurnoverFixed Asset TurnoverFixed Asset TurnoverFixed Asset Turnover

Net sales $53,553 $22,111Fixed assets (net):

Beginning of year $13,068 $ 7,035 End of year 15,375 8,663 Total $28,443 $15,688

Average $14,222 $ 7,844

Fixed Asset AnalysisFixed Asset Analysis

Net sales

Average net fixed assets

Net sales


Home Depot Lowe’s


3.77 2.82

14-56

Fixed Asset TurnoverFixed Asset TurnoverFixed Asset TurnoverFixed Asset Turnover

Net sales $53,553 $22,111Fixed assets (net):

Beginning of year $13,068 $ 7,035 End of year 15,375 8,663 Total $28,443 $15,688

Average $14,222 $ 7,844

Fixed Asset AnalysisFixed Asset Analysis

Net sales


Net sales


Home Depot Lowe’s


3.77 2.82

Use: To measure how many dollars of sales are being made from investments in stores and fixtures.

Use: To measure how many dollars of sales are being made from investments in stores and fixtures.

14-57

Determine and interpret leverage.4

Learning GoalLearning GoalLearning GoalLearning Goal

14-58

LeverageLeverage

× LeverageRate earned on total assets

= Rate earned on stockholders’ equity

14-59

LeverageLeverage

20%

10%

0%

Rate earned on total assets

Rate earned on stockholders’ equity

12.8%Leverage

Home Depot

8.1%

16.7%

Leverage

Lowe’s

18.4%

14-60

(All dollar amounts in millions)

Current Balance Sheet RelationshipsCurrent Balance Sheet Relationships

Current assets $550,000 $533,000Current liabilities 210,000 243,000Working capital $340,000 $290,000

Current ratioCurrent ratio 2.6 2.6 2.2 2.2

Working Capital and Current RatioWorking Capital and Current RatioWorking Capital and Current RatioWorking Capital and Current Ratio

Use: To indicate the ability to meet currently maturing obligations.

Use: To indicate the ability to meet currently maturing obligations.

Lincoln Co. Jefferson Corp.

Divide current

assets by current

liabilities

Divide current

assets by current

liabilities

14-61

Quick RatioQuick RatioQuick RatioQuick Ratio

Use: To indicate instant debt-paying ability.Use: To indicate instant debt-paying ability.

Home Depot Lowe’sQuick assets:

Cash $ 2,477 $ 799Temporary investments 69 54Accounts receivable (net) 920 166Total quick assets $ 3,466 $ 1,019

Current liabilities ÷6,501 ÷3,017Quick ratio 0.53 0.34

Current Balance Sheet RelationshipsCurrent Balance Sheet Relationships


14-62

Use: To indicate the margin of safety to long-term creditors.

Use: To indicate the margin of safety to long-term creditors.

Home Depot Lowe’s

Fixed assets (net) $15,375 $ 8,653Long-term liabilities ÷ 1,811 ÷ 3,734Ratio of fixed assets to

long-term liabilities 8.5 2.3

Ratio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term Liabilities

Long-Term Balance Sheet RelationshipsLong-Term Balance Sheet Relationships


14-63

Ratio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ Equity

Use: To indicate the margin of safety to creditors.Use: To indicate the margin of safety to creditors.

Total liabilities $ 8,312 $ 7,062Total stockholders’ equity ÷18,082 ÷ 6,674Ratio of liabilities to

stockholders’ equity 0.46 1.06


Home Depot Lowe’s


14-64

Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned

Net income $3,044 $1,023 Add income tax 1,913 601 Add interest expense 28 174Amount available for interest $4,985 $1,798Number of times interest charges earned 178.0 10.3



Home Depot Lowe’s

Use: To measure the relative risk of debtholders.Use: To measure the relative risk of debtholders.

14-65


Calculate and interpret shareholder ratios: earnings per share, price-earnings ratio, and dividend yield.

14-66

Net income $3,044 $1,023Shares of common stock ÷2,335 ÷ 769Earnings per share on common

stock $1.30 $1.33

Use: To assess the profitability of the investment by common stockholders.

Use: To assess the profitability of the investment by common stockholders.

Earning per ShareEarning per Share

Home Depot Lowe’s

(All amounts except EPS in millions)

14-67

Use: To indicate future earnings prospects, based on the relationship between market value of common stock and earnings.

Use: To indicate future earnings prospects, based on the relationship between market value of common stock and earnings.

Market price per share of common $50.00 $46.15Earnings per share on common ÷ 1.30 ÷ 1.33Price-earnings ratio on common

stock 38 35

Price-Earnings RatioPrice-Earnings Ratio

Home Depot Lowe’s

14-68

Use: To indicate the rate of return to common stockholders in terms of dividends.

Use: To indicate the rate of return to common stockholders in terms of dividends.

Dividends per share of common $ 0.20 $ 0.08Market price per share of common ÷ 50.00 ÷ 46.15Dividend yield on common stock 0.4% 0.2%

Dividend YieldDividend Yield

Home Depot Lowe’s

14-69

Summarize the uses and limitations of analytical measures.


14-70

Use Exhibit 9 of this chapter as a handy

reference tool.

Use Exhibit 9 of this chapter as a handy

reference tool.

Keep in mind that these measures are not a

substitute for sound judgment.

Keep in mind that these measures are not a

substitute for sound judgment.

14-71

Describe the contents of corporate annual reports.7

Learning GoalLearning GoalLearning GoalLearning Goal

14-72

Financial HighlightsFinancial HighlightsFinancial HighlightsFinancial Highlights

The financial highlights section summarizes the operating results

for the last year or two. It’s usually on the first few pages of

the annual report.

The financial highlights section summarizes the operating results

for the last year or two. It’s usually on the first few pages of

the annual report.

14-73

President’s Letter to President’s Letter to StockholdersStockholders

President’s Letter to President’s Letter to StockholdersStockholders

This letter usually

discusses reasons for

actions taken by the company during the year.

This letter usually

discusses reasons for

actions taken by the company during the year.

14-74

Management Discussion Management Discussion and Analysis (MDA)and Analysis (MDA)

Management Discussion Management Discussion and Analysis (MDA)and Analysis (MDA)

A required disclosure in the annual report

Includes an analysis of the results of operations

Discusses management’s opinion about future performance

An analysis of the company’s financial condition

14-75

Independent Auditor’s ReportIndependent Auditor’s ReportIndependent Auditor’s ReportIndependent Auditor’s Report

Before issuing annual statements, all publicly held corporations are

required to have an independent audit of

their financial statements.

Before issuing annual statements, all publicly held corporations are

required to have an independent audit of

their financial statements.

The CPAs who conduct the audit

render an opinion on the fairness of the

statement.

The CPAs who conduct the audit

render an opinion on the fairness of the

statement.

14-76

Historical SummaryHistorical SummaryHistorical SummaryHistorical Summary

This summary reports selected

financial and operating data of past periods, usually for

five or ten years.

This summary reports selected

financial and operating data of past periods, usually for

five or ten years.

14-77

The EndThe End

Chapter 14Chapter 14

14-78

Documents

14-1 Financial Statement Analysis Chapter 14 Electronic Presentation by Douglas Cloud Pepperdine University