Analyzing Financial Statements

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

I am excited about analyzing

the financial statements

of cat food companies!

14-3

Economy-wide

Factors

Industry

Factors

Individual

Company

Factors

Invest? No Yes

Understanding The Business

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Investors

Dividends Increase in

share price

Return on an equity

security investment

Understanding The Business

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“It’s not buy and hold, it’s buy and homework!”

14-6

Understanding a Company’s Strategy

Business

Strategy Operating

Decisions Transactions

Financial

Statements

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 USERS

. . . uses accounting data

to make product pricing

and expansion

decisions.

. . . use accounting data

for investment, credit,

tax, and public policy

decisions.

EXTERNAL DECISION

MAKERS MANAGEMENT

Financial Statement Analysis

14-8

THREE TYPES OF FINANCIAL

STATEMENT INFORMATION

Past Performance

Present Condition

Future Performance

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

McGraw-Hill/Irwin

Statements made in this presentation concerning projections or expectations of financial or operational performance or

economic outlook, or concerning other future events or results, or which refer to matters which are not historical facts, are

"forward-looking statements" within the meaning of the federal securities laws. Forward-looking statements involve a number

of risks and uncertainties, and actual results may differ materially from that projected or implied in those statements.

Important factors that could cause such differences include, but are not limited to, economic and industry conditions: material

adverse changes in economic or industry conditions, both within the United States and globally, customer demand, effects of

adverse economic conditions affecting shippers, adverse economic conditions in the industries and geographic areas that

produce and consume freight, competition and consolidation within the transportation industry, the extent to which BNSF

Railway is successful in gaining new long-term relationships with customers or retaining existing ones, changes in the

securities and capital markets, changes in fuel prices, and changes in labor costs and labor difficulties including stoppages

affecting either BNSF Railway’s operations or our customers’ abilities to deliver goods to BNSF Railway for shipment; legal and

regulatory factors: developments and changes in laws and regulations, the ultimate outcome of shipper and rate claims subject

to adjudication, environmental investigations or proceedings and other types of claims and litigation; and operating factors:

technical difficulties, changes in operating conditions and costs, commodity concentrations, the availability of equipment and

human resources to meet changes in demand, the Company’s ability to achieve its operational and financial initiatives and to

contain costs, as well as natural events such as severe weather,floods and earthquakes or man-made or other disruptions of

the Company’s operating systems, structures, or equipment.

The Company cautions against placing undue reliance on forward-looking statements, which reflect its current beliefs and are

based on information currently available to it as of the date a forward-looking statement is made. The Company undertakes no

obligation to revise forward-looking statements to reflect future events, changes in circumstances, or changes in beliefs. In the

event that the Company does update any forward-looking statements, no inference should be made that the Company will make

additional updates with respect to that statement, related matters, or any other forward-looking statements. Any corrections or

revisions may appear in BNSF’s public filings with the Securities and Exchange Commission, which are accessible at

www.sec.gov or on BNSF’s website at www.bnsf.com, and which you are advised to consult.

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14-13

Financial Statement Analysis

Examines a single company to identify

trends over time.

Financial statement analysis is based on comparisons.

Time series

analysis

Comparison with

similar companies

Provides insights concerning a

company’s relative performance.

14-14

Component Percentages

Express each item on a particular statement as a percentage of a single base amount.

Total assets

on the balance

sheet

Net sales

on the income

statement

The comparative income statements of Home Depot

for 2007 and 2006 appear on the next slide.

Prepare component percentage income statements

where net sales equal 100%.

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HOME DEPOT

Comparative Income Statements (Condensed)

Amounts in Millions Except Per Share Data

2007 Percent 2006 Percent

Net Sales 90,837$ 100.0% 81,511$ 100.0%

Cost of Merchandise Sold 61,054 67.2% 54,191 66.5%

Gross Profit 29,783 27,320

Operating Expenses 20,110 17,957

Operating Income 9,673 9,363

Interest and Investment Income 27 62

Interest Expense (392) (143)

Earnings Before Income Taxes 9,308 9,282

Income Taxes 3,547 3,444

Net Earnings 5,761$ 5,838$

Basic Earnings Per Share 2.80$ 2.73$

Weighted-Average Number of

Common Shares Outstanding 2,062 2,147

Diluted Earnings Per Share 2.79$ 2.72$

2007 Cost ÷ 2007 Sales

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HOME DEPOT

Comparative Income Statements (Condensed)

Amounts in Millions Except Per Share Data

2007 Percent 2006 Percent

Net Sales 90,837$ 100.0% 81,511$ 100.0%

Cost of Merchandise Sold 61,054 67.2% 54,191 66.5%

Gross Profit 29,783 32.8% 27,320 33.5%

Operating Expenses 20,110 22.1% 17,957 22.0%

Operating Income 9,673 10.6% 9,363 11.5%

Interest and Investment Income 27 0.0% 62 0.1%

Interest Expense (392) -0.4% (143) -0.2%

Earnings Before Income Taxes 9,308 10.2% 9,282 11.4%

Income Taxes 3,547 3.9% 3,444 4.2%

Net Earnings 5,761$ 6.3% 5,838$ 7.2%

Basic Earnings Per Share 2.80$ 2.73$

Weighted-Average Number of

Common Shares Outstanding 2,062 2,147

Diluted Earnings Per Share 2.79$ 2.72$

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Commonly Used Ratios

The 2007 and 2006 balance sheets for Home Depot are presented next.

We will be referring to these financial statements throughout the ratio analyses.

Home Depot

14-18

HOME DEPOT

Comparative Balance Sheets (Condensed)

Amounts in Millions

2007 2006

Assets

Cash and Cash Equivalents 600$ 793$

Short-Term Investments 14 14

Receivables, net 3,223 2,396

Merchandise Inventories 12,822 11,401

Other Current Assets 1,341 665

Total Current Assets 18,000 15,269

Property and Equipment, at cost 34,358 31,530

Less Accumulated Depreciation 7,753 6,629

Net Property and Equipment 26,605 24,901

Other Assets 7,658 4,235

Total Assets 52,263$ 44,405$

Continued

14-19

HOME DEPOT

Comparative Balance Sheets (Condensed)

Amounts in Millions

2007 2006

Liabilities

Current Liabilities 12,931$ 12,706$

Noncurrent Liabilities 14,302 4,790

Total Liabilities 27,233 17,496

Stockholders' Equity

Common Stock, $.05 par 121 120

Paid-in Capital 7,930 7,149

Retained Earnings 33,052 28,943

Accumulated Other Comprehensive Income 310 409

Total 41,413 36,621

Less: Treasury Stock (16,383) (9,712)

Total Stockholders' Equity 25,030 26,909

Total Liabilities & Stockholders' Equity 52,263$ 44,405$

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Test of Profitability ─ Return on Equity

Return on Equity $5,761

($25,030 + $26,909) ÷ 2 = = 22.2%

Net Income

Average Stockholders’ Equity Return on Equity =

This measure indicates how much income was

earned for every dollar invested by the owners.

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

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Test of Profitability ─ Return on Assets

Return on

Assets

Net Income + Interest Expense (net of tax)

Average Total Assets =

Return on

Assets

$5,761 + ($392 × (1 - .34))

($52,263 + $44,405) ÷ 2 = = 12.5%

This ratio is generally considered the best overall

measure of a company’s profitability.

Corporate tax rate

is 34%.

14-22

Test of Profitability ─ Financial Leverage Percentage

Financial

Leverage Return on Equity – Return on Assets =

9.7% = 22.2% – 12.5%

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.

14-23

Test of Profitability ─ Earnings per Share (EPS)

EPS $5,761

(1,970 + 2124) ÷ 2 = = $2.81

Earnings per share is probably the single

most widely watched financial ratio.

Average number of shares based on the number

of 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.

14-24

Test of Profitability ─ Quality of Income Quality

of Income

Cash Flow from Operating Activities

Net Income =

Cash Flow from Operating Activities

Net Income 5,761$

Add: Depreciation and Amortization 1,886

Decrease in Receivables, net 96

Increase in Accounts Payable 531

Increase in Deferred Income Taxes 46

Stock-based Compensation Expense 297

Other 178

Deduct: Increase in Deferred Revenue (123)

Increase in Merchandise Inventories (563)

Decrease in Income Taxes Payable (172)

Decrease in Other Current Assets (225)

Decrease in Other Long-term Liabilities (51)

Cash Flow from Operating Activities 7,661$

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Test of Profitability ─ Quality of Income

Quality

of Income

$7,661

$5,761 = = 1.33

A ratio higher than 1 indicates

high-quality earnings.

Quality

of Income

Cash Flow from Operating Activities

Net Income =

14-26

Test of Profitability ─ Profit Margin

= 6.3% Profit

Margin

$5,761

$90,837 =

This ratio tells us the percentage of

each sales dollar that is income.

Profit

Margin

Net Income

Net Sales =

14-27

Test of Profitability ─ Fixed Asset Turnover

Fixed

Asset

Turnover

$90,837

($26,605 + $24,901) ÷ 2 = = 3.53

Fixed

Asset

Turnover

Net Sales Revenue

Average Net Fixed Assets =

This ratio measures a company’s ability to generate

sales given an investment in fixed assets.

14-28

Tests of Liquidity ─ Cash Ratio

Cash

Ratio

Cash + Cash Equivalents

Current Liabilities =

= 0.05 to 1 Cash

Ratio

$600

$12,931 =

This ratio measures the

adequacy of available cash.

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

$18,000

$12,931 = = 1.39 to 1

This ratio measures the ability

of 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

$3,837

$9,554 = 0.40 to 1 =

Quick

Ratio

This ratio is like the current

ratio but measures the company’s

immediate ability to pay debts.

Cash & Cash Equivalents 600$

Receivables, net 3,223

Short-term Investments 14

Quick Assets 3,837$

14-31

Tests of Liquidity ─ Receivable Turnover

Net Credit Sales

Average Net Receivables

Receivable

Turnover =

Receivable

Turnover

$90,837

($3,223 + $2,396) ÷ 2 = 32.3 Times =

This ratio measures how

quickly a company collects its

accounts receivable.

14-32

Tests of Liquidity ─ Average Age of Receivables

Days in Year

Receivable Turnover

Average Age

of Receivables =

= 11.3 Days 365

32.3

Average Age

of Receivables =

This ratio measures the average number

of days it takes to collect receivables.

14-33

Tests of Liquidity ─ Inventory Turnover

Cost of Goods Sold

Average Inventory

Inventory

Turnover =

Inventory

Turnover

$61,054

($12,822 + $11,401) ÷ 2 = 5.0 Times =

This ratio measures how quickly

the company sells its inventory.

14-34

Tests of Liquidity ─ Average Days’ Supply in Inventory

Days in Year

Inventory Turnover

Average Days’

Supply in

Inventory

=

= 73 Days 365

5.0 =

Average Days’

Supply in

Inventory

This ratio measures the average

number of days it takes to sell the

inventory.

14-35

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.

$61,054

($7,356 + $6,032) ÷ 2 = 9.1 Times =

Accounts

Payable

Turnover

14-36

Tests of Liquidity ─ Average Age of Payables

Days in Year

Accounts Payable Turnover

Average Age

of Payables =

This ratio measures the average number

of days it takes to pay its suppliers.

= 40.1 Days 365

9.1 =

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 =

+ +

$5,761 + $392 + $3,547

$392

Times

Interest

Earned = = 24.7 Times

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

14-38

Tests of Solvency ─ Cash Coverage

Cash

Coverage

Cash Flow from Operating Activities

Before Interest and Taxes Paid

Interest Paid

=

Cash Flow from Operating Activities

Net Income 5,761$

Add: Depreciation and Amortization 1,886

Decrease in Receivables, net 96

Increase in Accounts Payable 531

Increase in Deferred Income Taxes 46

Stock-based Compensation Expense 297

Other 178

Deduct: Increase in Deferred Revenue (123)

Increase in Merchandise Inventories (563)

Decrease in Income Taxes Payable (172)

Decrease in Other Current Assets (225)

Decrease in Other Long-term Liabilities (51)

Cash Flow from Operating Activities 7,661$

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Cash

Coverage =

$7,661 + $270 + $3,963

$270 = 44.0

This ratio compares the cash generated with

the cash obligations of the period.

Cash interest paid 270$

Income tax paid 3,963

From Statement of Cash Flows

Cash

Coverage

Cash Flow from Operating Activities

Before Interest and Taxes Paid

Interest Paid

=

Tests of Solvency ─ Cash Coverage

14-40

Tests of Solvency ─ Debt-to-Equity Ratio

This ratio measures the amount of

liabilities that exists for each $1

invested by the owners.

$27,233

$25,030 = 1.09 =

Debt-to-Equity

Ratio

Total Liabilities

Stockholders’ Equity

Debt-to-Equity

Ratio =

14-41

“20”

14-42

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

P/E Ratio = Current Market Price Per Share

Earnings Per Share

P/E Ratio = $34

$2.80 = 12.1

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 $34 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.

14-43

Market Tests ─ Dividend Yield Ratio

Dividend

Yield

Dividends Per Share

Market Price Per Share =

Dividend

Yield

$0.675

$34 = = 2 %

This ratio is often used to compare the

dividend-paying performance of different

investment alternatives.

Home Depot paid dividends of $.675 per share

when the market price was $34 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, and accounting 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