Learning Objectives

1. Understand the nature of financial statement analysis.

2. Calculate and interpret horizontal and vertical analysis.

3. Assess profitability through the calculation and interpretation of ratios.

Learning Objectives

4. Assess liquidity through the calculation and interpretation of ratios.

5. Assess solvency through the calculation and interpretation of ratios.

6. Calculate and interpret a DuPont Analysis.

Financial Statement AnalysisLOI

All publicly traded companies must prepare audited financial statements each year and file them with the Securities and Exchange Commission. These statements include the income statement, the balance sheet, the statement of stockholders’ equity, and the statement of cash flows. Financial statements contain multiple years of data for comparative purposes and are the starting point for any analysis.

Financial AnalysisFinancial statement analysis is the process of applying analytical tools to a company’s financial statements to understand the company’sfinancial health and requires:

Financial information

Standards of

comparison

Analysis tools

Examples

In this chapter, the financial information provided by Best Buy Co.,

Inc. will be used to illustrate the process of financial analysis. For financial ratios, Best Buy will be

compared to hhgregg’s ratios, since both companies are in a similar

industry.

To ignore

product

safety??

Standards of Comparison• Often called

intracompany comparison (horizontal analysis)

• Often called intercompany comparison (vertical analysis)

1

2

3

To ignore

product

safety??

Analysis Tools• comparison of a company’s financial results across time.

• comparison of financial balances to a base account from the same company.

1

2

3

Horizontal AnalysisLO2

Horizontal analysis is an analysis technique that calculates thechange in an account balance from one period to the next and expresses that change in both dollar and percentage terms.

Balance Sheet – Horizontal – Best Buy (2008)

Best Buy ($ in millions, except per share amounts 2/28/09 3/1/08 $ Change % Change

Current Assets:Cash and cash equivalents $498 $1,438 $(940) -65.4%Receivables 1,868 549 1,319 240.3%Merchandise Inventories 4,753 4,708 45 1.0%Other current assets 1,073 647 426 65.8% Total Current Assets $8,192 $7,342 $850 11.6%Property and Equipment, net 4,174 3,306 868 26.3%Goodwill 2,203 1,088 1,115 102.5%Other Assets $1,257 $1,022 $235 23.0%Total Assets $80,000 $67,000 $13,000 24.1%

$ Current Year - $ Base Year = $1,868 – 549 = 240.3% $ Base Year $549

$ Change = $1,868 – 549 = $1,319

Income Statement Horizontal – Best Buy (2008)

Vertical Analysis

Vertical analysis is an analysis technique that states each account balance on a financial statement as a percentage of a base amount on the statement.

Balance Sheet Vertical – Best Buy (2008)

Asset accounts are stated as a percentage of Total Assets (set at 100%). For example, on 2/28/09, Receivables is 11.8% of Total Assets (calculated as $1,868 ÷ $15,826).

Income Statement Vertical– Best Buy (2008)

Overall Best Buy was profitable in 2008, but it was less profitable than in 2007 (3.5% in 2007 versus 2.2% in 2008). One reason for this was the increase in operating expenses.

Profitability AnalysisLO3

To ignore

product

safety??

• Indicates the ability to make required principal and interest payments.

• Indicates related stock price increases or dividends paid.

Profitability Ratios

Profit Margin Ratio

The profit margin ratio compares net income to net sales and measures the ability of a company to generate profits from sales. A higher ratio indicates a greater ability to generate profits from sales.

Return on EquityThe return on equity ratio compares net income to the average balance in stockholders’ equity during the year, showing how effectively a company uses the equity provided by stockholders during the year to generate additional equity for its owners. Stockholders naturally want this ratio to be as high as possible.

Return on AssetsThe return on assets ratio compares net income to averagetotal assets during the year, representing a company’s ability to generate profits from its entire resource base (not just those resources provided by owners). Like the return on equity, investors would like the ratio as high as possible.

Earnings Per ShareEarnings per share compares a company’s net income to the average number of shares of common stock outstanding during the year. The ratio represents the return on each share of stock owned by an investor.

Price to Earnings RatioThe price to earnings ratio compares net income to the current market price of the company’s common stock and provides an indication of investor perceptions of the company. A higher price to earnings ratio generally indicates that investors are more optimistic about the future prospects of a company.

Profitability Summary

Liquidity AnalysisLO4

Liquidity RatiosLiquidity ratios assess the ability of a company

to meet its immediate or short-term financial obligations. Failing to do so can result in additional expenses and, ultimately, bankruptcy.

Receivables Turnover Ratio

Quick

Ratio

Inventory

Turnover Ratio

Current Ratio

Current RatioThe current ratio is one of the most frequently used ratios in financial analysis and compares current assets to current liabilities. As such, it compares assets that should be turned into cash within one year to liabilities that should be paid within one year. A higher ratio indicates greater liquidity.

Quick RatioThe quick ratio (sometimes called the acid-test ratio) compares a company’s cash and near-cash assets, or quick assets, to its current liabilities. Quick assets include cash, short-term investments, and accounts receivable. Since the quick ratio measures the degree to which a company could pay off its current liabilities immediately, a higher quick ratio indicates greater liquidity.

Receivables Turnover RatioThe receivables turnover ratio compares a company’s credit sales during a period to its average accounts receivable balance during that period. A higher ratio means that the company is better able to generate and collect sales, leading to better liquidity.

Inventory Turnover RatioThe inventory turnover ratio compares a company’s cost of goods sold during a period to its average inventory balance during that period. It reveals how many times a company is able to sell its inventory balance in a period. A higher ratio is better because it indicates that the company sold more inventory while maintaining less inventory on hand.

Liquidity Summary

Ethics and Decision Making

In today’s business environment, companies have to be aware not only of the economic impact of their decisions,

but also of their ethical impact.

Information being used

for?

To falsify records??

To ignore

product

safety??

To exceed

government

limits??

Solvency Ratios

• Solvency refers to a company’s ability to remain in business over the long term.

Solvency focuses on capital structure and assesses the extent of borrowing needed.

Solvency Analysis

Debt to AssetsThe debt to assets ratio compares a company’s total liabilities to its total assets and yields the percentage of assets provided by creditors. As such, the ratio provides a measure of a company’s capital structure. A decreasing ratio shows that a company is taking on a less risky capital structure over time.

Debt to EquityThe debt to equity ratio compares a company’s total liabilities to its total equity. Higher debt to equity ratios indicate a riskiercapital structure and therefore greater risk of insolvency.

Times Interest EarnedThe times interest earned ratio compares a company’s net income to its interest expense. It shows how well a company can pay interest out of current-year earnings. A higher ratio indicatesa greater ability to make payments, and therefore less risk of insolvency.

Solvency Summary

DuPont Analysis

A DuPont analysis provides insight into how a company’s return on equity was generated by decomposing the return into three components: •operating efficiency,•asset effectiveness, and •capital structure.

LO6

DuPont CalculationThe higher the ratio, the more efficient a company is in turning sales into profits.

The higher the ratio, the more a company is financing its assets with debt rather than equity (riskier).This is the leverage multiplier.

The higher the ratio, the moreeffective a company is in generating sales given its assets.

Best Buy’s DuPont CalculationsThe analysis shows clearly why Best Buy’s return to its owners decreased from 2007 to 2008.

Profits from sales were down in 2008, resulting in a lower return on equity.

Benefit of DuPont AnalysisOne of the main benefits of a DuPont analysis is the ability to ask what-if questions.

???What if Best Buy was able to squeeze out another $.02 of profit on each dollar of sales? How would that affect the return to owners?Answer: 2008 returnwould increase to 0.407 (0.042 X 2.84 X 3.41).

What if the market for electronics took a significant downturn and Best Buy was only able to generate sales of 1.5 times assets on hand? Would that significantly affect the return to investors? Answer: 2008 return would fall almost in half to 0.113 (0.022 X 1.50 X 3.41).

End of Chapter 12