Analyzing Financial Statements

Chapter 14

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
14-1
 Understanding The Business

Individual
Company
Industry Factors Economy-wide
Factors Factors

Invest?
No Yes

14-2
 Understanding The Business

Return on an equity
security investment

Increase in
Dividends share price

Investors
14-3
 Understanding a Company’s Strategy
I need to know if the company is trying to earn
a high rate of return through product
differentiation or cost differentiation.

Business
Strategy
Operating
Decisions
Transactions
Financial
Statements
14-4
 Financial Statement Analysis
Financial statement analysis
is based on comparisons.

Time series Comparison with

analysis similar companies

Examines a single Provides insights

company to identify concerning a
trends over time. company’s relative
performance.

14-5
 Component Percentages
Express each item on a particular statement
as a percentage of a single base amount.

Net sales Total assets

on the income on the balance
statement sheet

The comparative income statements of Home Depot

for 2007, 2008, and 2009 appear on the next slide.
Prepare component percentage income statements
where net sales equal 100%.

14-6
 Net Sales will be set
to 100% and all other
components will be
expressed as a
percentage of Net
Sales.

14-7
 Net Sales will be set
to 100% and all other
components will be
expressed as a
2009 Cost of Sales ÷ 2009 Net Sales
percentage of Net
$47,298 ÷ $71,288 = .664 or 66.4%
Sales.
2009 Gross Profit ÷ 2009 Net Sales
$23,990 ÷ $71,288 = .336 or 33.6%
2009 Selling, G&A ÷ 2009 Net Sales
$17,846 ÷ $71,288 = .250 or 25.0%

14-8
 Component Percentages

14-9
 Commonly Used Ratios
The
The 2009
2009 and
and 2008
2008 balance
balance sheets
sheets for
for
Home
Home Depot
Depot are
are presented
presented next.
next.
We
We will
will be
be referring
referring to
to these
these financial
financial
statements
statements throughout
throughout the
the ratio
ratio
analyses.
analyses.

Home Depot

14-10
14-11
14-12
 Test of Profitability ─ Return on Equity
Profitability
Profitability is
is aa primary
primary measure
measure of
of
the
the overall
overall success
success ofof aa company.
company.

Net Income
Return on Equity = Average Stockholders’ Equity

$2,260
Return on Equity = = 12.7%
($17,777 + $17,714) ÷ 2

This
This measure
measure indicates
indicates how
how much
much income
income was
was
earned
earned for
for every
every dollar
dollar invested
invested by
by the
the owners.
owners.

14-13
 Test of Profitability ─ Return on Assets
Return on Net Income + Interest Expense (net of tax)
Assets =
Average Total Assets

Return on $2,260 + ($624 × (1 - .34))

= = 6.3%
Assets ($41,164 + $44,324) ÷ 2

Assume the corporate

tax rate is 34%.

Many
Many analysts
analysts consider
consider this
this ratio
ratio as
as the
the best
best
overall
overall measure
measure of
of aa company’s
company’s profitability.
profitability.

14-14
 Test of Profitability ─ Financial
Leverage Percentage

Financial
= Return on Equity – Return on Assets
Leverage

6.4% = 12.7% – 6.3%

Financial
Financial leverage
leverage isis the
the advantage
advantage oror disadvantage
disadvantage
that
that occurs
occurs as as the
the result
result of
of earning
earning aa return
return on
on equity
equity
that
that is
is different
different from
from the
the return
return on
on assets.
assets.

14-15
 Test of Profitability ─ Earnings per
Share (EPS)
Net Income*
EPS = Average Number of Shares
Outstanding for the Period
*If there are preferred dividends, the amount is subtracted from net income.

$2,260
EPS = = $1.34
(1,696 + 1,690) ÷ 2

Average number of shares based on the number

of shares at the beginning and end of the year.

Earnings
Earnings per
per share
share is
is probably
probably the
the single
single
most
most widely
widely watched
watched financial
financial ratio.
ratio.
14-16
 Test of Profitability ─ Quality of Income
Quality Cash Flow from Operating Activities
=
of Income
Net Income
Home Depot’s
Quality of Income
$5,528
= 2.45

$2,260

A ratio higher than 1

indicates high-quality
earnings.
14-17
 Test of Profitability ─ Profit Margin

Profit Net Income

=
Margin Net Sales

Profit $2,260
= = 3.2%
Margin $71,288

This
This ratio
ratio tells
tells us
us the
the percentage
percentage of of
each
each sales
sales dollar
dollar that
that is
is income.
income.

14-18
 Test of Profitability ─ Fixed Asset
Turnover
Fixed Net Sales Revenue
Asset =
Average Net Fixed Assets
Turnover

Fixed $71,288
Asset = = 2.65
($26,234 + $27,476) ÷ 2
Turnover

This
Thisratio
ratiomeasures
measuresaacompany’s
company’sability
ability to
to generate
generate
sales
salesgiven
givenan
aninvestment
investmentin
infixed
fixedassets.
assets.

14-19
 Tests of Liquidity ─ Cash Ratio
Tests
Tests of
of liquidity
liquidity focus
focus on
on the
the relationship
relationship between
between
current
current assets
assets and
and current
current liabilities.
liabilities.

Cash Cash + Cash Equivalents

=
Ratio Current Liabilities

Cash $519
= = 0.05 to 1
Ratio $11,153

This
This ratio
ratio measures
measures the
the
adequacy
adequacy ofof available
available cash.
cash.
14-20
 Tests of Liquidity ─ Current Ratio

Current Current Assets

=
Ratio Current Liabilities

Current $13,362
= = 1.20 to 1
Ratio
$11,153

This
This ratio
ratio measures
measures thethe ability
ability
of
of the
the company
company to to pay
pay current
current
debts
debts as
as they
they become
become due.
due.

14-21
 Tests of Liquidity ─ Quick Ratio
(Acid Test)
Quick Quick Assets
=
Ratio Current Liabilities

Quick $1,497
= = 0.13 to 1
Ratio $11,153

This
This ratio
ratio is
is like
like the
the current
current
ratio
ratio but
but measures
measures the the company’s
company’s
immediate
immediate ability
ability toto pay
pay debts.
debts.
14-22
 Tests of Liquidity ─ Receivable
Turnover
Receivable Net Credit Sales
=
Turnover Average Net Receivables

Receivable $71,288
= = 63.9 Times
Turnover ($972 + $1,259) ÷ 2

This
This ratio
ratio measures
measures how
how
quickly
quickly aa company
company collects
collects its
its
accounts
accounts receivable.
receivable.

14-23
 Tests of Liquidity ─ Average Age of
Receivables
Average Age Days in Year
=
of Receivables Receivable Turnover

Average Age 365

= = 5.7 Days
of Receivables 63.9

This
Thisratio
ratiomeasures
measuresthe theaverage
averagenumber
number
of
of days
daysitit takes
takesto
tocollect
collectreceivables.
receivables.

14-24
 Tests of Liquidity ─ Inventory Turnover

Inventory Cost of Goods Sold

Turnover = Average Inventory

Inventory $47,298
= ($10,673 + $11,731) ÷ 2 = 4.2 Times
Turnover

This
This ratio
ratio measures
measures howhow quickly
quickly
the
the company
company sells
sells its
its inventory.
inventory.

14-25
 Tests of Liquidity ─ Average Days’
Supply in Inventory
Average Days’ Days in Year
Supply in = Inventory Turnover
Inventory

Average Days’ 365

Supply in = = 86.9 Days
4.2
Inventory

This
This ratio
ratio measures
measures the the average
average number
number
of
of days
days itit takes
takes to
to sell
sell the
the inventory.
inventory.

14-26
 Tests of Liquidity ─ Accounts Payable
Turnover
Accounts Cost of Goods Sold
Payable = Average Accounts Payable
Turnover

Accounts $47,298
Payable = ($4,822 + $5,732) ÷ 2 = 9 Times
Turnover

This
This ratio
ratio measures
measures howhow quickly
quickly the
the
company
company pays
pays its
its accounts
accounts payable.
payable.

14-27
 Tests of Liquidity ─ Average Age of
Payables

Average Age Days in Year

= Accounts Payable Turnover
of Payables

Average Age 365

= = 40.6 Days
of Payables 9

This
This ratio
ratio measures
measures the the average
average number
number
of
of days
days itit takes
takes to
to pay
pay its
its suppliers.
suppliers.

14-28
 Tests of Solvency ─ Times Interest
Earned
Tests
Tests ofof solvency
solvency measure
measure aa company’s
company’s
ability
ability to
to meet
meet its
its long-term
long-term obligations.
obligations.
Times Net Interest Income Tax
+ +
Interest = Income Expense Expense
Earned Interest Expense

Times
Interest $2,260 + $624 + $1,278
= = 6.7 Times
Earned $624

This ratio indicates a margin of protection for creditors.

14-29
 Tests of Solvency ─ Cash Coverage
Cash Flow from Operating Activities
Cash
= Before Interest and Taxes Paid
Coverage
Interest Paid

Cash $5,528 + $622 + $1,225

= = 11.9
Coverage $622

This
This ratio
ratio compares
compares the
the cash
cash generated
generated with
with
the
the cash
cash obligations
obligations of
of the
the period.
period.
14-30
 Tests of Solvency ─ Debt-to-Equity
Ratio
Debt-to-Equity Total Liabilities
=
Ratio Stockholders’ Equity

Debt-to-Equity $23,387
= = 1.32
Ratio $17,777

This
Thisratio
ratiomeasures
measuresthe theamount
amount of
of
liabilities
liabilitiesthat
that exists
existsfor
foreach
each$1
$1
invested
invested bybythe
the owners.
owners.

14-31
 Market Tests ─ Price/Earnings (P/E)
Ratio
Market tests relate the current market price of a share of stock
to an indicator of the return that might accrue to the investor.

Current Market Price Per Share

P/E Ratio =
Earnings Per Share

$26 A recent price for

P/E Ratio = = 19.4 Home Depot stock
$1.34
was $26 per share.

This ratio measures the relationship between the current

market price of the stock and its earnings per share.
14-32
 Market Tests ─ Dividend Yield Ratio
Dividend Dividends Per Share
=
Yield Market Price Per Share

Dividend $0.90
= = 3.5 %
Yield $26

Home
Home Depot
Depot paid
paid dividends
dividends of
of $.90
$.90 per
per share
share
when
when the
the market
market price
price was
was $26
$26 per
per share.
share.

This
This ratio
ratio is
is often
often used
used to
to compare
compare thethe
dividend-paying
dividend-paying performance
performance of
of different
different
investment
investment alternatives.
alternatives.
14-33
 Interpreting Ratios

Ratios
Ratios may
may be
be interpreted
interpreted byby
comparison
comparison with
with ratios
ratios of
of other
other
companies
companies oror with
with industry
industry
average
average ratios.
ratios.

Ratios
Ratios may
may vary
vary because
because ofof
the
the company’s
company’s industry
industry
characteristics,
characteristics, nature
nature of
of
operations,
operations, size,
size, and
and
accounting
accounting policies.
policies.
14-34
 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.

14-35
 End of Chapter 14

14-36