AnalyzingFinancialStatements Chapter 14
IndividualCompanyFactors IndustryFactors Economy-wideFactors Understanding The Business Invest? No Yes
Increase inshare price Dividends Investors Understanding The Business Return on an equitysecurity investment
I need to know the company’s policies on product differentiation, pricing, and cost control to make my financial analysis more meaningful. Understanding a Company’s Strategy
. . . uses accounting data to make product pricing and expansion decisions. . . . use accounting data for investment, credit, tax, and public policy decisions. Financial Statement Analysis FINANCIAL STATEMENT USERS MANAGEMENT EXTERNAL DECISION MAKERS
Financial Statement Analysis 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 analysisis based on comparisons. Time seriesanalysis Comparison with similar companies Financial Statement Analysis Examines a single company to identify trends over time.
Time seriesanalysis Comparison with similar companies Company A Company B Financial Statement Analysis Financial statement analysisis based on comparisons. Provides insightsconcerning acompany’s relativeperformance.
Ratio analysis, or percentage analysis, is used to express the proportionate relationship between two different amounts. Ratio and Percentage Analyses
Express each item on a particular statement as a percentage of a single base amount. Net saleson the incomestatement Total assetson the balancesheet 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%. Home Depot Component Percentages
Component Percentages 2004 Cost ÷ 2004 Sales
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 Commonly Used Ratios
Continued Comparative Statements
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 Tests of Profitability
Net Income Average Owners’ Equity Return on Equity = $4,304 ($22,407 + $19,802) ÷ 2 Return on Equity = = 20.4% Return on Equity This measure indicates how much income was earned for every dollar invested by the owners.
Return on Assets Net Income + Interest Expense (net of tax) Average Total Assets = Return on Assets $4,304 + ($62 × (1 - .34)) ($34,437 + $30,011) ÷ 2 = = 13.5% Return on Assets Adding interest expense back to net income enables the return on assets to be compared for companies with different amounts of debt or over time for a single company that has changed its mix of debt and equity. Corporate tax rate is 34%. This ratio is generally considered one of the best overall measures of a company’s profitability.
Financial Leverage = Return on Equity – Return on Assets Financial Leverage Percentage 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.
Net Income AverageNumber of Shares ofCommon Stock Outstanding EPS = $4,304 2,283 EPS = = $1.88 Earnings per Share (EPS) Average number of shares outstanding is from Home Depot’s 2004 Income Statement. Earnings per share is probably the single most widely watched financial ratio.
Qualityof Income Cash Flow from Operating Activities Net Income = Quality of Income
Qualityof Income Cash Flow from Operating Activities Net Income = Qualityof Income $6,545 $4,304 = = 1.52 Quality of Income A ratio higher than 1 indicates high-quality earnings.
Net Income Net Sales Profit Margin = $4,304 $64,816 Profit Margin = 6.6% = Profit Margin This ratio tells us the percentage of each salesdollar that is income.
FixedAssetTurnover Net Sales RevenueAverage Net Fixed Assets = FixedAssetTurnover $64,816($20,063 + $17,168) ÷ 2 = = 3.5 Fixed Asset Turnover This ratio measures a company’s ability to generate sales given an investment in fixed assets.
Tests of liquidity focus on the relationship between current assets and current liabilities. Now, let’s look at the liquidity ratiosfor Home Depot for 2004. Home Depot Tests of Liquidity
Cash Ratio Cash + Cash Equivalents Current Liabilities = Cash Ratio $2,826 $9,554 = = 0.296 to 1 Cash Ratio This ratio measures theadequacy of available cash.
Current Ratio Current Assets Current Liabilities = Current Ratio $13,328 $9,554 = = 1.39 to 1 Current Ratio This ratio measures the ability of the company to pay current debts as they become due.
Quick Ratio Quick Assets Current Liabilities = Quick Ratio $3,949 $9,554 = = 0.41 to 1 Quick Ratio (Acid Test) Quick assets include Cash, Marketable Securities, Accounts Receivable and current Notes Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory.
Net Credit Sales Average Net Receivables Receivable Turnover = $64,816 ($1,097 + $1,072) ÷ 2 Receivable Turnover = 60 Times = Receivable Turnover This ratio measures how quickly a company collects its accounts receivable.
Average Age of Receivables Days in Year Receivable Turnover = 36559.8 Average Age of Receivables = 6.1 Days = Average Age of Receivables This ratio measures the average number of days it takes to collect receivables.
Inventory Turnover Cost of Goods Sold Average Inventory = $44,236 ($9,076 + $8,338) ÷ 2 Inventory Turnover = 5.1 Times = Inventory Turnover This ratio measures how quickly the company sells its inventory.
Average Days’ Supply in Inventory Days in Year Inventory Turnover = Average Days’ Supply in Inventory 3655.1 = 71.6 Days = Average Days’ Supply in Inventory This ratio measures the average number of days it takes to sell the inventory.
Accounts Payable Turnover Cost of Goods Sold Average Accounts Payable = $44,236 ($5,159 + $4,560) ÷ 2 = 9.1 Times = Accounts Payable Turnover Accounts Payable Turnover This ratio measures how quickly the company pays its accounts payable.
Days in Year Accounts Payable Turnover Average Age of Payables = 3659.1 = 40.1 Days = Average Age of Payables Average Age of Payables This ratio measures the average number of days it takes to pay its suppliers.
Tests of solvency measure a company’s ability to meet its long-term obligations. Now, let’s look at the solvency ratiosfor Home Depot for 2004. Home Depot Tests of Solvency
Times Interest Earned Net Interest Income Tax Income Expense Expense Interest Expense + + = Times Interest Earned $4,304 + $62 + $2,539$62 = 111 Times = Times Interest Earned This ratio indicates a margin of protection for creditors.
Cash Flow from Operating ActivitiesBefore Interest and TaxesInterest Paid CashCoverage = Cash Coverage
Cash Flow from Operating ActivitiesBefore Interest and TaxesInterest Paid CashCoverage = CashCoverage $6,545 + $70 + $2,539$70 = = 131 Cash Coverage This ratio compares the cash generated with the cash obligations of the period.
Debt-to-Equity Ratio Total Liabilities Owners’ Equity = Debt-to-Equity Ratio $12,030 $22,407 = = 0.54 Debt-to-Equity Ratio This ratio measures the amount of liabilities that exists for each $1 invested by the owners.
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 Market Tests
Current Market Price Per ShareEarnings Per Share P/E Ratio = $40$1.88 P/E Ratio = = 21 Price/Earnings (P/E) Ratio A recent price for Home Depotstock was $40 per share. This ratio measures the relationship between the current market price of the stock and its earnings per share.
Dividend Yield Dividends Per Share Market Price Per Share = Dividend Yield $0.27$40 = = 0.68% Dividend Yield Ratio Home Depot paid dividends of $.27 per share when the market price was $40 per share. This ratio is often used to compare the dividend-paying performance of different investment alternatives.
Ratios may be interpreted by comparisonwith ratios of other companies or withindustry average ratios. Ratios may vary because of thecompany’s industry characteristics,nature of operations, size, andaccounting policies. Interpreting Ratios
In addition to financial ratios, special factors might affect company analysis: Rapid growth. Uneconomical expansion. Subjective factors. Other Financial Information
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. Efficient Markets