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## Analyzing Financial Statements

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**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