Chap 14 Analyzing Financial Statements

( There will also be a handout.)

* Comparative Analysis
* Ratio Analysis
- profitability ratios
- liquidity ratios
- solvency ratios
- market test ratios
 14-8

Financial Statement Analysis

FINANCIAL STATEMENT USERS

EXTERNAL DECISION
MANAGEMENT
MAKERS

. . . uses accounting data . . . use accounting data

to make product pricing for investment, credit,
and expansion tax, and public policy
decisions. decisions.
 14-10

Financial Statement Analysis

Financial statement analysis

is based on comparisons.

Time series Comparison with

analysis similar companies
Examines a single
company to identify
trends over time.
 14-12

Ratio and Percentage Analyses

Ratio analysis, or percentage

analysis, is used to express the
proportionate relationship between
two different amounts.
 14-20

Commonly Used Ratios

The
The 2004
2004 and
and 2003
2003 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
 14-21

Comparative Statements
HOME DEPOT
Com pa ra tive Bala nce Shee ts (Condense d)
Am ounts in Millions
2004 2003
Assets
Cash and Cash Equivalents $ 2,826 $ 2,188
Short-T erm Investments 26 65
Receivables, net 1,097 1,072
Merchandise Inventories 9,076 8,338
Other Current Assets 303 254
T otal Current Assets 13,328 11,917
Property and Equipment, at cost 24,594 20,733
Less Accumulated Depreciation 4,531 3,565
Net Property and Equipment 20,063 17,168
Other Assets 1,046 926
T otal Assets $ 34,437 $ 30,011
Continued
 14-22

Comparative Statements
HOME DEPOT
Comparative Balance Sheets (Condensed)
Amounts in Millions
2004 2003
Liabilities
Current Liabilities $ 9,554 $ 8,035
Noncurrent Liabilities 2,476 2,174
Total Liabilities 12,030 10,209
Stockholders' Equity
Common Stock, $.05 par 119 118
Paid-in Capital 6,184 5,858
Retained Earnings 19,680 15,971
Accumulated Other Comprehensive Income 90 (82)
Unearned Compensation (76) (63)
Total 25,997 21,802
Less: Treasury Stock (3,590) (2,000)
Total Stockholders' Equity 22,407 19,802
Total Liabilities & Stockholders' Equity $ 34,437 $ 30,011
 14-24

Tests of Profitability

Profitability
Profitability is
is aa primary
primary measure
measure of
of the
the
overall
overall success
success ofof aa company.
company.
Now,
Now, let’s
let’s look
look at
at the
the profitability
profitability ratios
ratios for
for
Home
Home Depot
Depot for
for 2004.
2004.

Home Depot
 14-25

Return on Equity

Net Income
Return on Equity =
Average Owners’ Equity

$4,304
Return on Equity = = 20.4%
($22,407 + $19,802) ÷ 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.
 14-26

Return on Assets

Return on Net Income + Interest Expense (net of tax)

=
Assets Average Total Assets

Return on $4,304 + ($62 × (1 - .34))

= = 13.5%
Assets ($34,437 + $30,011) ÷ 2

Corporate tax rate

is 34%.

This
This ratio
ratio is
is generally
generally considered
considered
the
the best
best overall
overall measure
measure of of aa
company’s
company’s profitability.
profitability.
 14-27

Financial Leverage Percentage

Financial
= Return on Equity – Return on Assets
Leverage

6.9% = 20.4% – 13.5%

Financial
Financial leverage
leverage is
is the
the advantage
advantage or or
disadvantage
disadvantage that
that occurs
occurs asas 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.
 14-28

Earnings per Share (EPS)

Net Income
EPS =
Average Number of Shares of
Common Stock Outstanding

$4,304
EPS = = $1.88
2,283

Average number of shares outstanding is

from Home Depot’s 2004 Income Statement.

Earnings
Earnings per
per share
share is
is probably
probably the
the single
single
most
most widely
widely watched
watched financial
financial ratio.
ratio.
 14-30

Quality of Income

Quality Cash Flow from Operating Activities

=
of Income Net Income

Quality $6,545
= = 1.52
of Income $4,304

A
A ratio
ratio higher
higher than
than 11 indicates
indicates
high-quality
high-quality earnings.
earnings.
 14-31

Profit Margin

Profit Net Income

=
Margin Net Sales

Profit $4,304
= = 6.6%
Margin $64,816

This
This ratio
ratio tells
tells usus the
the
percentage
percentage of of each
each sales
sales
dollar
dollar that
that is
is income.
income.
 14-32

Fixed Asset Turnover

Fixed
Net Sales Revenue
Asset =
Turnover Average Net Fixed Assets

Fixed
$64,816
Asset = = 3.5
Turnover ($20,063 + $17,168) ÷ 2

This
This ratio
ratio measures
measures aa company’s
company’s
ability
ability to
to generate
generate sales
sales given
given an
an
investment
investment inin fixed
fixed assets.
assets.
 14-34

Tests of Liquidity

Tests
Tests of
of liquidity
liquidity focus
focus on on the
the relationship
relationship
between
between current
current assets
assets andand current
current
liabilities.
liabilities.
Now,
Now, let’s
let’s look
look at
at the
the liquidity
liquidity ratios
ratios for
for
Home
Home Depot
Depot for for 2004.
2004.

Home Depot
 14-35

Cash Ratio

Cash Cash + Cash Equivalents

=
Ratio Current Liabilities

Cash $2,826
= = 0.296 to 1
Ratio $9,554

This
This ratio
ratio measures
measures the
the
adequacy
adequacy ofof available
available cash.
cash.
 14-36

Current Ratio

Current Current Assets

=
Ratio Current Liabilities

Current $13,328
= = 1.39 to 1
Ratio $9,554

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.
 14-37

Quick Ratio (Acid Test)

Quick Quick Assets

=
Ratio Current Liabilities

Quick $3,949
= = 0.41 to 1
Ratio $9,554
Cash & Cash Equivalents $ 2,826
Receivables, net 1,097
Short-term Investments 26
Quick Assets $ 3,949

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.
 14-38

Receivable Turnover

Receivable Net Credit Sales

=
Turnover Average Net Receivables

Receivable $64,816
= = 60 Times
Turnover ($1,097 + $1,072) ÷ 2

This
This ratio
ratio measures
measures how
how
quickly
quickly aa company
company collects
collects its
its
accounts
accounts receivable.
receivable.
 14-39

Average Age of Receivables

Average Age Days in Year

=
of Receivables Receivable Turnover

Average Age 365

= = 6.1 Days
of Receivables 59.8

This
This ratio
ratio measures
measures thethe
average
average number
number of of days
days itit
takes
takes to
to collect
collect receivables.
receivables.
 14-40

Inventory Turnover

Inventory Cost of Goods Sold

=
Turnover Average Inventory

Inventory $44,236
= = 5.1 Times
Turnover ($9,076 + $8,338) ÷ 2

This
This ratio
ratio measures
measures how
how
quickly
quickly the
the company
company sells
sells its
its
inventory.
inventory.
 14-41

Average Days’ Supply in Inventory

Average Days’ Days in Year

Supply in =
Inventory Turnover
Inventory

Average Days’ 365

Supply in = = 71.6 Days
5.1
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.
 14-42

Accounts Payable Turnover

Accounts Cost of Goods Sold

Payable =
Average Accounts Payable
Turnover

Accounts $44,236
Payable = = 9.1 Times
($5,159 + $4,560) ÷ 2
Turnover

This
This ratio
ratio measures
measures how
how
quickly
quickly the
the company
company pays
pays its
its
accounts
accounts payable.
payable.
 14-43

Average Age of Payables

Average Age Days in Year

=
of Payables Accounts Payable Turnover

Average Age 365

= = 40.1 Days
of Payables 9.1

This
This ratio
ratio measures
measures thethe
average
average number
number of of days
days itit
takes
takes to
to pay
pay its
its suppliers.
suppliers.
 14-45

Tests of Solvency

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.

Now,
Now, let’s
let’s look
look at
at the
the solvency
solvency ratios
ratios for
for
Home
Home Depot
Depot for
for 2004.
2004.

Home Depot
 14-46

Times Interest Earned

Times Net Interest Income Tax

+ +
Interest = Income Expense Expense
Earned Interest Expense

Times
Interest $4,304 + $62 + $2,539
= = 111 Times
Earned $62

This
This ratio
ratio indicates
indicates aa margin
margin
of
of protection
protection for
for creditors.
creditors.
 14-47

Cash Coverage

Cash Flow from Operating Activities

Cash
= Before Interest and Taxes
Coverage
Interest Paid
Cash Flow from Operating Activities
Net Income $ 4,304
Add: Depreciation and Amortization 1,076
Decrease in Receivables, net 25
Increase in Accounts Payable 790
Increase in Deferred Revenue 279
Increase in Deferred Income Taxes 605
Other 186
Deduct: Increase in Merchandise Inventories (693)
Decrease in Income Taxes Payable (27)
Cash Flow from Operating Activities $ 6,545
 14-48

Cash Coverage

Cash Flow from Operating Activities

Cash
= Before Interest and Taxes
Coverage
Interest Paid

Cash $6,545 + $70 + $2,539

= = 131
Coverage $70

Cash interest paid $ 70

Income tax expense 2,539

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.
 14-49

Debt-to-Equity Ratio

Debt-to-Equity Total Liabilities

=
Ratio Owners’ Equity

Debt-to-Equity $12,030
= = 0.54
Ratio $22,407

This
Thisratio
ratio measures
measures the
theamount
amountofof
liabilities
liabilitiesthat
thatexists
existsfor
foreach
each $1
$1
invested
invested bybythe
theowners.
owners.
 14-51

Market Tests

Market
Market tests
tests relate
relate the
the current
current market
market price
price of
of
aa share
share of
of stock
stock to
to an
an indicator
indicator of
of the
the return
return
that
that might
might accrue
accrue toto the
the investor.
investor.

Now,
Now, let’s
let’s look
look at
at the
the market
market tests
tests for
for
Home
Home Depot
Depot for
for 2004.
2004.

Home Depot
 14-52

Price/Earnings (P/E) Ratio

Current Market Price Per Share

P/E Ratio =
Earnings Per Share

$40
P/E Ratio = = 21
$1.88

A recent price for Home Depot

stock was $40 per share.

This
This ratio
ratio measures
measures the the relationship
relationship
between
between thethe current
current market
market price
price of
of the
the
stock
stock andand its
its earnings
earnings per
per share.
share.
 14-53

Dividend Yield Ratio

Dividend Dividends Per Share

=
Yield Market Price Per Share

Dividend $0.27
= = 0.68%
Yield $40

Home
Home Depot
Depot paid
paid dividends
dividends of
of $.27
$.27 per
per share
share
when
when the
the market
market price
price was
was $40
$40 per
per share.
share.

This
This ratio
ratio is
is often
often used
used to
to compare
compare
the
the dividend-paying
dividend-paying performance
performance of
of
different
different investment
investment alternatives.
alternatives.
 14-54

Interpreting Ratios

Ratios
Ratios may
may be
be interpreted
interpreted by
by comparison
comparison
with
with ratios
ratios of
of other
other companies
companies or or 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.
 14-56

Efficient Markets

A
A securities
securities market
market inin which
which prices
prices fully
fully
reflect
reflect available
available information
information is
is called
called an
an
efficient
efficient market.
market.
In
In an
an efficient
efficient market,
market, aa company’s
company’s stock
stock
reacts
reacts quickly
quickly when
when new,
new, relevant
relevant
information
information isis released
released about
about the
the
company.
company.
 End of Chapter MC Questions
 Answers:
 1. c)
 2. c)
 3. c)
 4. c)
 5. a)
 6. d)
 7. c)
 8. a)
 9. b)
 10. d)
Homework Manager Assignment

E 14-5

P 14-8