© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Chapter 14 Analyzing Financial Statements

© McGraw-Hill Ryerson Limited, 2003McGraw-Hill Ryerson

Chapter 14

Analyzing Financial Statements


Business Background

FINANCIAL STATEMENT USERS

. . . uses accounting data to make product pricing

and expansion decisions.

. . . use accounting data for investment, credit, tax, and public policy

decisions.

EXTERNAL DECISIONMAKERSMANAGEMENT


Business Background

THREE TYPES OF FINANCIAL STATEMENT INFORMATION

PastPerformance

PresentCondition

FuturePerformance

Income, sales volume, cash

flows, return on investment,

EPS.

Assets, debt, inventory,

various ratios.

Sales and earnings trends are good

indicators of future performance.


Business Background

Investors

Dividends Increase inshare price

Return on an equitysecurity investment


Business Background

Economy-wideFactors

IndustryFactors

IndividualCompanyFactors

Invest?No Yes


Understanding a Company’s Strategy

I need to know the company’s policies on product differentiation,

pricing, and cost control to make my financial analysis more meaningful.


ROE Profit Driver Analysis

ROE Net ProfitMargin

AssetTurnover

FinancialLeverage= ××

Net IncomeAverage

Shareholders’Equity

Net IncomeNet Sales

Net SalesAverage

Total Assets

AverageTotal Assets

AverageShareholders’

Equity

× ×=


Profit Drivers and Business Strategy

High-value or product-differentiationHigh-value or product-differentiationRely on R&D and product promotion toRely on R&D and product promotion toconvince customers of the superiorityconvince customers of the superiority

of the company’s products.of the company’s products.

Low-CostLow-CostRely on efficient management of accountsRely on efficient management of accounts

receivable, inventory and productive assetsreceivable, inventory and productive assetsto produce high asset turnover.to produce high asset turnover.


Financial Statement Analysis

Examines a single company to identify

trends over time.

Financial statement analysisis based on comparisons.

Time seriesanalysis

Comparison with similar companies

Provides insightsconcerning a

company’s relativeperformance.


Financial Statement Analysis

Financial statement analysisis based on comparisons.

Time seriesanalysis

Comparison with similar companies

Company A Company

B


Ratio and Percentage Analyses

Ratio analysis, or percentage analysis, is used to express the

proportionate relationship between two different amounts.


Component Percentages

Express each item on a particular statement as a percentage of a single

base amount.

Total assetson the balance

sheet

Net saleson the income

statement


Component Percentages Example

The comparative income statements of Home Depot 2002 and 2001

appear on the next slide.

Prepare component percentage income statements where net sales

equal 100%.

Home Depot


Component PercentagesHOME DEPOT

Comparative Income Statements (Condensed)Amounts in Millions Except Per Share Data

2002 Percent 2001 Percent Net Sales 53,553$ 100.0% 45,738$ 100.0% Cost of Merchandise Sold 37,406 32,057 Gross Profit 16,147 13,681 Operating Expenses 11,215 9,490 Operating Income 4,932 4,191 Interest and Investment Income 53 47 Interest Expense 28 21 Earnings Before Income Taxes 4,957 4,217 Income Taxes 1,913 1,636 Net Earnings 3,044$ 2,581$ Basic Earnings Per Share 1.30$ 1.11$ Weighted-Average Number of Common Shares Outstanding 2,335 2,315 Diluted Earnings Per Share 1.29$ 1.10$




2002 Percent 2001 Percent Net Sales 53,553$ 100.0% 45,738$ 100.0% Cost of Merchandise Sold 37,406 32,057 Gross Profit 16,147 13,681 Operating Expenses 11,215 9,490 Operating Income 4,932 4,191 Interest and Investment Income 53 47 Interest Expense 28 21 Earnings Before Income Taxes 4,957 4,217 Income Taxes 1,913 1,636 Net Earnings 3,044$ 2,581$ Basic Earnings Per Share 1.30$ 1.11$ Weighted-Average Number of Common Shares Outstanding 2,335 2,315 Diluted Earnings Per Share 1.29$ 1.10$

2002 Cost ÷ 2002 Sales




2002 Percent 2001 Percent Net Sales 53,553$ 100.00% 45,738$ 100.00% Cost of merchandise sold 37,406 69.85% 32,057 70.09% Gross profit 16,147 30.15% 13,681 29.91% Operating expenses 11,215 20.94% 9,490 20.75% Operating Income 4,932 9.21% 4,191 9.16% Interest and Investment Income 53 0.10% 47 0.10% Interest Expense 28 0.05% 21 0.05% Earnings Before Income Taxes 4,957 9.26% 4,217 9.22% Income Taxes 1,913 3.57% 1,636 3.58% Net Earnings 3,044$ 5.68% 2,581$ 5.64% Basic Earnings Per Share 1.30$ 1.11$ Weighted-Average Number of Common Shares Outstanding 2,335 2,315 Diluted Earnings Per Share 1.29$ 1.10$


Now, let’s look at some

commonly used ratios.


Commonly Used Ratios

The 2002 and 2001 balance sheets for Home Depot are presented next.

We will be referring to these financial statements throughout the ratio

analyses.

Home Depot


Comparative Statements

Continued


Comparative Statements


Tests of Profitability

Profitability is a primary measure of the overall success of a company.

Now, let’s look at the profitability ratios for Home Depot for 2001.

Home Depot


Return on Equity

Return on Equity $3,044($15,004 + $18,082) / 2

= = 18.4%

Income* Average Owners’ EquityReturn on Equity =

This measure indicates how muchincome was earned for every dollar

invested by the owners.

*Income before extraordinary items


Return on Assets

Return on AssetsIncome + Interest Expense (net of tax) Average Total Assets

=

Return on Assets $3,044 + ($28 ×(1 - .39)) ($21,385 + $26,394) ÷ 2

= = 12.8%

This ratio is generally consideredthe best overall measure of a

company’s profitability.

Corporate tax rate is 39 percent.


Financial Leverage

Financial Leverage Return on Equity – Return on Assets=

5.6% = 18.4% – 12.8%

Financial leverage is the advantage or disadvantage that occurs as a result of

earning a return on equity that is different from the return on assets.


Earnings per Share (EPS)

Income Available to Common ShareholdersWeighted Average Number of Common

Shares OutstandingEPS =

EPS $3,044 2,335

= = $1.30

Earnings per share is probably the single most widely watched

financial ratio.


Quality of Income

Qualityof Income

Cash Flow from Operating Activities Net Income

=

Cash Flow from Operating Activities

Net Income 3,044$ Add: Depreciation and Amortization 764

Increase in Accounts Payable 2,078 Increase in Income Taxe Payable 272 Other 90

Deduct: Increase in Receivables (119) Increase in Inventories (166)

Cash Flow from Operating Activities 5,963$


Quality of Income

Qualityof Income

Cash Flow from Operating Activities Net Income

=

Qualityof Income

$5,693 $3,044

= = 1.96

A ratio higher than 1 indicates higher-quality earnings.


Profit Margin

= 5.7%ProfitMargin

$3,044$53,553

=

This ratio describes a company’s ability to earn

income from sales.

ProfitMargin

Income (before Extraordinary Items) Net Sales

=


Fixed Asset Turnover Ratio

FixedAsset

Turnover

$53,553 ($13,068 + $15,375) ÷ 2

= = 3.77

FixedAsset

Turnover

Net Sales RevenueAverage Net Fixed Assets

=

This ratio measures a company’s ability to generate sales given an

investment in fixed assets.


ROE Profit Driver Analysis

ROE Net ProfitMargin

AssetTurnover

FinancialLeverage= ××

Net IncomeAverage

Shareholders’Equity

Net IncomeNet Sales

Net SalesAverage

Total Assets

AverageTotal Assets

AverageShareholders’

Equity

× ×=

ROE = 0.057 x 2.242 x 1.444 = 0.184 or 18.4%


Tests of Liquidity

Tests of liquidity focus on the relationship between current assets

and current liabilities. Now, let’s look at the liquidity ratios for

Home Depot for 2001.

Home Depot


Cash Ratio

CashRatio

Cash + Cash EquivalentsCurrent Liabilities

=

= 0.38CashRatio

$2,472$6,501

=

This ratio measures theadequacy of available cash.


Current Ratio

CurrentRatio

Current Assets Current Liabilities=

CurrentRatio

$10,361

$6,501

= = 1.59

This ratio measures the abilityof the company to pay current

debts as they become due.


Quick Ratio (Acid Test)

Quick Assets Current Liabilities

=QuickRatio

$3,466 $6,501

= .53: 1=QuickRatio

Quick assets are Cash, Accounts Receivable, Notes Receivable, and Short-term Investments.

This ratio is like the currentratio but measures the company’s

ability to pay its current debts quickly.


Receivable Turnover

Net Credit Sales Average Net Trade Receivables

Receivable Turnover

=

Receivable Turnover

$53,553($835 + $920) ÷ 2

= 61 times=

This ratio measures how quickly a company collects its

accounts receivable.


Average Age of Receivables

Days in Year Receivable Turnover

Average Age of Receivables =

= 6 days36561

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

Inventory Turnover =

Inventory Turnover

$37,406($6,556 + $6,725) ÷ 2

= 5.6 times=

This ratio measures how quickly the company sells its inventory.


Average Days’ Supply in Inventory

Days in YearInventory Turnover


=

= 65 days3655.6=


This ratio measures the average number of days it takes to sell the

inventory.


Tests of Solvency and Equity Position

Tests of solvency measure a company’s ability to meet its obligations.

Now, let’s look at the solvency ratios for Home Depot for 2001.

Home Depot


This ratio indicates a margin of protection for creditors.

Times Interest Earned

Net Interest Income Tax Income Expense Expense Interest Expense


=+ +

$3,044 + $28 + $1,913$28


= = 178


Cash Coverage

Cash Flow from Operating Activities

Net Income 3,044$ Add: Depreciation and Amortization 764

Increase in Accounts Payable 2,078 Increase in Income Taxe Payable 272 Other 90

Deduct: Increase in Receivables (119) Increase in Inventories (166)

Cash Flow from Operating Activities 5,963$

CashCoverage

Cash Flow from Operating ActivitiesBefore Interest and Taxes

Interest Paid=


Cash Coverage

CashCoverage

= $5,693 + $18 + $1,685$18

= 425

CashCoverage

Cash Flow from Operating ActivitiesBefore Interest and Taxes

Interest Paid=

This ratio compares the cash generated with the interest obligations of the period.


Debt-to-Equity Ratio

Total LiabilitiesOwners’ Equity

Debt-to-Equity Ratio

=

$8,312$18,082

= 0.46Debt-to-Equity Ratio

=

This ratio measures the amount of liabilities that exists for each $1

invested by the owners.


Market Tests

Market tests relate the current market price per common share to an indicator of the return that might accrue to the investor.

Now, let’s look at the market tests forHome Depot for 2001.

Home Depot


Price/Earnings (P/E) Ratio

P/E Ratio = Current Market Price Per ShareEarnings Per Share

P/E Ratio = $46.31$1.30

= 35.6

This ratio measures the relationship between the current market price per share

and the company’s earnings per share.


Dividend Yield Ratio

DividendYield

Dividends Per Share Market Price Per Share

=

DividendYield

$0.17$46.31

= = 0.37%

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


Miscellaneous Ratios

Financial analysts may calculate many other financial ratios to help evaluate

and compare investment opportunities. Now, let’s look at book value per share as

an example of such a ratio for Home Depot for 2001.

Home Depot


Book Valueper Share

$18,0822,335

= = $7.74

Book Value per Share

Book Valueper Share

Common Shareholders’ EquityNumber of

Common Shares Outstanding

=

Book value per share measures the owners’ equity per common share.

Book value per share has no relationship to market value.


Other Analytical Considerations

In addition to financial ratios, special factors might affect the evaluation of a company:

Rapid growth.Uneconomical expansion.Subjective factors.


Interpreting Ratios

Ratios may be interpreted by comparison with ratios of other companies or with

industry average ratios.

Ratios may vary because of thecompany’s industry characteristics,

nature of operations, size, andaccounting policies.


Efficient Markets

A securities market in which prices fully reflect available information is called an

efficient market.

In an efficient market, the price of the company’s shares reacts quickly when new,

relevant information is released about the company.


End of Chapter 14

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© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Chapter 14 Analyzing Financial Statements