Libby Chap 14

Chap 14 Analyzing Financial StatementsChap 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 USERS

. . . uses accounting data to make product pricing

and expansion decisions.

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

decisions.

EXTERNAL DECISIONMAKERS

MANAGEMENT

Financial Statement Analysis

14-10

Financial Statement Analysis

Examines a singlecompany to identify

trends over time.

Financial statement analysisis based on comparisons.

Time seriesanalysis

Comparison withsimilar companies

14-12

Ratio and Percentage Analyses

Ratio analysis, or percentageanalysis, is used to express the

proportionate relationship between two different amounts.

14-20

Commonly Used Ratios

The 2004 and 2003 balance sheets for Home Depot are presented next.

We will be referring to these financial statements throughout the ratio

analyses.

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

14-21

Comparative StatementsHOME DEPOT

Comparative Balance Sheets (Condensed)

Amounts in Millions

2004 2003Assets

Cash and Cash Equivalents 2,826$ 2,188$ Short-Term Investments 26 65 Receivables, net 1,097 1,072

Merchandise Inventories 9,076 8,338 Other Current Assets 303 254

Total 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

Total Assets 34,437$ 30,011$

Continued

14-22

HOME DEPOTComparative Balance Sheets (Condensed)

Amounts in Millions

2004 2003Liabilities

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$

Comparative Statements

14-24

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 2004.

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

14-25

Return on Equity

Return on Equity$4,304

($22,407 + $19,802) ÷ 2= = 20.4%

Net Income

Average Owners’ EquityReturn on Equity =

This measure indicates how muchincome was earned for every dollar

invested by the owners.

This measure indicates how muchincome was earned for every dollar


14-26

Return on Assets

Return on

AssetsNet Income + Interest Expense (net of tax)

Average Total Assets=

Return on

Assets

$4,304 + ($62 × (1 - .34))

($34,437 + $30,011) ÷ 2= = 13.5%

This ratio is generally consideredthe best overall measure of a

company’s profitability.

This ratio is generally consideredthe best overall measure of a

company’s profitability.

Corporate tax rateis 34%.

14-27

Financial Leverage Percentage

Financial Leverage

Return on Equity – Return on Assets=

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.

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.

14-28

Earnings per Share (EPS)

Net Income

Average Number of Shares ofCommon Stock Outstanding

EPS =

EPS$4,304

2,283= = $1.88

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

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

Average number of shares outstanding is from Home Depot’s 2004 Income Statement.

14-30

Quality of Income

Quality

of Income

$6,545

$4,304= = 1.52

A ratio higher than 1 indicates high-quality earnings.

A ratio higher than 1 indicates high-quality earnings.

Quality

of Income

Cash Flow from Operating Activities

Net Income=

14-31

Profit Margin

= 6.6%Profit

Margin

$4,304

$64,816=

This ratio tells us the percentage of each sales

dollar that is income.

This ratio tells us the percentage of each sales

dollar that is income.

Profit

Margin

Net Income

Net Sales=

14-32

Fixed Asset Turnover

FixedAsset

Turnover

$64,816

($20,063 + $17,168) ÷ 2= = 3.5

FixedAsset

Turnover

Net Sales Revenue

Average Net Fixed Assets=

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

investment in fixed assets.

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

investment in fixed assets.

14-34

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 2004.

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 2004.

Home Depot

14-35

Cash Ratio

Cash

Ratio

Cash + Cash Equivalents

Current Liabilities=

= 0.296 to 1Cash

Ratio

$2,826

$9,554=

This ratio measures theadequacy of available cash.

This ratio measures theadequacy of available cash.

14-36

Current Ratio

Current

Ratio

Current Assets


Current

Ratio

$13,328

$9,554= = 1.39 to 1

This ratio measures the abilityof the company to pay current

debts as they become due.

This ratio measures the abilityof the company to pay current

debts as they become due.

14-37

Quick Ratio (Acid Test)

Quick Assets


Quick

Ratio

$3,949

$9,554= 0.41 to 1=

Quick

Ratio

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

immediate ability to pay debts.

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

immediate ability to pay debts.

Cash & Cash Equivalents 2,826$ Receivables, net 1,097 Short-term Investments 26 Quick Assets 3,949$

14-38

Receivable Turnover

Net Credit Sales

Average Net ReceivablesReceivable

Turnover=

Receivable

Turnover

$64,816

($1,097 + $1,072) ÷ 2= 60 Times=

This ratio measures how quickly a company collects its

accounts receivable.

This ratio measures how quickly a company collects its

accounts receivable.

14-39

Average Age of Receivables

Days in Year

Receivable Turnover

Average Age

of Receivables=

= 6.1 Days365

59.8Average Age

of Receivables=

This ratio measures the average number of days it

takes to collect receivables.

This ratio measures the average number of days it

takes to collect receivables.

14-40

Inventory Turnover

Cost of Goods Sold

Average Inventory

Inventory

Turnover=

Inventory

Turnover

$44,236

($9,076 + $8,338) ÷ 2= 5.1 Times=

This ratio measures how quickly the company sells its

inventory.

This ratio measures how quickly the company sells its

inventory.

14-41

Average Days’ Supply in Inventory

Days in Year

Inventory Turnover


=

= 71.6 Days365

5.1=


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

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

14-42

Accounts Payable Turnover

Cost of Goods Sold

Average Accounts Payable

Accounts Payable

Turnover=

$44,236

($5,159 + $4,560) ÷ 2= 9.1 Times=

This ratio measures how quickly the company pays its

accounts payable.

This ratio measures how quickly the company pays its

accounts payable.

Accounts Payable

Turnover

14-43

Average Age of Payables

Days in Year

Accounts Payable TurnoverAverage Age of Payables

=

= 40.1 Days365

9.1=

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

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

Average Age of Payables

14-45

Tests of Solvency

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

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

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

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

Home Depot

14-46

This ratio indicates a margin of protection for creditors.

This ratio indicates a margin of protection for creditors.

Times Interest Earned

Net Interest Income Tax

Income Expense Expense

Interest Expense

Times

Interest

Earned=

+ +

$4,304 + $62 + $2,539

$62

Times

Interest

Earned= = 111 Times

14-47

Cash Coverage

Cash

Coverage


Before Interest and Taxes

Interest Paid

=


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=

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

$70= 131

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

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

Cash interest paid 70$ Income tax expense 2,539

Cash

Coverage


Before Interest and Taxes

Interest Paid

=

Cash Coverage

14-49

Debt-to-Equity Ratio

Total Liabilities

Owners’ Equity

Debt-to-Equity

Ratio=

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


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


$12,030

$22,407= 0.54=

Debt-to-Equity

Ratio

14-51

Market Tests

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.

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

14-52

Price/Earnings (P/E) Ratio

P/E Ratio =Current Market Price Per Share

Earnings Per Share

P/E Ratio =$40

$1.88= 21

This ratio measures the relationship between the current market price of the

stock and its earnings per share.

This ratio measures the relationship between the current market price of the

stock and its earnings per share.

A recent price for Home Depotstock was $40 per share.

14-53

Dividend Yield Ratio

Dividend

Yield

Dividends Per Share

Market Price Per Share=

Dividend

Yield

$0.27

$40= = 0.68%

This ratio is often used to compare the dividend-paying performance of

different investment alternatives.

This ratio is often used to compare the dividend-paying performance of

different investment alternatives.

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

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

14-54

Interpreting Ratios

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

industry average ratios.

Ratios may vary because of thecompany’s industry characteristics,

nature of operations, size, andaccounting policies.

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

industry average ratios.

Ratios may vary because of thecompany’s industry characteristics,

nature of operations, size, andaccounting policies.

14-56

Efficient Markets

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.

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.

End of Chapter MC QuestionsEnd 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 AssignmentHomework Manager Assignment

E 14-5

P 14-8

Economy & Finance

Libby Chap 14