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 AnalysisFINANCIAL STATEMENT USERSMANAGEMENT EXTERNAL DECISION MAKERS

. . . uses accounting data to make product pricing and expansion decisions.

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

14-10

Financial Statement AnalysisFinancial statement analysis is based on comparisons.

Time series analysisExamines a single company to identify trends over time.

Comparison with similar companies

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 2004 and 2003 balance sheets for The 2004 and 2003 balance sheets for Home Depot are presented next. Home Depot are presented next. We will be referring to these financial We will be referring to these financial statements throughout the ratio statements throughout the ratio analyses. analyses.

Home Depot

14-21

Comparative StatementsHOME DEPOT Com pa ra tive Bala nce Shee ts (Condense d) Am ounts in Millions

2004 Assets Cash and Cash Equivalents Short-T erm Investments Receivables, net Merchandise Inventories Other Current Assets T otal Current Assets Property and Equipment, at cost Less Accumulated Depreciation Net Property and Equipment Other Assets T otal Assets $ 2,826 26 1,097 9,076 303 13,328 24,594 4,531 20,063 1,046 34,437 $

2003 2,188 65 1,072 8,338 254 11,917 20,733 3,565 17,168 926 30,011

$

$

Continued

14-22

Comparative StatementsHOME DEPOT Comparative Balance Sheets (Condensed) Amounts in Millions

2004 Liabilities Current Liabilities Noncurrent Liabilities Total Liabilities Stockholders' Equity Common Stock, $.05 par Paid-in Capital Retained Earnings Accumulated Other Comprehensive Income Unearned Compensation Total Less: Treasury Stock Total Stockholders' Equity Total Liabilities & Stockholders' Equity $

2003

9,554 $ 8,035 2,476 2,174 12,030 10,209 118 5,858 15,971 (82) (63) 21,802 (2,000) 19,802 30,011

119 6,184 19,680 90 (76) 25,997 (3,590) 22,407 $ 34,437 $

14-24

Tests of Profitability Profitability is a primary measure of the Profitability is a primary measure of the overall success of a company. overall success of a company. Now, lets look at the profitability ratios for Now, lets look at the profitability ratios for Home Depot for 2004. Home Depot for 2004.

Home Depot

14-25

Return on Equity

Return on Equity =

Net Income Average Owners Equity $4,304 ($22,407 + $19,802) 2 = 20.4%

Return on Equity =

This measure indicates how much This measure indicates how much income was earned for every dollar income was earned for every dollar invested by the owners. invested by the owners.

14-26

Return on AssetsReturn on Assets Return on Assets Net Income + Interest Expense (net of tax) Average Total Assets $4,304 + ($62 (1 - .34)) = 13.5% ($34,437 + $30,011) 2 Corporate tax rate is 34%. This ratio is generally considered This ratio is generally considered the best overall measure of a the best overall measure of a companys profitability. companys profitability.

=

=

14-27

Financial Leverage PercentageFinancial Leverage

=

Return on Equity Return on Assets

6.9%

=

20.4% 13.5%

Financial leverage is the advantage or Financial leverage is the advantage or disadvantage that occurs as the result disadvantage that occurs as the result of earning a return on equity that is of earning a return on equity that is different from the return on assets. different from the return on assets.

14-28

Earnings per Share (EPS)Net Income Average Number of Shares of Common Stock Outstanding $4,304 2,283 = $1.88

EPS =

EPS =

Average number of shares outstanding is from Home Depots 2004 Income Statement. Earnings per share is probably the single Earnings per share is probably the single most widely watched financial ratio. most widely watched financial ratio.

14-30

Quality of IncomeQuality = of Income Cash Flow from Operating Activities Net Income

Quality = of Income

$6,545 $4,304

= 1.52

A ratio higher than 1 indicates A ratio higher than 1 indicates high-quality earnings. high-quality earnings.

14-31

Profit Margin

Profit = Margin Profit = Margin

Net Income Net Sales $4,304 $64,816 = 6.6%

This ratio tells us the This ratio tells us the percentage of each sales percentage of each sales dollar that is income. dollar that is income.

14-32

Fixed Asset TurnoverFixed = Asset Turnover Fixed Asset = Turnover

Net Sales Revenue Average Net Fixed Assets $64,816 ($20,063 + $17,168) 2

= 3.5

This ratio measures a companys This ratio measures a companys ability to generate sales given an ability to generate sales given an investment in fixed assets. investment in fixed assets.

14-34

Tests of Liquidity Tests of liquidity focus on the relationship Tests of liquidity focus on the relationship between current assets and current between current assets and current liabilities. liabilities. Now, lets look at the liquidity ratios for Now, lets look at the liquidity ratios for Home Depot for 2004. Home Depot for 2004.Home Depot

14-35

Cash Ratio

Cash Ratio Cash Ratio

Cash + Cash Equivalents = Current Liabilities = $2,826 $9,554 = 0.296 to 1

This ratio measures the This ratio measures the adequacy of available cash. adequacy of available cash.

14-36

Current Ratio

Current Ratio Current Ratio

=

Current Assets Current Liabilities $13,328 $9,554 = 1.39 to 1

=

This ratio measures the ability This ratio measures the ability of the company to pay current of the company to pay current debts as they become due. debts as they become due.

14-37

Quick Ratio (Acid Test)Quick Ratio Quick Ratio = = Quick Assets Current Liabilities $3,949 $9,554 = 0.41 to 1$ 2,826 1,097 26 $ 3,949

Cash & Cash Equivalents Receivables, net Short-term Investments Quick Assets

This ratio is like the current This ratio is like the current ratio but measures the companys ratio but measures the companys immediate ability to pay debts. immediate ability to pay debts.

14-38

Receivable Turnover

Receivable Turnover Receivable Turnover

=

Net Credit Sales Average Net Receivables $64,816 ($1,097 + $1,072) 2

=

= 60 Times

This ratio measures how This ratio measures how quickly a company collects its quickly a company collects its accounts receivable. accounts receivable.

14-39

Average Age of Receivables

Average Age of Receivables

=

Days in Year Receivable Turnover 365 59.8

Average Age of Receivables

=

= 6.1 Days

This ratio measures the This ratio measures the average number of days it average number of days it takes to collect receivables. takes to collect receivables.

14-40

Inventory TurnoverInventory Turnover Cost of Goods Sold = Average Inventory

Inventory Turnover

$44,236 = ($9,076 + $8,338) 2

= 5.1 Times

This ratio measures how This ratio measures how quickly the company sells its quickly the company sells its inventory. inventory.

14-41

Average Days Supply in InventoryAverage Days Supply in Inventory Average Days Supply in Inventory

=

Days in Year Inventory Turnover 365 5.1

=

=

71.6 Days

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

14-42

Accounts Payable TurnoverAccounts Payable Turnover Accounts Payable Turnover Cost of Goods Sold Average Accounts Payable

=

$44,236 = ($5,159 + $4,560) 2

= 9.1 Times

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

14-43

Average Age of Payables

Average Age of Payables Average Age of Payables

=

Days in Year Accounts Payable Turnover 365 9.1

=

=

40.1 Days

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

14-45

Tests of Solvency Tests of solvency measure a companys Tests of solvency measure a companys ability to meet its long-term obligations. ability to meet its long-term obligations. Now, lets look at the solvency ratios for Now, lets look at the solvency ratios for Home Depot for 2004. Home Depot for 2004.Home Depot

14-46

Times Interest EarnedTimes Interest Earned Times Interest Earned Net Interest Income Tax + + Income Expense Expense Interest Expense

=

=

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

= 111 Times

This ratio indicates a margin This ratio indicates a margin of protection for creditors. of protection for creditors.

14-47

Cash CoverageCash = Coverage Cash Flow from Operating Activities Before Interest and Taxes 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 CoverageCash = Coverage Cash = Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid $6,545 + $70 + $2,539 $70Cash interest paid Income tax expense $ 70 2,539

= 131

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

14-49

Debt-to-Equity Ratio

Debt-to-Equity Ratio Debt-to-Equity Ratio

=

Total Liabilities Owners Equity $12,030 $22,407

=

=

0.54

This ratio measures the amount of This ratio measures the amount of liabilities that exists for each $1 liabilities that exists for each $1 invested by the owners. invested by the owners.

14-51

Market TestsMarket tests relate the current market price of Market tests relate the current market price of a share of stock to an indicator of the return a share of stock to an indicator of the return that might accrue to the investor. that might accrue to the investor. Now, lets look at the market tests for Now, lets look at the market tests for Home Depot for 2004. Home Depot for 2004.Home Depot

14-52

Price/Earnings (P/E) RatioP/E Ratio = Current Market Price Per Share Earnings Per Share $40 $1.88

P/E Ratio

=

=

21

A recent price for Home Depot stock was $40 per share.

This ratio measures the relationship This ratio measures the relationship between the current market price of the between the current market price of the stock and its earnings per share. stock and its earnings per share.

14-53

Dividend Yield RatioDividend Yield Dividend Yield = Dividends Per Share Market Price Per Share $0.27 $40

=

=

0.68%

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

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

14-54

Interpreting Ratios Ratios may be interpreted by comparison Ratios may be interpreted by comparison with ratios of other companies or with with ratios of other companies or with industry average ratios. industry average ratios. Ratios may vary because of the Ratios may vary because of the companys industry characteristics, companys industry characteristics, nature of operations, size, and nature of operations, size, and accounting policies. accounting policies.

14-56

Efficient Markets A securities market in which prices fully A securities market in which prices fully reflect available information is called an reflect available information is called an efficient market. efficient market. In an efficient market, a companys stock In an efficient market, a companys stock reacts quickly when new, relevant reacts quickly when new, relevant information is released about the information is released about 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 AssignmentE P

14-5 14-8