Analyzing Financial Statements

Chapter 14

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
14-1
 Understanding The Business

Individual
Company
Industry Factors Economy-wide
Factors Factors

Invest?
No Yes

14-2
 Understanding The Business

Return on an equity
security investment

Increase in
Dividends share price

Investors
14-3
 Understanding a Company’s Strategy
I need to know if the company is trying to earn
a high rate of return through product
differentiation or cost differentiation.

Business
Strategy
Operating
Decisions
Transactions
Financial
Statements
14-4
 Financial Statements
An Overview

Map or Maze

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 Financial Statements
An Overview

Map or Maze

Auditor’s Report MD&A

Statement of Cash Flows

Income Statement
Notes

Statement of Shareholders’ Equity

Balance Sheet

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 Map:
Helps its user reach a
desired destination
through clarity of
representation

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 Maze:

On the other hand. . .

Attempts to confuse its user by

purposefully introducing conflicting
elements and complexities that
prevent reaching the desired goal

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 Map or Maze
Financial statements are potentially
both MAP and MAZE

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 Financial Statements--MAP

Form basis for understanding the

financial position of a firm
Allow users to assess historical and
prospective financial performance
Present picture of firm’s financial
health, leading to informed
business decisions

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 Financial Statements--MAZE
Contain large amounts of information
Accounting policies and reporting
requirements are complex and
constantly changing
Allow management considerable
discretion
Hide or omit key information

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 Our Objective:
To ensure that financial statements serve as
a map, not a maze

The better one can read and understand the

financial statements, the more useful they
are as a MAP to intelligent decision-
making

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 Financial Statement Analysis
Financial statement analysis
is based on comparisons.

Time series Comparison with

analysis similar companies

Examines a single Provides insights

company to identify concerning a
trends over time. company’s relative
performance.

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 Component Percentages
Express each item on a particular statement
as a percentage of a single base amount.

Net sales Total assets

on the income on the balance
statement sheet

The comparative income statements of Home Depot

for 2007, 2008, and 2009 appear on the next slide.
Prepare component percentage income statements
where net sales equal 100%.

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 Net Sales will be set
to 100% and all other
components will be
expressed as a
percentage of Net
Sales.

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 Net Sales will be set
to 100% and all other
components will be
expressed as a
2009 Cost of Sales ÷ 2009 Net Sales
percentage of Net
$47,298 ÷ $71,288 = .664 or 66.4%
Sales.
2009 Gross Profit ÷ 2009 Net Sales
$23,990 ÷ $71,288 = .336 or 33.6%
2009 Selling, G&A ÷ 2009 Net Sales
$17,846 ÷ $71,288 = .250 or 25.0%

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 Component Percentages

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 Commonly Used Ratios
The 2009 and 2008 balance sheets for
Home Depot are presented next.
We will be referring to these financial
statements throughout the ratio
analyses.

Home Depot

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14-19
14-20
 Test of Profitability ─ Return on Equity
Profitability is a primary measure of
the overall success of a company.

Net Income
Return on Equity =
Average Stockholders’ Equity

$2,260
Return on Equity = = 12.7%
($17,777 + $17,714) ÷ 2

This measure indicates how much income was

earned for every dollar invested by the owners.

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 Test of Profitability ─ Return on Assets

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

=
Assets Average Total Assets

Return on $2,260 + ($624 × (1 - .34))

= = 6.3%
Assets ($41,164 + $44,324) ÷ 2

Assume the corporate

tax rate is 34%.

Many analysts consider this ratio as the best

overall measure of a company’s profitability.

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 Financial Leverage Percentage

Financial
= Return on Equity – Return on Assets
Leverage

6.4% = 12.7% – 6.3%

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.

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 Test of Profitability ─ Earnings per
Share (EPS)
Net Income*
EPS =
Average Number of Shares
Outstanding for the Period
*If there are preferred dividends, the amount is subtracted from net income.

$2,260
EPS = = $1.34
(1,696 + 1,690) ÷ 2

Average number of shares based on the number

of shares at the beginning and end of the year.

Earnings per share is probably the single

most widely watched financial ratio.
14-24
 Test of Profitability ─ Quality of Income
Quality Cash Flow from Operating Activities
=
of Income Net Income

Home Depot’s
Quality of Income
$5,528
= 2.45
$2,260

A ratio higher than 1

indicates high-quality
earnings.
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 Test of Profitability ─ Gross Profit
Margin
Gross Profit Gross Margin
=
Margin Net Sales

Profit $23,990
= = 33.65%
Margin $71,288

This ratio tells us the percentage of

each sales dollar that is gross margin.

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 Test of Profitability ─ Operating Profit
Margin
Operating Operating Margin
=
Margin Net Sales

Profit $4,359
= = 6.11%
Margin $71,288

This ratio tells us the percentage of

each sales dollar that is operating
margin.
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 Test of Profitability ─ Net Profit Margin

Net Profit Net Income

=
Margin Net Sales

Profit $2,260
= = 3.2%
Margin $71,288

This ratio tells us the percentage of

each sales dollar that is net income.

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 Activity Ratios─ Fixed Asset Turnover

Fixed Net Sales Revenue

Asset =
Average Net Fixed Assets
Turnover

Fixed $71,288
Asset = = 2.65
Turnover ($26,234 + $27,476) ÷ 2

This ratio measures a company’s ability to generate

sales given an investment in fixed assets.

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 Activity Ratios ─ Receivable Turnover

Receivable Net Credit Sales

=
Turnover Average Net Receivables

Receivable $71,288
= = 63.9 Times
Turnover ($972 + $1,259) ÷ 2

This ratio measures how

quickly a company collects its
accounts receivable.

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 Activity Ratios ─ Average Age of
Receivables
Average Age Days in Year
=
of Receivables Receivable Turnover

Average Age 365

= = 5.7 Days
of Receivables 63.9

This ratio measures the average number

of days it takes to collect receivables.

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 Activity Ratios ─ Inventory Turnover

Inventory Cost of Goods Sold

=
Turnover Average Inventory

Inventory $47,298
= = 4.2 Times
Turnover ($10,673 + $11,731) ÷ 2

This ratio measures how quickly

the company sells its inventory.

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 Activity Ratios ─ Average Days’ Supply
in Inventory
Average Days’ Days in Year
Supply in =
Inventory Turnover
Inventory

Average Days’ 365

Supply in = = 86.9 Days
4.2
Inventory

This ratio measures the average number

of days it takes to sell the inventory.

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 Activity Ratios ─ Accounts Payable
Turnover
Accounts Cost of Goods Sold
Payable =
Average Accounts Payable
Turnover

Accounts $47,298
Payable = = 9 Times
($4,822 + $5,732) ÷ 2
Turnover

This ratio measures how quickly the

company pays its accounts payable.

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 Activity Ratios ─ Average Age of
Payables

Average Age Days in Year

=
of Payables Accounts Payable Turnover

Average Age 365

= = 40.6 Days
of Payables 9

This ratio measures the average number

of days it takes to pay its suppliers.

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 Cash Conversion Cycle or
Net Trade Cycle
The normal cycle of a firm that consists of:

• Buying or manufacturing
inventory, with some purchases on
credit
• Selling inventory, with some sales
on credit
• Collecting the cash
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 Cash Conversion Cycle or
Net Trade Cycle (cont.)
Helps the analyst understand why cash
flow generation has improved or
deteriorated by analyzing:
Key balance sheet accounts that affect cash
flow from operating activities:
• Accounts Receivable
• Inventory
• Accounts Payable

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 Cash Conversion Cycle or
Net Trade Cycle (cont.)

Calculated as follows:
Average collection period
Plus
Days inventory held
Minus
Days payable outstanding
Equals
Cash conversion or net trade cycle

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 Tests of Liquidity ─ Current Ratio
Tests of liquidity focus on the relationship between
current assets and current liabilities.

Current Current Assets

=
Ratio Current Liabilities

Current $13,362
= = 1.20 to 1
Ratio $11,153

This ratio measures the ability

of the company to pay current
debts as they become due.
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 Tests of Liquidity ─ Quick Ratio
(Acid Test)
Quick Quick Assets
=
Ratio Current Liabilities

Quick $1,497
= = 0.13 to 1
Ratio $11,153

Cash & Cash Equivalents $ 519

Receivables, net 972
Short-term Investments 6
Quick Assets $ 1,497

This ratio is like the current

ratio but measures the company’s
immediate ability to pay debts.
14-40
 Tests of Liquidity ─ Cash Ratio

Cash Cash + Cash Equivalents

=
Ratio Current Liabilities

Cash $519
= = 0.05 to 1
Ratio $11,153

This ratio measures the

adequacy of available cash.

14-41
 Tests of Solvency ─ Debt-to-Equity
Ratio
Tests of solvency measure a company’s
ability to meet its long-term obligations.
Debt-to-Equity Total Liabilities
=
Ratio Stockholders’ Equity

Debt-to-Equity $23,387
= = 1.32
Ratio $17,777

This ratio measures the amount of

liabilities that exists for each $1
invested by the owners.
14-42
 Tests of Solvency ─ Times Interest
Earned

Times Net Interest Income Tax

+ +
Interest = Income Expense Expense
Earned Interest Expense

Times
Interest $2,260 + $624 + $1,278
= = 6.7 Times
Earned $624

This ratio indicates a margin of protection for creditors.

14-43
 Tests of Solvency ─ Cash Coverage
Cash Flow from Operating Activities
Cash
= Before Interest and Taxes Paid
Coverage
Interest Paid

Cash $5,528 + $622 + $1,225

= = 11.9
Coverage $622
From Statement of Cash Flows
Cash interest paid $ 622
Income tax paid 1,225

This ratio compares the cash generated with

the cash obligations of the period.
14-44
 Market Tests ─ Price/Earnings (P/E)
Ratio
Market tests relate the current market price of a share of stock
to an indicator of the return that might accrue to the investor.

Current Market Price Per Share

P/E Ratio =
Earnings Per Share

$26 A recent price for

P/E Ratio = = 19.4 Home Depot stock
$1.34
was $26 per share.

This ratio measures the relationship between the current

market price of the stock and its earnings per share.
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 Market Tests ─ Dividend Yield Ratio
Dividend Dividends Per Share
=
Yield Market Price Per Share

Dividend $0.90
= = 3.5 %
Yield $26

Home Depot paid dividends of $.90 per share

when the market price was $26 per share.

This ratio is often used to compare the

dividend-paying performance of different
investment alternatives.
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 Interpreting Ratios

Ratios may be interpreted by

comparison with ratios of other
companies or with industry
average ratios.

Ratios may vary because of the

company’s industry
characteristics, nature of
operations, size, and
accounting policies.
14-47
 Other Financial Information
In addition to financial ratios,
special factors might affect
company analysis:
 Rapid growth.

 Uneconomical expansion.

 Subjective factors.

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.

14-48
 What we have accomplished

Turned Maze
Auditor’s Report MD&A

Income Statement
Notes

Statement of Cash Flows

Statement of Shareholders’ Equity

Balance Sheet

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 Financial Statements
An Overview

into Map

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 End of Chapter 14

14-51