CHAPTER 13

ANALYZING FINANCIAL STATEMENTS

McGraw-Hill/Irwin Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

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QUESTIONS TO GET YOU THINKING

Why do analysts review nancial statements?

Why do analysts use ratios to evaluate companies?

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WHAT WE'LL COVER TODAY

Explain how a companys business strategy aects nancial analysis.

Discuss how analysts use nancial statements. Compute and interpret component percentages. Compute and interpret protability ratios. Compute and interpret liquidity ratios. Compute and interpret solvency ratios. Compute and interpret market test ratios.

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UNDERSTANDING THE BUSINESS

External Decision Makers Present and Potential Owners

Investment Analysts Creditors

Annual Report

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Industry Factors

Economy-wide Factors Individual

Company Factors

Invest? No Yes

THE INVESTMENT DECISION

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UNDERSTANDING A COMPANYS STRATEGY

I need to know if the company is trying to earn a high rate of return through product dierentiation or cost dierentiation.

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FINANCIAL STATEMENT ANALYSIS

Examines a single company to identify trends over time.

Financial statement analysis is based on comparisons.

Time series analysis

Comparison with similar companies

Provides insights concerning a

companys relative performance.

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COMPONENT PERCENTAGES Express each item on a particular statement as

a percentage of a single base amount.

Total assets on the balance

sheet

Net sales on the income statement

The comparative income statements of Home Depot for 2012, 2011, and 2010 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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2012 Cost of Sales 2012 Net Sales $46,133 $70,395 = .655 or 65.5%

2012 Gross Profit 2012 Net Sales $24,262 $70,390 = .345 or 34.5%

2012 Selling, G&A 2012 Net Sales $16,028 $70,395 = .228 or 22.8%

Net Sales will be set to 100% and all other components will be

expressed as a percentage of Net

Sales.

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COMPONENT PERCENTAGES

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COMMONLY USED RATIOS

The 2012 and 2011 balance sheets for Home Depot are presented next.

We will be referring to these nancial statements throughout the ratio analyses.

Home Depot

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TEST OF PROFITABILITY RETURN ON EQUITY

Return on Equity $3,883

($17,898 + $18,889) 2 = = 21.1%

Net Income Average Stockholders Equity Return on Equity

=

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

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

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TEST OF PROFITABILITY RETURN ON ASSETS Return on Assets

Net Income + Interest Expense (net of tax) Average Total Assets

=

Return on Assets

$3,883 + ($606 (1 - .34)) ($40,518 + $40,125) 2

= = 10.6%

This ratio measures how well assets have been employed by the business. Many analysts consider this

ratio as the best overall measure of a companys protability.

Assume the corporate tax rate is 34%.

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TEST OF PROFITABILITY FINANCIAL LEVERAGE PERCENTAGE

Financial Leverage Percentage Return on Equity Return on Assets =

10.5% = 21.1% 10.6%

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

on assets.

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TEST OF PROFITABILITY EARNINGS PER SHARE (EPS)

EPS $3,883

1,562 = = $2.49

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

Average number of shares based on the number of shares at the beginning and end of the year.

Net Income* Average Number of Shares Outstanding for the Period

EPS =

*If there are preferred dividends, the amount is subtracted from net income.

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TEST OF PROFITABILITY QUALITY OF INCOME

A ratio higher than 1 indicates high-quality

earnings.

Quality of Income

Cash Flow from Operating Activities Net Income

=

$6,651 $3,883

= 1.71

Home Depots Quality of Income

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TEST OF PROFITABILITY PROFIT MARGIN

This ratio tells us the percentage of each sales dollar, on average, that represents income.

Prot Margin

Net Income Net Sales Revenue

=

= 5.5% Prot Margin

$3,883 $70,395

=

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TEST OF PROFITABILITY GROSS PROFIT MARGIN

This ratio tells us the prot made on each sale.

Gross Prot Margin

Gross Prot Net Sales Revenue

=

= 34.5% Gross Prot Margin

$24,262 $70,395

=

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TEST OF PROFITABILITY FIXED ASSET TURNOVER

Fixed Asset

Turnover

$70,395 ($24,448 + $25,060) 2

= = 2.84

Fixed Asset

Turnover

Net Sales Revenue Average Net Fixed Assets

=

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

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TESTS OF LIQUIDITY CURRENT RATIO

Current Ratio

Current Assets Current Liabilities

=

Current Ratio

$14,520 $9,376

= = 1.55 to 1

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 Assets Current Liabilities

= Quick Ratio

$3,232 $9,376

= 0.35 to 1 = Quick Ratio

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

Cash & Cash Equivalents 1,987$ Receivables, net 1,245 Quick Assets 3,232$

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TESTS OF LIQUIDITY CASH RATIO

Cash Ratio

Cash + Cash Equivalents Current Liabilities

=

= 0.21 to 1 Cash Ratio

$1,987 $9,376

=

This ratio measures the adequacy of available cash.

Tests of liquidity focus on the relationship between current assets and current liabilities.

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TESTS OF LIQUIDITY RECEIVABLE TURNOVER

Net Credit Sales Average Net Receivables

Receivable Turnover

=

Receivable Turnover

$70,395 ($1,245 + $1,085) 2

= 60.4 Times =

This ratio measures how quickly a company collects its accounts

receivable.

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TESTS OF LIQUIDITY AVERAGE AGE OF RECEIVABLES

Days in Year Receivable Turnover

Average Age of Receivables =

= 6.0 Days 365 60.4

Average Age of Receivables

=

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

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TESTS OF LIQUIDITY INVENTORY TURNOVER

Cost of Goods Sold Average Inventory

Inventory Turnover

=

Inventory Turnover

$46,133 ($10,325 + $10,625) 2

= 4.4 Times =

This ratio measures how quickly the company sells its inventory.

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TESTS OF LIQUIDITY AVERAGE DAYS SUPPLY IN INVENTORY

Days in Year Inventory Turnover

Average Days Supply in Inventory

=

= 83 Days 365 4.4

= Average Days

Supply in Inventory

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

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TESTS OF LIQUIDITY ACCOUNTS PAYABLE TURNOVER RATIO

Cost of Goods Sold Average Accounts Payable

Accounts Payable Turnover

=

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

$46,133 ($4,856 + $4,717) 2

= 9.6 Times = Accounts Payable Turnover

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TESTS OF LIQUIDITY AVERAGE DAYS IN ACCOUNTS PAYABLE

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

Days in Year Accounts Payable Turnover

Average Days in Accounts Payable

=

= 38 Days 365 9.6

= Average Days in

Accounts Payable

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This ratio indicates a margin of protection for creditors.

TESTS OF SOLVENCY TIMES INTEREST EARNED

Net Interest Income Tax Income Expense Expense Interest Expense

Times Interest Earned

= + +

$3,883 + $606 + $2,185 $606

Times Interest Earned

= = 11.0 Times

Tests of solvency measure a companys ability to meet its long-term obligations.

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Cash Coverage

= $6,651 + $580 + $1,865

$580 = 15.7

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

Cash interest paid 580$ Income tax paid 1,865

From Statement of Cash Flows

Cash Coverage

Cash Flow from Operating Activities Before Interest and Taxes Paid

Interest Paid =

TESTS OF SOLVENCY CASH COVERAGE

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TESTS OF SOLVENCY DEBT-TO-EQUITY RATIO

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

invested by the owners.

$22,620 $17,898

= 1.26 = Debt-to-Equity

Ratio

Total Liabilities Stockholders Equity

Debt-to-Equity Ratio

=

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MARKET TESTS PRICE/EARNINGS (P/E) RATIO

P/E Ratio = Current Market Price Per Share

Earnings Per Share

P/E Ratio = $60 $2.49

= 24.1

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

A recent price for Home Depot stock was

$60 per share.

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

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MARKET TESTS DIVIDEND YIELD RATIO Dividend Yield

Dividends Per Share Market Price Per Share

=

Dividend Yield

$1.16 $60

= = 1.9%

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

alternatives.

Home Depot paid dividends of $1.16 per share when the market price was $60 per share.

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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

companys industry characteristics, nature of operations, size, and

accounting policies.

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OTHER FINANCIAL INFORMATION In addition to nancial ratios, special factors might aect company analysis:

lRapid growth. lUneconomical expansion. lSubjective factors.

A securities market in which prices fully reect available information is called an ecient market. In an ecient market, a companys stock reacts quickly when new, relevant information is released about the company.

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KEY TAKE AWAYS

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READING CHAPTER 13 EXERCISES E1, E2, E3, E4, AP3

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AP3. Coke and Pepsi are well-known international brands. Coca-Cola sells more than $13 billion worth of beverages each year while annual sales of PepsiCo products exceed $22 billion. Compare the two companies as a potential investment based on the following ratios: Ratio P/E Gross prot margin Prot margin Quick Current Debt-to-equity Return on equity Return on assets Dividend yield Dividend payout

Coca-Cola 65.0 69.3 12.2 0.4 0.6 0.7 27.4 28.0 1.0

65.0

Pepsi 26.5 58.4 8.8 0.7 1.1 0.4 29.1 16.6 1.6

41.0

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CASE STUDY ASSIGNMENT

Through Study.net, obtain the Harvard Business School : The Case of the Unidentied Industries 2013

With your team, prepare your assessment which nancial data matches which industry.

Document your analysis in the Excel Rubric format available in bCourses.

Be prepared to debrief the case in our next class meeting.

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THE FOLLOWING SELECTED FINANCIAL DATA PERTAIN TO FOUR UNIDENTIFIED COMPANIES:

BALANCE SHEET DATA (COMPONENT PERCENTAGE) CASH ACCOUNTS RECEIVABLE INVENTORY PROPERTY AND EQUIPMENT INCOME STATEMENT DATA (COMPONENT PERCENTAGE) GROSS PROFIT PROFIT BEFORE TAXES SELECTED RATIOS CURRENT RATIO INVENTORY TURNOVER RATIO DEBT-TO-EQUITY RATIO *N/A 5 NOT APPLICABLE.

1 3.5 16.9 46.8 18.3 22.0 2.1 1.3 3.6 2.6

2 4.7 28.9 35.6 21.7 22.5 0.7 1.5 9.8 2.6

3 8.2 16.8 57.3 7.6 44.8 1.2 1.6 1.5 3.2

4 11.7 51.9 4.8 18.7 N/A* 3.2 1.2 N/A* 3.2

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THIS FINANCIAL INFORMATION PERTAINS TO THE FOLLOWING COMPANIES: A. RETAIL FUR STORE B. ADVERTISING AGENCY C. WHOLESALE CANDY COMPANY D. CAR MANUFACTURER MATCH EACH COMPANY WITH ITS FINANCIAL INFORMATION.

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THE FOLLOWING SELECTED FINANCIAL DATA PERTAIN TO FOUR UNIDENTIFIED COMPANIES:

BALANCE SHEET DATA (COMPONENT PERCENTAGE) CASH ACCOUNTS RECEIVABLE INVENTORY PROPERTY AND EQUIPMENT INCOME STATEMENT DATA (COMPONENT PERCENTAGE) GROSS PROFIT PROFIT BEFORE TAXES SELECTED RATIOS CURRENT RATIO INVENTORY TURNOVER RATIO DEBT-TO-EQUITY RATIO *N/A 5 NOT APPLICABLE.

1 7.3 28.2 21.6 32.1 15.3 1.7 1.5 27.4 1.7

2 21.6 39.7 0.6 18.0 N/A* 3.2 1.2 N/A* 2.2

3 6.1 3.2 1.8 74.6 N/A* 2.4 0.6 N/A* 5.7

4 11.3 22.9 27.5 25.1 43.4 6.9 1.9 3.3 1.3

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THIS FINANCIAL INFORMATION PERTAINS TO THE FOLLOWING COMPANIES: A. TRAVEL AGENCY B. HOTEL C. MEAT PACKER D. DRUG COMPANY MATCH EACH COMPANY WITH ITS FINANCIAL INFORMATION.

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THE FOLLOWING SELECTED FINANCIAL DATA PERTAIN TO FOUR UNIDENTIFIED COMPANIES:

BALANCE SHEET DATA (COMPONENT PERCENTAGE) CASH ACCOUNTS RECEIVABLE INVENTORY PROPERTY AND EQUIPMENT INCOME STATEMENT DATA (COMPONENT PERCENTAGE) GROSS PROFIT PROFIT BEFORE TAXES SELECTED RATIOS CURRENT RATIO INVENTORY TURNOVER RATIO DEBT-TO-EQUITY RATIO *N/A 5 NOT APPLICABLE.

1 5.1 13.1 4.6 53.1 N/A* 0.3 0.7 N/A* 2.5

2 8.8 41.5 3.6 23.0 N/A* 16.0 2.2 N/A* 0.9

3 6.3 13.8 65.1 8.8 45.2 3.9 1.9 1.4 1.7

4 10.4 4.9 35.8 35.7 22.5 1.5 1.4 15.5 2.3

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THIS FINANCIAL INFORMATION PERTAINS TO THE FOLLOWING COMPANIES: A. CABLE TV COMPANY B. GROCERY STORE C. ACCOUNTING FIRM D. RETAIL JEWELRY STORE MATCH EACH COMPANY WITH ITS FINANCIAL INFORMATION.

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THE FOLLOWING SELECTED FINANCIAL DATA PERTAIN TO FOUR UNIDENTIFIED COMPANIES:

BALANCE SHEET DATA (COMPONENT PERCENTAGE) CASH ACCOUNTS RECEIVABLE INVENTORY PROPERTY AND EQUIPMENT INCOME STATEMENT DATA (COMPONENT PERCENTAGE) GROSS PROFIT PROFIT BEFORE TAXES SELECTED RATIOS CURRENT RATIO INVENTORY TURNOVER RATIO DEBT-TO-EQUITY RATIO *N/A 5 NOT APPLICABLE.

1 11.6 4.6 7.0 56.0 56.7 2.7 0.7 30.0 3.3

2 6.6 18.9 45.8 20.3 36.4 1.4 2.1 3.5 1.8

3 5.4 8.8 65.7 10.1 14.1 1.1 1.2 5.6 3.8

4 7.1 35.6 26.0 21.9 15.8 0.9 1.3 16.7 3.1

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THIS FINANCIAL INFORMATION PERTAINS TO THE FOLLOWING COMPANIES: A. FULL-LINE DEPARTMENT STORE B. WHOLESALE FISH COMPANY C. AUTOMOBILE DEALER (BOTH NEW AND USED CARS) D. RESTAURANT MATCH EACH COMPANY WITH ITS FINANCIAL INFORMATION.

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QUESTIONS?