Understanding The Business Industry Factors Individual Company Factors Economy-wide Factors Invest? No Yes
Understanding The Business Return on an equity security investment Investors Dividends Increase in share price
Understanding a Company’s Strategy Business Strategy Operating Decisions Transactions Financial Statements I need to know if the company is trying to earn a high rate of return through product differentiation or cost differentiation.
Financial Statement Analysis
Financial statement analysis is based on comparisons.
Examines a single company to identify trends over time. Provides insights concerning a company’s relative performance. Time series analysis Comparison with similar companies
Express each item on a particular statement as a percentage of a single base amount .
Total assets on the balance 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%. Net sales on the income statement
Net Sales will be set to 100% and all other components will be expressed as a percentage of Net Sales.
2009 Cost of Sales ÷ 2009 Net Sales $47,298 ÷ $71,288 = .664 or 66.4% 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% Net Sales will be set to 100% and all other components will be expressed as a percentage of Net Sales.
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.
Test of Profitability ─ Return on Equity This measure indicates how much income was earned for every dollar invested by the owners. Profitability is a primary measure of the overall success of a company. Return on Equity $2,260 ($17,777 + $17,714) ÷ 2 = = 12.7% Net Income Average Stockholders’ Equity Return on Equity =
Test of Profitability ─ Return on Assets Many analysts consider this ratio as the best overall measure of a company’s profitability. Assume the corporate tax rate is 34%. Return on Assets Net Income + Interest Expense (net of tax) Average Total Assets = Return on Assets $2,260 + ($624 × (1 - .34)) ($41,164 + $44,324) ÷ 2 = = 6.3%
Test of Profitability ─ Financial Leverage Percentage 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. Financial Leverage Return on Equity – Return on Assets =
Test of Profitability ─ Earnings per Share (EPS) Earnings per share is probably the single most widely watched financial ratio. Average number of shares based on the number of shares at the beginning and end of the year. *If there are preferred dividends, the amount is subtracted from net income. EPS $2,260 (1,696 + 1,690) ÷ 2 = = $1.34 Net Income * Average Number of Shares Outstanding for the Period EPS =
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 = $5,528 $2,260 = 2.45 Home Depot’s Quality of Income
Test of Profitability ─ Profit Margin This ratio tells us the percentage of each sales dollar that is income. = 3.2% Profit Margin $2,260 $71,288 = Profit Margin Net Income Net Sales =
Test of Profitability ─ Fixed Asset Turnover This ratio measures a company’s ability to generate sales given an investment in fixed assets. Fixed Asset Turnover $71,288 ($26,234 + $27,476) ÷ 2 = = 2.65 Fixed Asset Turnover Net Sales Revenue Average Net Fixed Assets =
Tests of Liquidity ─ Cash Ratio This ratio measures the adequacy of available cash. Tests of liquidity focus on the relationship between current assets and current liabilities. Cash Ratio Cash + Cash Equivalents Current Liabilities = = 0.05 to 1 Cash Ratio $519 $11,153 =
Tests of Liquidity ─ Current Ratio This ratio measures the ability of the company to pay current debts as they become due. Current Ratio Current Assets Current Liabilities = Current Ratio $13,362 $11,153 = = 1.20 to 1
Tests of Liquidity ─ Quick Ratio (Acid Test) This ratio is like the current ratio but measures the company’s immediate ability to pay debts. Quick Assets Current Liabilities = Quick Ratio $1,497 $11,153 = 0.13 to 1 = Quick Ratio
Tests of Liquidity ─ Receivable Turnover This ratio measures how quickly a company collects its accounts receivable. Net Credit Sales Average Net Receivables Receivable Turnover = Receivable Turnover $71,288 ($972 + $1,259) ÷ 2 = 63.9 Times =
Tests of Liquidity ─ Average Age of Receivables This ratio measures the average number of days it takes to collect receivables. Days in Year Receivable Turnover Average Age of Receivables = = 5.7 Days 365 63.9 Average Age of Receivables =
Tests of Liquidity ─ Inventory Turnover This ratio measures how quickly the company sells its inventory. Cost of Goods Sold Average Inventory Inventory Turnover = Inventory Turnover $47,298 ($10,673 + $11,731) ÷ 2 = 4.2 Times =
Tests of Liquidity ─ Average Days’ Supply in Inventory This ratio measures the average number of days it takes to sell the inventory. Days in Year Inventory Turnover Average Days’ Supply in Inventory = = 86.9 Days 365 4.2 = Average Days’ Supply in Inventory
Tests of Liquidity ─ Accounts Payable Turnover This ratio measures how quickly the company pays its accounts payable. Cost of Goods Sold Average Accounts Payable Accounts Payable Turnover = $47,298 ($4,822 + $5,732) ÷ 2 = 9 Times = Accounts Payable Turnover
Tests of Liquidity ─ Average Age of Payables This ratio measures the average number of days it takes to pay its suppliers. Days in Year Accounts Payable Turnover Average Age of Payables = = 40.6 Days 365 9 = Average Age of Payables
Tests of Solvency ─ Times Interest Earned This ratio indicates a margin of protection for creditors. Tests of solvency measure a company’s ability to meet its long-term obligations. Net Interest Income Tax Income Expense Expense Interest Expense Times Interest Earned = + + $2,260 + $624 + $1,278 $624 Times Interest Earned = = 6.7 Times
Tests of Solvency ─ Cash Coverage This ratio compares the cash generated with the cash obligations of the period. Cash Coverage = $5,528 + $622 + $1,225 $622 = 11.9 Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Paid Interest Paid =
Tests of Solvency ─ Debt-to-Equity Ratio This ratio measures the amount of liabilities that exists for each $1 invested by the owners. $23,387 $17,777 = 1.32 = Debt-to-Equity Ratio Total Liabilities Stockholders’ Equity Debt-to-Equity Ratio =
Market Tests ─ Price/Earnings (P/E) Ratio 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 $26 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. P/E Ratio = Current Market Price Per Share Earnings Per Share P/E Ratio = $26 $1.34 = 19.4
Market Tests ─ Dividend Yield Ratio This ratio is often used to compare the dividend-paying performance of different investment alternatives. Home Depot paid dividends of $.90 per share when the market price was $26 per share. Dividend Yield Dividends Per Share Market Price Per Share = Dividend Yield $0.90 $26 = = 3.5 %
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.
Other Financial Information
In addition to financial ratios, special factors might affect company analysis:
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.