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- 1. Chapter 14 Analyzing Financial Statements
- 2. Understanding The Business FINANCIAL STATEMENT USERS EXTERNAL DECISION MAKERS MANAGEMENT . . . uses accounting data to make product pricing and expansion decisions. . . . use accounting data for investment, credit, tax, and public policy decisions.
- 3. Understanding The Business THREE TYPES OF FINANCIAL STATEMENT INFORMATION Past Performance Present Condition Future Performance Income, sales volume, cash flows, return- on-investments, EPS. Assets, debt, inventory, various ratios. Sales and earnings trends are good indicators of future performance.
- 4. Understanding The Business Return on an equity security investment Investors Dividends Increase in share price
- 5. Understanding The Business Invest? No Yes Economy-wide Factors Industry Factors Individual Company Factors
- 6. Understanding a Company’s Strategy I need to know the company’s policies on product differentiation, pricing, and cost control to make my financial analysis more meaningful.
- 7. Financial Statement Analysis <ul><li>Financial statement analysis is based on comparisons. </li></ul>Examines a single company to identify trends over time. Time series analysis Comparison with similar companies
- 8. Financial Statement Analysis <ul><li>Financial statement analysis is based on comparisons. </li></ul>Provides insights concerning a company’s relative performance. Company A Company B Time series analysis Comparison with similar companies
- 9. Ratio and Percentage Analyses <ul><li>Ratio analysis, or percentage analysis, is used to express the proportionate relationship between two different amounts. </li></ul>
- 10. Component Percentages <ul><li>Express each item on a particular statement as a percentage of a single base amount . </li></ul>Total assets on the balance sheet Net sales on the income statement
- 11. Component Percentages Example <ul><li>The comparative income statements of Home Depot 2001 and 2000 appear on the next slide. </li></ul><ul><li>Prepare component percentage income statements where net sales equal 100%. </li></ul>Home Depot
- 12. Component Percentages
- 13. Component Percentages 2001 Cost ÷ 2001 Sales
- 14. Component Percentages
- 15. Now, let’s look at some commonly used ratios.
- 16. Commonly Used Ratios <ul><li>The 2001 and 2000 balance sheets for Home Depot are presented next. </li></ul><ul><li>We will be referring to these financial statements throughout the ratio analyses. </li></ul>Home Depot
- 17. Comparative Statements Continued
- 18. Comparative Statements
- 19. Tests of Profitability <ul><li>Profitability is a primary measure of the overall success of a company. </li></ul><ul><li>Now, let’s look at the profitability ratios for Home Depot for 2001. </li></ul>Home Depot
- 20. Return on Equity This measure indicates how much income was earned for every dollar invested by the owners. Return on Equity $2,581 ($15,004 + $12,341) ÷ 2 = = 18.9% Income Average Owners’ Equity Return on Equity =
- 21. Return on Assets This ratio is generally considered the best overall measure of a company’s profitability. Corporate tax rate is 34 percent. Return on Assets Income + Interest Expense (net of tax) Average Total Assets = Return on Assets $2,581 + ($21 ×(1 - .34)) ($21,385 + $17,081) ÷ 2 = = 13.5%
- 22. Financial Leverage 5.4% = 18.9% – 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 Return on Equity – Return on Assets =
- 23. Earnings per Share (EPS) Earnings per share is probably the single most widely watched financial ratio. Income Average Number of Shares of Common Stock Outstanding EPS = EPS $2,581 (2,324 + 2,304) ÷ 2 = = $1.12
- 24. Quality of Income Quality of Income Cash Flow from Operating Activities Net Income =
- 25. Quality of Income A ratio higher than 1 indicates higher-quality earnings. Quality of Income Cash Flow from Operating Activities Net Income = Quality of Income $2,796 $2,581 = = 1.08
- 26. Profit Margin This ratio describes a company’s ability to earn income from sales. = 5.6% Profit Margin $2,581 $45,738 = Profit Margin Income (before Extraordinary Items) Net Sales =
- 27. Fixed Asset Turnover This ratio measures a company’s ability to generate sales given an investment in fixed assets. Fixed Asset Turnover $45,738 ($13,068 + $10,227) ÷ 2 = = 3.9 Fixed Asset Turnover Net Sales Revenue Average Net Fixed Assets =
- 28. Tests of Liquidity <ul><li>Tests of liquidity focus on the relationship between current assets and current liabilities. </li></ul><ul><li>Now, let’s look at the liquidity ratios for Home Depot for 2001. </li></ul>Home Depot
- 29. Cash Ratio This ratio measures the adequacy of available cash. Cash Ratio Cash + Cash Equivalents Current Liabilities = = 0.04 : 1 Cash Ratio $167 $4,385 =
- 30. 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 $7,777 $4,385 = = 1.77 : 1
- 31. 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 $1,012 $4,385 = .23 : 1 = Quick Ratio
- 32. Receivable Turnover This ratio measures how quickly a company collects its accounts receivable. Net Credit Sales Average Net Trade Receivables Receivable Turnover = Receivable Turnover $45,738 ($835 + $587) ÷ 2 = 64 times =
- 33. 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 64 Average Age of Receivables =
- 34. Inventory Turnover This ratio measures how quickly the company sells its inventory. Cost of Goods Sold Average Inventory Inventory Turnover = Inventory Turnover $32,057 ($6,556 + $5,489) ÷ 2 = 5.3 times =
- 35. 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 = = 69 days 365 5.3 = Average Days’ Supply in Inventory
- 36. Tests of Solvency and Equity Position <ul><li>Tests of solvency measure a company’s ability to meet its obligations. </li></ul><ul><li>Now, let’s look at the solvency ratios for Home Depot for 2001. </li></ul>Home Depot
- 37. Times Interest Earned This ratio indicates a margin of protection for creditors. Net Interest Income Tax Income Expense Expense Interest Expense Times Interest Earned = + + $2,581 + $21 + $1,636 $21 Times Interest Earned = = 202
- 38. Cash Coverage Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid =
- 39. Cash Coverage This ratio compares the cash generated with the cash obligations of the period. Cash Coverage = $2,796 + $16 + $1,386 $16 = 262 Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid =
- 40. Debt/Equity Ratio This ratio measures the amount of liabilities that exists for each $1 invested by the owners. Total Liabilities Owners’ Equity Debt/Equity Ratio = $6,381 $15,004 = 0.43 Debt/Equity Ratio =
- 41. Market Tests <ul><li>Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor. </li></ul><ul><li>Now, let’s look at the market tests for Home Depot for 2001. </li></ul>Home Depot
- 42. 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 $35 per share. P/E Ratio = Current Market Price Per Share Earnings Per Share P/E Ratio = $35 $1.12 = 31.3
- 43. Dividend Yield Ratio This ratio is often used to compare the dividend-paying performance of different investment alternatives. Home Depot paid dividends of $.16 per share when the market price was $35 per share. Dividend Yield Dividends Per Share Market Price Per Share = Dividend Yield $0.16 $35 = = 0.46%
- 44. Other Analytical Considerations <ul><li>In addition to financial ratios, special factors might affect company analysis: </li></ul><ul><ul><li>Rapid growth. </li></ul></ul><ul><ul><li>Uneconomical expansion. </li></ul></ul><ul><ul><li>Subjective factors. </li></ul></ul>
- 45. Interpreting Ratios <ul><li>Ratios may be interpreted by comparison with ratios of other companies or with industry average ratios. </li></ul><ul><li>Ratios may vary because of the company’s industry characteristics, nature of operations, size, and accounting policies. </li></ul>
- 46. Efficient Markets <ul><li>A securities market in which prices fully reflect available information is called an efficient market . </li></ul><ul><li>In an efficient market, a company’s stock reacts quickly when new, relevant information is released about the company. </li></ul>
- 47. End of Chapter 14 Ratios Ratios Ratios Ratios Ratios

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