Analyzing Financial Statements

Some Users of Financial Statements Individuals Government regulatory agencies Businesses Taxing authorities Investors and creditors Nonprofit organizations

Understanding The Business Economy-wide Factors Industry Factors Individual Company Factors Lend? Sell on credit? Invest? In considering an investment decision in the stock of a corporation, potential investors should evaluate the company’s future income and growth potential on the basis of industry factors and economy-wide factors as well as individual company factors. Invest? No Yes

Analyzing Financial Statements Dollar and percentage changes on statements (Horizontal Analysis)/ Trend Analysis Analytical techniques used to examine relationships among financial statement items Common-size statements (Vertical Analysis) Ratios

Horizontal Analysis Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

Horizontal Analysis $12,000 – $23,500 = $(11,500) The dollar and percentage changes in the cash account are computed as shown. $12,000 – $23,500 = $(11,500) ($11,500 ÷ $23,500) × 100% = 48.9%

Horizontal Analysis The dollar and percentage changes for the remaining asset accounts are as shown. Can you calculate these numbers?

Horizontal Analysis The dollar and percentage changes for each account are as shown.

Trend Analysis

Trend Percentages Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent. Horizontal analysis can be even more useful when data from a number of years are used to compute trend percentages.

Trend Analysis × Trend Percentage Current Year Amount Base Year Amount 100% = × To compute a trend percentage, a base year is selected and the data for all years are stated in terms of a percentage of that base year. The equation for computing a trend percentage is current year amount divided by base year amount times 100 percent.

For the Years Ended December 31 Trend Analysis Berry Products Income Information For the Years Ended December 31 The trend percentages for the remaining years would be as shown. Notice that the cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin. By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.

Vertical Analysis Vertical analysis focuses on the relationships among financial statement items at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage. Vertical analysis focuses on the relationships among financial statement items at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.

Common-Size Statements Sales is usually the base and is expressed as 100%. Here are the comparative income statements for Clover Corporation for two thousand five and two thousand four. As previously mentioned, sales is usually the base and is expressed as one hundred percent.

Common-Size Statements The common-size percentages for the remaining items on the income statement are as shown.

Common-Size Statements In balance sheets, all items usually are expressed as a percentage of total assets (or total liabilities+equity). In balance sheets, all items are usually expressed as a percentage of total assets.

Ratio Analysis

Interpreting Ratios Ratios may be interpreted by comparison with ratios of earlier periods, other companies, or with industry average ratios. Ratios may vary because of the company’s industry characteristics, nature of operations, size, and accounting policies. We gain the most insight from financial ratios if they are compared to Ratios of other companies in the same line of business. Ratios from the same company over time. Industry average ratios. Care must be exercised when comparing ratios. Ratios may be computed differently by different companies. Earnings per share is the only ratio whose computation has been standardized by the accounting profession. In addition, different companies use different accounting practices that have an impact on ratios. For example, the choice of first-in, first-out inventory cost flow assumptions versus last-in, first-out inventory cost flow assumptions will produce different financial statement results.

Limitations of Financial Statement Analysis Differences in accounting methods between companies sometimes make comparisons difficult. Differences in accounting methods between companies sometimes make it difficult to compare their financial data. For example, if one company values its inventory using the LIFO method and another uses the average cost method, then direct comparisons of financial data, such as inventory valuations and cost of goods sold, may be misleading. Even with this limitation in mind, comparing financial ratios with other companies or industry averages can provide useful insights. We use the LIFO method to value inventory. We use the average cost method to value inventory.

Limitations of Ratio Analysis Analysts should look beyond the ratios. Changes within the company Industry trends Consumer tastes Technological changes Ratios should not be viewed as an end, but rather as a starting point. They raise many questions and point to opportunities for further analysis, but they rarely answer questions by themselves.   In addition to ratios, other sources of data should also be considered, such as industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the company itself. Economic factors

Profitability Ratios (The Common Stockholder)

Gross Margin Percentage Sales = This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit. Managers often pay close attention to the gross margin percentage, which is computed as gross margin divided by sales. The gross margin percentage tends to be more stable for retailing companies because cost of goods sold excludes fixed costs.

Earnings per (Common) Share (EPS) Net Income* Average Number of Shares Outstanding for the Period EPS = *If there are preferred dividends, the amount is subtracted from net income. EPS $5,761 (1,970 + 2124) ÷ 2 = = $2.81 Part I. Earnings per share is equal to net income less preferred stock dividends divided by the weighted-average number of common shares outstanding. The numerator of the equation is sometimes referred to as income available to common shareholders. Earnings per share is one of the most widely quoted financial ratios. It is a measure of the company’s ability to produce income for each common share outstanding. Part II. Home Depot’s earnings per share for 2007 is $2.81. Home Depot has no preferred stock dividends to subtract from income in the numerator. The average number of shares used in this computation is based on the beginning and ending number of shares for the year rather than the weighted-average number of shares reported in Home Depot’s income statement. 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.

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. P/E Ratio = Current Market Price Per Share Earnings Per Share A recent price for Home Depot stock was $45 per share. P/E Ratio = $45 $2.35 = 19X Part I. Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor. The price/earnings ratio measures the relationship between the current market price of the stock and its earnings per share. Once we know the earnings per share of stock we can calculate the price-earnings ratio by dividing the current market price per share of the company’s stock by the price/earnings ratio. Part II. Using a recent price of $34 per share for Home Depot’s common stock, we divide by the 2007 earnings per share of $2.80 to obtain a price earnings ratio of 12.1. We conclude that Home Depot’s common stock is selling in the market place for 12.1 times its earnings for 2007. This ratio measures the relationship between the current market price of the stock and its earnings per share.

Dividend Payout Ratio Dividend Payout Ratio Dividends Per Share Earnings Per Share = Dividend Payout Ratio $2.00 $2.42 = = 82.6% The dividend payout ratio is computed as shown. Investors who seek market price growth would like this ratio to be small, whereas investors who seek dividends prefer it to be large. Norton Corporation’s dividend payout ratio is 82.6 percent. This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking dividends (market price growth) would like this ratio to be large (small).

Dividend Yield Ratio Dividend Yield Dividends Per Share Market Price Per Share = Dividend Yield $0.675 $34 = = 2 % Home Depot paid dividends of $.675 per share when the market price was $34 per share. Part I. Investors are interested in the amount of income that they will receive in the form of dividends. One comparison that investors make is based on dividend yield. To determine the dividend yield ratio we divide the annual dividend per share by the market price per share of the company’s common stock. Part II. During 2007, Home Depot paid dividends of $0.675 per common share of stock outstanding. Dividing $0.675 by the share price of $34 dollars, we find that Home Depot’s dividend yield is 2 percent. This ratio is often used to compare the dividend-paying performance of different investment alternatives.

Net Income + Interest Expense (net of tax) Return on Total Assets Return on Assets Net Income + Interest Expense (net of tax) Average Total Assets = Return on Assets $5,761 + ($392 × (1 - .34)) ($52,263 + $44,405) ÷ 2 = = 12.5% Corporate tax rate is 34%. Part I. We can also determine the return a company earns on its total assets. To calculate this ratio we divide net income plus interest expense (net of tax) by the average total assets for the period. Because creditors provide financing for a portion of the assets, we add interest expense to income in the numerator of the ratio. Part II. Home Depot earned a return on its total assets of 12.5 percent. Please spend a few minutes going over the calculation of this ratio, especially the interest expense computation. Return on total assets measures how well assets have been employed by Home Depot. This ratio is generally considered a measure of a company’s profitability.

Return on Common Stockholders’ Equity Net Income – Preferred Dividends Average Stockholders’ Equity = Return on Common Stockholders’ Equity $53,690 – $0 ($180,000 + $234,390) ÷ 2 = = 25.91% The return on common stockholders’ equity is computed as shown. This measure indicates how well the company used the owners’ investments to earn net income. Norton Corporation’s return on common stockholders’ equity is 25.91 percent for the most recent year. This measure indicates how well the company used the owners’ investments to earn income.

Common Stockholders’ Equity Number of Common Shares Outstanding Book Value Per Share Book Value per Share Common Stockholders’ Equity Number of Common Shares Outstanding = = $8.55 Book Value per Share $234,390 27,400 = The book value per share is computed as shown. It measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts after all creditors were paid off. This measure is based entirely on historical cost. Norton Corporation’s book value per share is $8.55. This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts after all creditors were paid off.

Financial leverage involves acquiring assets with borrowed funds. Return on investment in assets > Interest rate on borrowed funds Positive financial leverage = Return on investment in assets < Interest rate on borrowed funds Negative financial leverage =

Financial Leverage Percentage Return on Equity – Return on Assets = 9.7% = 22.2% – 12.5% Part I. 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. Part II. Home Depot has positive financial leverage since the return on equity is higher than the return on assets. Positive financial leverage indicates that Home Depot has borrowed money at a low rate of interest and employed the borrowed funds at a higher rate of return. 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.

Liquidity Ratios (The Short-Term Creditor)

The excess of current assets over current liabilities is known as Working Capital The excess of current assets over current liabilities is known as working capital. Working capital is not free. It must be financed with long-term debt and equity. The excess of current assets over current liabilities is known as working capital. Working capital is not free. It must be financed with long-term debt and equity. Therefore, managers often seek to minimize working capital. A large and growing working capital balance may not be a good sign. For example, it could be the result of unwarranted growth in inventories.

Current Ratio This ratio measures the ability Current Assets Current Liabilities = Current Ratio $18,000 $12,931 = 1.39 to 1 Part I. Perhaps the most widely used measure of a company’s ability to pay current obligations is the current ratio. It is computed by dividing current assets by current liabilities. Part II. At Home Depot, the current ratio at the 2007 balance sheet date is 1.39. This means that for every dollar of current liabilities, Home Depot has $1.39 of current assets to pay those obligations. It might be tempting to say that the higher this ratio becomes, the better off the company is. However, maintaining a very high current ratio restricts the amount that can be invested elsewhere in the business. For years the accepted standard for the current ratio was 2.0. But with the ability to efficiently manage cash flows, most companies now maintain a current ratio somewhat less than 2.0. This ratio measures the ability of the company to pay current debts as they become due.

Quick Ratio (Acid Test) Quick Assets Current Liabilities = Quick Ratio $3,837 $9,554 = 0.40 to 1 Quick Ratio Part I. The quick ratio is a more stringent measure than the current ratio. We calculate this ratio by dividing quick assets by current liabilities. Quick assets include cash and cash equivalents, net receivables, and short-term investments. Part II. As you can see from looking back at Home Depot’s balance sheet, inventories are approximately three-fourths of current assets. Quick assets exclude inventories from the numerator. For that reason, Home Depot’s quick ratio of 0.40 at the 2007 balance sheet date is much lower than the current ratio. This ratio is like the current ratio but measures the company’s immediate ability to pay debts.

Average Net Receivables Receivable Turnover Net Credit Sales Average Net Receivables Receivable Turnover = Receivable Turnover $90,837 ($3,223 + $2,396) ÷ 2 = 32.3 Times = Part I. The receivable turnover ratio tells us the number of times per year a company can convert its accounts receivable into cash. For any company, the higher the turnover, the faster the cash collection on accounts receivable. We calculate receivable turnover by dividing net credit sales by average net receivables. This is yet another example of a ratio that contains an income measure in the numerator and a balance sheet measure in the denominator. Remember, in this type of ratio we always use an average amount in the denominator. Part II. At Home Depot, the receivable turnover for 2007 is 32.3 times. This means that, on average, the company collected its receivables 32.3 times per year. This ratio measures how quickly a company collects its accounts receivable.

Average Collection Period Days in Year Receivable Turnover Average Collection Period = = 11.3 Days 365 32.3 Average Collection Period = Part I. Average age of receivables is calculated by dividing 365 days by the receivable turnover ratio. This ratio measures the average number of days it takes to collect receivables. Part II. At Home Depot, the average age of receivables is only 11.3 days. This ratio measures the average number of days it takes to collect receivables.

This ratio measures how quickly the company sells its inventory. Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = Inventory Turnover $61,054 ($12,822 + $11,401) ÷ 2 = 5.0 Times = Part I. Like the receivable turnover ratio, we can also calculate the inventory turnover. The inventory turnover ratio measures the number of times inventory is sold and replaced during the year. Higher inventory turnover helps protect a company from obsolete inventory items. Inventory turnover is calculated by dividing cost of goods sold for the period by the average inventory. Part II. At Home Depot, the inventory turnover for 2007 is 5.0 times, telling us that Home Depot sells and replaces its inventory about 5.0 times per year. This ratio measures how quickly the company sells its inventory.

Average Sale Period Average Sale Period Days in Year Inventory Turnover Average Sale Period = = 73 Days 365 5.0 = Average Sale Period Part I. Average days’ supply in inventory is calculated by dividing 365 days by the inventory turnover ratio. This ratio measures the average number of days it takes a company to sell its inventory. Part II. Throughout 2007, Home Depot averaged 73 days of inventory available for sale. This ratio measures the average number of days it takes to sell the inventory.

Solvency Ratios (The Long-Term Creditor)

This ratio indicates a margin of protection for creditors. Times Interest Earned 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 = + $5,761 + $392 + $3,547 $392 Times Interest Earned = = 24.7 Times Part I. Tests of solvency measure a company’s ability to meet its long-term obligations. Times interest earned is a ratio that measures the ability of a company to meet its periodic interest payments. The ratio is calculated by dividing income before interest and taxes by interest expense for the period. Since interest expense is deducted before computing taxes and net income, we add both interest expense and income tax expense back to net income for the numerator of this ratio. Part II. In 2007, Home Depot earned 24.7 times the amount of its interest expense. This ratio indicates a margin of protection for creditors.

Debt-to-Equity Ratio Total Liabilities Stockholders’ Equity = $27,233 $25,030 = 1.09 = Debt-to-Equity Ratio Part I. The debt-to-equity ratio measures the amount of liabilities that exists for each $1 invested by the owners. We compute the ratio by dividing total liabilities by total stockholders’ equity. Part II. At the 2007 balance sheet date, Home Depot’s debt to equity ratio is 1.09, meaning the company’s creditors have provided more capital than the shareholders of Home Depot. This ratio measures the amount of liabilities that exists for each $1 invested by the owners.

End of Chapter 15 End of Chapter 15.