14 Financial Statement Analysis Bodie, Kane, and Marcus Essentials of Investments, 9th Edition

14.1 Major Financial Statements Income Statement Financial statement showing firm’s revenues and expenses during specified period Economic Earnings Real flow of cash firm could pay without impairing productive capacity Accounting Earnings Earnings of a firm as reported on income statement

14.1 Major Financial Statements Balance Sheet Accounting statement of firm’s financial position at specified time Statement of Cash Flows Financial statement showing firm’s cash receipts and cash payments during specified period

Table 14.1 Home Depot’s Income Statement Percent of $ Million Revenue Operating Revenues Net sales 67,997 100.0% Operating Expenses Cost of goods sold 42,975 63.2% Selling, general, & administrative expenses 15,849 23.3% Other 1,652 2.4% Depreciation 1,718 2.5% Earnings before interest and income taxes 5,803 8.5% Interest expense 530 0.8% Taxable income 5,273 7.8% Taxes 1,935 2.8% Net income 3,338 4.9% Allocation of net income Dividends 1,569 2.3% Addition to retained earnings 1,769 2.6% Note: Sums subject to rounding error

Table 14.2 Home Depot’s Balance Sheet Panel A: (millions of dollars) Percent of Assets $ million total assets Liabilities and shareholders' equity Current assets Cash and marketable securities 545 1.4% Current liabilities Receivables 1,085 2.7% Debt due for repayment 1,042 2.6% Inventories 10,625 26.5% Accounts payable 7,903 19.7% Other current assets 1,224 3.1% Other current liabilities 1,177 2.9% Total current assets 13,479 33.6% Total current liabilities 10,122 25.2% Fixed assets Long-term debt 8,707 21.7% Tangible fixed assets Other long-term liabilities 2,407 6.0% Property, plant, and equipment 25,060 62.5% Long-term Investments 139 0.3% Total liabilities 21,236 52.9% Total tangible fixed assets 25,199 62.8% Shareholders' equity Intangible fixed assets Common stock and other paid-in capital 3,894 9.7% Goodwill 1,187 3.0% Retained earnings 14,995 37.4% Total shareholders' equity 18,889 47.1% Total fixed assets 26,386 65.8% Total liabilities and shareholders' equity 40,125 100.0% Other assets 260 0.6% Total assets Source: Home Depot Annual Report, year ending January 2011

Table 14.3 Home Depot’s Statement of Cash Flows $ Million Cash provided by operations Net income $3,338 Adjustments to net income Depreciation 1,718 Changes in working capital Decrease (increase) in receivables (102) Decrease (increase) in inventories (355) Increase (decrease) in other current liabilities (269) Changes due to other operating activities 255 Total adjustments $1,247 4,585 Cash flows from investments Gross investment in tangible fixed assets ($1,096) Investments in other assets 84 Cash provided by (used for) investments ($1,012) Cash provided by (used for) financing activities Additions to (reductions in) long-term debt ($31) Net issues (repurchases of) shares (2,504) Dividends (1,569) Other (347) ($4,451) Net increase in cash ($878) Source: Home Depot Annual Report, year ending January 2011.

14.2 Measuring Firm Performance Investment Decisions Efficiency of assets Profitability of sales Financing Decisions Leverage Liquidity

Figure 14.1 Ratios

14.3 Profitability Measures  

Table 14.4 Nodett’s Profitability over Business Cycle

Table 14.5 Impact of Financial Leverage on ROE *Somdett’s after-tax profits equal .6(EBIT − $3.2 million). †Somdett’s equity is only $60 million.

14.3 Profitability Measures Economic Value Added Measure of dollar value of firm’s return in excess of opportunity cost Also known as residual income Spread between ROA and cost of capital multiplied by capital invested in firm

Table 14.6 Economic Value Added, 2011   EVA ($ billion) Capital ($ billion) ROA (%) Cost of Capital (%) ExxonMobil 6.90 171.31 10.8 6.8 Intel 4.29 52.87 16.1 8.0 Walmart 3.87 125.80 8.6 5.5 GlaxoSmithKline 3.02 34.75 15.3 6.6 Google 2.60 61.38 12.0 7.7 Hewlett Packard -0.91 68.86 5.9 7.2 AT&T -1.60 183.99 4.6 Honda -3.63 105.20 1.7 5.1 Source: Authors' calculations using data from finance.yahoo.com

14.4 Ratio Analysis  

14.4 Ratio Analysis Decomposition of ROE Total asset turnover (ATO) Annual sales generated by each dollar of assets (Sales/Assets) Interest coverage ratio Financial leverage measure EBIT divided by interest expenses

14.4 Ratio Analysis Decomposition of ROE Leverage ratio Measure of debt to total capitalization of firm ROE = Tax burden × Interest burden × Margin × Turnover × Leverage ROA = Margin × Turnover

Figure 14.2 Median ROA, Profit Margin, and Asset Turnover for 23 Industries

Table 14.7 Ratio Decomposition Analysis for Nodett and Somdett

Table 14.8 Differences between Profit Margin and Asset Turnover across Industries

14.4 Ratio Analysis  

14.4 Ratio Analysis Liquidity Ratios Liquidity: Ability to convert assets into cash at short notice Current ratio: Current assets/Current liabilities Quick ratio: Measure of liquidity similar to current ratio; excludes inventories Cash ratio: Cash and marketable securities to current liabilities

Table 14.9 Growth Industries Financial Statements 2011 2012 2013 2014

14.4 Ratio Analysis  

Table 14.10A Summary of Financial Ratios

Table 14.10B Summary of Financial Ratios

Figure 14.3 DuPont Composition for Home Depot Turnover x 10

Table 14.11 Financial Ratios: Major Industry Groups   LT Debt Assets Interest Coverage Current Ratio Quick Asset Turnover Profit Margin (%) Return on Assets (%) Equity (%) Payout All manufacturing 0.21 5.01 1.42 0.98 0.84 8.03 6.78 17.12 0.27 Food products 0.29 3.83 1.28 0.76 1.15 5.95 6.87 5.59 0.87 Clothing 0.19 7.02 2.32 1.31 9.29 11.91 22.03 Printing/publishing 0.40 3.04 1.52 1.19 1.32 7.40 9.75 25.69 0.23 Chemicals 0.26 4.41 0.94 0.51 14.08 7.14 17.38 0.30 Drugs 0.25 4.47 1.00 0.35 20.44 7.08 16.26 0.28 Machinery 0.17 5.18 1.39 0.92 0.83 8.78 7.25 16.27 Electrical 0.12 4.37 1.17 0.75 7.06 3.63 11.47 0.59 Motor vehicles 0.14 4.28 1.29 0.99 4.15 4.86 22.58 Computer and electronic 0.15 5.12 1.62 1.33 0.55 7.42 4.11 15.23 0.18 Source: U.S. Department of Commerce, Quarterly Financial Report for Manufacturing, Mining and Trade Corporations, third quarter 2011. Available at http://www2.census.gov/econ/qfr/current/qfr_pub.pdf

14.5 Illustration of Financial Statement Analysis Example: Growth Industries Sales, assets, operating income increased 20% ROE declining ROA not declining Rapid increase in year-to-year short-term debt and interest expense

Table 14.12 Key Financial Ratios: Growth Industries

Table 14.13 Growth Industries Cash Flows

14.6 Comparability Problems Inventory Valuation LIFO Last-in first-out inventory valuation FIFO First-in first-out inventory valuation

14.6 Comparability Problems Depreciation Economic Amount of operating cash flow that must be reinvested in firm to sustain real cash flow Accounting Amount of acquisition cost of asset that is allocated to each accounting period over arbitrarily specified life of asset

14.6 Comparability Problems Fair Value Accounting Use of current market values rather than historic costs in firm’s financial statements Relies heavily on estimates

14.6 Comparability Problems Quality of Earnings Realism and sustainability of reported earnings Factors that affect quality of earnings Allowance for bad debt Nonrecurring items Earnings smoothing Revenue recognition Off-balance-sheet assets and liabilities

14.6 Comparability Problems International Accounting Conventions Reserving practices Subject to more managerial discretion in U.S. Depreciation Other countries do not allow dual sets of accounts Most firms in foreign countries use accelerated depreciation Intangibles Treatment varies wildly from country to country

14.6 Comparability Problems International Accounting Conventions International Financial Reporting Standards (IFRS) Principles-based set of accounting rules adopted by around 100 countries, including European Union

Figure 14.4 Adjusted versus Reported Price-Earnings Ratios