© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Chapter 14 Analyzing Financial Statements

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background FINANCIAL STATEMENT USERS... uses accounting data to make product pricing and expansion decisions.... use accounting data for investment, credit, tax, and public policy decisions. EXTERNAL DECISION MAKERS MANAGEMENT

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background THREE TYPES OF FINANCIAL STATEMENT INFORMATION Past Performance Present Condition Future Performance Income, sales volume, cash flows, return on investment, EPS. Assets, debt, inventory, various ratios. Sales and earnings trends are good indicators of future performance.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background Investors Dividends Increase in share price Return on an equity security investment

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Business Background Economy-wide Factors Industry Factors Individual Company Factors Invest? NoYes

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson 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.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson ROE Profit Driver Analysis ROE Net Profit Margin Asset Turnover Financial Leverage =×× Net Income Average Shareholders’ Equity Net Income Average Shareholders’ Equity Net Income Net Sales Net Income Net Sales Average Total Assets Net Sales Average Total Assets Average Shareholders’ Equity Average Total Assets Average Shareholders’ Equity ×× =

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Profit Drivers and Business Strategy High-value or product-differentiation Rely on R&D and product promotion to convince customers of the superiority of the company’s products. of the company’s products. High-value or product-differentiation Rely on R&D and product promotion to convince customers of the superiority of the company’s products. of the company’s products. Low-Cost Rely on efficient management of accounts receivable, inventory and productive assets to produce high asset turnover. Low-Cost Rely on efficient management of accounts receivable, inventory and productive assets to produce high asset turnover.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson 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 company’s relative performance.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Financial Statement Analysis Financial statement analysis is based on comparisons. Time series analysis Comparison with similar companies Company A Company B

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Ratio and Percentage Analyses Ratio analysis, or percentage analysis, is used to express the proportionate relationship between two different amounts.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson 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

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Component Percentages Example The comparative income statements of Home Depot 2002 and 2001 appear on the next slide. Prepare component percentage income statements where net sales equal 100%. The comparative income statements of Home Depot 2002 and 2001 appear on the next slide. Prepare component percentage income statements where net sales equal 100%. Home Depot

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Component Percentages

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Component Percentages 2002 Cost ÷ 2002 Sales

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Component Percentages

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Now, let’s look at some commonly used ratios.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Commonly Used Ratios The 2002 and 2001 balance sheets for Home Depot are presented next. We will be referring to these financial statements throughout the ratio analyses. The 2002 and 2001 balance sheets for Home Depot are presented next. We will be referring to these financial statements throughout the ratio analyses. Home Depot

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Comparative Statements Continued

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Comparative Statements

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Tests of Profitability Profitability is a primary measure of the overall success of a company. Now, let’s look at the profitability ratios for Home Depot for Profitability is a primary measure of the overall success of a company. Now, let’s look at the profitability ratios for Home Depot for Home Depot

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Return on Equity $3,044 ($15,004 + $18,082) / 2 == 18.4% Income* Average Owners’ Equity Return on Equity = This measure indicates how much income was earned for every dollar invested by the owners. This measure indicates how much income was earned for every dollar invested by the owners. *Income before extraordinary items

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Return on Assets Income + Interest Expense (net of tax) Average Total Assets = Return on Assets $3,044 + ($28 ×(1 -.39)) ($21,385 + $26,394) ÷ 2 = = 12.8% This ratio is generally considered the best overall measure of a company’s profitability. This ratio is generally considered the best overall measure of a company’s profitability. Corporate tax rate is 39 percent.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Financial Leverage Financial Leverage Return on Equity – Return on Assets= 5.6% = 18.4% – 12.8% Financial leverage is the advantage or disadvantage that occurs as a result of earning a return on equity that is different from the return on assets.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Earnings per Share (EPS) Income Available to Common Shareholders Weighted Average Number of Common Shares Outstanding EPS= $3,044 2,335 == $1.30 Earnings per share is probably the single most widely watched financial ratio.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Quality of Income Cash Flow from Operating Activities Net Income =

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Quality of Income Cash Flow from Operating Activities Net Income = Quality of Income $5,693 $3,044 == 1.96 A ratio higher than 1 indicates higher-quality earnings.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Profit Margin = 5.7% Profit Margin $3,044 $53,553 = This ratio describes a company’s ability to earn income from sales. Profit Margin Income (before Extraordinary Items) Net Sales =

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Fixed Asset Turnover Ratio Fixed Asset Turnover $53,553 ($13,068 + $15,375) ÷ 2 == 3.77 Fixed Asset Turnover Net Sales Revenue Average Net Fixed Assets = This ratio measures a company’s ability to generate sales given an investment in fixed assets.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson ROE Profit Driver Analysis ROE Net Profit Margin Asset Turnover Financial Leverage =×× Net Income Average Shareholders’ Equity Net Income Average Shareholders’ Equity Net Income Net Sales Net Income Net Sales Average Total Assets Net Sales Average Total Assets Average Shareholders’ Equity Average Total Assets Average Shareholders’ Equity ×× = ROE = x x = or 18.4%

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Tests of Liquidity Tests of liquidity focus on the relationship between current assets and current liabilities. Now, let’s look at the liquidity ratios for Home Depot for Tests of liquidity focus on the relationship between current assets and current liabilities. Now, let’s look at the liquidity ratios for Home Depot for Home Depot

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Cash Ratio Cash Ratio Cash + Cash Equivalents Current Liabilities ==0.38 Cash Ratio $2,472 $6,501 = This ratio measures the adequacy of available cash.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Current Ratio Current Ratio Current Assets Current Liabilities = Current Ratio $10,361 $6,501 = =1.59 This ratio measures the ability of the company to pay current debts as they become due. This ratio measures the ability of the company to pay current debts as they become due.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Quick Ratio (Acid Test) Quick Assets Current Liabilities = Quick Ratio $3,466 $6,501 =.53: 1= Quick Ratio Quick assets are Cash, Accounts Receivable, Notes Receivable, and Short-term Investments. This ratio is like the current ratio but measures the company’s ability to pay its current debts quickly. This ratio is like the current ratio but measures the company’s ability to pay its current debts quickly.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Receivable Turnover Net Credit Sales Average Net Trade Receivables Receivable Turnover = $53,553 ($835 + $920) ÷ 2 = 61 times = This ratio measures how quickly a company collects its accounts receivable.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Average Age of Receivables Days in Year Receivable Turnover Average Age of Receivables = = 6 days Average Age of Receivables = This ratio measures the average number of days it takes to collect receivables.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = $37,406 ($6,556 + $6,725) ÷ 2 = 5.6 times = This ratio measures how quickly the company sells its inventory.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Average Days’ Supply in Inventory Days in Year Inventory Turnover Average Days’ Supply in Inventory == 65 days = Average Days’ Supply in Inventory This ratio measures the average number of days it takes to sell the inventory.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Tests of Solvency and Equity Position Tests of solvency measure a company’s ability to meet its obligations. Now, let’s look at the solvency ratios for Home Depot for Tests of solvency measure a company’s ability to meet its obligations. Now, let’s look at the solvency ratios for Home Depot for Home Depot

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson This ratio indicates a margin of protection for creditors. Times Interest Earned Net Interest Income Tax Income Expense Expense Interest Expense Times Interest Earned = ++ $3,044 + $28 + $1,913 $28 Times Interest Earned = = 178

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid =

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Cash Coverage = $5,693 + $18 + $1,685 $18 = 425 Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid = This ratio compares the cash generated with the interest obligations of the period.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Debt-to-Equity Ratio Total Liabilities Owners’ Equity Debt-to-Equity Ratio = $8,312 $18,082 = 0.46 Debt-to-Equity Ratio = This ratio measures the amount of liabilities that exists for each $1 invested by the owners.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Market Tests Market tests relate the current market price per common share to an indicator of the return that might accrue to the investor. Now, let’s look at the market tests for Home Depot for Market tests relate the current market price per common share to an indicator of the return that might accrue to the investor. Now, let’s look at the market tests for Home Depot for Home Depot

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Price/Earnings (P/E) Ratio P/E Ratio = Current Market Price Per Share Earnings Per Share P/E Ratio = $46.31 $1.30 = 35.6 This ratio measures the relationship between the current market price per share and the company’s earnings per share.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Dividend Yield Ratio Dividend Yield Dividends Per Share Market Price Per Share = Dividend Yield $0.17 $46.31 = = 0.37% This ratio is often used to compare the dividend-paying performance of different investment alternatives.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Miscellaneous Ratios Financial analysts may calculate many other financial ratios to help evaluate and compare investment opportunities. Now, let’s look at book value per share as an example of such a ratio for Home Depot for Financial analysts may calculate many other financial ratios to help evaluate and compare investment opportunities. Now, let’s look at book value per share as an example of such a ratio for Home Depot for Home Depot

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Book Value per Share $18,082 2,335 = = $7.74 Book Value per Share Common Shareholders’ Equity Number of Common Shares Outstanding = Book value per share measures the owners’ equity per common share. Book value per share has no relationship to market value.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Other Analytical Considerations In addition to financial ratios, special factors might affect the evaluation of a company: Rapid growth. Uneconomical expansion. Subjective factors. In addition to financial ratios, special factors might affect the evaluation of a company: Rapid growth. Uneconomical expansion. Subjective factors.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Interpreting Ratios 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. 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.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson Efficient Markets A securities market in which prices fully reflect available information is called an efficient market. In an efficient market, the price of the company’s shares reacts quickly when new, relevant information is released about the company.

© McGraw-Hill Ryerson Limited, 2003 McGraw-Hill Ryerson End of Chapter 14 Ratios