Transcript Libby Chapter 14 - University of Minnesota

Analyzing
Financial
Statements
Chapter 14
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
14-2
Understanding The Business
Industry
Factors
No
Individual
Company
Factors
Invest?
Economy-wide
Factors
Yes
14-3
Understanding The Business
Return on an equity
security investment
Increase in
share price
Dividends
Investors
14-4
Learning Objectives
Explain how a company’s business
strategy affects financial analysis.
14-5
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.
14-6
Understanding a Company’s Strategy
Business
Strategy
Operating
Decisions
Transactions
Financial
Statements
14-7
Learning Objectives
Discuss how analysts use financial statements.
14-8
Financial Statement Analysis
FINANCIAL STATEMENT USERS
MANAGEMENT
EXTERNAL DECISION
MAKERS
. . . uses accounting data
to make product pricing
and expansion
decisions.
. . . use accounting data
for investment, credit,
tax, and public policy
decisions.
14-9
Financial Statement Analysis
THREE TYPES OF FINANCIAL
STATEMENT INFORMATION
Past
Performance
Income, sales
volume, cash
flows, returnon-investments,
EPS.
Present
Condition
Assets, debt,
inventory,
various ratios.
Future
Performance
Sales and earnings
trends are good
indicators of future
performance.
14-10
Financial Statement Analysis
Financial statement analysis
is based on comparisons.
Time series
analysis
Examines a single
company to identify
trends over time.
Comparison with
similar companies
14-11
Financial Statement Analysis
Financial statement analysis
is based on comparisons.
Time series
analysis
Company
A
Company
B
Comparison with
similar companies
Provides insights
concerning a
company’s relative
performance.
14-12
Ratio and Percentage Analyses
Ratio analysis, or percentage
analysis, is used to express the
proportionate relationship between
two different amounts.
14-13
Learning Objectives
Compute and interpret component
percentages.
14-14
Component Percentages
Express each item on a particular statement as
a percentage of a single base amount.
Net sales
on the income
statement
Total assets
on the balance
sheet
14-15
Component Percentages
The comparative income statements
of Home Depot for 2004 and 2003
appear on the next slide.
Prepare component percentage income
statements where net sales equal
100%.
Home Depot
14-16
Component Percentages
HOME DEPOT
Comparative Income Statements (Condensed)
Amounts in Millions Except Per Share Data
2004
Percent
2003
Percent
Net Sales
$ 64,816
100.0% $ 58,247
100.0%
Cost of Merchandise Sold
44,236
40,139
Gross Profit
20,580
18,108
Operating Expenses
13,734
12,278
Operating Income
6,846
5,830
Interest and Investment Income
59
79
Interest Expense
(62)
(37)
Earnings Before Income Taxes
6,843
5,872
Income Taxes
2,539
2,208
Net Earnings
$ 4,304
$ 3,664
Basic Earnings Per Share
$
1.88
$
1.57
Weighted-Average Number of
Common Shares Outstanding
2,283
2,336
Diluted Earnings Per Share
$
1.88
$
1.56
14-17
Component Percentages
HOME DEPOT
Comparative Income Statements (Condensed)
Amounts in Millions Except Per Share Data
2004
Percent
2003
Percent
Net Sales
$ 64,816
100.0% $ 58,247
100.0%
Cost of Merchandise Sold
44,236
68.2%
40,139
Gross Profit
20,580
18,108
Operating Expenses
13,734
12,278
Operating Income
6,846
5,830
Interest and Investment Income
59
79
Interest Expense
(37)
2004(62)
Cost ÷ 2004 Sales
Earnings Before Income Taxes
6,843
5,872
Income Taxes
2,539
2,208
Net Earnings
$ 4,304
$ 3,664
Basic Earnings Per Share
$
1.88
$
1.57
Weighted-Average Number of
Common Shares Outstanding
2,283
2,336
Diluted Earnings Per Share
$
1.88
$
1.56
14-18
Component Percentages
HOME DEPOT
Comparative Income Statements (Condensed)
Amounts in Millions Except Per Share Data
2004
Percent
2003
Percent
Net Sales
$ 64,816
100.0% $ 58,247
100.0%
Cost of Merchandise Sold
44,236
68.2%
40,139
68.9%
Gross Profit
20,580
31.8%
18,108
31.1%
Operating Expenses
13,734
21.2%
12,278
21.1%
Operating Income
6,846
10.6%
5,830
10.0%
Interest and Investment Income
59
0.1%
79
0.1%
Interest Expense
(62)
-0.1%
(37)
-0.1%
Earnings Before Income Taxes
6,843
10.6%
5,872
10.1%
Income Taxes
2,539
3.9%
2,208
3.8%
Net Earnings
$ 4,304
6.7% $ 3,664
6.3%
Basic Earnings Per Share
$
1.88
$
1.57
Weighted-Average Number of
Common Shares Outstanding
2,283
2,336
Diluted Earnings Per Share
$
1.88
$
1.56
14-19
Now, let’s
look at some
commonly
used ratios.
14-20
Commonly Used Ratios
The 2004 and 2003 balance sheets for
Home Depot are presented next.
We will be referring to these financial
statements throughout the ratio
analyses.
Home Depot
14-21
Comparative Statements
HOME DEPOT
Comparative Balance Sheets (Condensed)
Amounts in Millions
2004
Assets
Cash and Cash Equivalents
Short-Term Investments
Receivables, net
Merchandise Inventories
Other Current Assets
Total Current Assets
Property and Equipment, at cost
Less Accumulated Depreciation
Net Property and Equipment
Other Assets
Total Assets
2003
$
2,826 $ 2,188
26
65
1,097
1,072
9,076
8,338
303
254
13,328
11,917
24,594
20,733
4,531
3,565
20,063
17,168
1,046
926
$ 34,437 $ 30,011
Continued
14-22
Comparative Statements
HOME DEPOT
Comparative Balance Sheets (Condensed)
Amounts in Millions
2004
2003
Liabilities
Current Liabilities
Noncurrent Liabilities
Total Liabilities
Stockholders' Equity
Common Stock, $.05 par
Paid-in Capital
Retained Earnings
Accumulated Other Comprehensive Income
Unearned Compensation
Total
Less: Treasury Stock
Total Stockholders' Equity
Total Liabilities & Stockholders' Equity
$
9,554 $ 8,035
2,476
2,174
12,030
10,209
119
6,184
19,680
90
(76)
25,997
(3,590)
22,407
$ 34,437 $
118
5,858
15,971
(82)
(63)
21,802
(2,000)
19,802
30,011
14-23
Learning Objectives
Compute and interpret profitability ratios.
14-24
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 2004.
Home Depot
14-25
Return on Equity
Net Income
Return on Equity =
Average Owners’ Equity
Return on Equity =
$4,304
($22,407 + $19,802) ÷ 2
This measure indicates how much
income was earned for every dollar
invested by the owners.
= 20.4%
14-26
Return on Assets
Return on
Assets
Return on
Assets
=
Net Income + Interest Expense (net of tax)
Average Total Assets
=
$4,304 + ($62 × (1 - .34))
= 13.5%
($34,437 + $30,011) ÷ 2
Corporate tax rate
is 34%.
This ratio is generally considered
the best overall measure of a
company’s profitability.
14-27
Financial Leverage Percentage
Financial
Leverage
6.9%
=
Return on Equity – Return on Assets
=
20.4% – 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.
14-28
Earnings per Share (EPS)
EPS =
EPS =
Net Income
Average Number of Shares of
Common Stock Outstanding
$4,304
2,283
= $1.88
Average number of shares outstanding is
from Home Depot’s 2004 Income Statement.
Earnings per share is probably the single
most widely watched financial ratio.
14-29
Quality of Income
Quality
=
of Income
Cash Flow from Operating Activities
Net Income
Cash Flow from Operating Activities
Net Income
$ 4,304
Add:
Depreciation and Amortization
1,076
Decrease in Receivables, net
25
Increase in Accounts Payable
790
Increase in Deferred Revenue
279
Increase in Deferred Income Taxes
605
Other
186
Deduct: Increase in Merchandise Inventories
(693)
Decrease in Income Taxes Payable
(27)
Cash Flow from Operating Activities
$ 6,545
14-30
Quality of Income
Quality
=
of Income
Cash Flow from Operating Activities
Quality
=
of Income
$6,545
Net Income
$4,304
= 1.52
A ratio higher than 1 indicates
high-quality earnings.
14-31
Profit Margin
Profit
=
Margin
Net Income
Profit
=
Margin
$4,304
Net Sales
= 6.6%
$64,816
This ratio tells us the
percentage of each sales
dollar that is income.
14-32
Fixed Asset Turnover
Fixed
=
Asset
Turnover
Net Sales Revenue
Average Net Fixed Assets
Fixed
=
Asset
Turnover
$64,816
($20,063 + $17,168) ÷ 2
= 3.5
This ratio measures a company’s
ability to generate sales given an
investment in fixed assets.
14-33
Learning Objectives
Compute and interpret liquidity ratios.
14-34
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 2004.
Home Depot
14-35
Cash Ratio
Cash
Ratio
Cash
Ratio
Cash + Cash Equivalents
=
Current Liabilities
=
$2,826
$9,554
=
0.296 to 1
This ratio measures the
adequacy of available cash.
14-36
Current Ratio
Current
Ratio
Current
Ratio
=
=
Current Assets
Current Liabilities
$13,328
$9,554
=
1.39 to 1
This ratio measures the ability
of the company to pay current
debts as they become due.
14-37
Quick Ratio (Acid Test)
Quick
Ratio
=
Quick Assets
Current Liabilities
Quick
Ratio
=
$3,949
$9,554
Cash & Cash Equivalents
Receivables, net
Short-term Investments
Quick Assets
=
0.41 to 1
$ 2,826
1,097
26
$ 3,949
This ratio is like the current
ratio but measures the company’s
immediate ability to pay debts.
14-38
Receivable Turnover
Receivable
Turnover
Receivable
Turnover
=
=
Net Credit Sales
Average Net Receivables
$64,816
($1,097 + $1,072) ÷ 2
This ratio measures how
quickly a company collects its
accounts receivable.
= 60 Times
14-39
Average Age of Receivables
Average Age
of Receivables
Average Age
of Receivables
=
=
Days in Year
Receivable Turnover
365
59.8
= 6.1 Days
This ratio measures the average
number of days it takes to
collect receivables.
14-40
Inventory Turnover
Inventory
Turnover
Cost of Goods Sold
=
Average Inventory
Inventory
Turnover
$44,236
=
($9,076 + $8,338) ÷ 2
= 5.1 Times
This ratio measures how
quickly the company sells its
inventory.
14-41
Average Days’ Supply in Inventory
Average Days’
Supply in
Inventory
Average Days’
Supply in
Inventory
=
=
Days in Year
Inventory Turnover
365
5.1
=
71.6 Days
This ratio measures the
average number of days it
takes to sell the inventory.
14-42
Accounts Payable Turnover
Accounts
Payable
Turnover
=
Accounts
Payable
Turnover
$44,236
=
($5,159 + $4,560) ÷ 2
Cost of Goods Sold
Average Accounts Payable
= 9.1 Times
This ratio measures how
quickly the company pays its
accounts payable.
14-43
Average Age of Payables
Average Age
of Payables
Average Age
of Payables
=
=
Days in Year
Accounts Payable Turnover
365
9.1
=
40.1 Days
This ratio measures the
average number of days it
takes to pay its suppliers.
14-44
Learning Objectives
Compute and interpret solvency ratios.
14-45
Tests of Solvency
Tests of solvency measure a company’s
ability to meet its long-term obligations.
Now, let’s look at the solvency ratios for
Home Depot for 2004.
Home Depot
14-46
Times Interest Earned
Times
Interest
Earned
Times
Interest
Earned
=
=
Net
Interest
Income Tax
+
+
Income
Expense
Expense
Interest Expense
$4,304 + $62 + $2,539
$62
= 111 Times
This ratio indicates a margin
of protection for creditors.
14-47
Cash Coverage
Cash
=
Coverage
Cash Flow from Operating Activities
Before Interest and Taxes
Interest Paid
Cash Flow from Operating Activities
Net Income
$ 4,304
Add:
Depreciation and Amortization
1,076
Decrease in Receivables, net
25
Increase in Accounts Payable
790
Increase in Deferred Revenue
279
Increase in Deferred Income Taxes
605
Other
186
Deduct: Increase in Merchandise Inventories
(693)
Decrease in Income Taxes Payable
(27)
Cash Flow from Operating Activities
$ 6,545
14-48
Cash Coverage
Cash
=
Coverage
Cash
=
Coverage
Cash Flow from Operating Activities
Before Interest and Taxes
Interest Paid
$6,545 + $70 + $2,539
$70
Cash interest paid
Income tax expense
$
= 131
70
2,539
This ratio compares the cash generated
with the cash obligations of the period.
14-49
Debt-to-Equity Ratio
Debt-to-Equity
Ratio
Debt-to-Equity
Ratio
=
=
Total Liabilities
Owners’ Equity
$12,030
$22,407
=
0.54
This ratio measures the amount of
liabilities that exists for each $1
invested by the owners.
14-50
Learning Objectives
Compute and interpret market test ratios.
14-51
Market Tests
Market tests relate the current market price of
a share of stock to an indicator of the return
that might accrue to the investor.
Now, let’s look at the market tests for
Home Depot for 2004.
Home Depot
14-52
Price/Earnings (P/E) Ratio
P/E Ratio
P/E Ratio
=
Current Market Price Per Share
Earnings Per Share
=
$40
$1.88
=
21
A recent price for Home Depot
stock was $40 per share.
This ratio measures the relationship
between the current market price of the
stock and its earnings per share.
14-53
Dividend Yield Ratio
Dividend
Yield
Dividend
Yield
=
Dividends Per Share
Market Price Per Share
=
$0.27
$40
=
0.68%
Home Depot paid dividends of $.27 per share
when the market price was $40 per share.
This ratio is often used to compare
the dividend-paying performance of
different investment alternatives.
14-54
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.
14-55
Other Financial Information
In addition to financial ratios, special factors
might affect company analysis:
 Rapid
growth.
 Uneconomical expansion.
 Subjective factors.
14-56
Efficient Markets
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.
14-57
End of Chapter 14