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Analyzing Financial Statements

Analyzing Financial Statements. Chapter 14. Individual Company Factors. Industry Factors. Economy-wide Factors. Understanding The Business. Invest?. No. Yes. Increase in share price. Dividends. Investors. Understanding The Business. Return on an equity security investment.

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Analyzing Financial Statements

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  1. AnalyzingFinancialStatements Chapter 14

  2. IndividualCompanyFactors IndustryFactors Economy-wideFactors Understanding The Business Invest? No Yes

  3. Increase inshare price Dividends Investors Understanding The Business Return on an equitysecurity investment

  4. Learning Objectives Explain how a company’s businessstrategy affects financial analysis. LO1

  5. I need to know the company’s policies on product differentiation, pricing, and cost control to make my financial analysis more meaningful. Understanding a Company’s Strategy

  6. Understanding a Company’s Strategy BusinessStrategy OperatingDecisions Transactions FinancialStatements

  7. Learning Objectives Discuss how analysts use financial statements. LO2

  8. . . . uses accounting data to make product pricing and expansion decisions. . . . use accounting data for investment, credit, tax, and public policy decisions. Financial Statement Analysis FINANCIAL STATEMENT USERS MANAGEMENT EXTERNAL DECISION MAKERS

  9. Financial Statement Analysis THREE TYPES OF FINANCIAL STATEMENT INFORMATION PastPerformance PresentCondition FuturePerformance Income, sales volume, cash flows, return- on-investments,EPS. Assets, debt, inventory, various ratios. Sales and earnings trends are good indicators of future performance.

  10. Financial statement analysisis based on comparisons. Time seriesanalysis Comparison with similar companies Financial Statement Analysis Examines a single company to identify trends over time.

  11. Time seriesanalysis Comparison with similar companies Company A Company B Financial Statement Analysis Financial statement analysisis based on comparisons. Provides insightsconcerning acompany’s relativeperformance.

  12. Ratio analysis, or percentage analysis, is used to express the proportionate relationship between two different amounts. Ratio and Percentage Analyses

  13. Learning Objectives Compute and interpret component percentages. LO3

  14. Express each item on a particular statement as a percentage of a single base amount. Net saleson the incomestatement Total assetson the balancesheet Component Percentages

  15. 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 Component Percentages

  16. Component Percentages

  17. Component Percentages 2004 Cost ÷ 2004 Sales

  18. Component Percentages

  19. Now, let’s look at some commonly used ratios.

  20. 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 Commonly Used Ratios

  21. Continued Comparative Statements

  22. Comparative Statements

  23. Learning Objectives Compute and interpret profitability ratios. LO4

  24. 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 Tests of Profitability

  25. Net Income Average Owners’ Equity Return on Equity = $4,304 ($22,407 + $19,802) ÷ 2 Return on Equity = = 20.4% Return on Equity This measure indicates how much income was earned for every dollar invested by the owners.

  26. Return on Assets Net Income + Interest Expense (net of tax) Average Total Assets = Return on Assets $4,304 + ($62 × (1 - .34)) ($34,437 + $30,011) ÷ 2 = = 13.5% Return on Assets Corporate tax rate is 34%. This ratio is generally considered the best overall measure of a company’s profitability.

  27. Financial Leverage = Return on Equity – Return on Assets Financial Leverage Percentage 6.9% = 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.

  28. Net Income AverageNumber of Shares ofCommon Stock Outstanding EPS = $4,304 2,283 EPS = = $1.88 Earnings per Share (EPS) 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.

  29. Qualityof Income Cash Flow from Operating Activities Net Income = Quality of Income

  30. Qualityof Income Cash Flow from Operating Activities Net Income = Qualityof Income $6,545 $4,304 = = 1.52 Quality of Income A ratio higher than 1 indicates high-quality earnings.

  31. Net Income Net Sales Profit Margin = $4,304 $64,816 Profit Margin = 6.6% = Profit Margin This ratio tells us the percentage of each salesdollar that is income.

  32. FixedAssetTurnover Net Sales RevenueAverage Net Fixed Assets = FixedAssetTurnover $64,816($20,063 + $17,168) ÷ 2 = = 3.5 Fixed Asset Turnover This ratio measures a company’s ability to generate sales given an investment in fixed assets.

  33. Learning Objectives Compute and interpret liquidity ratios. LO5

  34. Tests of liquidity focus on the relationship between current assets and current liabilities. Now, let’s look at the liquidity ratiosfor Home Depot for 2004. Home Depot Tests of Liquidity

  35. Cash Ratio Cash + Cash Equivalents Current Liabilities = Cash Ratio $2,826 $9,554 = = 0.296 to 1 Cash Ratio This ratio measures theadequacy of available cash.

  36. Current Ratio Current Assets Current Liabilities = Current Ratio $13,328 $9,554 = = 1.39 to 1 Current Ratio This ratio measures the ability of the company to pay current debts as they become due.

  37. Quick Ratio Quick Assets Current Liabilities = Quick Ratio $3,949 $9,554 = = 0.41 to 1 Quick Ratio (Acid Test) This ratio is like the current ratio but measures the company’s immediate ability to pay debts.

  38. Net Credit Sales Average Net Receivables Receivable Turnover = $64,816 ($1,097 + $1,072) ÷ 2 Receivable Turnover = 60 Times = Receivable Turnover This ratio measures how quickly a company collects its accounts receivable.

  39. Average Age of Receivables Days in Year Receivable Turnover = 36559.8 Average Age of Receivables = 6.1 Days = Average Age of Receivables This ratio measures the average number of days it takes to collect receivables.

  40. Inventory Turnover Cost of Goods Sold Average Inventory = $44,236 ($9,076 + $8,338) ÷ 2 Inventory Turnover = 5.1 Times = Inventory Turnover This ratio measures how quickly the company sells its inventory.

  41. Average Days’ Supply in Inventory Days in Year Inventory Turnover = Average Days’ Supply in Inventory 3655.1 = 71.6 Days = Average Days’ Supply in Inventory This ratio measures the average number of days it takes to sell the inventory.

  42. Accounts Payable Turnover Cost of Goods Sold Average Accounts Payable = $44,236 ($5,159 + $4,560) ÷ 2 = 9.1 Times = Accounts Payable Turnover Accounts Payable Turnover This ratio measures how quickly the company pays its accounts payable.

  43. Days in Year Accounts Payable Turnover Average Age of Payables = 3659.1 = 40.1 Days = Average Age of Payables Average Age of Payables This ratio measures the average number of days it takes to pay its suppliers.

  44. Learning Objectives Compute and interpret solvency ratios. LO6

  45. Tests of solvency measure a company’s ability to meet its long-term obligations. Now, let’s look at the solvency ratiosfor Home Depot for 2004. Home Depot Tests of Solvency

  46. Times Interest Earned Net Interest Income Tax Income Expense Expense Interest Expense + + = Times Interest Earned $4,304 + $62 + $2,539$62 = 111 Times = Times Interest Earned This ratio indicates a margin of protection for creditors.

  47. Cash Flow from Operating ActivitiesBefore Interest and TaxesInterest Paid CashCoverage = Cash Coverage

  48. Cash Flow from Operating ActivitiesBefore Interest and TaxesInterest Paid CashCoverage = CashCoverage $6,545 + $70 + $2,539$70 = = 131 Cash Coverage This ratio compares the cash generated with the cash obligations of the period.

  49. Debt-to-Equity Ratio Total Liabilities Owners’ Equity = Debt-to-Equity Ratio $12,030 $22,407 = = 0.54 Debt-to-Equity Ratio This ratio measures the amount of liabilities that exists for each $1 invested by the owners.

  50. Learning Objectives Compute and interpret market test ratios. LO7

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