Financial Statement Analysis

1. Chapter 14 Financial Statement Analysis Electronic Presentationby Douglas Cloud Pepperdine University

2. Learning Goals 1.Construct and interpret horizontal and vertical analyses. 2.Calculate and interpret the rate earned on stockholders’ equity and the rate earned on total assets. 3.Analyze the rate earned on total assets by evaluating the profit margin and the asset efficiency of a business.Anal After studying this chapter, you should be able to: Continued

3. Learning Goals 4. Determine and interpret leverage. 5. Calculate and interpret shareholder ratios: earnings per share, price-earnings ratio, and dividend yield. 6. Summarize the uses and limitations of analytical measures. 7. Describe the contents of corporate annual reports.

4. Your Need to Know • Value investing is an attempt to discover stocks with an intrinsic value that are greater than the stock prices. • In growth investing, the investor tries to identify companies that are growing sales and earnings through new products, markets, or opportunities. • Income investing is where investors purchase common stocks for their dividend stream. • Technical investing involves investors using technical analysis to find clues about future performance from past performance.

5. Learning Goal 1 Construct and interpret horizontal and vertical analyses.

6. Horizontal Analysis It’s an analysis of the percentage increases and decreases of related items in comparative financial statements. What is horizontal analysis?

7. 14-7 HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001 Condensed Increase (Decrease) Feb. 3, 2002 Jan. 28, 2001 Amount Percent Assets Current assets $10,361 $ 7,777 $2,584 33.2% Property and equipment, net 15,375 13,068 2,307 17.7 Other assets 658 540 118 21.9 Total assets $26,394 $21,385 $5,009 23.4 Liabilities Current liabilities $ 6,501 $ 4,385 $2,116 48.3 Long-term debt, excluding current installment 1,250 1,545 (295) (19.1) Other long-term liabilities 372 256 116 45.3 Deferred income taxes 189 195 (6) (3.1) Total long-term liabilities $ 1,811$ 1,996$ (185) (9.3) Total liabilities $ 8,312$ 6,381$1,931 30.3 The stockholders’ equity section is not displayed.

8. Horizontal Analysis: Difference $2,584 Base year $7,777 = 33.2% 14-8 HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001 Condensed Increase (Decrease) Feb. 3, 2002 Jan. 28, 2001 Amount Percent Assets Current assets $10,361 $ 7,777 $2,584 33.2% Property and equipment, net 15,375 13,068 2,307 17.7 Other assets 658 540 118 21.9 Total assets $26,394 $21,385 $5,009 23.4 Liabilities Current liabilities $ 6,501 $ 4,385 $2,116 48.3 Long-term debt, excluding current installment 1,250 1,545 (295) (19.1) Other long-term liabilities 372 256 116 45.3 Deferred income taxes 189 195 (6) (3.1) Total long-term liabilities $ 1,811$ 1,996$ (185) (9.3) Total liabilities $ 8,312$ 6,381$1,931 30.3 33.2%

9. Horizontal Analysis: Difference $2,307 Base year $13,068 = 17.7% 14-9 HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001 Condensed Increase (Decrease) Feb. 3, 2002 Jan. 28, 2001 Amount Percent Assets Current assets $10,361 $ 7,777 $2,584 33.2% Property and equipment, net 15,375 13,068 2,307 17.7 Other assets 658 540 118 21.9 Total assets $26,394 $21,385 $5,009 23.4 Liabilities Current liabilities $ 6,501 $ 4,385 $2,116 48.3 Long-term debt, excluding current installment 1,250 1,545 (295) (19.1) Other long-term liabilities 372 256 116 45.3 Deferred income taxes 189 195 (6) (3.1) Total long-term liabilities $ 1,811$ 1,996$ (185) (9.3) Total liabilities $ 8,312$ 6,381$1,931 30.3 33.2% 33.2% 17.7

10. 14-10 HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001 Condensed Increase (Decrease) Feb. 3, 2002 Jan. 28, 2001 Amount Percent Assets Current assets $10,361 $ 7,777 $2,584 33.2% Property and equipment, net 15,375 13,068 2,307 17.7 Other assets 658 540 11821.9 Total assets $26,394 $21,385 $5,009 23.4 Liabilities Current liabilities $ 6,501 $ 4,385 $2,116 48.3 Long-term debt, excluding current installment 1,250 1,545 (295) (19.1) Other long-term liabilities 372 256 116 45.3 Deferred income taxes 189 195 (6) (3.1) Total long-term liabilities $ 1,811$ 1,996$ (185) (9.3) Total liabilities $ 8,312$ 6,381$1,93130.3

11. Horizontal Analysis: Difference $7,815 Base year $45,738 = 17.1% 14-11 HOME DEPOT INC. Income Statement (in millions)For Periods Ended February 3, 2002 and January 28, 2001 Increase (Decrease) 2002 2001 Amount Percent 17.1% Sales (net) $53,553 $45,738 $7,815 Cost of merchandise sold 37,406 32,057 5,349 Gross profit $16,147$13,681$2,466 Selling and store operating exp. 10,280 8,655 1,625 General and administrative exp. 935 835 100 Total operating expenses $11,215$ 9,490$1,725 Income from operations $ 4,932 $ 4,191 $ 741 Other income and expenses: Interest and investment inc. 53 47 6 Interest expense (28) (21) (7) Income before income tax $ 4,957 $ 4,217 $ 740 Income taxes 1,913 1,636 277 Net income $ 3,044 $ 2,581 $ 463

12. Horizontal Analysis: Difference $5,349 Base year $32,057 = 16.7 14-12 HOME DEPOT INC. Income Statement (in millions)For Periods Ended February 3, 2002 and January 28, 2001 Increase (Decrease) 2002 2001 Amount Percent 17.1% Sales (net) $53,553 $45,738 $7,815 Cost of merchandise sold 37,406 32,057 5,349 Gross profit $16,147$13,681$2,466 Selling and store operating exp. 10,280 8,655 1,625 General and administrative exp. 935 835 100 Total operating expenses $11,215$ 9,490$1,725 Income from operations $ 4,932 $ 4,191 $ 741 Other income and expenses: Interest and investment inc. 53 47 6 Interest expense (28) (21) (7) Income before income tax $ 4,957 $ 4,217 $ 740 Income taxes 1,913 1,636 277 Net income $ 3,044 $ 2,581 $ 463 16.7

13. 17.1% 16.7 14-13 HOME DEPOT INC. Income Statement (in millions)For Periods Ended February 3, 2002 and January 28, 2001 Increase (Decrease) 2002 2001 Amount Percent Sales (net) $53,553 $45,738 $7,815 Cost of merchandise sold 37,406 32,057 5,349 Gross profit $16,147$13,681$2,466 Selling and store operating exp. 10,280 8,655 1,625 General and administrative exp. 935 835 100 Total operating expenses $11,215$ 9,490$1,725 Income from operations $ 4,932 $ 4,191 $ 741 Other income and expenses: Interest and investment inc. 53 47 6 Interest expense (28) (21) (7) Income before income tax $ 4,957 $ 4,217 $ 740 Income taxes 1,913 1,636 277 Net income $ 3,044 $ 2,581 $ 463 18.0 18.8 12.0 18.2 17.7 12.8 33.3 17.5 16.9 17.9

14. Horizontal Analysis: Difference $2,210 Base year $7,941 = 27.8% 14-14 HOME DEPOT INC. Comparative Retained Earnings Statement (in millions)For Periods Ended February 3, 2002 and January 28, 2001 Increase (Decrease) 2002 2001 Amount Percent Retained earnings, beginning $10,151 $ 7,941 $2,210 Net income for the year 3,044 2,581 463 Total $13,195 $10,522 $2,673 Dividends: On common stock 396 371 25 Retained earnings, ending $12,799 $10,151 $2,648 27.8%

15. 14-14 HOME DEPOT INC. Comparative Retained Earnings Statement (in millions)For Periods Ended February 3, 2002 and January 28, 2001 Increase (Decrease) 2002 2001 Amount Percent Retained earnings, beginning $10,151 $ 7,941 $2,210 Net income for the year 3,044 2,581 463 Total $13,195 $10,522 $2,673 Dividends: On common stock 396 371 25 Retained earnings, ending $12,799 $10,151 $2,648 27.8% 17.9 25.4 6.7 26.1

16. Vertical Analysis A percentage analysis can be used to show the relationship of each component to a total within a single statement.

17. Vertical Analysis The total, or 100% item, on the balance sheet is “total assets.”

18. 14-18 14-18 HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001 Condensed Feb. 3, 2002 Jan. 28, 2001 Amount Percent Amount Percent Assets Current assets $10,361 $ 7,777 Property and equipment, net 15,375 13,068 Other assets 58 540 Total assets $26,394 $21,385 Liabilities Current liabilities $ 6,501 $ 4,385 Long-term liabilities 1,811 1,996 Total liabilities $ 8,312$ 6,381 Stockholders’ Equity Common stock/paid-in capital $ 5,529 $ 4,926 RE & accumulated comp. loss 12,553 10,078 Total stockholders’ equity $18,082$15,004 Total liabilities and SE $26,394 $21,385 100.0% Total assets is 100.0%

19. Vertical Analysis: Current assets $10,361 Total assets $26,394 = 39.3% 14-19 HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001 Condensed Feb. 3, 2002 Jan. 28, 2001 Amount Percent Amount Percent Assets Current assets $10,361 $ 7,777 Property and equipment, net 15,375 13,068 Other assets 58 540 Total assets $26,394 $21,385 Liabilities Current liabilities $ 6,501 $ 4,385 Long-term liabilities 1,811 1,996 Total liabilities $ 8,312$ 6,381 Stockholders’ Equity Common stock/paid-in capital $ 5,529 $ 4,926 RE & accumulated comp. loss 12,553 10,078 Total stockholders’ equity $18,082$15,004 Total liabilities and SE $26,394 $21,385 39.3% 100.0%

20. 14-20 HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001 Condensed Feb. 3, 2002 Jan. 28, 2001 Amount Percent Amount Percent Assets Current assets $10,361 $ 7,777 Property and equipment, net 15,375 13,068 Other assets 58 540 Total assets $26,394 $21,385 Liabilities Current liabilities $ 6,501 $ 4,385 Long-term liabilities 1,811 1,996 Total liabilities $ 8,312$ 6,381 Stockholders’ Equity Common stock/paid-in capital $ 5,529 $ 4,926 RE & accumulated comp. loss 12,553 10,078 Total stockholders’ equity $18,082$15,004 Total liabilities and SE $26,394 $21,385 39.3% 58.2 2.5 100.0% 24.6% 6.9 31.5% 20.9% 47.6 68.5% 100.0%

21. 39.3% 58.2 2.5 100.0% 24.6% 6.9 31.5% 20.9% 47.6 68.5% 100.0% 14-21 HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001 Condensed Feb. 3, 2002 Jan. 28, 2001 Amount Percent Amount Percent Assets Current assets $10,361 $ 7,777 Property and equipment, net 15,375 13,068 Other assets 58 540 Total assets $26,394 $21,385 Liabilities Current liabilities $ 6,501 $ 4,385 Long-term liabilities 1,811 1,996 Total liabilities $ 8,312$ 6,381 Stockholders’ Equity Common stock/paid-in capital $ 5,529 $ 4,926 RE & accumulated comp. loss 12,553 10,078 Total stockholders’ equity $18,082$15,004 Total liabilities and SE $26,394 $21,385 100.0% Total assets is 100.0%

22. 39.3% 58.2 2.5 100.0% 24.6% 6.9 31.5% 20.9% 47.6 68.5% 100.0% Vertical Analysis: Current assets $7,777 Total assets $21,385 = 36.4% 14-22 HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001 Condensed Feb. 3, 2002 Jan. 28, 2001 Amount Percent Amount Percent Assets Current assets $10,361 $ 7,777 Property and equipment, net 15,375 13,068 Other assets 58 540 Total assets $26,394 $21,385 Liabilities Current liabilities $ 6,501 $ 4,385 Long-term liabilities 1,811 1,996 Total liabilities $ 8,312$ 6,381 Stockholders’ Equity Common stock/paid-in capital $ 5,529 $ 4,926 RE & accumulated comp. loss 12,553 10,078 Total stockholders’ equity $18,082$15,004 Total liabilities and SE $26,394 $21,385 36.4% 100.0%

23. 39.3% 58.2 2.5 100.0% 24.6% 6.9 31.5% 20.9% 47.6 68.5% 100.0% 14-23 HOME DEPOTComparative Balance Sheets (in Millions)February 3, 2002 and January 28, 2001 Condensed Feb. 3, 2002 Jan. 28, 2001 Amount Percent Amount Percent Assets Current assets $10,361 $ 7,777 Property and equipment, net 15,375 13,068 Other assets 58 540 Total assets $26,394 $21,385 Liabilities Current liabilities $ 6,501 $ 4,385 Long-term liabilities 1,811 1,996 Total liabilities $ 8,312$ 6,381 Stockholders’ Equity Common stock/paid-in capital $ 5,529 $ 4,926 RE & accumulated comp. loss 12,553 10,078 Total stockholders’ equity $18,082$15,004 Total liabilities and SE $26,394 $21,385 36.4% 61.1 2.5 100.0% 20.5% 9.3 29.8% 23.0% 47.1 70.2% 100.0%

24. 14-24 HOME DEPOT INC. Income Statement (in millions)For Periods Ended February 3, 2002 and January 28, 2001 2002 2001 Amount Percent Amount Percent Sales (net) $53,553 100.0% $45,738 100.0% Cost of merchandise sold 37,406 32,057 Gross profit $16,147$13,681 Selling and store operating exp. 10,280 8,655 General and administrative exp. 935 835 Total operating expenses $11,215$ 9,490 Income from operations $ 4,932 $ 4,191 Other income and expenses: Interest and investment inc. 53 47 Interest expense (28) (21) Income before income tax $ 4,957 $ 4,217 Income taxes 1,913 1,636 Net income $ 3,044 $ 2,581 Net sales is 100.0% Net sales is 100.0%

25. 2001 Vertical Analysis: Cost of Merchandise Sold $32,057 Net Sales $45,738 = 70.1% 14-25 HOME DEPOT INC. Income Statement (in millions)For Periods Ended February 3, 2002 and January 28, 2001 2002 2001 Amount Percent Amount Percent Sales (net) $53,553 100.0% $45,738 100.0% Cost of merchandise sold 37,406 32,057 Gross profit $16,147$13,681 Selling and store operating exp. 10,280 8,655 General and administrative exp. 935 835 Total operating expenses $11,215$ 9,490 Income from operations $ 4,932 $ 4,191 Other income and expenses: Interest and investment inc. 53 47 Interest expense (28) (21) Income before income tax $ 4,957 $ 4,217 Income taxes 1,913 1,636 Net income $ 3,044 $ 2,581 70.1

26. 2002 Vertical Analysis: Cost of Merchandise Sold $37,406 Net Sales $53,553 = 69.9% 14-26 HOME DEPOT INC. Income Statement (in millions)For Periods Ended February 3, 2002 and January 28, 2001 2002 2001 Amount Percent Amount Percent Sales (net) $53,553 100.0% $45,738 100.0% Cost of merchandise sold 37,406 32,057 Gross profit $16,147$13,681 Selling and store operating exp. 10,280 8,655 General and administrative exp. 935 835 Total operating expenses $11,215$ 9,490 Income from operations $ 4,932 $ 4,191 Other income and expenses: Interest and investment inc. 53 47 Interest expense (28) (21) Income before income tax $ 4,957 $ 4,217 Income taxes 1,913 1,636 Net income $ 3,044 $ 2,581 69.9 70.1

27. 14-27 HOME DEPOT INC. Income Statement (in millions)For Periods Ended February 3, 2002 and January 28, 2001 2002 2001 Amount Percent Amount Percent Sales (net) $53,553 100.0% $45,738 100.0% Cost of merchandise sold 37,406 32,057 Gross profit $16,147$13,681 Selling and store operating exp. 10,280 8,655 General and administrative exp. 935 835 Total operating expenses $11,215$ 9,490 Income from operations $ 4,932 $ 4,191 Other income and expenses: Interest and investment inc. 53 47 Interest expense (28) (21) Income before income tax $ 4,957 $ 4,217 Income taxes 1,913 1,636 Net income $ 3,044 $ 2,581 69.9 70.1 29.9% 18.9% 1.8 20.7% 9.2% 0.1 (0.1) 9.2% 3.6 5.6%

28. 14-28 HOME DEPOT INC. Income Statement (in millions)For Periods Ended February 3, 2002 and January 28, 2001 2002 2001 Amount Percent Amount Percent Sales (net) $53,553 100.0% $45,738 100.0% Cost of merchandise sold 37,406 32,057 Gross profit $16,147$13,681 Selling and store operating exp. 10,280 8,655 General and administrative exp. 935 835 Total operating expenses $11,215$ 9,490 Income from operations $ 4,932 $ 4,191 Other income and expenses: Interest and investment inc. 53 47 Interest expense (28) (21) Income before income tax $ 4,957 $ 4,217 Income taxes 1,913 1,636 Net income $ 3,044 $ 2,581 69.9 30.1% 19.2% 1.7 20.9% 9.2% 0.1 (0.0) 9.3% 3.6 5.7% 70.1 29.9% 18.9% 1.8 20.7% 9.2% 0.1 (0.1) 9.2% 3.6 5.6%

29. 14-29 HOME DEPOT INC. Income Statement (in millions)For Periods Ended February 3, 2002 and January 28, 2001 2002 2001 Amount Percent Amount Percent Sales (net) $53,553 100.0% $45,738 100.0% Cost of merchandise sold 37,406 32,057 Gross profit $16,147$13,681 Selling and store operating exp. 10,280 8,655 General and administrative exp. 935 835 Total operating expenses $11,215$ 9,490 Income from operations $ 4,932 $ 4,191 Other income and expenses: Interest and investment inc. 53 47 Interest expense (28) (21) Income before income tax $ 4,957 $ 4,217 Income taxes 1,913 1,636 Net income $ 3,044 $ 2,581 69.9 30.1% 19.2% 1.7 20.9% 9.2% 0.1 (0.0) 9.3% 3.6 5.7% 70.1 29.9% 18.9% 1.8 20.7% 9.2% 0.1 (0.1) 9.2% 3.6 5.6%

30. Learning Goal 2 Calculate and interpret the rate earned on stockholders’ equity and the rate earned on total assets.

31. Rate Earned on Stockholders’ Equity The stockholder desires a return on his or her investment. One measure of this return is the rate earned on stockholders’ equity.

32. Net income Average stockholders’ equity $3,044,000,000 ($15,004,000,000 + $18,082,000,000)/2 Rate Earned on Stockholders’ Equity Home Depot = 18.4%

33. Net income Average stockholders’ equity $1,023,000,000 ($5,494,000,000 + $6,674,000,000)/2 Rate Earned on Stockholders’ Equity Lowe's = 16.8%

34. Rate Earned on Total Assets Another ratio to measure the relative profitability of a firm is rate earned on total assets.

35. Net income Average total assets $3,044,000,000 ($21,385,000,000 + $26,394,000,000)/2 Rate Earned on Total Assets Home Depot = 12.8%

36. Net income Average total assets $1,023,000,000 ($11,358,000,000 + $13,736,000,000)/2 Rate Earned on Total Assets Lowe's = 8.1%

37. Comprehensive Profitability Analysis The exhibit on the next slide diagrams the comprehensive ratio relationship that can be used to analyze the rate earned on stockholders’ equity.

39. Comprehensive Profitability Analysis The rate earned on stockholders’ equity is normally higher than the rate earned on total assets when a company uses debt, or leverage.

40. Rate earned on total assets × leverage Rate earned on stockholders’ equity = Net income Average Stockholders’ Equity Average Total Assets Average Stockholders’ Equity = Net income Average Total Assets × Comprehensive Profitability Analysis Leverage Formula

41. Learning Goal 3 Analyze the rate earned on total assets by evaluating the profit margin and the asset efficiency of a business.

42. Net Income Net Sales Net Sales Average Total Assets Rate Earned on Total Assets Profit Margin × Asset Turnover ×

44. Margin Analysis Why is the profit margin of Home Depot over one percentage point stronger than Lowe’s?

45. Home Depot and Lowe’s Condensed Common-Size Income Statement For the Year Ended February 3 and February 1, 2002 Home Depot Lowe’s Home Depot has a higher gross profit percentage than Lowe’s. Home Depot’s higher selling expenses are somewhat offset by lower administrative expenses. Sales (net) 100.0%100.0% Cost of merchandise sold 69.9 71.2 Gross profit 30.1% 28.8% Selling expenses 19.2% 18.3% Administrative expenses 1.7 2.4 Total operating expenses 20.9% 20.7% Income from operations 9.2% 8.1% Other income 0.1 0.0 Interest expense (0.0) (0.8) Income before income taxes 9.3% 7.3% Income tax expense 3.6 2.7 Net income 5.7% 4.6% Although Home Depot pays more income taxes (percentage-wise), the overall profit percentage is higher than Lowe’s.

46. Asset Efficiency

47. Net sales on account Average accounts receivable Accounts Receivable Analysis Accounts Receivable Turnover Home Depot Lowe’s Net sales $53,553 $22,111 Accounts receivable (net): Beginning of year $ 835 $ 161 End of year 820 166 Total $ 1,755 $ 327 Average $ 878 $ 164 61.0 134.8 (all dollar amounts in millions)

48. Net sales on account Average accounts receivable 61.0 134.8 Accounts Receivable Analysis Accounts Receivable Turnover Home Depot Lowe’s Net sales $53,553 $22,111 Accounts receivable (net): Beginning of year $ 835 $ 161 End of year 820 166 Total $ 1,755 $ 327 Average $ 878 $ 164 Use: To assess the efficiency in collecting receivables and in the management of credit. (all amounts except ratios in millions)

49. Accounts receivable, end of year Average daily sales on account Accounts Receivable Analysis Number of Days’ Sales in Receivables Home Depot Lowe’s Accounts receivable (net) end of year $920 $166 Net sales on account $53,553 $22,111 Average daily sales on on account (net sales ÷ 365) $147 $61 6.3 2.7 (all dollar amounts in millions)

50. 6.3 2.7 Accounts receivable, end of year Average daily sales on account Accounts Receivable Analysis Number of Days’ Sales in Receivables Home Depot Lowe’s Accounts receivable (net) end of year $920 $166 Net sales on account $53,553 $22,111 Average daily sales on on account (net sales ÷ 365) $147 $61 Use: To assess the efficiency in collecting receivables and in the management of credit. (all amounts except ratios in millions)