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##### Chapter 14

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**Chapter 14**Analyzing Financial Statements 9/01/03**. . . uses accounting data to make product pricing and**expansion decisions. . . . use accounting data for investment, credit, tax, and public policy decisions. Understanding The Business FINANCIAL STATEMENT USERS MANAGEMENT EXTERNAL DECISION MAKERS**Understanding The Business**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.**Increase inshare price**Dividends Investors Understanding The Business Return on an equitysecurity investment**IndividualCompanyFactors**IndustryFactors Economy-wideFactors Understanding The Business Invest? No Yes**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**Fundamental Strategies**• Product differentiation: unique features, quality, I.e., Lexus • Cost advantage: lower costs, better efficiency, lower prices, I.e., Honda • What is Home Depot’s Strategy? Are they successful with it?**Time seriesanalysis**Comparison with similar companies Financial Statement Analysis Financial statement analysisis based on comparisons. Examines a single company to identify trends over time.**Time seriesanalysis**Comparison with similar companies Company A Company B Financial Statement Analysis Financial statement analysisis based on comparisons. Provides insightsconcerning acompany’s relativeperformance.**Ratio and Percentage Analyses**Ratio analysis, or percentage analysis, is used to express the proportionate relationship between two different amounts.**Net saleson the incomestatement**Total assetson the balancesheet Component Percentages Express each item on a particular statement as a percentage of a single base amount.**Home Depot**Component Percentages Example The comparative income statements of Home Depot 2001 and 2000 appear on the next slide. Prepare component percentage income statements where net sales equal 100%.**Component Percentages**2001 Cost ÷ 2001 Sales**Home Depot**Commonly Used Ratios The 2001 and 2000 balance sheets for Home Depot are presented next. We will be referring to these financial statements throughout the ratio analyses.**Continued**Comparative Statements**Home Depot**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 2001.**Income**Average Owners’ Equity Return on Equity = $2,581 ($15,004 + $12,341) ÷ 2 Return on Equity = = 18.9% Return on Equity This measure indicates how much income was earned for every dollar invested by the owners. Lowes ratio 15.9; ROT 15%+**Return on Assets**Income + Interest Expense (net of tax) AverageTotal Assets = Return on Assets $2,581 + ($21 ×(1 - .34)) ($21,385 + $17,081) ÷ 2 = = 13.5% Return on Assets Corporate tax rate is 34 percent. This ratio is generally considered the best overall measure of a company’s profitability. Lowes ratio 9.1%; ROT 10%+**Financial**Leverage = Return on Equity – Return on Assets Financial Leverage 5.4% = 18.9% – 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. Lowes 6.8%.**Income**Average Number of Shares ofCommon Stock Outstanding EPS = $2,581 (2,324 + 2,304) ÷ 2 EPS = = $1.11 Earnings per Share (EPS) Earnings per share is probably the single most widely watched financial ratio.**Qualityof Income**Cash Flow from Operating Activities Net Income = Quality of Income**Qualityof Income**Cash Flow from Operating Activities Net Income = Qualityof Income $2,796 $2,581 = = 1.08 Quality of Income A ratio higher than 1 indicates higher-quality earnings. No significant non-cash earnings. Cash from Current Assets/Liabilities balanced. ROT >1.0**Income (before Extraordinary Items)**Net Sales Profit Margin = $2,581 $45,738 Profit Margin = 5.6% = Profit Margin This ratio describes a company’s ability to earn income from sales. Lowes 4.3%; ROT >10%**FixedAssetTurnover**Net Sales RevenueAverage Net Fixed Assets = FixedAssetTurnover $45,738($13,068 + $10,227) ÷ 2 = = 3.9 Fixed Asset Turnover This ratio measures a company’s ability to generate sales given an investment in fixed assets. Lowes ratio 3.1; ROT > 1.0**Total Asset Turnover Ratio**Total Asset = Net Sales Revenue Turnover Average Total Assets Home Depot = $45,738 ($21,385 + $17,081) / 2 = 2.38 Lowes = 1.86**Home Depot**Tests of Liquidity Tests of liquidity focus on the relationship between current assets and current liabilities. Now, let’s look at the liquidity ratiosfor Home Depot for 2001.**Cash**Ratio Cash + Cash Equivalents Current Liabilities = Cash Ratio $167 $4,385 = = 0.04 : 1 Cash Ratio This ratio measures theadequacy of available cash. Lowes ratio 0.15**Current**Ratio Current Assets Current Liabilities = Current Ratio $7,777 $4,385 = = 1.77 : 1 Current Ratio This ratio measures the ability of the company to pay current debts as they become due. ROT 2.0 to 1**Quick**Ratio Quick Assets Current Liabilities = Quick Ratio $1,012 $4,385 = = .23 : 1 Quick Ratio (Acid Test)(Excludes inventory & other curr. Assets) This ratio is like the current ratio but measures the company’s immediate ability to pay debts.**Net Credit Sales**Average Net Trade Receivables Receivable Turnover = $45,738 ($835 + $587) ÷ 2 Receivable Turnover = 64 times = Receivable Turnover(per year) This ratio measures how quickly a company collects its accounts receivable.**Average Age of Receivables**Days in Year Receivable Turnover = 36564 Average Age of Receivables = 5.7 days = Average Age of Receivables(DSO) This ratio measures the average number of days it takes to collect receivables. ROT 45 to 60 days. Why is HD so low? Lots of Cash Sales.**Inventory Turnover**Cost of Goods Sold Average Inventory = $32,057 ($6,556 + $5,489) ÷ 2 Inventory Turnover = 5.3 times = Inventory Turnover This ratio measures how quickly the company sells its inventory. Lowes ratio 4.4 times ROT 4.0 times or better.**Average Days’ Supply in Inventory**Days in Year Inventory Turnover = Average Days’ Supply in Inventory 3655.3 = 69 days = Average Days’ Supply in Inventory This ratio measures the average number of days it takes to sell the inventory. Lowes days 83.**Home Depot**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 ratiosfor Home Depot for 2001.**Times Interest Earned**Net Interest Income Tax Income Expense Expense Interest Expense + + = Times Interest Earned $2,581 + $21 + $1,636$21 = 202 = Times Interest Earned This ratio indicates a margin of protection for creditors. ROT 7 times or better.**Cash Flow from Operating ActivitiesBefore Interest and**TaxesInterest Paid CashCoverage = Cash Coverage**Cash Flow from Operating ActivitiesBefore Interest and**TaxesInterest Paid CashCoverage = CashCoverage $2,796 + $16 + $1,386$16 = = 262 Cash Coverage This ratio compares the cash generated with the cash obligations of the period.**Debt/Equity Ratio**Total Liabilities Owners’ Equity = Debt/Equity Ratio $6,381 $15,004 = = 0.43 Debt/Equity Ratio This ratio measures the amount of liabilities that exists for each $1 invested by the owners. Lowes ratio 0.52. ROT >1.00.**Debt Ratio = Total Debt**Total Assets Home Depot = $6,381 = 29.8% $21,385 ROT > 50% Total Debt Ratio**Home Depot**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 forHome Depot for 2001.**Current Market Price Per ShareEarnings Per Share**P/E Ratio = $35$1.11 P/E Ratio = = 31.5 Price/Earnings (P/E) Ratio A recent price for Home Depotstock was $35 per share. This ratio measures the relationship between the current market price of the stock and its earnings per share. Lowes p/e ratio 14; ROT 20+**Other Analytical Considerations**In addition to financial ratios, special factors might affect company analysis: • Rapid growth. • Uneconomical expansion. • Subjective factors.**Interpreting Ratios**Ratios may be interpreted by comparison with ratios of other companies or with industry average ratios. Ratios may vary because of thecompany’s industry characteristics,nature of operations, size, andaccounting policies.**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.**End of Chapter 14**Ratios Ratios Ratios Ratios Ratios