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BSAD 221 Introductory Financial Accounting Donna Gunn, CA. Understanding The Business. Past Performance. Present Condition. Future Performance. Income, sales volume, cash flows, return- on-investments, EPS. Assets, debt, inventory, various ratios. .

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understanding the business
Understanding The Business

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.

the investment decision

IndividualCompanyFactors

IndustryFactors

Economy-wideFactors

The Investment Decision

No

Yes

Invest?

understanding a company s strategy
Understanding a Company’s Strategy

BusinessStrategy

OperatingDecisions

Transactions

FinancialStatements

financial statement analysis

Time seriesanalysis

Comparison with similar companies

Financial Statement Analysis

Financial statement analysisis based on comparisons.

ratio and percentage analyses
Ratio analysis, or percentageanalysis, is used to express the proportionate relationship between two different amounts.Ratio and Percentage Analyses
component percentages
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
component percentages1
The comparative income statements of Home Depot for 2006 and 2005 appear on the next slide.

Prepare component percentage income statements where net sales equal 100%.

Component Percentages
tests of liquidity
Tests of liquidity focus on the relationship between current assets and current liabilities.

Common Liquidity Ratios:

Current Ratio

Quick Ratio

Inventory Turnover

Receivable Turnover

Days’ Sales in Receivables

Tests of Liquidity
current ratio

Current

Ratio

Current Assets

Current Liabilities

=

Current

Ratio

$18,000

$12,931

=

=

1.39 to 1

Current Ratio

This ratio measures the ability of the company to pay current debts as they become due.

quick ratio acid test

Quick

Ratio

Quick Assets

Current Liabilities

=

Quick

Ratio

$3,837

$12,931

=

=

0.30 to 1

Quick Ratio (Acid Test)

This ratio is like the current ratio but measures the company’s immediate ability to pay debts.

inventory turnover

Inventory Turnover

Cost of Goods Sold

Average Inventory

=

$61,054

($11,401 + $12,822) ÷ 2

Inventory Turnover

= 5.0x

=

Inventory Turnover

This ratio measures how quickly the company sells its inventory.

average days supply in inventory

Average Days’ Supply in Inventory

Days in Year

Inventory Turnover

=

Average Days’ Supply in Inventory

3655.0

= 73 Days

=

Average Days’ Supply in Inventory

This ratio measures the average number of days it takes to sell the inventory.

receivable turnover

Net Credit Sales

Average Net Receivables

Receivable Turnover

=

$90,837

($2,396 + $3,223) ÷ 2

Receivable Turnover

= 32.3 Times

=

Receivable Turnover

This ratio measures how quickly a company collects its accounts receivable.

days sales in receivables

Days Sales in Receivables

Average Net A/R

One Days Sales

=

($2,396 + $3,223)÷2 $90,837÷ 365

=11.3 Days

=

Days Sales in Receivables

This ratio measures the average number of days it takes to collect receivables.

average age of receivables

Average Age of Receivables

Days in a Year

Receivable Turnover

=

36532.3

Average Age of Receivables

= 11.3 Days

=

Average Age of Receivables

This ratio measures the average number of days it takes to collect receivables.

Same as prior slide – just more common approach.

measuring ability to pay long term debt
Measuring Ability to Pay Long Term Debt
  • Measure a company’s ability to meet its long-term obligations.
  • Common Tests of Solvency:
      • Debt to Equity
      • Times Interest Earned
debt to equity ratio

Debt-to-Equity Ratio

Total Liabilities

Owners’ Equity

=

Debt-to-Equity Ratio

$27,233

$25,030

=

= 1.09 (or 109%)

Debt-to-Equity Ratio

This ratio measures the amount of liabilities that exists for each $1 invested by the owners.

times interest earned

Times Interest Earned

Net Interest Income Tax Income Expense Expense Interest Expense

+

+

=

Times Interest Earned

$5,761 + $392 + $3,547$392

= 24.7 Times

=

Times Interest Earned

This ratio indicates a margin of protection for creditors.

tests of profitability
Profitability is a primary measure of the overall success of a company

Common Profitability Ratios:

Return on Net Sales

Return on Assets

Return on Equity

EPS

Gross Margin

Tests of Profitability
return on net sales aka profit margin

Net Income

Net Sales

Return on

Net Sales

=

$5,761

$90,837

= 6.3%

=

Return on Net Sales (AKA Profit Margin)

This ratio tells us the percentage of each sales dollar that is income.

return on assets

Return on Assets

Net Income + Interest Exp. (net of tax)

Average Total Assets

=

$5,761 + ($392 × (1 - .38))

($44,405 + $52,263) ÷ 2

Return on Assets

=

= 12.4%

Return on Assets

Corporate tax rate is 38%.

This ratio is generally considered

the best overall measure of a

company’s profitability.

return on equity

Net Income –Pref. Dividends

Average CommonEquity

Return on Equity

=

$5,761

($26,909 + $25,030) ÷ 2

Return on Equity

=

= 22.2%

Return on Equity

This measure indicates how much

income was earned for every dollar

invested by the common share owners.

earnings per share eps

Net Income Available to Common Shareholders

Weighted-Average Number of Common Shares Outstanding

EPS

=

$5,761

2,054

EPS

=

= $2.80

Earnings per Share (EPS)

Average number of shares outstanding is from Home Depot’s 2006 Income Statement.

Earnings per share is probably the single most widely watched financial ratio.

gross profit margin

Net Sales - COGS

Net Sales

Gross

Profit Margin

=

$90,837- 61,054

$90,837

Gross

Profit Margin

= 32.8%

=

Gross Profit Margin

This ratio tells us the percentage of each sales dollar after we’ve paid for the cost of the product

analyzing shares as an investment
Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor.

Common Market Tests:

Price Earnings Ratio

Dividend Yield

Book Value per share of Common Stock

Analyzing Shares as An Investment
price earnings p e ratio

Current Market Price Per ShareEarnings Per Share

P/E Ratio =

$43.95$2.80

P/E Ratio =

= 15.7

Price/Earnings (P/E) Ratio

A recent price for Home Depot common share was $43.95 per share.

This ratio measures the relationship between the current market price of the stock and its earnings per share.

dividend yield ratio

Dividend

Yield

Dividends Per Share

Market Price Per Share

=

Dividend

Yield

$0.75$43.95

=

= 1.7%

Dividend Yield Ratio

Home Depot paid dividends of $0.75 per share when the market price was $43.95 per share.

This ratio is often used to compare the dividend-paying performance of different investment alternatives.

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.

Interpreting Ratios
other financial information
In addition to financial ratios, special factors might affect company analysis:

Rapid growth.

Uneconomical expansion.

Subjective factors.

Other Financial Information
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.

Efficient Markets