# Financial Leverage Percentage Return on Equity – Return on Assets

CHAPTER 13
ANALYZING FINANCIAL
STATEMENTS
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
FINANCIAL STATEMENT ANALYSIS
Financial statement analysis
is based on comparisons.
Time series
analysis
Comparison with
similar companies
Examines a single
company to identify
trends over time.
Provides insights
concerning a
company’s relative
performance.
13-2
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
The comparative income statements of Home Depot
for 2012, 2011, and 2010 appear on the next slide.
Prepare component percentage income statements
where net sales equal 100%.
13-3
Net Sales will be set
to 100% and all other
components will be
expressed as a
percentage of Net
Sales.
13-4
Net Sales will be set
to 100% and all other
components will be
expressed as a
percentage of Net
Sales.
2012 Cost of Sales &divide; 2012 Net Sales
\$46,133 &divide; \$70,395 = .655 or 65.5%
2012 Gross Profit &divide; 2012 Net Sales
\$24,262 &divide; \$70,390 = .345 or 34.5%
2012 Selling, G&amp;A &divide; 2012 Net Sales
\$16,028 &divide; \$70,395 = .228 or 22.8%
13-5
COMPONENT PERCENTAGES
13-6
COMMONLY USED RATIOS
The 2012 and 2011 balance sheets for
Home Depot are presented next.
We will be referring to these financial
statements throughout the ratio analyses.
Home Depot
13-7
13-8
13-9
TEST OF PROFITABILITY ─ RETURN
ON EQUITY
Profitability is a primary measure of
the overall success of a company.
Return on Equity =
Return on Equity =
Net Income
Average Stockholders’ Equity
\$3,883
(\$17,898 + \$18,889) &divide; 2
= 21.1%
This measure indicates how much income
was earned for every dollar invested by the
owners.
13-10
TEST OF PROFITABILITY ─ RETURN
ON ASSETS
Return on
Assets
Return on
Assets
=
Net Income + Interest Expense (net of tax)
Average Total Assets
=
\$3,883 + (\$606 &times; (1 - .34))
= 10.6%
(\$40,518 + \$40,125) &divide; 2
Assume the corporate
tax rate is 34%.
This ratio measures how well assets have been
employed by the business. Many analysts
consider this ratio as the best overall measure of
a company’s profitability.
13-11
TEST OF PROFITABILITY ─ FINANCIAL
LEVERAGE PERCENTAGE
Financial Leverage
= Return on Equity – Return on Assets
Percentage
10.5%
=
21.1% – 10.6%
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.
13-12
TEST OF PROFITABILITY ─ EARNINGS
PER SHARE (EPS)
EPS
=
Net Income*
Average Number of Shares
Outstanding for the Period
*If there are preferred dividends, the amount is subtracted from net income.
EPS =
\$3,883
1,562
= \$2.49
Average number of shares based on the number
of shares at the beginning and end of the year.
Earnings per share is probably the single
most widely watched financial ratio.
13-13
TEST OF PROFITABILITY ─ QUALITY
OF INCOME
Quality
=
of Income
Cash Flow from Operating Activities
Net Income
Home Depot’s
Quality of Income
\$6,651
= 1.71
\$3,883
A ratio higher than 1
indicates high-quality
earnings.
13-14
TEST OF PROFITABILITY ─ PROFIT
MARGIN
Profit
=
Margin
Net Income
Net Sales Revenue
Profit
=
Margin
\$3,883
\$70,395
= 5.5%
This ratio tells us the percentage of each sales
dollar, on average, that represents income.
13-15
TEST OF PROFITABILITY ─ FIXED
ASSET TURNOVER
Fixed
=
Asset
Turnover
Net Sales Revenue
Average Net Fixed Assets
Fixed
=
Asset
Turnover
\$70,395
(\$24,448 + \$25,060) &divide; 2
= 2.84
This ratio measures a company’s ability to
generate sales given an investment in fixed
assets.
13-16
TESTS OF LIQUIDITY ─ CASH RATIO
Tests of liquidity focus on the relationship between
current assets and current liabilities.
Cash
Ratio
Cash
Ratio
Cash + Cash Equivalents
=
Current Liabilities
=
\$1,987
\$9,376
=
0.21 to 1
This ratio measures the
13-17
TESTS OF LIQUIDITY ─ CURRENT
RATIO
Current
Ratio
Current
Ratio
=
=
Current Assets
Current Liabilities
\$14,520
\$9,376
=
1.55 to 1
This ratio measures the ability
of the company to pay current
debts as they become due.
13-18
TESTS OF LIQUIDITY ─ QUICK RATIO
(ACID TEST)
Quick
Ratio
=
Quick Assets
Current Liabilities
Quick
Ratio
=
\$3,232
\$9,376
Cash &amp; Cash Equivalents
Receivables, net
Quick Assets
=
0.35 to 1
\$ 1,987
1,245
\$ 3,232
This ratio is like the current
ratio but measures the company’s
immediate ability to pay debts.
13-19
TESTS OF LIQUIDITY ─ RECEIVABLE
TURNOVER
Receivable
Turnover
Receivable
Turnover
=
=
Net Credit Sales
Average Net Receivables
\$70,395
(\$1,245 + \$1,085) &divide; 2
= 60.4 Times
This ratio measures how quickly
a company collects its accounts
receivable.
13-20
TESTS OF LIQUIDITY ─ AVERAGE AGE
OF RECEIVABLES
Average Age
of Receivables
Average Age
of Receivables
=
=
Days in Year
Receivable Turnover
365
60.4
= 6.0 Days
This ratio measures the average number
of days it takes to collect receivables.
13-21
TESTS OF LIQUIDITY ─ INVENTORY
TURNOVER
Inventory
Turnover
Cost of Goods Sold
=
Average Inventory
Inventory
Turnover
\$46,133
= 4.4 Times
=
(\$10,325 + \$10,625) &divide; 2
This ratio measures how quickly
the company sells its inventory.
13-22
TESTS OF LIQUIDITY ─ AVERAGE
DAYS’ SUPPLY IN INVENTORY
Average Days’
Supply in
Inventory
Average Days’
Supply in
Inventory
=
=
Days in Year
Inventory Turnover
365
4.4
=
83 Days
This ratio measures the average number
of days it takes to sell the inventory.
13-23
TESTS OF LIQUIDITY ─ ACCOUNTS
PAYABLE TURNOVER RATIO
Accounts
Payable
Turnover
=
Accounts
Payable
Turnover
\$46,133
=
(\$4,856 + \$4,717) &divide; 2
Cost of Goods Sold
Average Accounts Payable
= 9.6 Times
This ratio measures how quickly the
company pays its accounts payable.
13-24
TESTS OF SOLVENCY ─ TIMES
INTEREST EARNED
Tests of solvency measure a company’s
ability to meet its long-term obligations.
Times
Interest
Earned
Times
Interest
Earned
=
=
Net
Interest
Income Tax
+
+
Income
Expense
Expense
Interest Expense
\$3,883 + \$606 + \$2,185
\$606
= 11.0 Times
This ratio indicates a margin of protection for creditors.
13-25
TESTS OF SOLVENCY ─ CASH
COVERAGE
Cash Flow from Operating Activities
Before Interest and Taxes Paid
Interest Paid
Cash
=
Coverage
Cash
=
Coverage
\$6,651 + \$580 + \$1,865
\$580
= 15.7
From Statement of Cash Flows
Cash interest paid
Income tax paid
\$
580
1,865
This ratio compares the cash generated with
the cash obligations of the period.
13-26
TESTS OF SOLVENCY ─ DEBT-TOEQUITY RATIO
Debt-to-Equity
Ratio
Debt-to-Equity
Ratio
=
=
Total Liabilities
Stockholders’ Equity
\$22,620
\$17,898
=
1.26
This ratio measures the amount
of liabilities that exists for each
\$1 invested by the owners.
13-27
MARKET TESTS ─ PRICE/EARNINGS
(P/E) RATIO
Market tests relate the current market price of a share of stock
to an indicator of the return that might accrue to the investor.
P/E Ratio
P/E Ratio
=
Current Market Price Per Share
Earnings Per Share
=
\$60
\$2.49
=
24.1
A recent price for
Home Depot stock
was \$60 per share.
This ratio measures the relationship between the current
market price of the stock and its earnings per share.
13-28
MARKET TESTS ─ DIVIDEND YIELD
RATIO
Dividend
Yield
Dividend
Yield
Dividends Per Share
Market Price Per Share
=
=
\$1.16
\$60
=
1.9%
Home Depot paid dividends of \$1.16 per share
when the market price was \$60 per share.
This ratio is often used to compare the
dividend-paying performance of different
investment alternatives.
13-29
END OF CHAPTER 13
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