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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 Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. 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 ÷ 2012 Net Sales $46,133 ÷ $70,395 = .655 or 65.5% 2012 Gross Profit ÷ 2012 Net Sales $24,262 ÷ $70,390 = .345 or 34.5% 2012 Selling, G&A ÷ 2012 Net Sales $16,028 ÷ $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) ÷ 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 × (1 - .34)) = 10.6% ($40,518 + $40,125) ÷ 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) ÷ 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 adequacy of available cash. 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 & 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) ÷ 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) ÷ 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) ÷ 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 13-30