Analyzing Financial Statements
McGraw-Hill/Irwin
© 2009 The McGraw-Hill Companies, Inc.
I am excited about analyzing
the financial statements
of cat food companies!
Understanding The Business
Individual
Company
Factors
Industry
Factors
Economy-wide
Factors
Invest?
No
Yes
14-3
Understanding The Business
Return on an equity
security investment
Increase in
share price
Dividends
Investors
14-4
“It’s not buy and hold, it’s buy and homework!”
McGraw-Hill/Irwin
Understanding a Company’s Strategy
I need to know the company’s policies on
product differentiation, pricing, and cost control
to make my financial analysis more meaningful.
Business
Strategy
Operating
Decisions
Transactions
Financial
Statements
14-6
Financial Statement Analysis
FINANCIAL STATEMENT USERS
MANAGEMENT
EXTERNAL DECISION
MAKERS
. . . uses accounting data
to make product pricing
and expansion
decisions.
. . . use accounting data
for investment, credit,
tax, and public policy
decisions.
14-7
Financial Statement Analysis
THREE TYPES OF FINANCIAL
STATEMENT INFORMATION
Past
Performance
Income, sales
volume, cash
flows, returnon-investments,
EPS.
Present
Condition
Assets, debt,
inventory,
various ratios.
Future
Performance
Sales and earnings
trends are good
indicators of future
performance.
14-8
Statements made in this presentation concerning projections or expectations of financial or operational performance or
economic outlook, or concerning other future events or results, or which refer to matters which are not historical facts, are
"forward-looking statements" within the meaning of the federal securities laws. Forward-looking statements involve a number
of risks and uncertainties, and actual results may differ materially from that projected or implied in those statements.
Important factors that could cause such differences include, but are not limited to, economic and industry conditions: material
adverse changes in economic or industry conditions, both within the United States and globally, customer demand, effects of
adverse economic conditions affecting shippers, adverse economic conditions in the industries and geographic areas that
produce and consume freight, competition and consolidation within the transportation industry, the extent to which BNSF
Railway is successful in gaining new long-term relationships with customers or retaining existing ones, changes in the
securities and capital markets, changes in fuel prices, and changes in labor costs and labor difficulties including stoppages
affecting either BNSF Railway’s operations or our customers’ abilities to deliver goods to BNSF Railway for shipment; legal and
regulatory factors: developments and changes in laws and regulations, the ultimate outcome of shipper and rate claims subject
to adjudication, environmental investigations or proceedings and other types of claims and litigation; and operating factors:
technical difficulties, changes in operating conditions and costs, commodity concentrations, the availability of equipment and
human resources to meet changes in demand, the Company’s ability to achieve its operational and financial initiatives and to
contain costs, as well as natural events such as severe weather,floods and earthquakes or man-made or other disruptions of
the Company’s operating systems, structures, or equipment.
The Company cautions against placing undue reliance on forward-looking statements, which reflect its current beliefs and are
based on information currently available to it as of the date a forward-looking statement is made. The Company undertakes no
obligation to revise forward-looking statements to reflect future events, changes in circumstances, or changes in beliefs. In the
event that the Company does update any forward-looking statements, no inference should be made that the Company will make
additional updates with respect to that statement, related matters, or any other forward-looking statements. Any corrections or
revisions may appear in BNSF’s public filings with the Securities and Exchange Commission, which are accessible at
www.sec.gov or on BNSF’s website at www.bnsf.com, and which you are advised to consult.
McGraw-Hill/Irwin
McGraw-Hill/Irwin
McGraw-Hill/Irwin
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.
14-13
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 2007 and 2006 appear on the next slide.
Prepare component percentage income statements
where net sales equal 100%.
14-14
HOME DEPOT
Comparative Income Statements (Condensed)
Amounts in Millions Except Per Share Data
2007
Percent
2006
Percent
Net Sales
$ 90,837
100.0% $ 81,511
100.0%
Cost of Merchandise Sold
61,054
67.2%
54,191
66.5%
Gross Profit
29,783
27,320
Operating Expenses
20,110
17,957
Operating Income
9,673
9,363
Interest and Investment Income
27
62
Interest Expense
(392)
(143)
2007
Cost ÷ 2007 Sales
Earnings Before Income Taxes
9,308
9,282
Income Taxes
3,547
3,444
Net Earnings
$ 5,761
$ 5,838
Basic Earnings Per Share
$
2.80
$
2.73
Weighted-Average Number of
Common Shares Outstanding
2,062
2,147
Diluted Earnings Per Share
$
2.79
$
2.72
14-15
HOME DEPOT
Comparative Income Statements (Condensed)
Amounts in Millions Except Per Share Data
2007
Percent
2006
Percent
Net Sales
$ 90,837
100.0% $ 81,511
100.0%
Cost of Merchandise Sold
61,054
67.2%
54,191
66.5%
Gross Profit
29,783
32.8%
27,320
33.5%
Operating Expenses
20,110
22.1%
17,957
22.0%
Operating Income
9,673
10.6%
9,363
11.5%
Interest and Investment Income
27
0.0%
62
0.1%
Interest Expense
(392)
-0.4%
(143)
-0.2%
Earnings Before Income Taxes
9,308
10.2%
9,282
11.4%
Income Taxes
3,547
3.9%
3,444
4.2%
Net Earnings
$ 5,761
6.3% $ 5,838
7.2%
Basic Earnings Per Share
$
2.80
$
2.73
Weighted-Average Number of
Common Shares Outstanding
2,062
2,147
Diluted Earnings Per Share
$
2.79
$
2.72
14-16
Commonly Used Ratios
The 2007 and 2006 balance sheets for Home
Depot are presented next.
We will be referring to these financial
statements throughout the ratio analyses.
Home Depot
14-17
HOME DEPOT
Comparative Balance Sheets (Condensed)
Amounts in Millions
2007
Assets
Cash and Cash Equivalents
Short-Term Investments
Receivables, net
Merchandise Inventories
Other Current Assets
Total Current Assets
Property and Equipment, at cost
Less Accumulated Depreciation
Net Property and Equipment
Other Assets
Total Assets
2006
$
600 $
793
14
14
3,223
2,396
12,822
11,401
1,341
665
18,000
15,269
34,358
31,530
7,753
6,629
26,605
24,901
7,658
4,235
$ 52,263 $ 44,405
Continued
14-18
HOME DEPOT
Comparative Balance Sheets (Condensed)
Amounts in Millions
2007
2006
Liabilities
Current Liabilities
Noncurrent Liabilities
Total Liabilities
Stockholders' Equity
Common Stock, $.05 par
Paid-in Capital
Retained Earnings
Accumulated Other Comprehensive Income
Total
Less: Treasury Stock
Total Stockholders' Equity
Total Liabilities & Stockholders' Equity
$ 12,931 $ 12,706
14,302
4,790
27,233
17,496
121
7,930
33,052
310
41,413
(16,383)
25,030
$ 52,263 $
120
7,149
28,943
409
36,621
(9,712)
26,909
44,405
14-19
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
$5,761
($25,030 + $26,909) ÷ 2
= 22.2%
This measure indicates how much income was
earned for every dollar invested by the owners.
14-20
Test of Profitability ─ Return on Assets
Return on
Assets
Return on
Assets
=
Net Income + Interest Expense (net of tax)
Average Total Assets
=
$5,761 + ($392 × (1 - .34))
= 12.5%
($52,263 + $44,405) ÷ 2
Corporate tax rate
is 34%.
This ratio is generally considered the best overall
measure of a company’s profitability.
14-21
Test of Profitability ─ Financial Leverage
Percentage
Financial
Leverage
9.7%
=
Return on Equity – Return on Assets
=
22.2% – 12.5%
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.
14-22
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 =
$5,761
(1,970 + 2124) ÷ 2
= $2.81
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.
14-23
Test of Profitability ─ Quality of Income
Quality
=
of Income
Cash Flow from Operating Activities
Net Income
Cash Flow from Operating Activities
Net Income
Add:
Depreciation and Amortization
Decrease in Receivables, net
Increase in Accounts Payable
Increase in Deferred Income Taxes
Stock-based Compensation Expense
Other
$ 5,761
1,886
96
531
46
297
178
Deduct:
(123)
(563)
(172)
(225)
(51)
$ 7,661
Increase in Deferred Revenue
Increase in Merchandise Inventories
Decrease in Income Taxes Payable
Decrease in Other Current Assets
Decrease in Other Long-term Liabilities
Cash Flow from Operating Activities
14-24
Test of Profitability ─ Quality of Income
Quality
=
of Income
Cash Flow from Operating Activities
Quality
=
of Income
$7,661
Net Income
$5,761
= 1.33
A ratio higher than 1 indicates
high-quality earnings.
14-25
Test of Profitability ─ Profit Margin
Profit
=
Margin
Net Income
Profit
=
Margin
$5,761
Net Sales
= 6.3%
$90,837
This ratio tells us the percentage of
each sales dollar that is income.
14-26
Test of Profitability ─ Fixed Asset Turnover
Fixed
=
Asset
Turnover
Net Sales Revenue
Average Net Fixed Assets
Fixed
$90,837
=
= 3.53
Asset
($26,605 + $24,901) ÷ 2
Turnover
This ratio measures a company’s ability to generate
sales given an investment in fixed assets.
14-27
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
=
$600
$12,931
=
0.05 to 1
This ratio measures the
adequacy of available cash.
14-28
Tests of Liquidity ─ Current Ratio
Current
Ratio
Current
Ratio
=
=
Current Assets
Current Liabilities
$18,000
$12,931
=
1.39 to 1
This ratio measures the ability
of the company to pay current
debts as they become due.
14-29
Tests of Liquidity ─ Quick Ratio (Acid Test)
Quick
Ratio
=
Quick Assets
Current Liabilities
Quick
Ratio
=
$3,837
$9,554
Cash & Cash Equivalents
Receivables, net
Short-term Investments
Quick Assets
=
0.40 to 1
$
600
3,223
14
$ 3,837
This ratio is like the current
ratio but measures the company’s
immediate ability to pay debts.
14-30
Tests of Liquidity ─ Receivable Turnover
Receivable
Turnover
Receivable
Turnover
=
=
Net Credit Sales
Average Net Receivables
$90,837
= 32.3 Times
($3,223 + $2,396) ÷ 2
This ratio measures how
quickly a company collects its
accounts receivable.
14-31
Tests of Liquidity ─ Average Age of Receivables
Average Age
of Receivables
Average Age
of Receivables
=
=
Days in Year
Receivable Turnover
365
32.3
= 11.3 Days
This ratio measures the average number
of days it takes to collect receivables.
14-32
Tests of Liquidity ─ Inventory Turnover
Inventory
Turnover
Inventory
Turnover
Cost of Goods Sold
=
Average Inventory
$61,054
= 5.0 Times
=
($12,822 + $11,401) ÷ 2
This ratio measures how quickly
the company sells its inventory.
14-33
Tests of Liquidity ─ Average Days’ Supply in Inventory
Average Days’
Supply in
Inventory
Average Days’
Supply in
Inventory
=
=
Days in Year
Inventory Turnover
365
5.0
=
73 Days
This ratio measures the average
number of days it takes to sell the
inventory.
14-34
Tests of Liquidity ─ Accounts Payable Turnover
Accounts
Payable
Turnover
=
Accounts
Payable
Turnover
$61,054
=
($7,356 + $6,032) ÷ 2
Cost of Goods Sold
Average Accounts Payable
= 9.1 Times
This ratio measures how quickly the
company pays its accounts payable.
14-35
Tests of Liquidity ─ Average Age of Payables
Average Age
of Payables
Average Age
of Payables
=
=
Days in Year
Accounts Payable Turnover
365
9.1
=
40.1 Days
This ratio measures the average number
of days it takes to pay its suppliers.
14-36
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
$5,761 + $392 + $3,547
$392
= 24.7 Times
This ratio indicates a margin of protection for creditors.
14-37
Tests of Solvency ─ Cash Coverage
Cash
=
Coverage
Cash Flow from Operating Activities
Before Interest and Taxes Paid
Interest Paid
Cash Flow from Operating Activities
Net Income
Add:
Depreciation and Amortization
Decrease in Receivables, net
Increase in Accounts Payable
Increase in Deferred Income Taxes
Stock-based Compensation Expense
Other
$ 5,761
1,886
96
531
46
297
178
Deduct:
(123)
(563)
(172)
(225)
(51)
$ 7,661
Increase in Deferred Revenue
Increase in Merchandise Inventories
Decrease in Income Taxes Payable
Decrease in Other Current Assets
Decrease in Other Long-term Liabilities
Cash Flow from Operating Activities
14-38
Tests of Solvency ─ Cash Coverage
Cash Flow from Operating Activities
Before Interest and Taxes Paid
Interest Paid
Cash
=
Coverage
Cash
=
Coverage
$7,661 + $270 + $3,963
$270
=
44.0
From Statement of Cash Flows
Cash interest paid
Income tax paid
$
270
3,963
This ratio compares the cash generated with
the cash obligations of the period.
14-39
Tests of Solvency ─ Debt-to-Equity Ratio
Debt-to-Equity
Ratio
Debt-to-Equity
Ratio
=
=
Total Liabilities
Stockholders’ Equity
$27,233
$25,030
=
1.09
This ratio measures the amount of
liabilities that exists for each $1
invested by the owners.
14-40
“20”
14-41
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
=
$34
$2.80
=
12.1
A recent price for
Home Depot stock
was $34 per share.
This ratio measures the relationship between the current
market price of the stock and its earnings per share.
14-42
Market Tests ─ Dividend Yield Ratio
Dividend
Yield
Dividend
Yield
=
Dividends Per Share
Market Price Per Share
=
$0.675
$34
=
2%
Home Depot paid dividends of $.675 per share
when the market price was $34 per share.
This ratio is often used to compare the
dividend-paying performance of different
investment alternatives.
14-43
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.
14-44
Other Financial Information
In addition to financial ratios, special factors might affect
company analysis:
 Rapid growth.
 Uneconomical expansion.
 Subjective factors.
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.
14-45
No .. Let us analyze a real firm!
McGraw-Hill/Irwin
McGraw-Hill/Irwin
End of Chapter 14
McGraw-Hill/Irwin
© 2009 The McGraw-Hill Companies, Inc.