Analyzing Financial
Statements
Instructor: Michael Booth

Return on an equity security investment
Dividends
Increase in share price
Investors

How a company’s business strategy affects financial analysis.

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

Discuss how analysts use financial statements.

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.

THREE TYPES OF FINANCIAL
STATEMENT INFORMATION
Past
Performance
Income, sales volume, cash flows, return- on-investments,
EPS.
Present
Condition
Future
Performance
Assets, debt, inventory, various ratios.
Sales and earnings trends are good indicators of future performance.

Financial statement analysis is based on comparisons.
Time series analysis
Examines a single
company to identify
trends over time.
Comparison with
similar companies
Google Finance

Financial statement analysis is based on comparisons.
Time series analysis
Company
A Company
B
Comparison with
similar companies
Provides insights concerning a company’s relative performance.

Compute and interpret 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

Component Percentages
The comparative income statements
of Home Depot for 2004 and 2003 appear on the next slide.
Prepare component percentage income statements where net sales equal 100%.
Home Depot

HOME DEPOT
Comparative Income Statements (Condensed)
Amounts in Millions Except Per Share Data
2004 Percent 2003
Net Sales
Cost of Merchandise Sold
$ 64,816
44,236
100.0% $ 58,247
40,139
Gross Profit
Operating Expenses
Operating Income
Interest and Investment Income
Interest Expense
Earnings Before Income Taxes
Income Taxes
Net Earnings
20,580
13,734
$
6,846
59
(62)
6,843
2,539
4,304
18,108
12,278
$
5,830
79
(37)
5,872
2,208
3,664
Basic Earnings Per Share
Weighted-Average Number of
Common Shares Outstanding
Diluted Earnings Per Share
$ 1.88
2,283
$ 1.88
$ 1.57
2,336
$ 1.56
Percent
100.0%

HOME DEPOT
Comparative Income Statements (Condensed)
Amounts in Millions Except Per Share Data
2004 Percent 2003
Net Sales
Cost of Merchandise Sold
$ 64,816
44,236
100.0% $ 58,247
68.2% 40,139
Gross Profit
Operating Expenses
Operating Income
Interest and Investment Income
Interest Expense
Earnings Before Income Taxes
Income Taxes
Net Earnings
20,580
13,734
6,846
59
18,108
12,278
5,830
79
2004 Cost ÷ 2004 Sales
6,843 5,872
2,539 2,208
$ 4,304 $ 3,664
Basic Earnings Per Share
Weighted-Average Number of
Common Shares Outstanding
Diluted Earnings Per Share
$ 1.88
2,283
$ 1.88
$ 1.57
2,336
$ 1.56
Percent
100.0%

Comparative Income Statements (Condensed)
Amounts in Millions Except Per Share Data
2004 Percent 2003
Net Sales
Cost of Merchandise Sold
$ 64,816
44,236
100.0% $ 58,247
68.2% 40,139
Gross Profit
Operating Expenses
Operating Income
Interest and Investment Income
Interest Expense
Earnings Before Income Taxes
Income Taxes
Net Earnings
20,580
13,734
6,846
59
(62)
6,843
2,539
$ 4,304
31.8% 18,108
21.2% 12,278
10.6%
0.1%
-0.1%
5,830
79
(37)
10.6%
3.9%
6.7%
5,872
2,208
$ 3,664
Basic Earnings Per Share
Weighted-Average Number of
Common Shares Outstanding
Diluted Earnings Per Share
$ 1.88
2,283
$ 1.88
$ 1.57
2,336
$ 1.56
Percent
100.0%
68.9%
31.1%
21.1%
10.0%
0.1%
-0.1%
10.1%
3.8%
6.3%

Financial Statement to be used in Ratio Analysis
Comparative Statements
Continued

Compute and interpret profitability ratios.

Ratios Measuring Profitability,
Operating Results, and
Efficiency
 Rate of return on common stockholders’ equity
 Rate of return on total assets
 Earnings per share of common stock (EPS)
 Financial Leverage Ratio.
 Price-earnings ratio.
 Quality of Income
 Fixed Asset turnover.

Return on Equity =
Net Income
Average Owners’ Equity
Return on Equity =
$4,304
($22,407 + $19,802) ÷ 2
= 20.4%
Net Sales
Comparative Income Statements (Condensed)
Amounts in Millions Except Per Share Data
Cost of Merchandise Sold
HOME DEPOT
2004
44,236
Percent
100.0%
68.2%
2003
$ 58,247
40,139
Gross Profit
Operating Expenses
20,580
13,734
31.8%
21.2%
18,108
12,278
Operating Income
Interest and Investment Income
Interest Expense
Earnings Before Income Taxes
Income Taxes
Net Earnings
6,846
59
(62)
6,843
2,539
10.6%
0.1%
-0.1%
10.6%
3.9%
6.7%
5,830
$
79
(37)
5,872
2,208
3,664
Basic Earnings Per Share
Weighted-Average Number of
Common Shares Outstanding
Diluted Earnings Per Share
$ 1.88
2,283
$ 1.88
$ 1.57
2,336
$ 1.56
Percent
100.0%
68.9%
31.1%
21.1%
10.0%
0.1%
-0.1%
10.1%
3.8%
6.3%
This measure indicates how much income was earned for every dollar invested by the owners.

Return on
Assets
=
Net Income + Interest Expense (net of tax)
Average Total Assets
Return on
Assets
=
$4,304 + ($62 × (1 - .37))
($34,437 + $30,011) ÷ 2
= 13.5%
Corporate tax rate
is 37%.
This ratio is generally considered the best overall measure of a company’s profitability.

Financial
Leverage
= Return on Equity – Return on Assets
=
6.9% = 20.4% – 13.5%
Return on Equity =
Net Income
Average Owners’ Equity
-
Return on
Assets
=
Net Income + Interest Expense (net of tax)
Average Total Assets
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. (Positive indicates borrowed money at low rate and employed at a higher rate of return.

EPS
Net Income (less preferred stock dividends)
=
Average Number of Shares of
Common Stock Outstanding
EPS =
$4,304
= $1.82
2,368
Average number of shares outstanding is from Home Depot’s 2004 Income Statement.
Earnings per share is probably the single most widely watched financial ratio. Ability to produce income per share of stock

(see page 712 in text)
Quality of Income
=
Cash Flow from Operating Activities
Net Income
Add: Depreciation and Amortization
Decrease in Receivables, net
Increase in Accounts Payable
Increase in Deferred Revenue
Increase in Deferred Income Taxes
Other
Deduct: Increase in Merchandise Inventories
Decrease in Income Taxes Payable
Cash Flow from Operating Activities
$ 4,304
1,076
25
790
279
605
186
(693)
(27)
$ 6,545

Quality of Income
Quality of Income
=
=
Cash Flow from Operating Activities
Net Income
$6,545
= 1.52
$4,304
A ratio higher than 1 indicates high-quality earnings.

Profit
Margin
=
Net Income
Net Sales
Profit
Margin
=
$4,304
$64,816
= 6.6%
This ratio tells us the percentage of each sales dollar that is income.

Fixed
Asset
Turnover
=
Fixed
Asset
Turnover
=
Net Sales Revenue
Average Net Fixed Assets
$64,816
($20,063 + $17,168) ÷ 2
= 3.5
This ratio measures a company’s ability to generate sales given an investment in fixed assets.

Compute and interpret liquidity ratios.

Ratios Measuring Liquidity
 Cash Ratio
 Current Ratio
 Quick (Acid-test) ratio
 Accounts receivable turnover
 Inventory turnover

Cash
Ratio
=
Cash + Cash Equivalents
Current Liabilities
Cash
Ratio
=
$2,826
$9,554
= 0.296 to 1
This ratio measures the adequacy of available cash. This must be viewed in conjunction with Cash Flow from operating activity, inventory turns, and A/R turns.

Current
Ratio
=
Current Assets
Current Liabilities
Current
Ratio
=
$13,328
= 1.39 to 1
$9,554
This ratio measures the abilityof the company to pay current debts as they become due. Highly dependent on management of cash flows. A ratio of 2 is acceptable, but less can also be
OK if cash flow support debt.

Quick
Ratio
=
Quick Assets
Current Liabilities
Quick
Ratio
=
$3,949
$9,554
Cash & Cash Equivalents
Receivables, net
Short-term Investments
Quick Assets
= 0.41 to 1
$ 2,826
1,097
26
$ 3,949
This ratio is like the current ratio but measures the company’s immediate ability to pay debts.

Receivable
Turnover
=
Net Credit Sales
Average Net Receivables
Receivable
Turnover
=
$64,816
($1,097 + $1,072) ÷ 2
= (59.8) or 60 Times/yr
This ratio measures how quickly a company collects its accounts receivable. Can be over stated if Credit sales are not available, and total sales are use as surrogate.
Note: If credit sales is not available, total sales can be used, but possibly inflate the ratio

Average Age of Receivables
=
Days in Year
Receivable Turnover
Average Age of Receivables
=
365
59.8
= 6.1 Days
This ratio measures the average number of days it takes to collect receivables.

Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
Inventory
Turnover
=
$44,236
($9,076 + $8,338) ÷ 2
= 5.1 Times
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
365
5.1
= 71.6 Days
This ratio measures the average number of days it takes to sell the inventory.

Accounts
Payable
Turnover
=
Cost of Goods Sold
Average Accounts Payable
Accounts
Payable
Turnover
=
$44,236
($5,159 + $4,560) ÷ 2
= 9.1 Times
This ratio measures how quickly the company pays its accounts payable.

Average Age of Payables
=
Days in Year
Accounts Payable Turnover
Average Age of Payables
=
365
9.1
= 40.1 Days
This ratio measures the average number of days it takes to pay its suppliers.

Compute and interpret solvency ratios.

Ratios Measuring Solvency
 Times Interest Earned Ratio
 Cash coverage Ratio
 Debt-to-Equity Ratio

Times
Interest
Earned
= Income Expense Expense
Interest Expense
Times
Interest
Earned
=
$4,304 + $62 + $2,539
$62
= 111 Times
This ratio indicates a margin of protection for creditors.

Cash
Coverage
=
Cash Flow from Operating Activities
Before Interest and Taxes
Interest Paid
Cash Flow from Operating Activities
Net Income
Add: Depreciation and Amortization
Decrease in Receivables, net
Increase in Accounts Payable
Increase in Deferred Revenue
Increase in Deferred Income Taxes
Other
Deduct: Increase in Merchandise Inventories
Decrease in Income Taxes Payable
Cash Flow from Operating Activities
$ 4,304
1,076
25
790
279
605
186
(693)
(27)
$ 6,545

Cash
Coverage
=
Cash Flow from Operating Activities
Before Interest and Taxes
Interest Paid
Cash
Coverage
=
$6,545 + $70 + $2,539
$70
Cash interest paid
Income tax expense
$ 70
2,539
= 131
This ratio compares the cash generated with the cash obligations of the period.

Debt-to-Equity
Ratio
=
Total Liabilities
Owners’ Equity
Debt-to-Equity
Ratio
=
$12,030
$22,407
= 0.54
This ratio measures the amount of liabilities that exists for each $1 invested by the owners.

Compute and interpret market test ratios.

Market Tests
 Price/Earnings (PE) Ratio
 Cash coverage Ratio
 Dividend Yield

P/E Ratio =
Current Market Price Per Share
Earnings Per Share
P/E Ratio =
$40
$1.88
= 21
A recent price for Home Depot stock was $40 per share.
This ratio measures the relationship between the current market price of the stock and its earnings per share.

Dividend
Yield
=
Dividends Per Share
Market Price Per Share
Dividend
Yield
=
$0.27
$40
= 0.68%
Home Depot paid dividends of $.27 per share when the market price was $40 per share.
This ratio is often used to compare the dividend-paying performance of different investment alternatives.

Interpreting Ratios (Notice!!!)



Ratios may be interpreted by comparison:
Ratios of other companies in the same industry
Ratios from the same company over time
Industry average ratios
Note: Ratios may vary because of the company’s industry characteristics, nature of operations, size, and accounting policies. Care must be exercise with comparing ratios!!! Only EPS is a standardized ratio within the accounting profession, and is found on the
Income Statement!!!

In addition to financial ratios, special factors might affect company analysis:



Rapid growth.
Uneconomical expansion.
Subjective factors.

See web: http//www.cabrillo.edu/~mbooth
This will be updated weekly as required
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