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.

UNDERSTANDING THE BUSINESS
External Decision Makers
Present and Potential Owners
Investment Analysts
Creditors
Annual
Report
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THE INVESTMENT DECISION
Industry
Factors
Economy-wide
Factors Individual
Company Factors
Invest?
No Yes
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UNDERSTANDING A COMPANY’S
STRATEGY
I need to know if the company is trying to earn a high rate of return through product differentiation or cost differentiation.
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FINANCIAL STATEMENT ANALYSIS
Financial statement analysis is based on comparisons.
Time series analysis
Examines a single company to identify trends over time.
Comparison with similar companies
Provides insights concerning a company’s relative performance.
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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%.
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Net Sales will be set to 100% and all other components will be expressed as a percentage of Net
Sales.
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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%
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COMPONENT PERCENTAGES
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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
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TEST OF PROFITABILITY ─ RETURN
ON EQUITY
Profitability is a primary measure of the overall success of a company.
Return on Equity =
Net Income
Average Stockholders’ Equity
Return on 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.
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TEST OF PROFITABILITY ─ RETURN
ON ASSETS
Return on Net Income + Interest Expense (net of tax)
=
Assets Average Total Assets
Return on
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.
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TEST OF PROFITABILITY ─ FINANCIAL
LEVERAGE PERCENTAGE
Financial Leverage
Percentage
= Return on Equity – Return on Assets
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.
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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.
$3,883
EPS = = $2.49
1,562
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.
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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.
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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.
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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.
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TESTS OF LIQUIDITY ─ CASH RATIO
Tests of liquidity focus on the relationship between current assets and current liabilities.
Cash
Ratio
=
Cash + Cash Equivalents
Current Liabilities
Cash
Ratio
=
$1,987
$9,376
= 0.21 to 1
This ratio measures the adequacy of available cash.
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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.
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TESTS OF LIQUIDITY ─ QUICK RATIO
(ACID TEST)
Quick Quick Assets
=
Ratio Current Liabilities
Quick
Ratio
=
$3,232
$9,376
= 0.35 to 1
Cash & Cash Equivalents
Receivables, net
Quick Assets
$ 1,987
1,245
$ 3,232
This ratio is like the current ratio but measures the company’s immediate ability to pay debts.
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TESTS OF LIQUIDITY ─ RECEIVABLE
TURNOVER
Receivable
Turnover
=
Net Credit Sales
Average Net Receivables
Receivable
Turnover
=
$70,395
($1,245 + $1,085) ÷ 2
= 60.4 Times
This ratio measures how quickly a company collects its accounts receivable.
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TESTS OF LIQUIDITY ─ AVERAGE AGE
OF RECEIVABLES
Average Age of Receivables
=
Days in Year
Receivable Turnover
Average Age of Receivables
=
365
60.4
= 6.0 Days
This ratio measures the average number of days it takes to collect receivables.
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TESTS OF LIQUIDITY ─ INVENTORY
TURNOVER
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
Inventory
Turnover
=
$46,133
($10,325 + $10,625) ÷ 2
= 4.4 Times
This ratio measures how quickly the company sells its inventory.
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TESTS OF LIQUIDITY ─ AVERAGE
DAYS’ SUPPLY IN INVENTORY
Average Days’
Supply in
Inventory
=
Days in Year
Inventory Turnover
Average Days’
Supply in
Inventory
=
365
4.4
= 83 Days
This ratio measures the average number of days it takes to sell the inventory.
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TESTS OF LIQUIDITY ─ ACCOUNTS
PAYABLE TURNOVER RATIO
Accounts
Payable
Turnover
=
Cost of Goods Sold
Average Accounts Payable
Accounts
Payable
Turnover
=
$46,133
($4,856 + $4,717) ÷ 2
= 9.6 Times
This ratio measures how quickly the company pays its accounts payable.
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TESTS OF SOLVENCY ─ TIMES
INTEREST EARNED
Tests of solvency measure a company’s ability to meet its long-term obligations.
Times
Interest
Earned
=
Net Interest Income Tax
+ +
Income Expense Expense
Interest Expense
Times
Interest
Earned
=
$3,883 + $606 + $2,185
$606
= 11.0 Times
This ratio indicates a margin of protection for creditors.
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TESTS OF SOLVENCY ─ CASH
COVERAGE
Cash
Coverage
=
Cash Flow from Operating Activities
Before Interest and Taxes Paid
Interest Paid
Cash
Coverage
=
$6,651 + $580 + $1,865
$580
From Statement of Cash Flows
Cash interest paid
Income tax paid
$ 580
1,865
= 15.7
This ratio compares the cash generated with the cash obligations of the period.
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TESTS OF SOLVENCY ─ DEBT-TO-
EQUITY RATIO
Debt-to-Equity
Ratio
=
Total Liabilities
Stockholders’ Equity
Debt-to-Equity
Ratio
=
$22,620
$17,898
= 1.26
This ratio measures the amount of liabilities that exists for each
$1 invested by the owners.
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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 =
Current Market Price Per Share
Earnings Per Share
P/E Ratio =
$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.
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MARKET TESTS ─ DIVIDEND YIELD
RATIO
Dividend Dividends Per Share
=
Yield Market Price Per Share
Dividend
Yield
=
$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.
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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.
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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.
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