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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 13-2

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 13-9

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)) ($40,518 + $40,125) ÷ 2 = 10.6% 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. 13-28

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. 13-33

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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