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 CHAPTER 13 ANALYZING FINANCIAL STATEMENTS .
financial accounting, financial statement analysis, tests of profitability and liquidity, solvency, ratios
TRANSCRIPT
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
CHAPTER 13
ANALYZING FINANCIAL STATEMENTS
.
Presenter
Presentation Notes
Chapter 13: Analyzing Financial Statements
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FINANCIAL STATEMENT ANALYSIS
Examines a single company to identify
trends over time.
Financial statement analysis is based on comparisons.
Time series analysis
Comparison with similar companies
Provides insights concerning a
company’s relative performance.
Presenter
Presentation Notes
In order to compare companies or to assess the status of a single company, analysts use two different forms of analysis. Time series analysis examines a single company’s financial performance over time. � It is also important to compare the company with those of other companies in the same industry. Financial results are often affected by industry factors and economy-wide factors. By comparing one company’s financial performance with other companies in the same line of business, in the same time period, we get an indication of the relative performance of the companies.
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COMPONENT PERCENTAGES Express each item on a particular statement
as a percentage of a single base amount.
Total assets on the balance
sheet
Net sales on the income
statement
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%.
Presenter
Presentation Notes
Component percentages express all items on a financial statement in terms of one component of that statement. For the income statement, we generally express all items as a percent of net sales revenue. For the balance sheet, we generally express all items as a percent of total assets. The comparative income statements of Home Depot for 2012, 2011, and 2010 appear on the next slide. Let’s prepare component percentage income statements for each year 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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Presentation Notes
First, we will look at the year 2012. We will set net sales to 100% and express all other line-items on the income statement as a percentage of net sales.
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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%
Net Sales will be set to 100% and all other components will be
expressed as a percentage of Net
Sales.
Presenter
Presentation Notes
Next, we determine the cost of sales as a percentage of net sales. For 2012, divide cost of sales of $46,133 by net sales of $70,395 and multiply by 100%. For 2012, cost of sales is 65.5% of net sales. We repeat the process for gross profit and selling, general, and administrative expenses to determine that gross profit is 34.5% of net sales and that selling, general, and administrative expenses are 22.8% of net sales.
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COMPONENT PERCENTAGES
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Presentation Notes
Remember that component percentages express all items on a financial statement in terms of one component of that statement. For the income statement, we expressed all items as a percent of net sales revenue. The comparative income statements of Home Depot for 2012, 2011, and 2010 show that the cost of merchandise sold has declined slightly but remained generally constant at approximately 66% over the three year period, while selling, general and administrative expenses have decreased each year.
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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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Presentation Notes
The 2012 and 2011 balance sheets for Home Depot are presented on the next two slides. We will be referring to the balance sheets as well as the income statement throughout the ratio analyses.
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Presentation Notes
On this slide, you see the asset section of Home Depot’s balance sheets for both 2012 and 2011.
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Presentation Notes
On this screen, you see the liabilities and stockholders’ equity sections of Home Depot’s balance sheets for both 2012 and 2011.
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TEST OF PROFITABILITY ─ RETURN ON EQUITY
Return on Equity $3,883 ($17,898 + $18,889) ÷ 2
= = 21.1%
Net Income Average Stockholders’ Equity Return on Equity =
This measure indicates how much income was earned for every dollar invested by the
owners.
Profitability is a primary measure of the overall success of a company.
Presenter
Presentation Notes
Return on equity measures how well the company employed the owners’ investments to earn income. This ratio is calculated by dividing net income by average stockholders’ equity. Home Depot’s 2012 net income is $3,883 million. Ending stockholders’ equity for 2012 is $18,889 and ending owners’ equity for 2011 is $17,898. When the income is divided by the average stockholders’ equity, we see that the return on equity at Home Depot for 2012 is 21.1%.
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TEST OF PROFITABILITY ─ RETURN ON ASSETS
Return on Assets
Net Income + Interest Expense (net of tax) Average Total Assets =
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.
Assume the corporate tax rate is 34%.
Presenter
Presentation Notes
Return on total assets measures how well assets have been employed by the business. To calculate this ratio we divide net income plus interest expense (net of tax) by the average total assets for the period. Because creditors provide financing for a portion of the assets, we add interest expense to income in the numerator of the ratio. Home Depot earned a return on its total assets of 10.6 percent. Please spend a few minutes going over the calculation of this ratio, especially the interest expense computation.
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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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Presentation Notes
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. Home Depot has positive financial leverage since the return on equity is higher than the return on assets. Positive financial leverage indicates that Home Depot has borrowed money at a low rate of interest and employed the borrowed funds at a higher rate of return.
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TEST OF PROFITABILITY ─ EARNINGS PER SHARE (EPS)
EPS $3,883 1,562
= = $2.49
Earnings per share is probably the single most widely watched financial ratio.
Average number of shares based on the number of shares at the beginning and end of the year.
Net Income* Average Number of Shares Outstanding for the Period
EPS =
*If there are preferred dividends, the amount is subtracted from net income.
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Presentation Notes
Earnings per share is equal to net income less preferred stock dividends divided by the weighted-average number of common shares outstanding. The numerator of the equation is sometimes referred to as income available to common shareholders. Earnings per share is one of the most widely quoted financial ratios. It is a measure of the company’s ability to produce income for each common share outstanding. Home Depot’s earnings per share for 2012 is $2.49. Home Depot has no preferred stock dividends to subtract from income in the numerator. The average number of shares used in this computation is based on the beginning and ending number of shares for the year rather than the weighted-average number of shares reported in Home Depot’s income statement.
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TEST OF PROFITABILITY ─ QUALITY OF INCOME
A ratio higher than 1 indicates high-quality
earnings.
Quality of Income
Cash Flow from Operating Activities Net Income
=
$6,651 $3,883
= 1.71
Home Depot’s Quality of Income
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Presentation Notes
Remember that in the cash flow from operating activities section of the cash flow statement there is a reconciliation of net earnings to net cash provided by operating activities. One method of evaluating the quality of a company’s earnings is to compare its reported earnings to its cash flows from operating activities, as shown in this ratio. Dividing Home Depot’s cash flow from operating activities by net income, we see that Home Depot’s quality of income is 1.71. A quality of income ratio higher than 1 indicates high-quality earnings because each dollar of income is supported by more than one dollar of cash flow from operations.
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TEST OF PROFITABILITY ─ PROFIT MARGIN
This ratio tells us the percentage of each sales dollar, on average, that represents income.
Profit Margin
Net Income Net Sales Revenue =
= 5.5% Profit Margin
$3,883 $70,395
=
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Presentation Notes
Profit margin tells us how effective the company is at producing bottom line net income. It is the percentage of each sales dollar, on average, that represents income. The ratio is determined by dividing net income by net sales.� At Home Depot, after all expenses and taxes have been paid, the company was able to produce a profit margin of 5.5% of sales in 2012.
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TEST OF PROFITABILITY ─ FIXED ASSET TURNOVER
Fixed Asset
Turnover
$70,395 ($24,448 + $25,060) ÷ 2
= = 2.84
Fixed Asset
Turnover
Net Sales Revenue Average Net Fixed Assets
=
This ratio measures a company’s ability to generate sales given an investment in fixed
assets.
Presenter
Presentation Notes
The fixed asset turnover ratio is equal to net sales revenue divided by average net fixed assets. By net fixed assets, we mean property, plant, and equipment, net of accumulated depreciation. To compute average net fixed assets, we add the beginning and ending balances of net property, plant and equipment from the balance sheets, and divide by 2. The fixed asset turnover ratio is a measure of how effectively management is using the company’s investment in fixed assets to generate sales revenue. At Home Depot, the fixed asset turnover ratio is 2.84 for 2012.
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TESTS OF LIQUIDITY ─ CASH RATIO
Cash Ratio
Cash + Cash Equivalents Current Liabilities =
= 0.21 to 1 Cash Ratio
$1,987 $9,376 =
This ratio measures the adequacy of available cash.
Tests of liquidity focus on the relationship between current assets and current liabilities.
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Presentation Notes
Liquidity refers to a company’s ability to meet its currently maturing debts. Tests of liquidity focus on the relationship between current assets and current liabilities. The cash ratio is a measure of the adequacy of available cash to pay current liabilities. We compute the cash ratio by dividing the sum of cash and cash equivalents by current liabilities. At the 2012 balance sheet date, Home Depot’s cash ratio is 0.21 to 1, meaning Home Depot has 21 cents in cash on hand for each dollar of current liabilities. While this number might seem alarming, Home Depot generates large amounts of cash from operations that will be available before cash payments are due. Managing cash flow is extremely important. Certainly the company must have sufficient cash to meet its obligations, but holding too much cash is an unproductive use of the asset.
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TESTS OF LIQUIDITY ─ CURRENT RATIO
Current Ratio
Current Assets Current Liabilities
=
Current Ratio
$14,520 $9,376
= = 1.55 to 1
This ratio measures the ability of the company to pay current
debts as they become due.
Presenter
Presentation Notes
Perhaps the most widely used measure of a company’s ability to pay current obligations is the current ratio. It is computed by dividing current assets by current liabilities. At Home Depot, the current ratio at the 2012 balance sheet date is 1.55 to 1. This means that for every dollar of current liabilities, Home Depot has $1.55 of current assets to pay those obligations. It might be tempting to say that the higher this ratio becomes, the better off the company is. However, maintaining a very high current ratio restricts the amount of cash that can be invested elsewhere in the business. For years, the accepted standard for the current ratio was 2.0. However, with the ability to efficiently manage cash flows, most companies now maintain a current ratio somewhat less than 2.0.
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TESTS OF LIQUIDITY ─ QUICK RATIO (ACID TEST)
Quick Assets Current Liabilities
= Quick Ratio
$3,232 $9,376
= 0.35 to 1 = Quick Ratio
This ratio is like the current ratio but measures the company’s
The quick ratio is a more stringent measure than the current ratio. We calculate this ratio by dividing quick assets by current liabilities. Quick assets include cash and cash equivalents, net receivables, and short-term investments. The quick ratio excludes inventories from the numerator. For that reason, Home Depot’s quick ratio of 0.35 at the 2012 balance sheet date is much lower than the current ratio. �
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TESTS OF LIQUIDITY ─ RECEIVABLE TURNOVER
Net Credit Sales Average Net Receivables
Receivable Turnover
=
Receivable Turnover
$70,395 ($1,245 + $1,085) ÷ 2
= 60.4 Times =
This ratio measures how quickly a company collects its accounts
receivable.
Presenter
Presentation Notes
The receivable turnover ratio tells us the number of times per year a company can convert its accounts receivable into cash. For any company, the higher the turnover, the faster the cash collection on accounts receivable. We calculate receivable turnover by dividing net credit sales by average net receivables. This is yet another example of a ratio that contains an income measure in the numerator and a balance sheet measure in the denominator. Remember, in this type of ratio we always use an average amount in the denominator. At Home Depot, the receivable turnover for 2012 is 60.4 times. This means that, on average, the company collected its receivables 60.4 times per year.�
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TESTS OF LIQUIDITY ─ AVERAGE AGE OF RECEIVABLES
Days in Year Receivable Turnover
Average Age of Receivables =
= 6.0 Days 365 60.4
Average Age of Receivables
=
This ratio measures the average number of days it takes to collect receivables.
Presenter
Presentation Notes
Average age of receivables is calculated by dividing 365 days by the receivable turnover ratio. This ratio measures the average number of days it takes to collect receivables. At Home Depot, the average age of receivables is only 6.0 days.
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TESTS OF LIQUIDITY ─ INVENTORY TURNOVER
Cost of Goods Sold Average Inventory
Inventory Turnover =
Inventory Turnover
$46,133 ($10,325 + $10,625) ÷ 2 = 4.4 Times =
This ratio measures how quickly the company sells its inventory.
Presenter
Presentation Notes
Like the receivable turnover ratio, we can also calculate the inventory turnover. The inventory turnover ratio measures the number of times inventory is sold and replaced during the year. Higher inventory turnover helps protect a company from obsolete inventory items. Inventory turnover is calculated by dividing cost of goods sold for the period by the average inventory. At Home Depot, the inventory turnover for 2012 is 4.4 times, telling us that Home Depot sells and replaces its inventory about 4.4 times per year. ��
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TESTS OF LIQUIDITY ─ AVERAGE DAYS’ SUPPLY IN INVENTORY
Days in Year Inventory Turnover
Average Days’ Supply in Inventory
=
= 83 Days 365 4.4 =
Average Days’ Supply in Inventory
This ratio measures the average number of days it takes to sell the inventory.
Presenter
Presentation Notes
Average days’ supply in inventory is calculated by dividing 365 days by the inventory turnover ratio. This ratio measures the average number of days it takes a company to sell its inventory. Throughout 2012, Home Depot averaged 83 days of inventory available for sale.
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TESTS OF LIQUIDITY ─ ACCOUNTS PAYABLE TURNOVER RATIO
Cost of Goods Sold Average Accounts Payable
Accounts Payable Turnover
=
This ratio measures how quickly the company pays its accounts payable.
$46,133 ($4,856 + $4,717) ÷ 2 = 9.6 Times =
Accounts Payable Turnover
Presenter
Presentation Notes
Like the inventory turnover ratio and the receivables turnover ratio, we can also calculate the accounts payable turnover ratio. The accounts payable turnover ratio measures the number of times purchases on account are paid each year. The accounts payable turnover ratio is calculated by dividing cost of goods sold for the period by the average accounts payable. At Home Depot, the accounts payable turnover ratio for 2012 is 9.6 times, telling us that, on average, Home Depot pays the balance owed to its suppliers about 9.6 times per year. �
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This ratio indicates a margin of protection for creditors.
TESTS OF SOLVENCY ─ TIMES INTEREST EARNED
Net Interest Income Tax Income Expense Expense Interest Expense
Times Interest Earned
= + +
$3,883 + $606 + $2,185 $606
Times Interest Earned
= = 11.0 Times
Tests of solvency measure a company’s ability to meet its long-term obligations.
Presenter
Presentation Notes
Tests of solvency measure a company’s ability to meet its long-term obligations. Times interest earned is a ratio that measures the ability of a company to meet its periodic interest payments. The ratio is calculated by dividing income before interest and taxes by interest expense for the period. Since interest expense is deducted before computing taxes and net income, we add both interest expense and income tax expense back to net income for the numerator of this ratio. In 2012, Home Depot generated net income at a level equal to 11 times the amount of its interest expense.
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Cash Coverage
= $6,651 + $580 + $1,865
$580 = 15.7
This ratio compares the cash generated with the cash obligations of the period.
Cash interest paid 580$ Income tax paid 1,865
From Statement of Cash Flows
Cash Coverage
Cash Flow from Operating Activities Before Interest and Taxes Paid
Interest Paid =
TESTS OF SOLVENCY ─ CASH COVERAGE
Presenter
Presentation Notes
The cash coverage ratio compares the cash generated from operations to cash obligations. The ratio is calculated by dividing cash flow from operations before interest and taxes by the amount of interest paid. On your screen, you see the cash flow from operating activities portion of Home Depot’s 2012 Statement of Cash Flows. In the numerator of this ratio, you see that we added interest paid (not interest expense) and income tax paid (not income tax expense) to cash flow from operating activities to get cash flow from operating activities before interest and taxes. Note that interest paid used in this ratio is a different amount than interest expense used in the times interest earned ratio. Home Depot generated approximately 15.7 dollars in cash for each dollar of interest paid in 2012.
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TESTS OF SOLVENCY ─ DEBT-TO-EQUITY RATIO
This ratio measures the amount of liabilities that exists for each
$1 invested by the owners.
$22,620 $17,898
= 1.26 = Debt-to-Equity
Ratio
Total Liabilities Stockholders’ Equity
Debt-to-Equity Ratio
=
Presenter
Presentation Notes
The debt-to-equity ratio measures the amount of liabilities that exists for each $1 invested by the owners. We compute the ratio by dividing total liabilities by total stockholders’ equity. At the 2012 balance sheet date, Home Depot’s debt to equity ratio is 1.26, meaning the company’s creditors have provided more capital than the shareholders of Home Depot.
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MARKET TESTS ─ PRICE/EARNINGS (P/E) RATIO
P/E Ratio = Current Market Price Per Share
Earnings Per Share
P/E Ratio = $60
$2.49 = 24.1
This ratio measures the relationship between the current market price of the stock and its earnings per share.
A recent price for Home Depot stock was $60 per share.
Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor.
Presenter
Presentation Notes
Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor. The price/earnings ratio measures the relationship between the current market price of the stock and its earnings per share. Once we know the earnings per share of stock, we can calculate the price-earnings ratio by dividing the current market price per share of the company’s stock by the earnings per share. Using a recent price of $60 per share for Home Depot’s common stock, we divide by the 2012 earnings per share of $2.49 to obtain a price earnings ratio of 24.1. We conclude that Home Depot’s common stock is selling in the market place for 24.1 times its earnings for 2012.
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MARKET TESTS ─ DIVIDEND YIELD RATIO
Dividend Yield
Dividends Per Share Market Price Per Share
=
Dividend Yield
$1.16 $60
= = 1.9%
This ratio is often used to compare the dividend-paying performance of different
investment alternatives.
Home Depot paid dividends of $1.16 per share when the market price was $60 per share.
Presenter
Presentation Notes
Investors are interested in the amount of income that they will receive in the form of dividends. One comparison that investors make is based on dividend yield. To determine the dividend yield ratio, we divide the annual dividend per share by the market price per share of the company’s common stock. During 2012, Home Depot paid dividends of $1.16 per common share of stock outstanding. Dividing $1.16 by the share price of $60, we find that Home Depot’s dividend yield is 1.9 percent.
