Week 14, Chap14 Accounting 1A, Financial Accounting Analyzing Financial Statements Instructor: Michael Booth
Understanding The Business Return on an equity security investment Dividends Increase in share price Investors
How a company s business strategy affects financial analysis.
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.
Understanding a Company s Strategy Business Strategy Operating Decisions Transactions Financial Statements
Learning Objectives Discuss how analysts use financial statements.
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.
Financial Statement Analysis THREE TYPES OF FINANCIAL STATEMENT INFORMATION Past Performance Present Condition Future Performance Income, sales volume, cash flows, returnon-investments, EPS. Assets, debt, inventory, various ratios. Sales and earnings trends are good indicators of future performance.
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 Google Finance
Financial Statement Analysis Financial statement analysis is based on comparisons. Time series analysis Comparison with similar companies Company A Company B Provides insights concerning a company s relative performance.
Learning Objectives Compute and interpret component percentages.
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
Component Percentages HOME DEPOT Comparative Income Statements (Condensed) Amounts in Millions Except Per Share Data 2004 Percent 2003 Percent Net Sales $ 64,816 100.0% $ 58,247 100.0% Cost of Merchandise Sold 44,236 40,139 Gross Profit 20,580 18,108 Operating Expenses 13,734 12,278 Operating Income 6,846 5,830 Interest and Investment Income 59 79 Interest Expense (62) (37) Earnings Before Income Taxes 6,843 5,872 Income Taxes 2,539 2,208 Net Earnings $ 4,304 $ 3,664 Basic Earnings Per Share $ 1.88 $ 1.57 Weighted-Average Number of Common Shares Outstanding 2,283 2,336 Diluted Earnings Per Share $ 1.88 $ 1.56
Component Percentages HOME DEPOT Comparative Income Statements (Condensed) Amounts in Millions Except Per Share Data 2004 Percent 2003 Percent Net Sales $ 64,816 100.0% $ 58,247 100.0% Cost of Merchandise Sold 44,236 68.2% 40,139 Gross Profit 20,580 18,108 Operating Expenses 13,734 12,278 Operating Income 6,846 5,830 Interest and Investment Income 59 79 Interest Expense (62) (37) 2004 Cost 2004 Sales Earnings Before Income Taxes 6,843 5,872 Income Taxes 2,539 2,208 Net Earnings $ 4,304 $ 3,664 Basic Earnings Per Share $ 1.88 $ 1.57 Weighted-Average Number of Common Shares Outstanding 2,283 2,336 Diluted Earnings Per Share $ 1.88 $ 1.56
Component Percentages HOME DEPOT Comparative Income Statements (Condensed) Amounts in Millions Except Per Share Data 2004 Percent 2003 Percent Net Sales $ 64,816 100.0% $ 58,247 100.0% Cost of Merchandise Sold 44,236 68.2% 40,139 68.9% Gross Profit 20,580 31.8% 18,108 31.1% Operating Expenses 13,734 21.2% 12,278 21.1% Operating Income 6,846 10.6% 5,830 10.0% Interest and Investment Income 59 0.1% 79 0.1% Interest Expense (62) -0.1% (37) -0.1% Earnings Before Income Taxes 6,843 10.6% 5,872 10.1% Income Taxes 2,539 3.9% 2,208 3.8% Net Earnings $ 4,304 6.7% $ 3,664 6.3% Basic Earnings Per Share $ 1.88 $ 1.57 Weighted-Average Number of Common Shares Outstanding 2,283 2,336 Diluted Earnings Per Share $ 1.88 $ 1.56
Financial Statement to be used in Ratio Analysis Comparative Statements Continued
Comparative Statements
Learning Objectives 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 Return on Equity Return on Equity HOME DEPOT Comparative Income Statements (Condensed) Amounts in Millions Except Per Share Data 2004 Percent 2003 Percent Net Sales $ 64,816 100.0% $ 58,247 100.0% Cost of Merchandise Sold 44,236 68.2% 40,139 68.9% Gross Profit 20,580 31.8% 18,108 31.1% Operating Expenses 13,734 21.2% 12,278 21.1% Operating Income 6,846 10.6% 5,830 10.0% Interest and Investment Income 59 0.1% 79 0.1% Interest Expense (62) -0.1% (37) -0.1% Earnings Before Income Taxes 6,843 10.6% 5,872 10.1% Income Taxes 2,539 3.9% 2,208 3.8% Net Earnings $ 4,304 6.7% $ 3,664 6.3% Basic Earnings Per Share $ 1.88 $ 1.57 Weighted-Average Number of Common Shares Outstanding 2,283 2,336 Diluted Earnings Per Share $ 1.88 $ 1.56 Net Income Average Owners Equity $4,304 20.4% ($22,407 + $19,802) 2 This measure indicates how much income was earned for every dollar invested by the owners.
Return on Assets Return on Assets Net Income + Interest Expense (net of tax) Average Total Assets Return on Assets $4,304 + ($62 (1 -.37)) 13.5% ($34,437 + $30,011) 2 This ratio is generally considered the best overall measure of a company s profitability. Corporate tax rate is 37%.
Financial Leverage Percentage Financial Leverage Return on Equity Return on Assets 6.9% 20.4% 13.5% Net Income Return on Equity - 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.
Earnings per Share (EPS) Net Income (less preferred stock dividends) EPS Average Number of Shares of Common Stock Outstanding EPS $4,304 2,368 $1.82 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
Quality of Income(see page 712 in text) Quality of Income Cash Flow from Operating Activities Net Income Cash Flow from Operating Activities Net Income $ 4,304 Add: Depreciation and Amortization 1,076 Decrease in Receivables, net 25 Increase in Accounts Payable 790 Increase in Deferred Revenue 279 Increase in Deferred Income Taxes 605 Other 186 Deduct: Increase in Merchandise Inventories (693) Decrease in Income Taxes Payable (27) Cash Flow from Operating Activities $ 6,545
Quality of Income Quality of Income Quality of Income Cash Flow from Operating Activities Net Income $6,545 $4,304 1.52 A ratio higher than 1 indicates high-quality earnings.
Profit Margin 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 Fixed Asset Turnover $64,816 3.5 ($20,063 + $17,168) 2 This ratio measures a company s ability to generate sales given an investment in fixed assets.
Learning Objectives Compute and interpret liquidity ratios.
Ratios Measuring Liquidity Cash Ratio Current Ratio Quick (Acid-test) ratio Accounts receivable turnover Inventory turnover
Cash Ratio 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 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 (Acid Test) Quick Ratio Quick Assets Current Liabilities Quick Ratio $3,949 $9,554 0.41 to 1 Cash & Cash Equivalents $ 2,826 Receivables, net 1,097 Short-term Investments 26 Quick Assets $ 3,949 This ratio is like the current ratio but measures the company s immediate ability to pay debts.
Receivable Turnover 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 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 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 Average Days Supply in Inventory 365 5.1 71.6 Days This ratio measures the average number of days it takes to sell the inventory.
Accounts Payable Turnover 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 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 Times Interest Earned Net Interest Income Tax + + Income Expense Expense Interest Expense Times Interest Earned $4,304 + $62 + $2,539 111 Times $62 This ratio indicates a margin of protection for creditors.
Cash Coverage Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid Cash Flow from Operating Activities Net Income $ 4,304 Add: Depreciation and Amortization 1,076 Decrease in Receivables, net 25 Increase in Accounts Payable 790 Increase in Deferred Revenue 279 Increase in Deferred Income Taxes 605 Other 186 Deduct: Increase in Merchandise Inventories (693) Decrease in Income Taxes Payable (27) Cash Flow from Operating Activities $ 6,545
Cash Coverage Cash Coverage Cash Flow from Operating Activities Before Interest and Taxes Interest Paid Cash Coverage $6,545 + $70 + $2,539 $70 131 Cash interest paid $ 70 Income tax expense 2,539 This ratio compares the cash generated with the cash obligations of the period.
Debt-to-Equity Ratio 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.
Learning Objectives Compute and interpret market test ratios.
Market Tests Price/Earnings (PE) Ratio Cash coverage Ratio Dividend Yield
Price/Earnings (P/E) Ratio 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 Ratio Dividend Yield Dividends Per Share Market Price Per Share Dividend Yield $0.27 0.68% $40 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!!!
Other Financial Information In addition to financial ratios, special factors might affect company analysis: Rapid growth. Uneconomical expansion. Subjective factors.
Assignments: See web: http//www.cabrillo.edu/~mbooth This will be updated weekly as required Update your weekly journal for the Final Journal Work weekly on your final project, do the analysis with information learned during the week Note: Use McGrawHill HOMEWORK manager to submit assignments