Analyzing Financial Statements Chapter 14 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Analyzing Financial StatementsAnalyzing Financial Statements

Chapter 14

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Slide 2McGraw-Hill/IrwinMcGraw-Hill/Irwin

THREE TYPES OF FINANCIAL STATEMENT INFORMATION

PastPerformance

PresentCondition

FuturePerformance

Income, sales volume, cash flows, return-

on-investments,EPS.

Assets, debt, inventory,

various ratios.

Sales and earnings trends are good

indicators of future performance.

Financial Statement Analysis

Slide 3McGraw-Hill/IrwinMcGraw-Hill/Irwin

Financial Statement Analysis

Examines a single company to identify

trends over time.

Financial statement analysisis based on comparisons.

Time seriesanalysis

Comparison with similar companies

Provides insightsconcerning a

company’s relativeperformance.

Slide 4McGraw-Hill/IrwinMcGraw-Hill/Irwin

Component Percentages

Express each item on a particular statement as a percentage of a single base amount.

Total assetson the balance

sheet

Net saleson the income

statement

The comparative income statements of Home Depot for 2007 and 2006 appear on the next slide.

Prepare component percentage income statements where net sales equal 100%.

Slide 5McGraw-Hill/IrwinMcGraw-Hill/Irwin

HOME DEPOTComparative Income Statements (Condensed)

Amounts in Millions Except Per Share Data2007 Percent 2006 Percent

Net Sales 90,837$ 100.0% 81,511$ 100.0% Cost of Merchandise Sold 61,054 67.2% 54,191 66.5%

Gross Profit 29,783 32.8% 27,320 33.5% Operating Expenses 20,110 22.1% 17,957 22.0%

Operating Income 9,673 10.6% 9,363 11.5% Interest and Investment Income 27 0.0% 62 0.1% Interest Expense (392) -0.4% (143) -0.2%

Earnings Before Income Taxes 9,308 10.2% 9,282 11.4% Income Taxes 3,547 3.9% 3,444 4.2% Net Earnings 5,761$ 6.3% 5,838$ 7.2%

Basic Earnings Per Share 2.80$ 2.73$ Weighted-Average Number of Common Shares Outstanding 2,062 2,147 Diluted Earnings Per Share 2.79$ 2.72$

Slide 6McGraw-Hill/IrwinMcGraw-Hill/Irwin

Commonly Used Ratios

The 2007 and 2006 balance sheets for Home Depot are presented next.

We will be referring to these financial statements throughout the ratio analyses.

The 2007 and 2006 balance sheets for Home Depot are presented next.

We will be referring to these financial statements throughout the ratio analyses.

Home Depot

Slide 7McGraw-Hill/IrwinMcGraw-Hill/Irwin

Continued

Slide 8McGraw-Hill/IrwinMcGraw-Hill/Irwin

Slide 9McGraw-Hill/IrwinMcGraw-Hill/Irwin

Test of Profitability ─ Return on Equity

Return on Equity $5,761

($25,030 + $26,909) ÷ 2= = 22.2%

This measure indicates how much income was earned for every dollar invested by the owners.This measure indicates how much income was earned for every dollar invested by the owners.

Profitability is a primary measure ofthe overall success of a company.

Profitability is a primary measure ofthe overall success of a company.

Net Income

Average Stockholders’ EquityReturn on Equity =

Slide 10McGraw-Hill/IrwinMcGraw-Hill/Irwin

Test of Profitability ─ Earnings per Share (EPS)

EPS $5,761

(1,970 + 2124) ÷ 2= = $2.81

Earnings per share is probably the single most widely watched financial ratio.

Earnings per share is probably the single most widely watched financial ratio.

Average number of shares based on the numberof 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.

Slide 11McGraw-Hill/IrwinMcGraw-Hill/Irwin

Tests of Liquidity ─ Current Ratio

Current

Ratio

Current Assets

Current Liabilities=

Current

Ratio

$18,000

$12,931

= = 1.39 to 1

This ratio measures the abilityof the company to pay current

debts as they become due.

This ratio measures the abilityof the company to pay current

debts as they become due.

Slide 12McGraw-Hill/IrwinMcGraw-Hill/Irwin

Tests of Liquidity ─ Receivable Turnover

Net Credit Sales

Average Net ReceivablesReceivable

Turnover=

Receivable

Turnover

$90,837

($3,223 + $2,396) ÷ 2= 32.3 Times=

This ratio measures how quickly a company collects its

accounts receivable.

This ratio measures how quickly a company collects its

accounts receivable.

Slide 13McGraw-Hill/IrwinMcGraw-Hill/Irwin

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=

+ +

$5,761 + $392 + $3,547

$392

Times

Interest

Earned= = 24.7 Times

Tests of solvency measure a company’sability to meet its long-term obligations.

Tests of solvency measure a company’sability to meet its long-term obligations.

Slide 14McGraw-Hill/IrwinMcGraw-Hill/Irwin

Tests of Solvency ─ Debt-to-Equity Ratio

This ratio measures the amount of liabilities that exists for each $1

invested by the owners.

This ratio measures the amount of liabilities that exists for each $1

invested by the owners.

$27,233

$25,030= 1.09=

Debt-to-Equity

Ratio

Total Liabilities

Stockholders’ Equity

Debt-to-Equity

Ratio=

Slide 15McGraw-Hill/IrwinMcGraw-Hill/Irwin

Market Tests ─ Price/Earnings (P/E) Ratio

P/E Ratio =Current Market Price Per Share

Earnings Per Share

P/E Ratio =$34

$2.80= 12.1

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 $34 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.

Slide 16McGraw-Hill/IrwinMcGraw-Hill/Irwin

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.