Chapter 14

Analyzing Financial
Statements

14-2

Understanding The Business

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.

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Understanding The Business

THREE TYPES OF FINANCIAL
STATEMENT INFORMATION
Past
Performance
Income, sales
volume, cash
flows, returnon-investments,
EPS.
McGraw-Hill/Irwin

Present
Condition

Future
Performance

Assets, debt,
inventory,
various ratios.

Sales and earnings

trends are good
indicators of future
performance.

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14-4

Financial Statement Analysis

Financial statement analysis
is based on comparisons.

Time series
analysis

Comparison with
similar companies

Examines a single
company to identify
trends over time.
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14-5

Ratio and Percentage Analyses

Ratio analysis, or percentage analysis, is used to
express the proportionate relationship between
two different amounts.
Ratios can be computed using amounts in one
financial statement or two different ones (ex.
Balance sheet and income statement)
The ratios can then be examined to determine
trends and reasons for changes in the financial
statement from month to month.

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Component Percentages
Express each item on a particular statement
as a percentage of a single base amount.
All balance sheet items are divided by

total assets
All income statement items are divided by

net sales

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14-7

Component Percentages
Example

The
The comparative
comparative income
income statements
statements
of
of Home
Home Depot
Depot 2001
2001 and
and 2000
2000 appear
appear on
on
the
the next
next slide.
slide.
Prepare
Prepare component
component percentage
percentage income
income
statements
statements where
where net
net sales
sales is
is the
the base
base
amount.
amount.
Home Depot

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14-8

DEPOT
Component HOME
Percentages

Comparative Income Statements (Condensed)

Amounts in Millions Except Per Share Data
2001
Percent
2000
Net Sales
$ 45,738
100.0% $ 38,434
Cost of merchandise sold
32,057
27,023
Gross profit
13,681
11,411
Operating expenses
9,490
7,603
Operating Income
4,191
3,808
Interest and Investment Income
47
37
Interest Expense
21
41
Earnings Before Income Taxes
4,217
3,804
Income Taxes
1,636
1,484
Net Earnings
$ 2,581
$ 2,320
Basic Earnings Per Share
$
1.11
$
1.03
Weighted-Average Number of
Common Shares Outstanding
2,315
2,244
Diluted Earnings Per Share
$
1.10
$
1.00
McGraw-Hill/Irwin

Percent
100.0%

2004 The McGraw-Hill Companie

14-9

DEPOT
Component HOME
Percentages

Comparative Income Statements (Condensed)

Amounts in Millions Except Per Share Data
2001
Percent
2000
Percent
Net Sales
$ 45,738
100.0% $ 38,434
100.0%
Cost of merchandise sold
32,057
70.1%
27,023
Gross profit
13,681
11,411
Operating expenses
9,490
7,603
Operating Income
4,191
3,808
Interest and Investment Income
47
37
Interest Expense
41
2001 21
Cost 2001 Sales
Earnings Before Income Taxes
4,217
3,804
Income Taxes
1,636
1,484
Net Earnings
$ 2,581
$ 2,320
Basic Earnings Per Share
$
1.11
$
1.03
Weighted-Average Number of
Common Shares Outstanding
2,315
2,244
Diluted Earnings Per Share
$
1.10
$
1.00
McGraw-Hill/Irwin

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14-10

DEPOT
Component HOME
Percentages

Comparative Income Statements (Condensed)

Amounts in Millions Except Per Share Data
2001
Percent
2000
Percent
Net Sales
$ 45,738
100.0% $ 38,434
100.0%
Cost of merchandise sold
32,057
70.1%
27,023
70.3%
Gross profit
13,681
29.9%
11,411
29.7%
Operating expenses
9,490
20.7%
7,603
19.8%
Operating Income
4,191
9.2%
3,808
9.9%
Interest and Investment Income
47
0.1%
37
0.1%
Interest Expense
21
0.0%
41
0.1%
Earnings Before Income Taxes
4,217
9.2%
3,804
9.9%
Income Taxes
1,636
3.6%
1,484
3.9%
Net Earnings
2,320
6.0%
Gross profit increase can$ be2,581
attributed5.6%
to an$increase
in sales
and to $an improvement
in $
the margin
Basic Earnings
Perrevenues
Share
1.11
1.03
between Number
selling price
and cost of goods sold. This
Weighted-Average
of
improvement
is offset by an2,315
increase in operating
expenses.
Common
Shares Outstanding
2,244
Diluted Earnings Per Share
$
1.10
$
1.00
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14-11

Ratio analysis
Ratio analysis expresses the relationship among
selected items of financial statement data.
Financial Ratio Classifications
Liquidity

Profitability

Solvency

Measures shortterm ability of

the company to
pay its maturing
obligations and to
meet unexpected
needs for cash.

Measures the
income or
operating success
of a company for
a given period of
time.

Measures the
ability of the
company to
survive over a
long period of
time.

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Ratio analysis
A single ratio by itself is not very meaningful.
The discussion of ratios will
include the following types of
comparisons.

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Ratio analysis
Balance sheet amounts relate to an istant

in time, while income statement amounts

to an entire period;
When computing ratios, balance sheet
amounts should theoretically be
expressed as an average of the beginning
and ending balances
Often, ending balances are used instead.
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Profitability ratios
Measure the income or operating success of a company
for a given period of time.
Income, or the lack of it, affects the companys
ability to obtain debt and equity financing,
liquidity position, and the ability to grow.
Ratios include the profit and gross margin, ROS,
asset turnover, ROA, ROE, earnings per share,
price-earnings, quality of earnings, payout ratio.

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Return on Assets (ROA)

Return on
Net Income
Assets = Average Total Assets
Measures the overall ability of the firm to use the assets
in which it has invested (invested capital) to earn a profit!
It tells how much the firm earned for each dollar of
investment
This ratio is not affected by the way in which assets are
financed (as with ROE)

This
Thisratio
ratiois
isgenerally
generallyconsidered
considered
the
thebest
bestoverall
overallmeasure
measureof
ofaa
companys
companysprofitability.
profitability.
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Return on Assets (ROA)

Some investors add interest expense back into

net income when performing this calculation.

Since the denominator includes resources
provided by both owners and creditors, also the
numerator must include the return that was
available to each group, net of taxes.
Return on
Assets

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Net Income + Interest Expense (1-tax rate)

Average Total Assets

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Disaggregating ROA
Return on
Net Income
Assets = Average Total Assets

=Net income/net sales *net sales/av.total

asset
=Net profit margin/total assets turnover

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Gross Margin, Profit Margin

Gross Margin Gross Profit
=
Net sales
= Net sales COGS/ Net sales

Profit Margin Net Profit (income)

=
Net sales
This
This ratios
ratios describe
describeaa
companys
companysability
abilityto
toearn
earn
income
income(gross/net)
(gross/net) from
from sales.
sales.
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Return on sales (ROS)

ROS=operating income /net sales
If the firm has no non-operating revenues or
expenses, EBIT can be used
Also known as a firms operating margin.
Although ROS is used to analyze profitability, it
is perhaps a better indicator of efficiency.
It provides insight into how much profit is being
produced per dollar of sales.
ROS shows how efficiently management uses
the sales dollar, thus reflecting its ability to
manage costs and overhead.
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Return on sales (ROS)

A high return on sales indicates that the company is

selling its products well and its profits are likely
sustainable
If the company wants its ROS to increase, it must
decrease operating costs (ex. costs of goods sold, labour
costs..)
Most calculations use operating profit before subtracting
interest and taxes (EBIT); others use after-tax income.
Either figure is acceptable as long as ROS comparisons
are consistent.
Obviously, using income before interest and taxes will
produce a higher ratio.

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Return on Equity (ROE)

Return on Equity =

Net Income
Average SE*

This
Thismeasure
measureindicates
indicates how
how much
much
income
incomewas
wasearned
earnedfor
forevery
everydollar
dollar
invested
invested by
bythe
theowners.
owners.

* Also the market value of stockholders equity

sometimes can be used.

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Return on Equity (ROE)

Return on Equity =

Net Income
Average SE

In the long run, firms with high ROE are expected to have higher
stock prices.
ROE can rise when the rate of return on the shareholders equity is
going up.
It can rise because the company is failing to invest in R&D or in
modernizing plant and equipment.
It can also rise simply when the company takes on more debt.
This would increase the leverage of the company, which will make
the stock more risky.
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Return on Equity (ROE)

ROE= Net profit margin * Asset
turnover * Financial Leverage (or
Equity multiplier)
=Net income/net sales * net sales/av.total
assets * av.total assets/av.SEs equity
DU PONT FORMULA (three-step)

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Return on Equity (ROE)

If a company's ROE goes up due to an increase in the net profit
margin or asset turnover, this is a positive sign for the company!
Net profit margin: how much profit the company gets
out of its sales
Asset turnover: how effectively the company makes
use of its assets
Financial leverage: the firm uses more debt financing
relative to equity financing.
Since interest payments to creditors are tax deductible,
but dividend payments to shareholders are not, ROE
increases.
However, financial leverage benefits diminish as the risk of
defaulting on interest payments increases. If the firm takes on too
much debt, the cost of debt rises as creditors demand a higher
risk premium, and ROE decreases. This can also make the stock
more risky.
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Return on Equity (ROE)

ROE= Net profit margin * Asset turnover * Financial
Leverage (or Equity multiplier)
=Net income/net sales * net sales/av.total assets *
av.total assets/av.SE
If Net income = (EBT)(1 - tax rate)
=(EBT / net sales) * (net sales / av.total assets) *
(av.total assets / av.SE) * (1 tax rate)
If Net income = (EBIT interest expense)(1 - tax rate)
=[(EBIT / net sales) * (net sales / av.total assets)
(interest expense / av.total assets)] * (av.total assets
/av.SE) * (1 tax rate)

DU PONT FORMULA (five-step)

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Return on Common Stockholders

equity
ROCE

Net Income-preferred dividends

Average Common SE

Its ROE in which preferred dividends are subtracted from

net income and preferred stock is subtracted from
shareholders' equity
A measure of the return that a firm's management is able
to earn on common stockholders' investment. Return on
common stock equity is calculated by dividing the net
income minus preferred dividends by the owners' equity.

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Earnings per Share (EPS)

EPS =

Net Income
Average Number of Shares of
Common Stock Outstanding

Earnings
Earnings per
per share
shareis
isprobably
probably
the
thesingle
singlemost
mostwidely
widelywatched
watched
financial
financial ratio.
ratio.
It is a measure of return on investment based on the
number of shares outstanding.

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Quality of Income
Quality
=
of Income

Cash Flow from Operating Activities

Net Income
Cash Flow from Operating
Activities
Net Income
$ 2,581
Add:
Depreciation and Amortization
601
Increase in Current Liabilities
754
Increase in Income Taxes Payable
151
Other
30
Deduct: Increase in Receivables, net
(246)
Increase in Merchandise Inventories (1,075)
Cash Flow from Operating Activities
$ 2,796
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Quality of Income
Quality
=
of Income

Cash Flow from Operating Activities

Net Income

It measures the portion of income that was generated in cash

Because some accounting procedures allow to report a higher
income (ex. Lifo)
A ratio higher than 1 indicates high-quality earnings
Each dollar of income is supported by 1 dollar or more of CF

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Fixed Asset Turnover

Fixed
=
Asset
Turnover

Net Sales Revenue

Average Net Fixed Assets

This
Thisratio
ratio measures
measuresaacompanys
companys
ability
abilityto
togenerate
generatesales
salesgiven
given an
an
investment
investmentin
infixed
fixedassets.
assets.
It is widely used to analyze capital-intensive companies

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Asset Turnover
Asset
Turnover =

Net Sales Revenue

Average Total Assets

This
Thisratio
ratiomeasures
measuresaacompanys
companysability
abilityto
to
generate
generatesales
salesgiven
givenits
itstotal
totalassets.
assets.
Used for companies with large amounts of inventory and
account receivable
The ratio can fluctuate during the season. Season high
sales bring the ratio up. An increase of inventory to face
heavy sales makes the ratio decline
Also a declining ratio could mean a relaxing credit policy to
new customers (increase in Account Receivable)
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Payout Ratio
Cash Dividends
Net Income

Payout
Ratio

Measures the percentage of earnings distributed in

the form of cash dividends.

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Liquidity ratios
Measure the short-term ability of the company to pay
its maturing obligations and to meet unexpected needs
for cash.
Short-term creditors such as bankers and
suppliers are particularly interested in assessing
liquidity.
Ratios include the current ratio, the cash ratio,
the acid-test ratio, receivables turnover, and
inventory turnover.

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Cash Ratio
Cash
Ratio
Cash
Ratio

For each 1$ of current liabilities

the company has 0.04 $ of cash

Cash + Cash Equivalents

=
Current Liabilities

$167
$4,385

0.04 : 1

This
Thisratio
ratiomeasures
measuresthe
the
adequacy
adequacyof
ofavailable
availablecash.
cash.
It should not be too high because holding too much cash is
uneconomical
It is very sensitive to small events (collection of account
receivable)
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Current Ratio
Current
Ratio
Current
Ratio

For each 1$ of current liabilities

the company has 1.77 $ of cash
Current Assets
Current Liabilities
$7,777

1.77 : 1

$4,385

This
Thisratio
ratiomeasures
measuresthe
theability
abilityof
ofthe
thecompany
companyto
topay
paycurrent
current
debts
debtsas
asthey
theybecome
becomedue.
due.

For companies with large inventories (retail), the

current ratio is high.
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Quick Ratio (Acid Test)

Quick
Ratio

Quick Assets
Current Liabilities

Cash & Cash Equivalents

Receivables, net
Short-term Investments
Quick Assets

167
835
10
$ 1,012

This
Thisratio
ratiois
islike
likethe
thecurrent
current
ratio
ratiobut
but measures
measures the
the companys
companys
immediate
immediateability
abilityto
topay
paydebts.
debts.
It does not include inventory because of the uncertainty of
the timing of CF from its sale. Also pre-paid expenses are not
included.
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Receivable Turnover
Receivable
Turnover

Net Sales
Average Net Account Receivables

This
Thisratio
ratiomeasures
measureshow
howquickly
quicklyaacompany
companycollects
collectsits
its
accounts
accountsreceivable.
receivable.
A high ratio means that the company is effective in its
collection activities
A too high ratio could also mean that a too stringent
credit policy in place

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14-38

Average Age of Receivables

Average Age
of Receivables

Days in Year
Receivable Turnover

The receivable turnover ratio is converted on a time

basis
This means that receivables are collected on average
every X days.
The rule of thumb is that the average days to collect
receivables should not exceed 1.5 times the credit terms

This
Thisratio
ratiomeasures
measuresthe
theaverage
average
number
number of
of days
daysitittakes
takes to
to collect
collect
receivables.
receivables.
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Inventory Turnover
Inventory
Turnover

Cost of Goods Sold

= Average Inventory

This
Thisratio
ratiomeasures
measureshow
howquickly
quicklythe
thecompany
companysells
sellsits
its
inventory.
inventory.
It measures the frequency of inventory rotation
An increase in the ratio is good because each time the
inventory is sold it realizes profits
However, if it is too high it could mean that desired items
where not in stock
High ratio for food industry
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14-40

Average Days Supply in

Inventory
Average Days
Supply in
Inventory

Days in Year
Inventory Turnover

The inventory turnover ratio is converted into this

ratio

This
Thisratio
ratiomeasures
measuresthe
theaverage
average
number
numberof
ofdays
daysitit takes
takesto
tosell
sell
the
theinventory.
inventory.
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14-41

Solvency and Equity Ratios

Solvency and equity ratios measure the ability of a
company to survive over a long period of time and to
meet its obligations.
Debt to total assets, debt/equity, cash
coverage, times interest earned are ratios that
provide information about debt-paying ability.

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Times Interest Earned

Times
Interest
Earned

Net
Interest
Income Tax
+
+
Income
Expense
Expense
Interest Expense

This
Thisratio
ratioindicates
indicatesaamargin
marginof
ofprotection
protectionfor
for
creditors
creditorsin
incase
caseof
ofdeterioration
deteriorationof
of
profitability.
profitability.

It compares the income generated (before income taxes and

interest) to its interest obligation
It states for each $ of interest expense how many $ of income
are generated.
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Cash Coverage
Cash
=
Coverage

Cash Flow from Operating Activities

Before Interest and Taxes
Interest Paid

analysts tend to prefer this ratio

because compares the cash generated by
a company to its cash obligaitons
Interest paid is taken from the
statement of cash flow (not interest
expense from income statement)
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Cash Coverage
Cash
=
Coverage
Cash
=
Coverage

Cash Flow from Operating Activities

Before Interest and Taxes
Interest Paid
$2,796 + $16 + $1,386
$16

Cash payments made for:

Interest
Income Taxes

262

16
1,386

This
Thisratio
ratiocompares
comparesthe
thecash
cash generated
generated
with
withthe
thecash
cashobligations
obligationsof
of the
theperiod.
period.
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Debt/Equity Ratio
Debt/Equity
Ratio

Total Liabilities
Owners Equity

This
Thisratio
ratiomeasures
measuresthe
theamount
amountof
of
liabilities
liabilitiesthat
that exists
existsfor
foreach
each$1
$1
invested
invested by
bythe
theowners.
owners.
Equity is less risky than debt
Debt has some advantages:
interest expense is tax deductible
financial leverage
McGraw-Hill/Irwin

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Debt/Total assets
Debt/Total
assets

Total Debt
Total assets

This
Thisratio
ratio measures
measuresthe
the Percentage
Percentage of
of
assets
assetsfinanced
financed by
bylong-term
long-term and
and
short-term
short-term debt
debt

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Market value ratios

They relate the current market price of a
share of a stock to an indicator of the return
that might accrue to an investor

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Price/Earnings (P/E) Ratio

P/E Ratio

Current Market Price Per Share

Earnings Per Share

This
Thisratio
ratiomeasures
measuresthe
therelationship
relationship
between
betweenthe
the current
current market
marketprice
priceof
of the
the
stock
stockand
andits
itsearnings
earningsper
pershare.
share.
It reflects the stock market assessment of a companys
future performance
A high ratio indicates that earnings are expected to grow
rapidly
If a company with high ratio does not meet the level of
earnings expected by the market, negative impact.
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Dividend Yield Ratio

Dividend
Yield

Dividends Per Share

Market Price Per Share

This
Thisratio
ratiois
isoften
oftenused
usedto
tocompare
comparethe
the
dividend-paying
dividend-payingperformance
performance of
of different
different
investment
investmentalternatives.
alternatives.
Usually the dividend yield for most stock is not high
compared to alternative investments
People tend to acceot lower dividends if they expect the
stock price to rise.

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Interpreting Ratios
Ratios
Ratios may
may be
be interpreted
interpreted by
by comparison
comparison with
with
ratios
ratios of
of other
other companies
companies or
or with
with industry
industry
average
average ratios.
ratios.
Ratios
Ratios may
may vary
vary because
because of
of the
the
companys
companys industry
industry characteristics,
characteristics,
nature
nature of
of operations,
operations, size,
size, and
and
accounting
accounting policies.
policies.

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End of Chapter 14
Rat
ios
s

Rat
io

s
McGraw-Hill/Irwin

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Rati
os
Rati

Rat
io

2004 The McGraw-Hill Companie