ANALYZING

FINANCIAL
STATEMENTS
CHAPTER 13

McGraw-Hill/Irwin

Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

QUESTIONS TO GET YOU THINKING

Why do analysts review nancial statements?
Why do analysts use ratios to evaluate
companies?

13-2

WHAT WE'LL COVER TODAY

Explain how a companys business strategy aects nancial
analysis.
Discuss how analysts use nancial statements.
Compute and interpret component percentages.
Compute and interpret protability ratios.
Compute and interpret liquidity ratios.
Compute and interpret solvency ratios.
Compute and interpret market test ratios.

13-3

UNDERSTANDING THE BUSINESS

External Decision Makers

Present and Potential Owners
Investment Analysts
Creditors

Annual
Report

13-4

THE INVESTMENT DECISION

Economy-wide
Factors

Industry
Factors

No

Invest?

Individual
Company Factors

Yes

13-5

UNDERSTANDING A COMPANYS
STRATEGY
I need to know if the company is trying to earn a
high rate of return through product
dierentiation or cost dierentiation.

13-6

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.

Provides insights
concerning a
companys relative
performance.
13-7

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%.
13-8

Net Sales will be set

to 100% and all other
components will be
expressed as a
percentage of Net
Sales.

13-9

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%

13-10

 COMPONENT PERCENTAGES

13-11

 COMMONLY USED RATIOS

The 2012 and 2011 balance sheets for Home
Depot are presented next.
We will be referring to these nancial
statements throughout the ratio analyses.

Home Depot

13-12

13-13

13-14

TEST OF PROFITABILITY
RETURN ON EQUITY
Protability is a primary measure of
the overall success of a company.
Return on Equity

Return on Equity

Net Income
=
Average Stockholders 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.
13-15

TEST OF PROFITABILITY
RETURN ON ASSETS
Return on
Assets

Return on
Assets

$3,883 + ($606 (1 - .34))

=
($40,518 + $40,125) 2

Net Income + Interest Expense (net of tax)

Average Total Assets
= 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 companys
protability.
13-16

TEST OF PROFITABILITY
FINANCIAL LEVERAGE PERCENTAGE
Financial Leverage
= Return on Equity Return on Assets
Percentage
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 dierent from the return
on assets.
13-17

TEST OF PROFITABILITY
EARNINGS PER SHARE (EPS)
Net Income*
EPS =
Average Number of Shares
Outstanding for the Period
*If there are preferred dividends, the amount is subtracted from net income.

EPS =

$3,883
1,562

= $2.49

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 nancial ratio.
13-18

TEST OF PROFITABILITY
QUALITY OF INCOME
Quality
Cash Flow from Operating Activities
=
of Income
Net Income
Home Depots
Quality of Income
$6,651
= 1.71
$3,883

A ratio higher than 1

indicates high-quality
earnings.
13-19

TEST OF PROFITABILITY PROFIT MARGIN

Prot
=
Margin

Prot =
Margin

Net Income
Net Sales Revenue

$3,883
$70,395

= 5.5%

This ratio tells us the percentage of each sales dollar,

on average, that represents income.

13-20

TEST OF PROFITABILITY
GROSS PROFIT MARGIN
Gross
Prot
Margin

Gross Prot =
Margin

Gross Prot
Net Sales Revenue

$24,262
$70,395

= 34.5%

This ratio tells us the prot made on each sale.

13-21

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 companys ability to

generate sales given an investment in xed assets.
13-22

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.

13-23

TESTS OF LIQUIDITY QUICK RATIO

(ACID TEST)
Quick
Ratio
Quick
Ratio

Quick Assets
=
Current Liabilities
=

$3,232
$9,376

Cash & Cash Equivalents

Receivables, net
Quick Assets

0.35 to 1
$ 1,987
1,245
$ 3,232

This ratio is like the current

ratio but measures the companys
immediate ability to pay debts.
13-24

TESTS OF LIQUIDITY CASH RATIO

Tests of liquidity focus on the relationship between
current assets and current liabilities.
Cash
Ratio
Cash
Ratio

Cash + Cash Equivalents

Current Liabilities
$1,987
$9,376

0.21 to 1

This ratio measures the

adequacy of available cash.
13-25

TESTS OF LIQUIDITY
RECEIVABLE TURNOVER
Receivable
Turnover
Receivable
Turnover

Net Credit Sales

Average Net Receivables
$70,395
($1,245 + $1,085) 2

= 60.4 Times

This ratio measures how quickly a

company collects its accounts
receivable.
13-26

TESTS OF LIQUIDITY
AVERAGE AGE OF RECEIVABLES
Average Age of
Receivables
Average Age of
Receivables

Days in Year
Receivable Turnover

365
60.4

= 6.0 Days

This ratio measures the average number of

days it takes to collect receivables.
13-27

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.

13-28

TESTS OF LIQUIDITY
AVERAGE DAYS SUPPLY IN INVENTORY
Average Days
Supply in
Inventory
Average Days
Supply in
Inventory

Days in Year
Inventory Turnover

365
4.4

= 83 Days

This ratio measures the average number of

days it takes to sell the inventory.
13-29

TESTS OF LIQUIDITY
ACCOUNTS PAYABLE TURNOVER RATIO
Accounts
Payable
Turnover

Accounts
Payable
Turnover

$46,133
=
($4,856 + $4,717) 2

Cost of Goods Sold

Average Accounts Payable

= 9.6 Times

This ratio measures how quickly the

company pays its accounts payable.
13-30

TESTS OF LIQUIDITY
AVERAGE DAYS IN ACCOUNTS PAYABLE
Average Days in
Accounts
Payable
Average Days in
Accounts
Payable

Days in Year
=
Accounts Payable Turnover

365
9.6

= 38 Days

This ratio measures the average number of

days it takes to pay its accounts payable.
13-31

TESTS OF SOLVENCY
TIMES INTEREST EARNED
Tests of solvency measure a companys
ability to meet its long-term obligations.

Times
Interest
Earned
Times
Interest
Earned

Net Interest Income Tax

+
+
Income Expense Expense
Interest Expense

$3,883 + $606 + $2,185

$606

= 11.0 Times

This ratio indicates a margin of protection for creditors.

13-32

TESTS OF SOLVENCY CASH COVERAGE

Cash Flow from Operating Activities
Before Interest and Taxes Paid
Interest Paid

Cash
=
Coverage
Cash
=
Coverage

$6,651 + $580 + $1,865

$580

= 15.7

From Statement of Cash Flows

Cash interest paid
Income tax paid

580
1,865

This ratio compares the cash generated with the

cash obligations of the period.
13-33

TESTS OF SOLVENCY
DEBT-TO-EQUITY RATIO
Debt-to-Equity
Ratio
Debt-to-Equity
Ratio

Total Liabilities
Stockholders Equity
$22,620
$17,898

= 1.26

This ratio measures the amount of

liabilities that exists for each $1
invested by the owners.
13-34

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 =

P/E Ratio =

Current Market Price Per Share

Earnings Per Share
$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.
13-35

MARKET TESTS DIVIDEND YIELD RATIO

Dividend
Yield
Dividend
Yield

Dividends Per Share

Market Price Per Share

$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 dierent investment
alternatives.
13-36

INTERPRETING RATIOS
Ratios may be interpreted by
comparison with ratios of other
companies or with industry average
ratios.

Ratios may vary because of the
companys industry characteristics,
nature of operations, size, and
accounting policies.
13-37

OTHER FINANCIAL INFORMATION

In addition to nancial ratios,
special factors might aect
company analysis:
Rapid growth.
l Uneconomical expansion.
l Subjective factors.
l

A securities market in which prices fully reect available

information is called an ecient market. In an ecient
market, a companys stock reacts quickly when new,
relevant information is released about the company.
13-38

KEY TAKE AWAYS

13-39

READING

CHAPTER 13

EXERCISES

E1, E2, E3, E4, AP3

13-40

AP3. Coke and Pepsi are well-known international brands.

Coca-Cola sells more than $13 billion worth of beverages
each year while annual sales of PepsiCo products exceed $22
billion. Compare the two companies as a potential
investment based on the following ratios:

Ratio
Coca-Cola
Pepsi
P/E
65.0
26.5
Gross prot margin
69.3
58.4
Prot margin
12.2
8.8
Quick
0.4
0.7
Current
0.6
1.1
Debt-to-equity
0.7
0.4
Return on equity
27.4
29.1
Return on assets
28.0
16.6
Dividend yield
1.0
1.6
Dividend payout
65.0
41.0
13-41

CASE STUDY ASSIGNMENT

Through Study.net, obtain the Harvard Business School :
The Case of the Unidentied Industries 2013
With your team, prepare your assessment which nancial
data matches which industry.
Document your analysis in the Excel Rubric format available
in bCourses.
Be prepared to debrief the case in our next class meeting.

13-42

THE FOLLOWING SELECTED FINANCIAL DATA PERTAIN TO FOUR

UNIDENTIFIED COMPANIES:


1
2
3
4
BALANCE SHEET DATA




(COMPONENT PERCENTAGE)
3.5
4.7
8.2
11.7
CASH
16.9 28.9
16.8
51.9
ACCOUNTS RECEIVABLE
46.8 35.6
57.3
4.8
INVENTORY
18.3 21.7
7.6
18.7
PROPERTY AND EQUIPMENT




INCOME STATEMENT DATA




(COMPONENT PERCENTAGE)
22.0 22.5
44.8 N/A*
GROSS PROFIT
2.1
0.7
1.2
3.2
PROFIT BEFORE TAXES




SELECTED RATIOS
1.3
1.5
1.6
1.2
CURRENT RATIO
3.6 9.8
1.5
N/A*
INVENTORY TURNOVER RATIO
2.6 2.6
3.2
3.2
DEBT-TO-EQUITY RATIO
*N/A 5 NOT APPLICABLE.
13-43

THIS FINANCIAL INFORMATION PERTAINS TO

THE FOLLOWING COMPANIES:

A. RETAIL FUR STORE
B. ADVERTISING AGENCY
C. WHOLESALE CANDY COMPANY
D. CAR MANUFACTURER

MATCH EACH COMPANY WITH ITS FINANCIAL
INFORMATION.

13-44

THE FOLLOWING SELECTED FINANCIAL DATA PERTAIN TO FOUR

UNIDENTIFIED COMPANIES:


1
2
3
4
BALANCE SHEET DATA




(COMPONENT PERCENTAGE)
7.3
21.6
6.1
11.3
CASH
28.2 39.7
3.2
22.9
ACCOUNTS RECEIVABLE
21.6 0.6
1.8
27.5
INVENTORY
32.1 18.0 74.6
25.1
PROPERTY AND EQUIPMENT




INCOME STATEMENT DATA




(COMPONENT PERCENTAGE)
15.3 N/A* N/A* 43.4
GROSS PROFIT
1.7 3.2
2.4
6.9
PROFIT BEFORE TAXES




SELECTED RATIOS
1.5
1.2
0.6
1.9
CURRENT RATIO
27.4 N/A* N/A* 3.3
INVENTORY TURNOVER RATIO
1.7
2.2
5.7
1.3
DEBT-TO-EQUITY RATIO
*N/A 5 NOT APPLICABLE.
13-45

THIS FINANCIAL INFORMATION PERTAINS TO

THE FOLLOWING COMPANIES:

A. TRAVEL AGENCY
B. HOTEL
C. MEAT PACKER
D. DRUG COMPANY

MATCH EACH COMPANY WITH ITS FINANCIAL
INFORMATION.

13-46

THE FOLLOWING SELECTED FINANCIAL DATA PERTAIN TO FOUR

UNIDENTIFIED COMPANIES:


1
2
3
4
BALANCE SHEET DATA




(COMPONENT PERCENTAGE)
5.1
8.8
6.3
10.4
CASH
13.1 41.5
13.8
4.9
ACCOUNTS RECEIVABLE
4.6 3.6
65.1
35.8
INVENTORY
53.1 23.0 8.8
35.7
PROPERTY AND EQUIPMENT




INCOME STATEMENT DATA




(COMPONENT PERCENTAGE)
N/A* N/A* 45.2
22.5
GROSS PROFIT
0.3 16.0 3.9
1.5
PROFIT BEFORE TAXES




SELECTED RATIOS
0.7
2.2
1.9
1.4
CURRENT RATIO
N/A* N/A* 1.4
15.5
INVENTORY TURNOVER RATIO
2.5
0.9
1.7
2.3
DEBT-TO-EQUITY RATIO
*N/A 5 NOT APPLICABLE.
13-47

THIS FINANCIAL INFORMATION PERTAINS TO

THE FOLLOWING COMPANIES:

A. CABLE TV COMPANY
B. GROCERY STORE
C. ACCOUNTING FIRM
D. RETAIL JEWELRY STORE

MATCH EACH COMPANY WITH ITS FINANCIAL
INFORMATION.

13-48

THE FOLLOWING SELECTED FINANCIAL DATA PERTAIN TO FOUR

UNIDENTIFIED COMPANIES:


1
2
3
4
BALANCE SHEET DATA




(COMPONENT PERCENTAGE)
11.6 6.6
5.4
7.1
CASH
4.6 18.9
8.8
35.6
ACCOUNTS RECEIVABLE
7.0
45.8
65.7
26.0
INVENTORY
56.0 20.3 10.1
21.9
PROPERTY AND EQUIPMENT




INCOME STATEMENT DATA




(COMPONENT PERCENTAGE)
56.7 36.4
14.1
15.8
GROSS PROFIT
2.7 1.4
1.1
0.9
PROFIT BEFORE TAXES




SELECTED RATIOS
0.7
2.1
1.2
1.3
CURRENT RATIO
30.0 3.5
5.6
16.7
INVENTORY TURNOVER RATIO
3.3
1.8
3.8
3.1
DEBT-TO-EQUITY RATIO
*N/A 5 NOT APPLICABLE.
13-49

THIS FINANCIAL INFORMATION PERTAINS TO

THE FOLLOWING COMPANIES:

A. FULL-LINE DEPARTMENT STORE
B. WHOLESALE FISH COMPANY
C. AUTOMOBILE DEALER (BOTH NEW AND USED
CARS)
D. RESTAURANT

MATCH EACH COMPANY WITH ITS FINANCIAL
INFORMATION.

13-50

QUESTIONS?

13-51