LLH9e Chapter 13

chapter 13 Analyzing Financial Statements
Financial Accounting
9e
Libby • Libby • Hodge
Copyright ©2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 13-1
Understanding the Business
External Decision Makers Include

Ø Present and potential owners Annual
Ø Investment analysts Report
Ø Creditors
The Investment Decision
Economy-wide
Industry Factors
Individual
Factors Company Factors
Invest?
No Yes
Understanding a Company’s Strategy
Is the company trying to earn a high rate of return through product

differentiation or cost differentiation?
Financial Statement Analysis
Financial statement analysis

is based on comparisons.
Time-series analysis Cross-sectional analysis
Examines a single Provides insights concerning

company to identify a company’s relative
trends over time. performance to other
companies.
Component Percentages
Express each item on a particular statement as a

percentage of a single base amount.
Net sales Total assets

on the income on the balance
statement sheet
The comparative income statements of The Home Depot

for 2013, 2014, and 2015 appear on the next slide.
Prepare component percentage income statements

where net sales equal 100 percent.
Exhibit 13.1
The Home Depot Financial Statements
Net sales will be set to
100 percent,THE
andHOME DEPOT, INC., AND SUBSIDIARIES
all other
Consolidated Statement of Earnings
components will be in millions, except per share data)
(amounts
expressed as a Fiscal Year Ended
February 1, February 2, February 3,
percentage of net sales. 2015 2014 2013
Net Sales $83,176 $78,812 $74,754
Cost of Sales 54,222 51,422 48,912
Gross Profit 28,954 27,390 25,842
Operating Expenses:
Selling, General and Administrative 16,834 16,597 16,508
Depreciation and Amortization 1,651 1,627 1,568
Total Operating Expenses 18,485 18,224 18,076
Operating Income 10,469 9,166 7,766
Interest and Other (Income) Expense:
Interest and Investment Income (337) (12) (20)
Interest Expense 830 711 632
Other — — (67)
Interest and Other, net 493 699 545
Earnings before Provision for Income Taxes 9,976 8,467 7,221
Provision for Income Taxes 3,631 3,082 2,686
Net Earnings $ 6,345 $ 5,385 $ 4,535
Weighted Average Common Shares 1,338 1,425 1,499
Basic Earnings per Share $ 4.74 $ 3.78 $ 3.03
Diluted Weighted Average Common Shares 1,346 1,434 1,511
Diluted Earnings per Share $ 4.71 $ 3.76 $ 3.00
Exhibit 13.1
Net sales will be set to
100 percent,THE
andHOME DEPOT, INC., AND SUBSIDIARIES
all other 2014 Cost of Sales ÷ 2014 Net
Consolidated Statement of Earnings
components will be in millions, except per shareSales$54,222
(amounts data) ÷ $83,176 = 0.6519 or
expressed as a 65.19%
Fiscal Year Ended
February 1, February 2, February 3,
percentage of net sales. 2015 2014 2013
Net Sales $83,176 $78,812 $74,754
Cost of Sales 54,222 2014 Gross
51,422 Profit
2014 Net Sales÷
48,912
Gross Profit 28,954 27,390 25,842
Operating Expenses: $28,954 ÷ $83,176 = 0.3481 or 34.81%
Selling, General and Administrative 16,834 16,597 16,508
Depreciation and Amortization 1,651 1,627 1,568
Total Operating Expenses 18,485 18,224 18,076
Operating Income 10,469
2014 Selling, G&A
9.166 7,766
÷
2014 Net Sales
Interest and Other (Income) Expense: $16,834 ÷ $83,176 = 0.2024 or 20.24%
Interest and Investment Income (337) (12) (20)
Interest Expense 830 711 632
Other — — (67)
Interest and Other, net 493 699 545
Earnings before Provision for Income Taxes 9,976 8,467 7,221
Provision for Income Taxes 3,631 3,082 2,686
Net Earnings $ 6,345 $ 5,385 $ 4,535
Weighted Average Common Shares 1,338 1,425 1,499
Basic Earnings per Share $ 4.74 $ 3.78 $ 3.03
Diluted Weighted Average Common Shares 1,346 1,434 1,511
Diluted Earnings per Share $ 4.71 $ 3.76 $ 3.00
Exhibit 13.2
Component Percentages for The Home Depot
COMPONENT PERCENTAGES*
February 1, 2015 February 2, 2014 February 3, 2013
Income Statement (fiscal 2014) (fiscal 2013) (fiscal 2012)
Net sales 100.00% 100.00% 100.00%
Cost of Sales 65.19 65.25 65.43
Gross profit 34.81 34.75 34.57
Operating Expenses:
Selling, General, and Administrative 20.24 21.06 22.08
Depreciation and Amortization 1.98 2.06 2.10
Total Operating Expenses 22.22 23.12 24.18
Operating Income 12.59 11.63 10.39
Interest and Other (Income) Expense:
Interest and Investment Income (0.41) (0.01) (0.03)
Interest Expense 1.00 0.90 0.85
Other 0.00 0.00 (0.09)
Interest and Other, net 0.59 0.89 0.73
Earnings before Provision for Income Taxes 12.00 10.74 9.66
Provision for Income Taxes 4.37 3.91 3.59
Net Earnings 7.63 6.83 6.07
*Numbers are rounded.
Widely Used Accounting Ratios
Profitability Ratios
ü Return on equity (ROE)
ü Return on assets (ROA)
ü Financial leverage percentage
ü Net profit margin
ü Earnings per share (EPS)
ü Earnings quality
The 2014 and 2015 balance sheets for The Home Depot are
presented next. We will be referring to these financial
statements throughout the ratio analyses.
Exhibit 13.1
THE HOME DEPOT, INC., AND SUBSIDIARIES
Consolidated Balance Sheets
(amounts in millions, except share and per share data)
February 1, February 2,
2015 2014
ASSETS
Current Assets:
Cash and Cash Equivalents $ 1,723 $ 1,929
Receivables, net 1,484 1,398
Merchandise Inventories 11,079 11,057
Other Current Assets 1,016 895
Total Current Assets 15,302 15,279
Property and Equipment, at cost 38,513 39,064
Less Accumulated Depreciation and Amortization 15,793 15,716
Net Property and Equipment 22,720 23,348
Goodwill 1,353 1,289
Other Assets 571 602
Total Assets $39,946 $40,518
Exhibit 13.1
February 1, February 2,
2015 2014
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Short-Term Debt $ 290 $ —
Accounts Payable 5,807 5,797
Accrued Salaries and Related Expenses 1,391 1,428
Sales Taxes Payable 434 396
Deferred Revenue 1,468 1,337
Income Taxes Payable 35 12
Current Installments of Long-Term Debt 38 33
Other Accrued Expenses 1,806 1,746
Total Current Liabilities 11,269 10,749
Long-Term Debt, excluding current installments 16,869 14,691
Other Long-Term Liabilities 1,844 2,042
Deferred Income Taxes 642 514
Total Liabilities 30,624 27,996
STOCKHOLDERS’ EQUITY
Common Stock, par value $0.05; authorized: 10 billion shares; issued: 1.768
billion shares at February 1, 2015, and 1.761 billion shares at February 2, 2014;
outstanding: 1.307 billion shares at February 1, 2015, and 1.380 billion shares
at February 2, 2014 88 88
Paid-In Capital 8,885 8,402
Retained Earnings 26,995 23,180
Accumulated Other Comprehensive (Loss) Income (452) 46
Treasury Stock, at cost, 461 million shares at February 1, 2015, and 381 million
shares at February 2, 2014 (26,194) (19,194)
Total Stockholders’ Equity 9,322 12,522
Total Liabilities and Stockholders’ Equity $39,946 $40,518
Return on Equity (ROE)
Profitability is a primary measure of

the overall success of a company.
Net Income
Return on Equity =
Average Stockholders’ Equity
$6,345
Return on Equity = = 58.09%
($9,322 + $12,522) ÷ 2
This measure indicates how much income was earned for every dollar
invested by the owners.
Return on Assets (ROA)
Return on Net Income

Assets = Average Total Assets
Return on $6,345
= = 15.77%
Assets ($39,946 + $40,518) ÷ 2
This ratio measures how well assets have been employed by the business.
Financial Leverage Percentage
Financial Leverage
Percentage = Return on Equity – Return on Assets
Financial Leverage
Percentage = 58.09% – 15.77% = 42.32%
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.
Net Profit Margin
Net Profit Net Income

Margin =
Net Sales Revenue
Net Profit $6,345

Margin = = 7.63%
$83,176
This ratio tells us the percentage of each sales dollar, on average, that
represents income.
Earnings per Share (EPS)
Net Income*
EPS =
Weighted Average Number
of Shares Outstanding
Remember from Chapter 11 that if there are preferred dividends,

the amount is subtracted from net income.
$6,345
EPS = = $4.74
1,338
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

financial ratio.
Earnings Quality
Earnings Cash Flows from Operating Activities
Quality = Net Income
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Earnings $6,345
The Home Depot’s Reconciliation of Net Earnings to Net Cash
Earnings Quality Provided by Operating Activities:
Depreciation and Amortization 1,786
Stock-Based Compensation Expense 225
$8,242 Gain on Sales of Investments (323)
= 1.30 Goodwill Impairment —
$6,345
Changes in Assets and Liabilities, net of the
effects of acquisitions:
Receivables, net $ (81)
Merchandise Inventories (124)
A ratio higher than 1 indicates Other Current Assets (199)
Accounts Payable and Accrued Expenses 244
high-quality earnings. Deferred Revenue 146
Income Taxes Payable 168
Deferred Income Taxes 159
Other Long-Term Liabilities (152)
Other 48
Net Cash Provided by Operating Activities 8,242
Asset Turnover Ratios

ü Total asset turnover ratio
ü Fixed asset turnover ratio
ü Receivable turnover ratio
ü Inventory turnover ratio
We will be referring to the financial statements

of The Home Depot throughout our discussion of
asset turnover ratios.
Total Asset Turnover Ratio
Total Asset Net Sales Revenue

=
Turnover Average Total Assets
Total Asset $83,176

= = 2.07
Turnover ($39,946 + $40,518) ÷ 2
This ratio captures how well a company uses its assets to generate
revenue.
Fixed Asset Turnover Ratio
Fixed
Net Sales Revenue
Asset =
Turnover Average Net Fixed Assets
Fixed
$83,176
Asset = = 3.61
Turnover ($22,720 + $23,348) ÷ 2
This ratio measures a company’s ability to generate sales given an

investment in fixed assets.
Receivable Turnover Ratio
Receivable Turnover Net Credit Sales

=
Ratio Average Net Receivables
Receivable Turnover $83,176

= = 57.72 times
Ratio ($1,484 + $1,398) ÷ 2
This ratio measures how quickly a company collects its

accounts receivable.
Inventory Turnover Ratio
Inventory Cost of Goods Sold

Turnover Ratio = Average Inventory
Inventory $54,222
= = 4.90 times
Turnover Ratio ($11,079 + $11,057) ÷ 2
This ratio measures how quickly the company sells its

inventory.
The DuPont Model
FINANCIAL ANALYSIS
The DuPont model brings together several of the ratios

$$$
we have discussed so far and reflects how these ratios
are related. The model is:
ROE Net Profit Total Asset Financial

= × Turnover Leverage
Margin
×
Net Sales
Net Income Net Income Revenue Average Total Assets
Average Total Stockholders’
= Net Sales
× Average Total
× Average Total Stockholders’
Equity Revenue Assets Equity
Liquidity Ratios
ü Current ratio
ü Quick ratio
ü Cash ratio

liquidity ratios.
Current Ratio
Current Current Assets

= Current Liabilities
Ratio
Current $15,302
= = 1.36
Ratio $11,269
This ratio measures the ability

of the company to pay current
debts as they become due.
Quick Ratio
Quick Quick Assets

=
Ratio Current Liabilities
Quick ($1,723 + $1,484 + $0) =

= 0.28
Ratio $11,269
This ratio is like the current ratio, but it measures the

company’s immediate ability to pay debts.
Cash Ratio
Tests of liquidity focus on the relationship between current assets and

current liabilities.
Cash Cash + Cash Equivalents

=
Ratio Current Liabilities
Cash $1,723
Ratio = = 0.15
$11,269
This ratio measures the

adequacy of available cash.
Solvency Ratios
ü Times interest earned ratio
ü Cash coverage ratio
ü Debt-to-equity ratio

solvency ratios.
Times Interest Earned Ratio
Tests of solvency measure a company’s ability to meet its long-term

obligations.
Net Interest Income Tax

+ +
Times Interest = Income Expense Expense
Earned
Interest Expense
Times Interest $6,345 + $830 + $3,631

Earned = = 13.02 times
$830
This ratio indicates a margin of protection for creditors.
Cash Coverage Ratio
Cash Cash Flows from Operating Activities

Coverage Ratio =
Interest Paid
Cash $8,242
= = 10.54 times
Coverage Ratio $782
This ratio compares the cash from operations to the cash needed
to make required interest payments.
Debt-to-Equity Ratio
Total Liabilities
Debt-to-Equity Ratio =
Stockholders’ Equity
$30,624
Debt-to-Equity Ratio = = 3.29
$9,322
This ratio measures the amount of liabilities that exists for

each $1 invested by the owners.
Market Ratios
ü Price/earnings (P/E) ratio
ü Dividend yield ratio

market ratios.
Price/Earnings (P/E) Ratio
The price/earnings ratio reflects the stock market’s assessment of a

company’s future performance.
Current Market Price per Share

P/E Ratio =
Earnings per Share
$104.43
P/E Ratio = = 22.03
$4.74
At the end of fiscal 2014, The Home

Depot’s stock was trading at
$104.43 per share.
This ratio measures the relationship between the current market price of the
stock and its earnings per share.
Dividend Yield Ratio
Dividend Dividends per Share

=
Yield Ratio Market Price per Share
Dividend $1.16
= = 1.11%
Yield Ratio $104.43
The Home Depot paid dividends of $1.16 per share when the market
price was $104.43 per share.
This ratio is often used to compare the dividend-paying performance of

different investment alternatives.
Interpreting Ratios
Ø Ratios may be interpreted by comparison with ratios of

other companies or with industry average ratios.
Ø Ratios may vary because of the company’s industry

characteristics, nature of operations, size, and accounting
policies.
Ø Because ratios are based on the aggregation of information,

they may obscure underlying factors that are of interest to
the analyst.
Ø A company’s accounting policy choices will influence its

ratios.
Other Financial Information
In addition to financial ratios, special factors might affect

company analysis:
Ø Rapid growth
Ø Uneconomical expansion
Ø Subjective factors

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LLH9e Chapter 13

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chapter 13 Analyzing Financial Statements

External Decision Makers Include

Is the company trying to earn a high rate of return through product

Financial statement analysis

Time-series analysis Cross-sectional analysis

Examines a single Provides insights concerning

Express each item on a particular statement as a

Net sales Total assets

The comparative income statements of The Home Depot

Prepare component percentage income statements

ü Return on assets (ROA)

ü Financial leverage percentage

ü Net profit margin

ü Earnings per share (EPS)

Profitability is a primary measure of

Return on Net Income

Financial leverage is the advantage or disadvantage that occurs as the

Net Profit Net Income

Net Profit $6,345

Remember from Chapter 11 that if there are preferred dividends,

Average number of shares based on the number

Earnings per share is probably the single most widely watched

Asset Turnover Ratios

ü Fixed asset turnover ratio

ü Receivable turnover ratio

ü Inventory turnover ratio

We will be referring to the financial statements

Total Asset Net Sales Revenue

Total Asset $83,176

This ratio measures a company’s ability to generate sales given an

Receivable Turnover Net Credit Sales

Receivable Turnover $83,176

This ratio measures how quickly a company collects its

Inventory Cost of Goods Sold

This ratio measures how quickly the company sells its

The DuPont model brings together several of the ratios

ROE Net Profit Total Asset Financial

We will be referring to the financial statements

Current Current Assets

This ratio measures the ability

Quick Quick Assets

Quick ($1,723 + $1,484 + $0) =

This ratio is like the current ratio, but it measures the

Tests of liquidity focus on the relationship between current assets and

Cash Cash + Cash Equivalents

This ratio measures the

ü Cash coverage ratio

We will be referring to the financial statements

Tests of solvency measure a company’s ability to meet its long-term

Net Interest Income Tax

Times Interest $6,345 + $830 + $3,631

This ratio indicates a margin of protection for creditors.

Cash Cash Flows from Operating Activities

This ratio measures the amount of liabilities that exists for

ü Dividend yield ratio

We will be referring to the financial statements

The price/earnings ratio reflects the stock market’s assessment of a

Current Market Price per Share

At the end of fiscal 2014, The Home

Dividend Dividends per Share

This ratio is often used to compare the dividend-paying performance of

Ø Ratios may be interpreted by comparison with ratios of

Ø Ratios may vary because of the company’s industry