Ch13 ACCT1101 S1 2223 Moodle

13
ACCT1101
Dr. Olivia Leung Analyzing Financial Statements
chapter
Financial Accounting
11e
Libby • Libby •Hodge
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
Learning Objectives
After studying this chapter, you should be able to:
13-3 Compute and interpret component percentages (E13-5)
Overview of Ratio Analysis
(13-4 Compute and interpret profitability ratios

13-5 Compute and interpret asset turnover ratios (E13-7)
(Dupont Model is not covered in exam)
13-6 Compute and interpret liquidity ratios (E13-10)
13-7 Compute and interpret solvency ratios

13-8 Compute and interpret market ratios
Lecture Exercises: P13-1 and AP13-4

Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 13-2
Understanding the Business
Financial statements help people make better economic decisions.

Published financial statements are designed primarily to meet the
needs of external decision makers.
Designed for external decision makers such as

Financial Ø Present and potential owners
Statements Ø Investment analysts
Ø Creditors
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 13-3
The Investment Decision
Economy-wide
Industry Factors
Individual
Factors Company Factors
Buy?
No Hold? Yes
Sell?
Understanding a Company’s Strategy (1 of 2)
While financial statements reflect transactions, each of those

transactions is the result of a company’s operating decisions as
it implements its business strategy.
Financial Statement Analysis
Financial statement analysis

is based on comparisons.
Time-Series Analysis Cross-Sectional Analysis
Information for a Information for multiple

single company is companies is compared
compared over time. at a point in time.
Insider Information
Insider Information = Knowing financial information before it is made

available to the public.
• Trading on insider information is a serious criminal offense often

resulting in large fines and jail time.
• In some cases, determining whether something is insider information
is difficult.
• Many public accounting firms prohibit their staff from investing in
companies that they audit to discourage insider trading.
Learning Objective 13-3
13-3 Component Percentages

Exercise E13-5
Component Percentages
Component percentages express each item on a particular financial

statement as a percentage of a single base amount.
Income Statement: Balance Sheet:

Net Sales Total Assets
The comparative income statements of The Home Depot

for 2020, 2019, and 2018 appear on the next slide.
Prepare component percentage income statements

where net sales equal 100 percent.
Exhibit 13.1 (1 of 3)
The Home Depot Financial Statements
Net sales will be
set to 100 percent, 2020 Cost of Sales ÷ 2020 Net Sales
and all other $87,257 ÷ $132,110 = 0.6605 or 66.05%
components will be
expressed as a
percentage of net 2020 Gross Profit ÷ 2020 Net Sales
sales. $44,853 ÷ $132,110 = 0.3395 or 33.95%
2020 Selling, G&A ÷ 2020 Net Sales

$24,447 ÷ $132,110 = 0.1851 or 18.51%
Exhibit 13.2
Component Percentages for The Home Depot
Using Data Visualization Tools to Assess a Company’s Performance
Data visualization tools (e.g., Tableau or Microsoft BI) can help analyze a
company’s financial data. This type of data analytics is especially useful when
communicating findings during meetings or in printed form.
E13-5
Overview of Ratio Analysis
Exercise E13-4
Ratio Analysis
Ratio analysis helps decision makers identify significant relationships

and make meaningful comparisons.
Component percentage ratios are computed using amounts from the

same financial statement, either the income statement or balance
sheet. Other ratios compare amounts from different financial
statements, such as net income to total assets.
Analysts will compute ratios that are most useful in a given situation.
Financial statement analysis involves a lot of judgment.
The more clearly you define the questions you want answered, the
easier it is to select the most appropriate ratios to compute.
The 2020 and 2019 balance sheets for The Home Depot are
presented on the next slides. We will be referring to these
financial statements throughout the ratio analyses.
Note: use the average balance sheet amount when comparing a balance
sheet number to an income statement number.
Exhibit 13.1 The Home Depot Financial Statements (1 of 2)
(2 of 3)
Exhibit 13.1 The Home Depot Financial Statements (2 of 2)
(3 of 3)
Exhibit 13.2
Component Percentages for The Home Depot
13-4 Compute and interpret profitability ratios.
Profitability Ratios
Profitability ratios focus on net income and how it compares to other
amounts reported on the financial statements.
We will be referring to the financial statements of The Home Depot

throughout our discussion of profitability ratios.
Return on Equity (ROE)
Return on Equity relates income earned to the investment made by the
owners. Investors expect to earn a return on the money they invest.
The ROE ratio for The Home Depot for fiscal 2020 is computed as follows:
*We normally use average stockholders’ equity for the denominator; however, because The Home
Depot reported negative stockholders’ equity in fiscal 2019, we are using the ending balance for
fiscal year 2020. For comparability reasons, we are also using the ending balance for Lowe’s.
On average, for every $1.00 equity investors contributed to

The Home Depot, the company earned $3.90 in fiscal 2020.
Comparison with Lowes: ROE for Lowe’s was 406.05 percent, indicating that
Lowe’s produced a better return on its owners’ investment than did The Home
Depot in fiscal 2020.
Return on Assets (ROA)
This ratio compares income to the total assets used to generate the income .
On average, for every $1.00 of assets reported on The Home Depot’s

balance sheet, the company earned just over 21 cents in fiscal 2020.
Comparison with Lowes: The ROA for Lowe’s was 13.54 percent,
considerably lower than the ROA for The Home Depot. This comparison
indicates that The Home Depot is utilizing its assets to generate income
more effectively than Lowe’s.
Gross Profit Margin Ratio
This ratio reflects gross profit as a percent of sales.
If not shown separately on a company’s income statement, gross profit is
computed by subtracting cost of sales from net sales.
After subtracting the direct costs associated with selling products, The
Home Depot had approximately 34 cents of each dollar of sales
remaining to cover other expenses.
Comparison with Lowes: The gross profit margin ratio for Lowe’s was
33.01%, almost identical to Home Depot. The companies likely follow
similar business strategies and sell similar products, perhaps from the
same suppliers.
Net Profit Margin Ratio
This ratio reflects net income as a percentage of sales and is used as a
measure of operating efficiency.
For fiscal 2020, each dollar of The Home Depot’s sales generated over 9
cents of profit. For each dollar of sales, The Home Depot is subtracting
just under 91 cents in expenses.
Note it is difficult to compare profit margins for companies in different

industries. There is a trade-off between profit margin and sales volume!
Comparison with Lowes: The net profit margin ratio for Lowe’s was
6.51%, or 6.5 cents for each dollar of sales. The Home Depot is
subtracting just under 91 cents in expenses while Lowe’s is subtracting
approximately 94 cents.
Earnings per Share Ratio (EPS)
The earnings per share ratio is a measure of return on investment that is
based on the number of common shares outstanding.
EPS and the average number of shares outstanding is reported on

the bottom of the income statement.
Managers can significantly alter EPS by selling shares of common
stock or repurchasing shares of common stock.
Earnings per share is probably the single most widely reported
financial ratio, and it is the only ratio required by GAAP.
Comparison with Lowes: The earnings per share for Lowe’s was $7.77 per
share. It is difficult to compare the EPS for different companies because
of the difference in the number of shares outstanding.
Quality of Income Ratio
The quality of income ratio compares net income to cash flows from
operating activities.
A ratio higher than 1 indicates high-quality income because each dollar

of income is supported by one or more dollars of cash flows.
Net income can be affected by accounting procedures, such as using

a longer estimated useful life for depreciation.
Comparison with Lowes: Lowe’s quality of income ratio was 1.89 for
2020, so both Lowe’s and The Home Depot have quality of income ratios
above 1.00.
13-5 Compute and interpret asset turnover ratios.
Asset Turnover Ratios
Asset turnover ratios focus on capturing how efficiently a company

uses its assets.

throughout our discussion of asset turnover ratios.
Total Asset Turnover Ratio
This ratio captures how well a company uses its assets to generate revenue.
On average, every dollar of assets on The Home Depot's balance sheet

generates $2.17 of revenue. The Home Depot’s total asset turnover
ratio has declined from fiscal 2018 to fiscal 2020.
Comparison with Lowes: Lowe’s Total Asset Turnover Ratio was 2.08
indicating The Home Depot was slightly more effective using its assets to
generate revenue.
Fixed Asset Turnover Ratio
This ratio measures a company’s ability to generate sales given an
investment in fixed assets.
For each dollar The Home Depot invested in property, plant, and
equipment, the company was able to generate $5.57 in sales revenue.
Comparison with Lowes: Lowe’s Fixed Asset Turnover Ratio was 4.73
indicating The Home Depot is more effective at using its fixed assets to
generate revenue.
Receivable Turnover Ratio
This ratio measures how quickly a company collects its accounts receivable.
A high receivable turnover ratio suggests that a company collects

its accounts receivable many times during a year. On average, The
Home Depot collects its accounts receivable over 51 times a year.
Because we did not know the amount of the credit sales, we used
total sales as an approximation. However, most customers use a
bank credit card such as MasterCard or Visa, which are like cash
sales. Therefore, this ratio is less meaningful for The Home
Depot.
*If credit sales are not reported separately, use total net sales as an approximation
Receivable Turnover Ratio – Converted to Days
The receivable turnover ratio often is converted to reflect the number

of days, on average, it takes a company to collect its receivables.
The Home Depot’s average days to collect receivables ratio implies that it
takes the company an average of just over seven days to collect its
accounts receivable.
Many of The Home Depot customers pay with a credit card, which is the
equivalent of a cash sale. As a result, net sales does not approximate net
credit sales, so this ratio analysis is less meaningful.
Inventory Turnover Ratio
This ratio measures how quickly the company sells its inventory.
An increase in this ratio is usually favorable. However, if the ratio is too high, it
may be an indication that sales were lost because desired items were not in
stock. A company must balance the cost of holding inventory with the
potential cost of losing a sale. On average, The Home Depot’s inventory was
acquired and sold to customers over 5 times during the year.
Comparison with Lowes: Inventory turnover for Lowe’s was 4.09,

indicating a competitive advantage for The Home Depot.
Inventory Turnover Ratio – Converted to Days
The inventory turnover ratio often is converted to reflect the number

of days, on average, it takes a company to sell its inventory.
The Home Depot’s average days to sell inventory ratio implies

that, on average, it takes the company just over sixty-five days
to sell its inventory.
Using Ratios to Analyze the Operating Cycle
The operating cycle is the time it takes for a company to pay cash to its
suppliers, sell goods to its customers, and collect cash from its customers.
Analysts are interested in the operating cycle because it helps them evaluate
a company’s cash needs and is a good indicator of operating efficiency.
The operating cycle for most companies involves three distinct phases:
1) the acquisition of inventory
2) the sale of the inventory
3) the collection of cash from the customer.
Several ratios are helpful when evaluating a company’s operating cycle:
E13-7
13-6 Compute and interpret liquidity ratios.
Liquidity Ratios
Liquidity ratios measure a company's ability to meet its
short-term obligations.

throughout our discussion of liquidity ratios.
Current Ratio
This ratio measures the ability of the company to pay current
debts as they become due.
A ratio greater than 1 implies that a company’s current assets are

sufficient to cover its current liabilities. If a company’s current ratio is less
than 1, analysts will want to understand how the company intends to
meet its short-term obligations.
Analysts become concerned if a company’s current ratio is high

compared to similar companies. A firm is operating inefficiently when it
ties up too much money in inventory or accounts receivable.
Comparison with Lowes: At the end of fiscal 2020, Lowe’s had $1.19 in
current assets for each $1.00 in current liabilities (slightly less than The
Home Depot).
E13-10
Quick Ratio
This ratio is a more stringent test of short-term liquidity
than the current ratio.
Cash and Cash Equivalents $ 7,895

Receivables, net 2,992
Marketable Securities -
Quick Assets $ 10,887
Quick assets are defined as cash and near-cash assets (net accounts
receivable and marketable securities). Inventory and Prepaid expenses are
omitted from quick assets. The Home Depot has 47 cents in cash and near-
cash assets for every $1.00 in current liabilities.
Comparison with Lowes: Lowe’s quick assets were significantly lower at

$0.28.
Cash Ratio
This ratio measures the

adequacy of available cash.
At the end of fiscal 2020, The Home Depot has 34 cents of cash for
each $1.00 of current liabilities.
Cash is the lifeblood of a business. Without cash, a company cannot

pay its employees or meet its obligations to creditors.
Even a profitable business will fail without sufficient cash.
However, holding too much cash also means the company is not
investing the cash in productive assets that will grow the business.
13-7 Compute and interpret solvency ratios.
Solvency Ratios
Solvency ratios measure a company’s ability to meet its
long-term obligations.

throughout our discussion of solvency ratios.
Times Interest Earned Ratio
This ratio compares the income available to pay interest in a period to a

company’s interest obligation for the same period.
This ratio indicates a margin of protection for creditors. Interest expense
and income tax expense are included in the numerator because these
amounts are available to pay interest.
A high ratio indicates a secure position for creditors.

In fiscal 2020, The Home Depot generated $13.60 in income for
each $1.00 of interest expense.
Some analysts believe that the times interest earned ratio is

flawed because interest expense is paid in cash, not with net
income. These analysts prefer to use the cash coverage ratio.
Cash Coverage Ratio
This ratio compares the cash from operations to the cash needed to
make required interest payments.
The Home Depot’s cash coverage ratio shows that the

company generated $15.18 in cash for every $1.00 of interest
paid, which is strong coverage.
Debt-to-Equity Ratio
This ratio expresses a company’s debt as a proportion of its
stockholders’ equity.
In fiscal 2020, for each $1.00 of stockholders’ equity, The Home

Depot had $20.39 of liabilities.
Debt is risky because interest payments must be made even if the

company has not earned sufficient income to pay them.
In contrast, dividends are always at the company’s discretion and are
not legally enforceable until they are declared.
Comparison with Lowes: Lowe’s debt-to-equity ratio was higher at

$31.52, indicating increased risk compared to The Home Depot.
13-8 Compute and interpret market ratios.
Market Ratios
Market ratios relate the current price per share of a company’s stock to
the return that accrues to stockholders.
Analysts find these ratios helpful because they are based on the current
value of an owner’s investment in a company.

throughout our discussion of market ratios.
Price/Earnings (P/E) Ratio
This ratio measures the relationship between the current market price of a
company’s stock and its earnings per share.
* At the end of fiscal 2020, The Home

Depot’s stock was trading at $269.13
per share.
The P/E ratio reflects the stock market’s assessment of a company’s

future performance. A high ratio indicates that earnings are expected to
grow rapidly. The P/E ratio for The Home Depot indicates that the
market expects them to perform well in the future. This P/E ratio
indicates that The Home Depot’s stock was selling at a price that was just
over 22 times its earnings per share.
Comparison with Lowes: Lowe’s P/E ratio was 21.33.
Dividend Yield Ratio
This ratio reflects the return on investment solely due to the dividends a
company pays.
Investors are willing to accept low dividend yields if they expect that the
price of a stock will increase while they own it.
Stocks with low growth potential tend to offer much higher dividend
yields than stocks with high growth potential. Stocks with high dividend
yields often appeal to retired investors who need current income rather
than future growth potential.
Comparison with Lowes: Lowe’s Dividend Yield Ratio was slightly less
than The Home Depot’s at 1.38 percent for 2020.
INTERPRETING RATIOS
& ESG REPORTING
Interpreting Ratios and Other Analytical Considerations
Ø Analysts must decide which ratios to use based on their decision

objective.
Ø Ratios can be interpreted only by comparing them to other ratios or a

benchmark value.
Ø Comparing ratios for two firms is appropriate only if the companies are
comparable in terms of their industry, operations, 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.

Different companies rarely use the exact same accounting policies.
Other Relevant Information
Understanding the broader economic environment in which a

company operates and other relevant information is important
when interpreting its ratios and analyzing a company.
Analysts commonly consider:
Ø Reasons for rapid growth
Ø Uneconomical expansion
Ø Non-financial information
Environmental, Social, & Governance (ESG) Reporting
Source: The Home

Depot’s 2020 10K
LECTURE EXERCISE: P13-1
13-61
AP13-4
(See next 2 slides for financial statements)
13-63
13-64
13-65
13-66
13-67
13-68

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13

13-3 Compute and interpret component percentages (E13-5)

Overview of Ratio Analysis

(13-4 Compute and interpret profitability ratios

13-6 Compute and interpret liquidity ratios (E13-10)

13-7 Compute and interpret solvency ratios

Lecture Exercises: P13-1 and AP13-4

Financial statements help people make better economic decisions.

Designed for external decision makers such as

While financial statements reflect transactions, each of those

Financial statement analysis

Time-Series Analysis Cross-Sectional Analysis

Information for a Information for multiple

Insider Information = Knowing financial information before it is made

• Trading on insider information is a serious criminal offense often

13-3 Component Percentages

Component percentages express each item on a particular financial

Income Statement: Balance Sheet:

The comparative income statements of The Home Depot

Prepare component percentage income statements

2020 Selling, G&A ÷ 2020 Net Sales

Ratio analysis helps decision makers identify significant relationships

Component percentage ratios are computed using amounts from the

We will be referring to the financial statements of The Home Depot

On average, for every $1.00 equity investors contributed to

On average, for every $1.00 of assets reported on The Home Depot’s

Note it is difficult to compare profit margins for companies in different

EPS and the average number of shares outstanding is reported on

A ratio higher than 1 indicates high-quality income because each dollar

Net income can be affected by accounting procedures, such as using

Asset turnover ratios focus on capturing how efficiently a company

We will be referring to the financial statements of The Home Depot

On average, every dollar of assets on The Home Depot's balance sheet

A high receivable turnover ratio suggests that a company collects

The receivable turnover ratio often is converted to reflect the number

Comparison with Lowes: Inventory turnover for Lowe’s was 4.09,

The inventory turnover ratio often is converted to reflect the number

The Home Depot’s average days to sell inventory ratio implies

Several ratios are helpful when evaluating a company’s operating cycle:

We will be referring to the financial statements of The Home Depot

A ratio greater than 1 implies that a company’s current assets are

Analysts become concerned if a company’s current ratio is high

Cash and Cash Equivalents $ 7,895

Comparison with Lowes: Lowe’s quick assets were significantly lower at

This ratio measures the

Cash is the lifeblood of a business. Without cash, a company cannot

We will be referring to the financial statements of The Home Depot

This ratio compares the income available to pay interest in a period to a

A high ratio indicates a secure position for creditors.

Some analysts believe that the times interest earned ratio is

The Home Depot’s cash coverage ratio shows that the

In fiscal 2020, for each $1.00 of stockholders’ equity, The Home

Debt is risky because interest payments must be made even if the

Comparison with Lowes: Lowe’s debt-to-equity ratio was higher at

We will be referring to the financial statements of The Home Depot

* At the end of fiscal 2020, The Home

The P/E ratio reflects the stock market’s assessment of a company’s

Comparison with Lowes: Lowe’s P/E ratio was 21.33.

Ø Analysts must decide which ratios to use based on their decision

Ø Ratios can be interpreted only by comparing them to other ratios or a

Ø Because ratios are based on the aggregation of information, they may

Ø A company’s accounting policy choices will influence its ratios.