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Understanding Financial

Statements

Subject Faculty
Prof.Rahul Ghosale
B.Com, MBA(Fin), NET(Mgt), GDC&A, Ph.D(Pursuing)

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.

Understanding The Business


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

Present
Condition

Future
Performance

Assets, debt,
inventory,
various ratios.

Sales and earnings


trends are good
indicators of future
performance.

Understanding The Business


Return on an equity
security investment
Increase in
share price

Dividends

Investors

Understanding The Business


Industry
Factors

No

14-6

Individual
Company
Factors

Invest?

Economy-wide
Factors

Yes

Understanding a Companys
Strategy
I need to know the companys
policies on product differentiation,
pricing, and cost control to make my
financial analysis more meaningful.

Financial Statement
Analysis
Financial statement analysis
is based on comparisons.

Time series
analysis
Examines a single
company to identify
trends over time.
14-8

Comparison with
similar companies

Financial Statement
Analysis
Financial statement analysis
is based on comparisons.

14-9

Time series
analysis

Comparison with
similar companies

Company
A
Company
B

Provides insights
concerning a
companys relative
performance.

Ratio and Percentage


Analyses
Ratio analysis, or percentage
analysis, is used to express the
proportionate relationship between
two different amounts.

14-10

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

Net sales
on the income
statement
14-11

Total assets
on the balance
sheet

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 equal
equal 100%.
100%.
Home Depot
14-12

Component Percentages
HOME DEPOT
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
14-13

Percent
100.0%

Component Percentages
HOME DEPOT
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
200121
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
14-14

Component Percentages
HOME DEPOT
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
70.1%
27,023
Gross profit
13,681
29.9%
11,411
Operating expenses
9,490
20.7%
7,603
Operating Income
4,191
9.2%
3,808
Interest and Investment Income
47
0.1%
37
Interest Expense
21
0.0%
41
Earnings Before Income Taxes
4,217
9.2%
3,804
Income Taxes
1,636
3.6%
1,484
Net Earnings
$ 2,581
5.6% $ 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
14-15

Percent
100.0%
70.3%
29.7%
19.8%
9.9%
0.1%
0.1%
9.9%
3.9%
6.0%

Now, lets
look at some
commonly
used ratios.

14-16

Commonly Used Ratios


The
The 2001
2001 and
and 2000
2000 balance
balance sheets
sheets
for
for Home
Home Depot
Depot are
are presented
presented
next.
next.
We
We will
will be
be referring
referring to
to these
these
financial
financial statements
statements throughout
throughout
the
the ratio
ratio analyses.
analyses.
Home Depot
14-17

Comparative Statements
HOME DEPOT
Comparative Balance Sheets (Condensed)
Amounts in Millions

2001
Assets
Cash and Cash Equivalents
Receivables, net
Merchandise inventories
Other Current Assets
Total Current Assets
Property and Equipment, at cost
Less Accumulated Depreciation
Net Property and Equipment
Other Assets
Total Assets
14-18

2000

167 $
168
835
587
6,556
5,489
219
146
7,777
6,390
15,232
11,890
2,164
1,663
13,068
10,227
540
464
$ 21,385 $ 17,081

Continued

Comparative Statements
HOME DEPOT
Comparative Balance Sheets (Condensed)
Amounts in Millions

2001

2000

Liabilities
Current Liabilities
Noncurrent Liabilities
Total Liabilities
Stockholders' Equity
Common Stock, $.05 par
Paid-in Capital
Retained Earnings
Accumulated Other Comprehensive Income
Total
Less: Treasury Stock
Total Stockholders' Equity
Total Liabilities & Stockholders' Equity
14-19

4,385 $
1,996
6,381

3,656
1,084
4,740

116
115
4,810
4,319
10,151
7,941
(67)
(27)
15,010
12,348
6
7
15,004
12,341
$ 21,385 $ 17,081

Tests of Profitability
Profitability
Profitability is
is aa primary
primary measure
measure of
of
the
the overall
overall success
success of
of aa company.
company.
Now,
Now, lets
lets look
look at
at the
the profitability
profitability
ratios
ratios for
for Home
Home Depot
Depot for
for 2001.
2001.

Home Depot
14-20

Return on Equity
Return on Equity =

Return on Equity =

Income
Average Owners Equity
$2,581
($15,004 + $12,341) 2

This
Thismeasure
measureindicates
indicateshow
how much
much
income
incomewas
wasearned
earned for
for every
everydollar
dollar
invested
investedby
bythe
the owners.
owners.
14-21

= 18.9%

Return on Assets
Return on
Assets
Return on
Assets

Income + Interest Expense (net of tax)


Average Total Assets

$2,581 + ($21 (1 - .34))


($21,385 + $17,081) 2

= 13.5%

Corporate tax rate


is 34 percent.
This
Thisratio
ratiois
isgenerally
generallyconsidered
considered
the
thebest
best overall
overallmeasure
measureof
of aa
companys
companysprofitability.
profitability.
14-22

Financial Leverage
Financial
Leverage

5.4%

Return on Equity Return on Assets

18.9%

13.5%

Financial
Financial leverage
leverageis
isthe
theadvantage
advantageor
or
disadvantage
disadvantagethat
thatoccurs
occursas
asthe
theresult
result of
of
earning
earningaareturn
return on
on equity
equitythat
that is
isdifferent
different
from
from the
thereturn
return on
on assets.
assets.
14-23

Earnings per Share (EPS)


EPS =

EPS =

Income
Average Number of Shares of
Common Stock Outstanding
$2,581
(2,324 + 2,304) 2

= $1.12

Earnings
Earningsper
per share
share is
isprobably
probably
the
thesingle
single most
most widely
widelywatched
watched
financial
financial ratio.
ratio.
14-24

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
14-25

Quality of Income
Quality
=
of Income

Cash Flow from Operating Activities


Net Income

Quality
=
of Income

$2,796

= 1.08

$2,581
AAratio
ratio higher
higherthan
than 11 indicates
indicates
higher-quality
higher-qualityearnings.
earnings.

14-26

Profit Margin
Profit
=
Margin
Profit
=
Margin

Income (before Extraordinary Items)


Net Sales
$2,581
$45,738

= 5.6%

This
Thisratio
ratiodescribes
describesaa
companys
companysability
abilityto
toearn
earn
income
incomefrom
fromsales.
sales.
14-27

Fixed Asset Turnover


Fixed
=
Asset
Turnover

Net Sales Revenue


Average Net Fixed Assets

Fixed
Asset
=
Turnover

$45,738
($13,068 + $10,227) 2

= 3.9

This
Thisratio
ratiomeasures
measuresaa companys
companys
ability
abilityto
to generate
generatesales
salesgiven
givenan
an
investment
investment in
in fixed
fixedassets.
assets.
14-28

Tests of Liquidity
Tests
Tests of
of liquidity
liquidity focus
focus on
on the
the
relationship
relationship between
between current
current
assets
assets and
and current
current liabilities.
liabilities.
Now,
Now, lets
lets look
look at
at the
the liquidity
liquidity ratios
ratios
for
for Home
Home Depot
Depot for
for 2001.
2001.

Home Depot
14-29

Cash Ratio
Cash
Ratio
Cash
Ratio

Cash + Cash Equivalents


=
Current Liabilities

$167
$4,385

0.04 : 1

This
Thisratio
ratiomeasures
measuresthe
the
adequacy
adequacyof
ofavailable
availablecash.
cash.
14-30

Current Ratio
Current
Ratio
Current
Ratio

Current Assets
Current Liabilities
$7,777

1.77 : 1

$4,385
This
Thisratio
ratiomeasures
measuresthe
theability
ability
of
of the
thecompany
companyto
topay
paycurrent
current
debts
debtsas
asthey
theybecome
becomedue.
due.
14-31

Quick Ratio (Acid Test)


Quick
Ratio

Quick Assets
Current Liabilities

Quick
Ratio

$1,012
$4,385

Cash & Cash Equivalents


Receivables, net
Short-term Investments
Quick Assets

14-32

.23 : 1
$

167
835
10
$ 1,012

This
Thisratio
ratio is
is like
like the
thecurrent
current
ratio
ratiobut
but measures
measures the
the companys
companys
immediate
immediateability
abilityto
topay
paydebts.
debts.

Receivable Turnover
Receivable
Turnover
Receivable
Turnover

Net Credit Sales


Average Net Trade Receivables
$45,738
($835 + $587) 2

= 64 times

This
Thisratio
ratiomeasures
measureshow
how
quickly
quicklyaacompany
companycollects
collectsits
its
accounts
accountsreceivable.
receivable.
14-33

Average Age of Receivables


Average Age
of Receivables

Average Age
of Receivables

Days in Year
Receivable Turnover
365
64

= 5.7 days

This
Thisratio
ratio measures
measuresthe
the average
average
number
number of
of days
daysitit takes
takesto
tocollect
collect
receivables.
receivables.
14-34

Inventory Turnover
Inventory
Turnover

Cost of Goods Sold


= Average Inventory

Inventory
Turnover

$32,057
= ($6,556 + $5,489) 2

= 5.3 times

This
Thisratio
ratio measures
measures how
how quickly
quickly
the
thecompany
companysells
sells its
its inventory.
inventory.
14-35

Average Days Supply in


Inventory
Average Days
Supply in
Inventory
Average Days
Supply in
Inventory

Days in Year
Inventory Turnover
365
5.3

69 days

This
Thisratio
ratiomeasures
measuresthe
theaverage
average
number
number of
of days
daysitit takes
takes to
to sell
sell
the
theinventory.
inventory.
14-36

Tests of Solvency and Equity


Position
Tests
Tests of
of solvency
solvency measure
measure aa companys
companys
ability
ability to
to meet
meet its
its obligations.
obligations.
Now,
Now, lets
lets look
look at
at the
the solvency
solvency ratios
ratios for
for
Home
Home Depot
Depot for
for 2001.
2001.

Home Depot
14-37

Times Interest Earned


Times
Interest
Earned
Times
Interest
Earned

Net
Interest
Income Tax
+
+
Income
Expense
Expense
Interest Expense
$2,581 + $21 + $1,636
$21

This
Thisratio
ratio indicates
indicates aa margin
margin of
of
protection
protection for
for creditors.
creditors.
14-38

= 202

Cash Coverage
Cash
=
Coverage

Cash Flow from Operating Activities


Before Interest and Taxes
Interest Paid

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
14-39

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

16
1,386

This
Thisratio
ratio compares
compares the
thecash
cashgenerated
generated
with
withthe
the cash
cash obligations
obligationsof
of the
theperiod.
period.
14-40

262

Debt/Equity Ratio
Debt/Equity
Ratio
Debt/Equity
Ratio

Total Liabilities
Owners Equity
$6,381
$15,004

0.43

This
Thisratio
ratiomeasures
measuresthe
theamount
amount of
of
liabilities
liabilitiesthat
thatexists
existsfor
for each
each$1
$1
invested
investedby
bythe
the owners.
owners.
14-41

Market Tests
Market
Market tests
tests relate
relate the
the current
current market
market
price
price of
of aa share
share of
of stock
stock to
to an
an
indicator
indicator of
of the
the return
return that
that might
might
accrue
accrue to
to the
the investor.
investor.
Now,
Now, lets
lets look
look at
at the
the market
market tests
tests for
for
Home
Home Depot
Depot for
for 2001.
2001.
Home Depot
14-42

Price/Earnings (P/E) Ratio


P/E Ratio

P/E Ratio

Current Market Price Per Share


Earnings Per Share

$35
$1.12

31.3

A recent price for Home Depot


stock was $35 per share.
This
Thisratio
ratio measures
measuresthe
therelationship
relationship
between
betweenthe
the current
current market
market price
priceof
of the
the
stock
stockand
andits
itsearnings
earningsper
per share.
share.
14-43

Dividend Yield Ratio


Dividend
Yield
Dividend
Yield

Dividends Per Share


Market Price Per Share

$0.16
$35

0.46%

Home
HomeDepot
Depot paid
paiddividends
dividendsof
of$.16
$.16per
pershare
share
when
when the
the market
market price
price was
was $35
$35 per
per share.
share.
This
Thisratio
ratio is
is often
often used
used to
to compare
compare the
the
dividend-paying
dividend-payingperformance
performanceof
of different
different
investment
investment alternatives.
alternatives.
14-44

Other Analytical
Considerations
In
In addition
addition to
to financial
financial ratios,
ratios, special
special
factors
factors might
might affect
affect company
company
analysis:
analysis:

Rapid
Rapid growth.
growth.

Uneconomical
Uneconomical expansion.
expansion.

Subjective
Subjective factors.
factors.
14-45

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.
14-46

Efficient Markets
A securities market in which prices
fully reflect available information is
called an efficient market.
In an efficient market, a companys
stock reacts quickly when new,
relevant information is released
about the company.

14-47