© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Commonly Used Ratios

The 1999 and 1998 balance sheets for Home Depot are presented next.

We will be referring to these financial statements throughout the ratio

analyses.

The 1999 and 1998 balance sheets for Home Depot are presented next.

We will be referring to these financial statements throughout the ratio

analyses.

Home Depot

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Comparative StatementsHOME DEPOT

Comparative Balance Sheets (Condensed)Amounts in Millions

1999 1998Assets

Cash and Cash Equivalents 62$ 172$ Receivables, net 469 556 Merchandise inventories 4,293 3,602 Other Current Assets 109 130 Total Current Assets 4,933 4,460 Property and Equipment, at cost 9,422 7,487 Less Accumulated Depreciation 1,262 978 Net Property and Equipment 8,160 6,509 Other Assets 372 260 Total Assets 13,465$ 11,229$

Continued

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Comparative StatementsHOME DEPOT

Comparative Balance Sheets (Condensed)Amounts in Millions

1999 1998Liabilities

Current Liabilities 2,857$ 2,456$ Noncurrent Liabilities 1,868 1,675 Total Liabilities 4,725 4,131

Stockholders' Equity Common Stock, $.05 par 74 73 Paid-in Capital 2,854 2,626 Retained Earnings 5,876 4,430 Accumulated Other Comprehensive Income (61) (28) Total 8,743 7,101 Less: Treasury Stock 3 3 Total Stockholders' Equity 8,740 7,098

Total Liabilities & Stockholders' Equity 13,465$ 11,229$

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Tests of Profitability

Profitability is a primary measure of the overall success of a company.

Now, let’s look at the profitability ratiosfor Home Depot for 1999.

Profitability is a primary measure of the overall success of a company.

Now, let’s look at the profitability ratiosfor Home Depot for 1999.

Home Depot

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Return on Equity

Return on Equity$1,614

($8,740 + $7,098) ÷ 2= = 20.4%

Income Average Owners’ EquityReturn on Equity =

This measure indicates how muchincome was earned for every dollar

invested by the owners.

This measure indicates how muchincome was earned for every dollar

invested by the owners.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Return on Assets

Return on AssetsIncome + Interest Expense (net of tax)

Average Total Assets=

Return on Assets$1,614 + ($37 ×(1 - .34)) ($13,465 + $11,229) ÷ 2

= = 13.3%

This ratio is generally consideredthe best overall measure of a

company’s profitability.

This ratio is generally consideredthe best overall measure of a

company’s profitability.

Corporate tax rateis 34 percent.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Financial Leverage

Financial Leverage Return on Equity – Return on Assets=

7.1% = 20.4% – 13.3%

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.

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.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Earnings per Share (EPS)

IncomeAverage Number of Shares ofCommon Stock Outstanding

EPS =

EPS$1,614

(1,471 + 1,459) ÷ 2= = $1.10

Earnings per share is probably the single most widely watched

financial ratio.

Earnings per share is probably the single most widely watched

financial ratio.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Quality of Income

Qualityof Income

Cash Flow from Operating Activities Net Income

=

Cash Flow from Operating Activities

Net Income 1,614$ Add: Depreciation 373

Deferred Income Tax Expense 7 Decrease in Receivables, net 85 Increase in Current Liabilities 536

Deduct: Increase in Merchandise Inventories (698) Cash Flow from Operating Activities 1,917$

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Quality of Income

Qualityof Income

Cash Flow from Operating Activities Net Income

=

Qualityof Income

$1,917 $1,614

= = 1.19

A ratio higher than 1 indicates higher-quality earnings.

A ratio higher than 1 indicates higher-quality earnings.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Profit Margin

= 5.3%ProfitMargin

$1,614$30,219

=

This ratio describes a company’s ability to earn

income from sales.

This ratio describes a company’s ability to earn

income from sales.

ProfitMargin

Income (before Extraordinary Items) Net Sales

=

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Fixed Asset Turnover Ratio

FixedAsset

Turnover

$30,219($8,160 + $6,509) ÷ 2

= = 4.12

FixedAsset

Turnover

Net Sales RevenueAverage Net Fixed Assets

=

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

investment in fixed assets.

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

investment in fixed assets.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Tests of Liquidity

Tests of liquidity focus on the relationship between current assets

and current liabilities. Now, let’s look at the liquidity ratios

for Home Depot for 1999.

Tests of liquidity focus on the relationship between current assets

and current liabilities. Now, let’s look at the liquidity ratios

for Home Depot for 1999.

Home Depot

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Cash Ratio

CashRatio

Cash + Cash EquivalentsCurrent Liabilities

=

= 0.022 : 1CashRatio

$62$2,857

=

This ratio measures theadequacy of available cash.

This ratio measures theadequacy of available cash.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Current Ratio

CurrentRatio

Current Assets Current Liabilities

=

CurrentRatio

$4,933 $2,857

= = 1.73 : 1

This ratio measures the abilityof the company to pay current

debts as they become due.

This ratio measures the abilityof the company to pay current

debts as they become due.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Quick Ratio (Acid Test)

Quick Assets Current Liabilities

=QuickRatio

$531 $2,857

= .19 : 1=QuickRatio

Quick assets are Cash, Accounts Receivable, and Notes Receivable, and Short-term Investments.

This ratio is like the currentratio but measures the company’s

immediate ability to pay debts.

This ratio is like the currentratio but measures the company’s

immediate ability to pay debts.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Receivable Turnover

Net Credit Sales Average Net Trade Receivables

Receivable Turnover

=

Receivable Turnover

$30,219($469 + $556) ÷ 2

= 59 times=

This ratio measures how quickly a company collects its

accounts receivable.

This ratio measures how quickly a company collects its

accounts receivable.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Average Age of Receivables

Days in Year Receivable Turnover

Average Age of Receivables =

= 6.2 days36559

Average Age of Receivables

=

This ratio measures the average number of days it takes to collect

receivables.

This ratio measures the average number of days it takes to collect

receivables.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Inventory Turnover

Cost of Goods SoldAverage Inventory

Inventory Turnover =

Inventory Turnover

$21,614($4,293 + $3,602) ÷ 2 = 5.5 times=

This ratio measures how quickly the company sells its inventory.

This ratio measures how quickly the company sells its inventory.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Average Days’ Supply in Inventory

Days in YearInventory Turnover

Average Days’ Supply in Inventory

=

= 66 days3655.5=

Average Days’ Supply in Inventory

This ratio measures the average number of days it takes to sell

the inventory.

This ratio measures the average number of days it takes to sell

the inventory.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Tests of Solvency and Equity Position

Tests of solvency measure a company’s ability to meet its obligations.

Now, let’s look at the solvency ratios for Home Depot for 1999.

Tests of solvency measure a company’s ability to meet its obligations.

Now, let’s look at the solvency ratios for Home Depot for 1999.

Home Depot

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

This ratio indicates a margin of protection for creditors.

This ratio indicates a margin of protection for creditors.

Times Interest Earned

Net Interest Income Tax Income Expense Expense

Interest Expense

Times Interest Earned

=+ +

$1,614 + $37 + $1,040$37

Times Interest Earned

= = 72.7

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Cash Coverage

Cash Flow from Operating Activities

Net Income 1,614$ Add: Depreciation 373

Deferred Income Tax Expense 7 Decrease in Receivables, net 85 Increase in Current Liabilities 536

Deduct Increase in Merchandise Inventories (698) Cash Flow from Operating Activities 1,917$

CashCoverage

Cash Flow from Operating ActivitiesBefore Interest and Taxes

Interest Paid=

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Cash Coverage

CashCoverage

= $1,917 + $37 + $1,040$37

= 80.9

CashCoverage

Cash Flow from Operating ActivitiesBefore Interest and Taxes

Interest Paid=

This ratio compares the cash generated with the cash obligations

of the period.

This ratio compares the cash generated with the cash obligations

of the period.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Debt/Equity Ratio

Total LiabilitiesOwners’ Equity

Debt/Equity Ratio

=

$4,725$8,740

= 0.54Debt/Equity Ratio

=

This ratio measures the amount of liabilities that exists for each $1

invested by the owners.

This ratio measures the amount of liabilities that exists for each $1

invested by the owners.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Market Tests

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

Now, let’s look at the market tests forHome Depot for 1999.

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

Now, let’s look at the market tests forHome Depot for 1999.

Home Depot

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Price/Earnings (P/E) Ratio

P/E Ratio =Current Market Price Per Share

Earnings Per Share

P/E Ratio =$62

$1.10= 56.4

This ratio measures the relationship between the current market price of the

stock and its earnings per share.

This ratio measures the relationship between the current market price of the

stock and its earnings per share.

A recent price for Home Depotstock was $62 per share.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Dividend Yield Ratio

DividendYield

Dividends Per Share Market Price Per Share

=

DividendYield

$0.23$62

= = 0.37%

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

investment alternatives.

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

investment alternatives.

Home Depot paid dividends of $.23 per share when the market price was $62 per share.

Home Depot paid dividends of $.23 per share when the market price was $62 per share.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Miscellaneous Ratios

Financial analysts may calculate many other financial ratios to help evaluate

and compare investment opportunities.

Now, let’s look at book value per share as an example of such a ratio for Home

Depot for 1999.

Financial analysts may calculate many other financial ratios to help evaluate

and compare investment opportunities.

Now, let’s look at book value per share as an example of such a ratio for Home

Depot for 1999.

Home Depot

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Book Valueper Share

$8,7401,471

= = $5.94

Book Value per Share

Book Valueper Share

Common Stock EquityNumber of Shares of

Common Stock Outstanding

=

Book value per share measures the owners’ equity in terms of common stock outstanding. Book value per share has

no relationship to market value.

Book value per share measures the owners’ equity in terms of common stock outstanding. Book value per share has

no relationship to market value.

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

End of Chapter 14

Ratios

Ratios

Ratios RatiosRatios