What does the income statement tell you? How much income you made? But that's just scratching the surface. And we will discuss why knowing how much the company made is really not a meaningful measure of anything. Are you shocked by that statement? Let's test that statement.

And you tell me what you think. If I tell you that ABC company has made $1 million, what does that mean? I'll pause for a few seconds and allow you to consider an answer. You would be correct if you said it means the company is profitable. But if I told you that the company has a billion dollars in assets, are you still excited? In fact, 1 million in earnings would be a horrible result for a company with a billion dollars in assets.

What if I told you that there was 100 million shares outstanding, in which case your $1 million of earnings amounted to just one cent for each share you hold if you paid $100. For that share that is a horrible result, do you get the idea that the gross amount of earnings in and of itself is a pretty meaningless number to bring meaning to the gross amount of earnings, we need to perform some financial analysis. In this lesson, we will pull out our calculators and crunch some numbers. This is more for the sake of illustration because in reality, the company itself or the investment websites do a lot of the calculations for us. But if you're going to learn this stuff, you need to learn the fundamentals. First, we're going to break down financial analysis in the coming lessons into a handful of modules.

In this first lesson, we're going to look at the profitability indicators. Our goal is to evaluate how much money the company is making and evaluate whether this is a good or a bad result. In the second lesson, we're going to look at the operating performance here we want to drill into the aggregated numbers that have been presented. This will help us better understand the business drivers and the overall productivity for the resources the company has deployed. In our third lesson, we're going to evaluate the financial strength. And we do this by looking at financial leverage and financial liquidity.

Leverage speaks to how debt is used to finance the business. And liquidity speaks to how well we are positioned to pay our bills as they come due. In the fourth lesson, we're going to evaluate cash flow. Here we want to calculate how much cash the business is generating for its shareholders, which is not necessarily the same thing as earnings as we will learn. Also, what is the company doing what the cash that is generating? In our final lesson, we will look at the valuation metrics of the company.

We will want to get a feel for how well the stock price reflects the fundamental performance of the business and this source of analysis will support a buy sell or a hold investment decision. So let's begin in this video by looking at profitability. And that question is answered in a couple of places within our 10 K. Let's start with the financial statements themselves. As for many private businesses, this is all you're going to get to do your financial analysis. Financial statements are composed of a series of tables of numbers. The income statements sometimes called the statement of earnings is where we will start Note how the years are described in the header that is for the year ended, which means that the statements aggregate all the activity that has happened through a 12 month period ending with the date noted to contrast this wording that found on the balance sheet which reads January 30 2011.

Some other statements may also read as at a certain date you interpret this language to mean balance of the account at a specific moment in time. In our example, with Home Depot as of midnight on January 30. Company held 540 $5 million in cash. We will look at the other statements the balance sheet, the statement of changes in equity the cash flow statement in later lessons and return to this concept of has that and for the period ended. Let's start at the top of the income statement and work our way down. First look at the sales and particularly the sales trend.

This helps us evaluate the company's lifecycle stage and evaluate the growth trajectory of the company. Is the company in its infancy with low revenues and high expenses. Is it in the growth phase where top line revenues are growing at a high rate is it it's in a maturity phase where the revenues are growing at a slower rate or being held steady or they are in decline phase where the revenues are deteriorating year after year. Realize that sales can also be a reflection of the macro environment. Or they may reflect acquisitions and divestiture activities. Home Depot has been fairly stable in its business operations in recent years.

And the volatility that we observe here is most likely caused by the housing weakness in the US during the years that have been presented unless so from the opening of stores, or closing of stores or any acquisition activity. The next line to stop at as we work our way down the income statement is the gross profit line. In a retail business, gross profit is a key indicator of strength in the business. And this gives us the perfect opportunity to talk about emergent analysis. That is how much money do we make off of each dollar of sales. This is often expressed as a percentage of sales.

The gross margin then is the gross profit dollars divided by the net sales dollars. From calculating this ratio for each of the three years presented. We can To see that this margin has been slowly increasing. This is a good thing as it means that Home Depot has been able to maintain margins and grow them in a tough macro economic environment. This can also be compared with other retailers, such as its main competitor Lowe's to see how they compare. The next lines on the income statements disclose the operating expenses.

Here you want to compare the balances to prior years and to evaluate the trend in the context of the overall business activity level. Now the business activity level can be implied by the level of net sales. Often most of these costs are fixed, though some may be variable. A fixed cost is one that doesn't vary with the level of activity. For example, things like management salaries, insurance costs utility costs. A variable cost is one that does, for example, the associate Commission's that are paid, using fixed costs in a business is called operating leverage a business with high operating leverage, we'll see increasing amounts of income as sales increase.

However, bear in mind that leverage is always a double edged sword. And when sales fall, you'll still have to pay those fixed costs, which increased the loss to the bottom line. With that in mind, when we look at the Home Depot, we don't see a large amount of variation in the SGA line, which implies that these costs are largely fixed. Now aggregating all the SG and a costs into a single line on the income statement is not all that informative. You may have more detailed statements with a breakdown of these costs. Or you may go to the management discussion and analysis to get more color commentary on what the money was spent on and how it's changed year over a year.

On the next line down we have depreciation and entry. ization depreciation and amortization is always a non cash charge against earnings, which is an accounting way of spreading the capital cost of assets over their useful life. I like comparing this number to the capital expenditure number that we'll see later on the cash flow statement. Just to see how close the two numbers are. This is often one of the most significant differences between earnings and cash flow. Now, Eva, that is earnings before interest, taxes, depreciation and amortization is an extremely common measure that is never disclosed on the financial statements.

But you'll easily calculate it by inserting a subtotal between the SGA and the depreciation. investment bankers will use eba in the context of valuations, mergers, acquisitions, divestitures, equity issues, determining how much debt leverage is possible amongst a whole other host Even a margin is a common metric which would also be calculated as eba divided by net sales and expressed as a percentage, which leaves us with operating income and operating income is the amount of income that the business is generating from continuing operations. This is an important line to look at to determine the operating strength of the business. Home Depot has significantly improved operating income in the past three years, even without improving sales. Let's see if we can understand the reasons why they've been able to improve operating income. There are a few reasons for this improvement.

One Home Depot has been successful in improving its gross margin, which means they have captured a larger gross profit dollar in spite of the fact that their sales have been not growing. Secondly, they have have found ways to cut their SG and a costs. Thirdly, it has reduced appreciation by nearly a couple hundred million dollars, all resulting in an improvement in the operating income. Below the operating income, we have three items to consider. First, the financing costs. These are the interest costs on the borrowed money.

And these will be driven by two things either interest rates or the amount of financial leverage that is the amount of borrowings that the company has taken out. Home Depot has seen savings here. And as you look at their balance sheet, you'll notice that their debt really hasn't declined substantially year over year. So it's likely that they have pay a lower interest rate in the most current here. Second, we have income taxes. These can be extremely volatile on an effective tax rate basis.

That is your tax expense divided by your earnings before tax. Now one would expect the statutory rate to result from this calculation, which is approximately 40% in the US and 30%. In Canada, however, this is rarely the case for any number of reasons, which we won't get into in this course. Now, obviously, income taxes are a big number, but it's one that few analysts spend much time on. However, from a value creation perspective, nothing could be further from the truth, because as you can see, nearly $2 billion in tax expense is nothing to sneeze out. Now, keep in mind that the number here is an expense, the actual amount of taxes that Home Depot actually pays the to the IRS is likely much different.

To figure that out. You can look at the bottom of the cash flow statement to see how much income tax was actually paid during the year. And in this case, it was actually higher $2.1 billion to get a sense of how much tax has been refer to a future year, you can look at the balance sheet at the deferred taxes account. Another number few people pay any attention to. And the reason the two are different is that gap accounting and tax accounting are different basis of accounting. What you can detect for accounting purposes is often different than what you can deduct for tax purposes.

I'll leave it at that for now. Finally, we have other income and we have income from discontinued operations. The items here would include income from investments gains, losses on sale of assets, discontinued earnings and losses are those associated with a business that's no longer a part of the Home Depot entity, that is businesses that have been either closed or sold off. This slide helps keep the top part of the income statement focused on continuing operations. And there you have it, what's left over is the net earnings or loss. Again we can calculate a margin ratio to see how much flow through, we are earning on each incremental dollar of sales.

And compare this to the Home Depot peers such as Lowe's see which one is more effective had maximizing the earnings flow through. There are a few other ratios that can help us bring more meaning to the earnings number that we refer to at the outset. Let's cover those now. The first is return on equity. Now the return on equity ratio is calculated by dividing net earnings into the average balance of shareholders equity, which you'll get from the balance sheet. And this gives the original shareholders an indication of the return the company is earning on their investment.

I say original shareholders intentionally because the amount paid by subsequent Home Depot investors like the likes of possibly you and me is like Different than the book value reflected on the balance sheet which reflects the amounts that the original Home Depot shareholders would have paid for their shares. Return on equity is interesting because stockholders know they're taking on more risk. So hopefully the company is generating a sufficient return to compensate for the risk taken by the shareholder class. 10% is what a shareholder in a regulated electric utility can expect. So for most businesses, the expectation of return on equity goes up from there. The second ratio we can calculate is the return on assets.

The downside of focusing in on the return on equity ratio is that it can be distorted depending on the amount of debt leverage in a company. And this is well illustrated in the US financial industry in the years leading up to 2008. If Company A is earning 10% return on equity with no debt Company B is earning the same 10% return on equity. But as 50% of its assets financed with debt, a company B is in fact earning a lower return. The reason for this is that company B has not generated an incremental return to compensate itself for the additional financial risk has taken on by borrowing other people's money. The return on asset calculation alleviates this problem by comparing net earnings with total assets, which common sizes returns between the companies that are financed to differing degrees with debt.

Another variation of a return calculation and my personal favorite is the return on capital employed though it's a little harder to calculate it to strips out the financing impact but in a more theoretically correct way than the return on assets because the return on assets is still skewed by the interest expense that Including the net earnings number, return on capital employed or Roki typically normalizes the tax expense. Also, to calculate Roki properly, you would have to take your net operating profit after tax or no path and divide that by your capital employed. Now no pad is your operating profit minus your cash taxes your capital employed is your shareholders equity plus the value of your funded debt. The resulting percentage can loosely be compared against your weighted average cost of capital to determine whether you're earning more or less than your cost of capital. Now, Earned Value Added or EPA is a similar sort of analysis only it calculates the dollar amount of earnings over or below your notional cost of capital.

So there are a handful of metrics you can use to determine whether the net earnings achieved are poor, good or a strong result. Home Depot has performed well on each of these metrics, as indicated by the table here. Now the earnings number by itself has limited value to the shareholders as we've discussed because it doesn't specify their entitlement to that income. The earnings per share numbers disclose below this information is far more informative. The Home Depot has grown earnings per share in the last three years considerably. Most of this improvement has been due to the improvement in net earnings.

Note that the number of common shares outstanding were lower in 2011, which also had an impact on increasing the earnings per share. This is most likely a reflection of the stock buybacks that the company has been undertaking. Before I finish this video, let me introduce the other important sections of the 10 K. Were profitability information reside the management discussion and analysis section. mdna item seven in the 10 K is where management discusses the results. The early sections of the mdna will give you an analysis of the profitability results with commentary on why results have changed year over year. You may also get information on revenues by region, by product category or by any other categorization that would help you better understand the consolidated results.

Note that the Home Depot has already provided us with a common size income statement which saves us the trouble of calculating the various margin percentages that we talked about during this lesson. And lastly, I like when a company provides a supplementary table of the long term results. Note in the last section how the Home Depot has provided us with a five year analysis of the historical results in financial ratios. Now that you used to provide a 10 year summary which I always found very interesting when you really want to stand back and look at the company over a number of economic cycles. So far we've just looked at the top portion of this table, but in the next lesson, we will tackle the other sections. So until next time, don't stop you get to the top when you get to the top, don't stop.