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Chapter One | Overview of Financial Statement Analysis 7

increased by 111%. This earnings growth was driven by both a 44% increase in revenues
and an increase of approximately 30% in operating profit margin. Thus, Colgate has
grown earnings rapidly, despite modest growth in revenues, through increased margins
arising from cost reduction. Colgate pays generous dividends: over the past 10 years it
has paid more than $4 billion in cash dividends and almost $7 billion through stock re-
purchases (see movement in treasury stock). Therefore, Colgate has returned around
$11 billion to its shareholders over the past 10 years, which comprises most of its earn-
ings during this period. By paying out most of its earnings, Colgate has been able to
maintain a small equity base—shareholder’s equity actually decreased over this period. All
this makes Colgate’s earnings growth story even more compelling: the company has
grown earnings without increasing its invested capital. Its return on equity has conse-
quently exploded from 35% in 1997 to 98% in 2006. One downside of maintaining a
small equity base is Colgate’s high leverage—for example, the company’s ratio of total
liabilities to equity is above 5. However, the extremely stable nature of Colgate’s finan-
cial performance affords such structuring of the balance sheet to leverage returns for its
equity shareholders.
Further examination of Exhibit 1.3 reveals that much of Colgate’s earnings growth
over the past decade has occurred primarily in the first seven years. The most recent
three years’ performance has been fairly lackluster. After dropping slightly in 2004,
earnings have since remained stagnant and Colgate has been able to achieve modest
growth in earnings per share over this period only by reducing its equity base. However,
this earnings stagnation is partly because of costs related to Colgate’s restructuring pro-
gram that commenced in 2004; earnings grew 12% over the last three years after re-
moving the costs related to restructuring activities.
Is the summary financial information sufficient to use as a basis for deciding whether
or not to invest in Colgate’s stock or in making other business decisions? The answer is
clearly no. To make informed business decisions, it is important to evaluate Colgate’s
business activities in a more systematic and complete manner. For example, equity in-
vestors desire answers to the following types of questions before deciding to buy, hold,
or sell Colgate stock:

What are Colgate’s future business prospects? Are Colgate’s markets expected to
grow? What are Colgate’s competitive strengths and weaknesses? What strategic FALLING STAR
initiatives has Colgate taken, or does it plan to take, in response to business op- Regulators slapped a fine
portunities and threats? on Merrill Lynch and
What is Colgate’s earnings potential? What is its recent earnings performance? banned one of its star
How sustainable are current earnings? What are the “drivers” of Colgate’s prof- analysts from the securities
industry for life for privately
itability? What estimates can be made about earnings growth? questioning a telecom
What is Colgate’s current financial condition? What risks and rewards does stock while he publicly
Colgate’s financing structure portray? Are Colgate’s earnings vulnerable to vari- boosted it.
ability? Does Colgate possess the financial strength to overcome a period of poor
profitability?
How does Colgate compare with its competitors, both domestically and globally?
What is a reasonable price for Colgate’s stock?

Creditors and lenders also desire answers to important questions before entering into
lending agreements with Colgate. Their questions include the following:

What are Colgate’s business plans and prospects? What are Colgate’s needs for
future financing?