Financial Accounting:Tools for Business Decision Making, 2nd Ed.

Kimmel, Weygandt, Kieso

ELS

Chapter 14`

3

Chapter 14Financial Analysis:

The Big Picture

After studying Chapter 14, you should be able to:

Understand the concept of earning power and indicate how irregular items are presented.

Discuss the need for comparative analysis and identify the tools of financial statement analysis.

Explain and apply horizontal analysis.Describe and apply vertical analysis.

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After studying Chapter 14, you should be able to:

Identify and compute ratios and describe their purpose and use in analyzing a firm's liquidity, solvency, and profitability.

Discuss the limitations of financial statement analysis.

Chapter 14Financial Analysis:

The Big Picture

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Earning Power

The value of a company is a function of its future cash flows.

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Earning Power...

Is net income adjusted for irregular items.

Is the most likely level of income to be obtained in the future.

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Irregular Items

Three types of irregular items are reported -- (all net of taxes)

discontinued operationsextraordinary itemschanges in accounting principle

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Discontinued Operations...

Refers to the disposal of a significant segment of a business... the elimination of a major class of customers or an entire activity.

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Assume Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million or net income of $800,000 from continuing operations in 2001.

During 2001 the company discontinued and sold its unprofitable chemical division. The loss in 2001 from chemical operations (net of $60,000 taxes) was $140,000, and the loss on disposal of the chemical division (net of $30,000 taxes) was $70,000.

Discontinued Operations

Rozek Inc. Income Statement (Partial)

For the Year Ended December 31, 2001

Income before income taxes $800,000Income tax expense (30% Tax Rate) 240,000Income from continuing operations 560,000

Discontinued operationsLoss from operations of chemical division, net of $60,000 income tax saving $140,000

Loss from disposal of chemical division, net of $30,000 income tax saving 70,000 210,000

Net income before extraordinary item 350,000

Illustration 14-1

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Extraordinary Items...

Are events and transactions that meet two conditions: Unusual in nature

Infrequent in occurrence

Extraordinary ItemsIllustration 14-2

Ordinary ItemsIllustration 14-2

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In 2001 a revolutionary foreign government expropriated property held as an investment by Rozek Inc.

The loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000.

Extraordinary Items

Rozek Inc.Income Statement(Partial)

For the Year Ended December 31, 2001

Income before income taxes $800,000Income tax expense 240,000Income from continuing operations 560,000

Discontinued operationsLoss from operations of chemical division, net of $60,000 income tax saving $140,000

Loss from disposal of chemical division, net of $30,000 income tax saving 70,000 210,000

Net income before extraordinary item 350,000Extraordinary item

Expropriation of investment, net of $21,000 income tax saving 49,000

Net income $301,000

Illustration 14-3

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Change in Accounting Principle

Occur when the principle used in the current year is different from the one used in the preceding year.

Is permitted, when management can show that the new principle is

preferable to the old and the effects of the change are clearly disclosed in the

income statement. Examples:

a change in depreciation methods (such as declining-balance to straight-line)

a change in inventory costing methods (such as FIFO to average cost).

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The new principle should be used in reporting the results of operations of the current year.

The cumulative effect of the change on all prior-year income statements should be disclosed net of applicable taxes in a special section immediately preceding Net Income.

Change in Accounting Principle

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Rozek Inc. changes from the straight-line method to the declining-balance method for equipment purchased on January 1, 1998.

The cumulative effect on prior-year income statements (statements for 1998-2000) is to increase depreciation expense and decrease income before income taxes by $24,000.

If there is a 30% tax rate, the net-of-tax effect of the change is $16,800 ($24,000 x 70%).

Changes in Accounting Principle

Rozek Inc.Partial Income Statement

For the Year Ended December 31, 2001Income before income taxes $800,000Income tax expense 240,000Income from continuing operations 560,000

Discontinued operationsLoss from operations of chemical division, net of $60,000 income tax saving $140,000

Loss from disposal of chemical division, net of $30,000 income tax saving 70,000 210,000

Net income before extraordinary item 350,000Extraordinary item

Expropriation of investment, net of $21,000 income tax saving 49,000

Cumulative effect of change in accounting principle Effect on prior years of change in depreciation

method, net of $ 7,200 tax 16,800 Net Income 284,200

Illustration 14-4

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Most revenues, expenses, gains, and losses recognized during the period are included in net income.

Specific exceptions to this practice have developed - these items bypass income and are reported directly in stockholders’ equity.

Comprehensive Income

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Unrealized gains and losses on available-for-sale securities are excluded from net income because disclosing them separately - reduces the volatility of net income due

to fluctuations in fair value, yet informs the financial statement user of

the gain or loss that would be incurred if the securities were sold at fair value.

Comprehensive Income

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The FASB now requires that, in addition to reporting net income, a company must also report comprehensive income.

Comprehensive Income

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Comprehensive Income...

Includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders.

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Comparative Analysis

Any item reported in a financial statement has significance: Its inclusion indicates that the item exists at a

given time and in a certain quantity. For example, when Kellogg Company reports

$136.4 million on its balance sheet as cash, we know that Kellogg did have cash and that the quantity was $136.4 million.

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Whether the amount represents an increase over prior years, or whether it is adequate in relation to the company's needs, cannot be determined from the amount alone.

The amount must be compared with other financial data to provide more information.

Comparative Analysis

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There are three types of comparisons to provide decision usefulness of financial information:

Intracompany basisIntercompany basisIndustry averages

Comparative Analysis

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Intracompany Basis

Comparisons within a company are often useful to detect changes in financial relationships and significant trends.

A comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease.

A comparison of Kellogg's year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash.

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Intercompany Basis

Comparisons with other companies provide insight into a company's competitive position.

Kellogg's total sales for the year can be compared with the total sales of its competitors such as Quaker Oats and General Mills.

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Comparisons with industry averages

provide information about a company's relative position within the industry.

Kellogg's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's.

Industry Averages

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Financial Statement Analysis

Three basic tools are used in financial statement analysis :

1.Horizontal analysis2.Vertical analysis3.Ratio analysis

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Horizontal Analysis

Is a technique for evaluating a series of financial statement data over a period of time.

Purpose is to determine whether an increase or decrease has taken place.

The increase or decrease can be expressed as either an amount or a percentage.

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KELLOGG COMPANY

Net Sales (in millions)

Base Period 1994

1998 1997 1996 1995 1994

6,762.1 6,830.1 6,676.6 7,003.7 6,562.0

Horizontal AnalysisIllustration 14-7

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CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT BASE-YEAR AMOUNT

7,003.7 - 6,562.0 = 6.7%

6,562.0

Net sales for Kellogg company increased approximately 6.7% from 1994 to 1995.

Horizontal AnalysisIllustration 14-6

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Percentage Change in Sales

The percentage change in sales for each of the 5 years, assuming 1994 as the base period is:

Kellogg Company Net Sales (in millions) Base

Period 1994

1998 1997 1996 1995 1994

6,762.1 6,830.1 6,676.6 7,003.7 6,562.0

103.0% 104.1% 101.7% 106.7% 100.0%

Illustration 14-7

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Horizontal Analysis of a Balance Sheet

KELLOGG COMPANY, INC.Condensed Balance Sheets

December 31(In millions)

Increase (Decrease) during 1998

1998 1997 Amount PercentAssetsCurrent Assets $1,496.5 $1,467.7 $ 28.8 2.0 Plant assets 2,888.8 2,773.3 115.5 4.2Other assets 666.2 636.6 27.6 4.6Total assets $5,051.5 $4,877.6 $173.9 3.6

Illustration 14-8

Increase (Decrease)

during 1998

1998 1997 Amount Percent

Liabilities andStockholders' EquityCurrent liabilities $1,718.5 $1,657.3 61.2 3.7Long-term liabilities 2,443.2 2,222.8 220.4 9.9 Total liabilities 4,161.7 3,880.1 281.6 7.3Stockholders' equity Common stock 208.8 196.3 12.5 6.4 Retained earnings

and other 1,075.3 958.5 116.8 12.2 Treasury stock (394.3) (157.3) 237.0

(150.7)Total stockholders'

equity 889.8 997.5 (107.7) (10.8)Total liabilities and stockholders' equity $5,051.5 $4,877.6 $173.9 3.6

Horizontal Analysis of a Balance Sheet

Illustration 14-8

KELLOGG COMPANY, INC.Condensed Income Statement

For the Years Ended December 31(In millions)

Increase (Decrease)

during 1998 1998 1997 Amount

PercentNet sales $6,762.1 $6,830.1 ($68.0) (1.0)Cost of goods sold 3,282.6 3,270.1 12.5 0.4Gross profit 3,479.5 3,560.0 (80.5) (2.3)Selling & Admin. 2,513.9 2,366.8 147.1 6.2Nonrecurring charges 70.5 184.1 (113.6) (61.7)Income from operations 895.1 1,009.1 (114.0)

(11.3)Interest expense 119.5 108.3 11.2 10.3Other income

(expense), net 6.9 3.7 3.2 86.5Income before taxes 782.5 904.5 (122.0)

(13.5)Income tax expense 279.9 340.5 (60.6)

(17.8) Net income $502.6 $564.0 ($61.4) (10.9)

Illustration 14-9

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Vertical Analysis

Is a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount.

Total assets is always the base amount in vertical analysis of a balance sheet.

Net sales is always the base amount in vertical analysis of an income statement.

KELLOGG COMPANY, INC.Condensed Balance Sheets

December 31(In millions)

1998 1997 Assets Amount Percent Amount Percent

Current Assets $1,496.5 29.6 $1,467.7 30.1Plant assets 2,888.8 57.2 2,733.3 56.9Other assets 666.2 13.2 636.6 13.0 Total assets $5,051.5 100.0% $4,877.6 100.0%

Illustration 14-10

1998 1997Liabilities and Amount Percent Amount PercentStockholders' EquityCurrent liabilities $1,718.5 34.0 $1,657.3 34.0 Long-term liabilities 2,443.2 48.4 2,222.8 45.5 Total liabilities 4,161.7 82.4 3,880.1 79.5Stockholders' equity Common stock 208 8 4.1 196.3 4.0 Retained earnings

and other 1,075.3 21.3 958.5 19.7 Treasury stock (394.3) ( 7.8) (157.3) (3.2) Total stockholders'

equity 889.8 17.6 997.5 20.5 Total liabilities and stockholders' equity $5,051.5 100.0% $4,877.6 100.0%

KELLOGG COMPANY, INC.Condensed Balance Sheets

December 31(In millions)

Illustration 14-10

KELLOGG COMPANY, INC.Condensed Income Statement

For the Years Ended December 31(In millions)

1998 1997 Amount Percent Amount Percent

Net sales $6,762.1 100.0 $6,830.1 100.0

Cost of goods sold 3,282.6 48.6 3,270.1 47.9

Gross profit 3,479.5 51.4 3,560.0 52.1

Selling & Admin. 2,513.9 37.2 2,366.8 34.6

Nonrecurring Chgs 70.5 1.0 184.1 2.7

Income operations 895.1 13.2 1,009.1 14.8

Interest expense 119.5 1.8 108.3 1.6 Other income

(expense),net 6.9 0.1 3.7 0.1

Income before income taxes 782.5 11.5 904.5 13.3

Income tax expense 279.9 4.1 340.5 5.0

Net income $502.6 7.4 $564.0 8.3

Illustration 14-11

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Condensed Income StatementsFor the Year Ended December 31,1998

(in millions)The Quaker

Kellogg Company, Inc. Oats Company Amount Percent Amount

Percent Net sales $6,762.1 100.0 $4,842.5 100.0 Cost of goods sold 3,282.6 48.6 2,374.4 49.0 Gross profit 3,479.5 51.4 2,468.1 51.0Selling and administrative

expenses 2,513.9 37.2 1,872.5 38.7Nonrecurring charges 70.5 1.0 128.5 2.6Income from operations 895.1 13.2 467.1 9.7Other expenses and

revenues (including income taxes) 392.5 5.8 182.6 3.8

Net income $502.6 7.4 $284.5 5.9

Illustration 14-12

Ratio Analysis

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Ratios

Three types:Liquidity ratiosSolvency ratios Profitability ratios

Can provide clues to underlying conditions that may not be apparent from an inspection of the individual components.

Single ratio by itself is not very meaningful

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Liquidity Ratios

Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash.

WHO CARES?Short-term creditors such as bankers and suppliers

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Current ratioAcid-test ratioCurrent cash debt coverage ratioReceivables turnover ratioAverage collection periodInventory turnoverAverage days in inventory

Liquidity Ratios

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Current Ratio

Indicates short-term debt-paying ability

Current AssetsCurrent Liabilities

Illustration 14-17

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Acid-Test Ratio

Indicates immediate short-term debt-paying ability

Cash + Short-term Investments + Net Receivable Current Liabilities

Illustration 14-18

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Current Cash Debt Coverage Ratio

Indicates short-term debt-paying ability (cash basis)

Cash provided by operations Average current liabilities

Illustration 14-19

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Receivables Turnover Ratio

Indicates liquidity of receivables

Net Credit SalesAverage Net Receivables

Illustration 14-20

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Average Collection Period

Indicates liquidity of receivables and collection success

365 daysReceivables Ratio Turnover

Illustration 14-21

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Inventory Turnover Ratio

Indicates liquidity of inventory

Cost of Goods SoldAverage Inventory

Illustration 14-22

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Indicates liquidity of inventory and inventory management

365 days

Inventory Turnover Ratio

Average Days in InventoryIllustration 14-23

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Solvency Ratios

Measure the ability of the enterprise to survive over a long period of time

WHO CARES?Long-term creditors and stockholders

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Debt to total assets ratioTimes interest earned ratioCash debt coverage ratioFree cash flow

Solvency Ratios

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Debt to Total Assets Ratio

Indicates % of total assets provided by creditors

Total Liabilities

Total Assets

Illustration 14-24

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Times Interest Earned Ratio

Indicates company’s ability to meet interest payments as they come due

Interest Before Interest

Expense & Income Tax

Interest Expense

Illustration 14-25

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Cash Debt Coverage Ratio

Indicates long-term debt-paying ability (cash basis)

Cash provided by operations Average total liabilities

Illustration 14-26

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Indicates cash available for paying dividends or expanding operations

Cash Provided By Operations

- Capital Expenditures

- Dividends Paid

Free Cash Flow

Free Cash FlowIllustration 14-27

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Profitability Ratios

Measure the income or operating success of an enterprise for a given period of time

WHO CARES? Everybody

WHY? A company’s income affects: its ability to obtain debt and equity financingits liquidity positionits ability to grow

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Return on common stockholders’ equity ratio

Return on assets ratioProfit margin ratioAssets turnover ratioGross profit rateOperating expenses to sales ratioCash return on sales ratioEarnings per share (EPS)Price-earnings ratioPayout ratio

Profitability Ratios

Relationships Among Profitability Measures

Illustration 14-28

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Return on Common Stockholders’ Equity Ratio

Indicates profitability of common

stockholders’ investment

Net income -preferred stock dividends

Average common stockholders’ equity

Illustration 14-29

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Return On Assets Ratio

Reveals the amount of net income generated by each dollar invested

Net incomeAverage total assets

Higher value suggests favorable efficiency.

Illustration 14-30

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Profit Margin Ratio

Indicates net income generated by each dollar of sales

Higher value suggests favorable return on each dollar of sales.

Illustration 14-31

Net incomeNet sales

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Asset Turnover Ratio

Indicates how efficiently assets are used to generate sales

Net sales

Average total assets

Illustration 14-32

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Gross Profit Rate

Indicates margin between selling price and cost of good sold

Gross profit

Net sales

Illustration 14-34

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Operating Expensesto Sales Ratio

Indicates the cost incurred to support each dollar of sales

Operating expenses

Net sales

Illustration 14-35

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Cash Return on Sales Ratio

Indicates net cash flow generated by each dollar of sales

Cash provided by operationsNet sales

Illustration 14-36

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Earnings Per Share (EPS)

Indicates net income earned on each share of common stock sales

Income available to common stockholders

Average number of outstanding common shares

Illustration 14-37

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Price Earnings Ratio

Indicates relationship between market price per share and earnings per share

Stock PriceEarnings Per Share

Illustration 14-38

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Payout Ratio

Indicates % of earnings distributed in the form of cash dividends

Cash DividendsNet Income

Illustration 14-39

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Limitations Of Financial Analysis

Horizontal, vertical, and ratio analysis are frequently used in making significant business decisions.

One should be aware of the limitations of these tools and the financial statements.

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Estimates

Financial statements are based on estimates. allowance for uncollectible accounts depreciation costs of warranties contingent losses

To the extent that these estimates are inaccurate, the financial ratios and percentages are also inaccurate.

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Cost

Traditional financial statements are based on historical cost and are not adjusted for price level changes.

Comparisons of unadjusted financial data from different periods may be rendered invalid by significant inflation or deflation.

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Alternative Accounting Methods

One company may use the FIFO method, while another company in the same industry may use LIFO.

If the inventory is significant for both companies, it is unlikely that their current ratios are comparable.

In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization.

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Atypical Data

Fiscal year-end data may not be typical of a company's financial condition during the year.

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Diversification

Diversification in American industry also limits the usefulness of financial analysis.

Many firms are so diverse they cannot be classified by industry.

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