slide 14-1. slide 14-2 chapter 14 financial statement analysis financial accounting, seventh edition

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Chapter 14

Financial Statement Financial Statement

AnalysisAnalysis

Financial Accounting, Seventh Edition

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1. Discuss the need for comparative analysis.

2. Identify the tools of financial statement analysis.

3. Explain and apply horizontal analysis.

4. Describe and apply vertical analysis.

5. Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

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

7. Understand the concept of quality of earnings.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

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Balance Balance sheetsheet

Income Income statementstatement

Retained Retained earnings earnings statementstatement

Basics of Basics of Financial Financial Statement Statement AnalysisAnalysis

Basics of Basics of Financial Financial Statement Statement AnalysisAnalysis

Horizontal and Horizontal and Vertical Vertical AnalysisAnalysis

Horizontal and Horizontal and Vertical Vertical AnalysisAnalysis

Ratio AnalysisRatio AnalysisRatio AnalysisRatio AnalysisEarning Power Earning Power and Irregular and Irregular

ItemsItems

Earning Power Earning Power and Irregular and Irregular

ItemsItems

Quality of Quality of EarningsEarningsQuality of Quality of EarningsEarnings

Need for Need for comparative comparative analysisanalysis

Tools of Tools of analysisanalysis

LiquidityLiquidity

ProfitabilityProfitability

SolvencySolvency

SummarySummary

Discontinued Discontinued operationsoperations

Extraordinary Extraordinary itemsitems

Changes in Changes in accounting accounting principleprinciple

ComprehensiveComprehensive incomeincome

Alternative Alternative accounting accounting methodsmethods

Pro forma Pro forma incomeincome

Improper Improper recognitionrecognition

Financial Statement AnalysisFinancial Statement AnalysisFinancial Statement AnalysisFinancial Statement Analysis

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Analyzing financial statements involves:

Basics of Financial Statement Basics of Financial Statement AnalysisAnalysisBasics of Financial Statement Basics of Financial Statement AnalysisAnalysis

CharacteristicsComparison

BasesTools of Analysis

Liquidity

Profitability

Solvency

Intracompany

Industry averages

Intercompany

Horizontal

Vertical

Ratio

SO 1 Discuss the need for comparative analysis.

SO 2 Identify the tools of financial statement analysis.

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SO 3 Explain and apply horizontal analysis.

Horizontal AnalysisHorizontal AnalysisHorizontal AnalysisHorizontal Analysis

Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time.

Its purpose is to determine the increase or decrease that has taken place.

Horizontal analysis is commonly applied to the balance sheet, income statement, and statement of retained earnings.

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Illustration 14-5

These changes suggest that the company expanded its asset base during 2007 and financed this expansion primarily by retaining income rather than assuming additional long-term debt.

Balance Sheet

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Illustration 14-5

Overall, gross profit and net income were up substantially. Gross profit increased17.1%, and net income, 26.5%. Quality’s profit trend appears favorable.

Income Statement

Illustration 14-6

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We saw in the horizontal analysis of the balance sheet that ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities.


Retained Earnings Statement

Illustration 14-7

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Illustration: Summary financial information for Rosepatch Company is as follows.

Compute the amount and percentage changes in 2011 using horizontal analysis, assuming 2010 is the base year.

Solution on notes page

Solution

SO 4 Describe and apply horizontal analysis.


2011

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SO 4 Describe and apply vertical analysis.

Vertical AnalysisVertical AnalysisVertical AnalysisVertical Analysis

Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount.

On an income statement, we might say that selling expenses are 16% of net sales.

Vertical analysis is commonly applied to the balance sheet and the income statement.

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These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt.



Balance Sheet

Illustration 14-8

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Quality appearsto be a profitable enterprise that is becoming even more successful.



Income Statement

Illustration 14-9

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Enables a comparison of companies of different sizes.

Illustration 14-10Intercompany income statement comparison



J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C. Penney’s net income as a percent of each sales dollar (5.6%) is only 4% of Quality’s (12.6%).

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SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis

Ratio analysis expresses the relationship among selected items of financial statement data.

LiquidityLiquidity ProfitabilityProfitability SolvencySolvency

Measures short-term ability of

the company to pay its maturing obligations and

to meet unexpected

needs for cash.

Financial Ratio Classifications

Measures the income or operating

success of a company for a given period of

time.

Measures the ability of the company to

survive over a long period of

time.

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The discussion of ratios will include the following types of comparisons.

A single ratio by itself is not very meaningful.

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Liquidity RatiosLiquidity Ratios

Measure the short-term ability of the company to pay

its maturing obligations and to meet unexpected

needs for cash.

Short-term creditors such as bankers and suppliers are

particularly interested in assessing liquidity.

Ratios include the current ratio, the acid-test ratio,

receivables turnover, and inventory turnover.

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Ratio Analysis Ratio Analysis Ratio Analysis Ratio Analysis

Compute the Current Ratio for 2007.

The ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets.

Current Assets

Current Liabilities = Current Ratio

$1,020,000

$344,500 = 2.96 : 1


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Ratio Analysis Ratio Analysis Ratio Analysis Ratio Analysis

Compute the Acid-Test Ratio for 2007.


Illustration 14-13

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Compute the Acid-Test Ratio for 2007.

The acid-test ratio measures immediate liquidity.

Cash + Short-Term Investments + Receivables (Net)

Current Liabilities

Acid-Test Ratio

$100,000 + $20,000 + $230,000

$344.500 = 1.02 : 1

=


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Compute the Receivables Turnover ratio for 2007.

It measures the number of times, on average, the company collects receivables during the period.

$2,097,000

($180,000 + $230,000) / 2 = 10.2 times

Net Credit Sales

Average Net Receivables

Receivables Turnover=


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A variant of the receivables turnover ratio is to convert it to an average collection period in terms of days.

This means that receivables are collected on average every 36 days.

$2,097,000

($180,000 + $230,000) / 2= 10.2 times


365 days / 10.2 times = every 35.78 days

Receivables Turnover

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Compute the Inventory Turnover ratio for 2007.

Inventory turnover measures the number of times, on average, the inventory is sold during the period.

$1,281,000

($500,000 + $620,000) / 2 = 2.31 times

Cost of Good Sold

Average Inventory

Inventory Turnover=


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A variant of inventory turnover is the days in inventory.

Inventory turnover ratios vary considerably among industries.


365 days / 2.3 times = every 159 days

$1,281,000

($500,000 + $620,000) / 2 = 2.3 times

Inventory Turnover

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Profitability RatiosProfitability Ratios

Measure the income or operating success of a

company for a given period of time.

Income, or the lack of it, affects the company’s ability

to obtain debt and equity financing, liquidity position,

and the ability to grow.

Ratios include the profit margin, asset turnover,

return on assets, return on common

stockholders’ equity, earnings per share, price-

earnings, and payout ratio.

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Compute the Profit Margin ratio for 2007.

Measures the percentage of each dollar of sales that results in net income.

$263,800

$2,097,000 = 12.6%

Net Income

Net Sales

Profit Margin=


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Compute the Asset Turnover ratio for 2007.

Measures how efficiently a company uses its assets to generate sales.

$2,097,000

($1,95,000 + $1,835,000) / 2 = 1.22 times

Net Sales

Average Assets

Asset Turnover=


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Compute the Return on Assets ratio for 2007.

An overall measure of profitability.

$263,800

($1,595,000 + $1,835,000) / 2 = 15.4%

Net Income

Average Assets

Return on Assets=


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Compute the Return on Common Stockholders’ Equity ratio for 2007.

Shows how many dollars of net income the company earned for each dollar invested by the owners.

$263,000 - $0

($795,000 + $1,003,000) / 2 = 29.3%

Net Income – Preferred Dividends

Average Common Stockholders’ Equity

Return on Common

Stockholders’ Equity

=


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Compute the Earnings Per Share for 2007.

A measure of the net income earned on each share of common stock.

$263,800

270,000 + 275,400 / 2= $0.97 per share

Net Income

Weighted Average Common Shares Outstanding

Earnings Per Share=


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Compute the Price Earnings Ratio for 2007.

The price-earnings (PE) ratio reflects investors’ assessments of a company’s future earnings.

$12.00

$0.97= 12.4 times

Market Price per Share of Stock

Earnings Per Share

Price Earnings

Ratio=


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Compute the Payout Ratio for 2007.

Measures the percentage of earnings distributed in the form of cash dividends.

$61,200

$263,800= 23.2%

Cash Dividends

Net Income

Payout Ratio=


*

* From analysis of retained earnings.

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Solvency RatiosSolvency Ratios

Solvency ratios measure the ability of a company to

survive over a long period of time.

Debt to total assets and times interest earned

are two ratios that provide information about debt-

paying ability.

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Compute the Debt to Total Assets Ratio for 2007.

Measures the percentage of the total assets that creditors provide.

$832,000

$1,835,000= 45.3%

Total Debt

Total Assets

Debt to Total

Assets Ratio

=


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Compute the Times Interest Earned ratio for 2007.

Provides an indication of the company’s ability to meet interest payments as they come due.

$468,000

$36,000= 13 times

Income before Income Taxes and Interest Expense

Interest Expense

Times Interest Earned

=


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SO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular ItemsEarning Power and Irregular ItemsEarning Power and Irregular ItemsEarning Power and Irregular Items

Earning power means the normal level of income to be obtained in the future.

“Irregular” items are separately identified on the income statement. Two types are:

1. Discontinued operations.

2. Extraordinary items.

These “irregular” items are reported net of income taxes.

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Discontinued Operations

(a) Refers to the disposal of a significant

component of a business.

(b) Report the income (loss) from discontinued

operations in two parts:

1. income (loss) from operations (net of tax) and

2. gain (loss) on disposal (net of tax).



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Illustration: During 2011 Acro Energy Inc. has income before taxes of $800,000. During 2011 Acro discontinued and sold its unprofitable chemical division. The loss in 2011 from chemical operations (net of $60,000 taxes) was $140,000. The loss on disposal of the chemical division (net of $30,000 taxes) was $70,000. Assuming a 30% tax rate.



Solution on notes page

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Other revenue (expense):

I nterest revenue 17,000 I nterest expense (21,000)

Total other (4,000) I ncome bef ore taxes 79,000 I ncome tax expense 24,000 I ncome from continuing operations 55,000

Discontinued operations:

Loss from operations, net of tax 315

Loss on disposal, net of tax 189

Total loss on discontinued operations 504

Net income 54,496$

I ncome Statement (in thousands)

Sales 285,000$

Cost of goods sold 149,000 Discontinued Discontinued

Operations are Operations are reported after “Income reported after “Income

from continuing from continuing operations.”operations.”

Previously labeled as “Net Income”.

Moved to



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Extraordinary items are nonrecurring material items that differ significantly from a company’s typical business activities.

An extraordinary item must be both of an

Unusual Nature and Occur Infrequently

Company must consider the environment in which it operates.

Amounts reported “net of tax.”



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Are these considered Extraordinary Items?(a) A large portion of a tobacco

manufacturer’s crops are destroyed by a hail storm. Severe damage from hail storms in the locality where the manufacturer grows tobacco is rare.

(b) A citrus grower's Florida crop is damaged by frost.

(c) Loss from sale of temporary investments.

(d) Loss attributable to a labor strike.

YESYES

NONO

NONO


NONO


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(d) Loss from flood damage. (The nearby Black River floods every 2 to 3 years.)

(e) An earthquake destroys one of the oil refineries owned by a large multi-national oil company. Earthquakes are rare in this geographical location.

(f) Write-down of obsolete inventory.

(g) Expropriation of a factory by a foreign government.

NONO

YESYES

YESYES


NONO

Are these considered Extraordinary Items?


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Illustration: In 2011 a foreign government expropriated property held as an investment by Acro Energy Inc. If the loss is $70,000 before applicable income taxes of $21,000, the income statement will report a deduction of $49,000.


Illustration 14-30

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Other revenue (expense):

I nterest revenue 17,000 I nterest expense (21,000)

Total other (4,000) I ncome bef ore taxes 79,000 I ncome tax expense 24,000 I ncome from continuing operations 55,000

Extraordinary loss, net of tax 539

Net income 54,461$


Sales 285,000$

Cost of goods sold 149,000 Extraordinary Items Extraordinary Items

are reported after are reported after “Income from “Income from

continuing continuing operations.”operations.”

Previously labeled as “Net Income”.

Moved to



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I nterest expense (21,000) Total other (4,000)

I ncome bef ore taxes 79,000 I ncome tax expense 24,000 I ncome from continuing operations 55,000

Discontinued operations:

Loss from operations, net of tax 315

Loss on disposal, net of tax 189

Total loss on discontinued operations 504

I ncome before extraordinary item 54,496

Extraordinary loss, net of tax 539

Net income 53,957$


Sales 285,000$

Cost of goods sold 149,000

Reporting when both Reporting when both

Discontinued Discontinued

Operations and Operations and

Extraordinary Items Extraordinary Items

are present. are present.

Discontinued OperationsDiscontinued Operations

Extraordinary ItemExtraordinary Item



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Change in Accounting Principle

Occurs when the principle used in the current

year is different from the one used in the

preceding year.

Accounting rules permit a change if justified.

Changes are reported retroactively.

Example would include a change in inventory

costing method such as FIFO to average cost.



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Sales 285,000$

Cost of goods sold 149,000 Gross profi t 136,000

Operating expenses:

Advertising expense 10,000 Depreciation expense 43,000

Total operating expense 53,000 I ncome from operations 83,000

Other revenue:

I nterest revenue 17,000 Total other 17,000

I ncome bef ore taxes 100,000 I ncome tax expense 24,000 Net income 76,000$

Unrealized gains and losses on available-for-sale securities.

Plus other items

+

Reported in Stockholders’ Equity

Comprehensive Income



All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders.

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Comprehensive Income

Why are gains and losses on available-for-sale

securities excluded from net income?

Because disclosing them separately

1. reduces the volatility of net income due to

fluctuations in fair value,

2. yet informs the financial statement user of the

gain or loss that would be incurred if the

securities were sold at fair value.



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Companies have incentives to manage income to meet or beat Wall Street expectations, so that

the market price of stock increases and

the value of stock options increase.

A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements.

Quality of EarningsQuality of EarningsQuality of EarningsQuality of Earnings

SO 7 Understand the concept of quality of earnings.

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Alternative Accounting Methods

Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings.



Pro Forma Income

Pro forma income usually excludes items that the company thinks are unusual or nonrecurring.

Some companies have abused the flexibility that pro forma numbers allow.

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Improper Recognition

Some managers have felt pressure to continually

increase earnings and have manipulated the earnings

numbers to meet these expectations.

Abuses include:

Improper recognition of revenue (channel stuffing).

Improper capitalization of operating expenses

(WorldCom).

Failure to report all liabilities (Enron).



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83.4 million Americans own stock investments, either through mutual funds or individual stocks; 89% of stock investors own stock mutual funds.

44% of the people who own stock bought their first stock before 1990.

The typical equity investor is in his or her late 40s, is married, is employed, and has a household income in the low $60,000s.

Should I Play the Market?

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58% of people who own stock said that they rely on

professional financial advisors when making decisions

regarding the purchase and sale of stock.

46% of people who own stock used the Internet to check

stock prices, and 38% use it to read online financial

publications.

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The percentage of Americans who buy stock, either through mutual funds or individual shares, has increased significantly inrecent years. A big part of this increase is due to the increasing prevalence of employer-sponsored retirement plans, such as 401(k) plans.Source: “Equity Ownership in America,” Investment Company Institute and the Securities IndustryAssociation, 2002, p. 1.

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Rachael West has been working at her new job for six months. She has a good salary, with lots of opportunities for growth. She has already accumulated $8,000 in savings, which right now is sitting in a bank savings account earning very little interest. She has decided to take $7,000 out of this savings account and buy common stock of her employer, a young company that has been in business for two years. Rachael’s liquid assets, including her savings account, total $10,000. Her monthly expenses are approximately $3,000. Should Rachael make this investment?YES: She has a good income, and this is a great opportunity for her to get in on the ground floor of her employer’s fast-growing company.

NO: She shouldn’t invest all of her money in one company, particularly the company at which she works.

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slide 14-1. slide 14-2 chapter 14 financial statement analysis financial accounting, seventh edition

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