what we do now determines the future. james m. sugden – (right now)

What we do now

determines the future.

James M. Sugden – (right now)

Chapter 14

FINANCIAL STATEMENT FINANCIAL STATEMENT ANALYSIS: ANALYSIS:

The Big PictureThe Big Picture

Chapter 14

After studying Chapter 14, you should be able to:

• Understand the concept of sustainable income.

• Indicate how irregular items are presented.• Explain the concept of comprehensive

income.• Describe and apply horizontal analysis.

• Describe and apply vertical analysis.

Chapter 14

After studying Chapter 14, you should be able to:

• Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

• Understand the concept of quality of earnings.

Components of the Income Statement

Irregular Items

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

• discontinued operations

• extraordinary items

Discontinued Operations...

The disposal of a significant segment of a business...

–the elimination of a major class of customers or

–an entire activity.

Rozek net income of $800,000 from continuing

operations in 2007.During 2007 the company discontinued and sold its unprofitable chemical division. The loss in 2007 from chemical operations (net of $90,000 taxes) was $210,000. The tax rate is 30%.

Discontinued Operations

Extraordinary Items...

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

occurrence

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• In 2007 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

Presentation of Extraordinary Items...

Extraordinary Items

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

NONONONO

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

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

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

g) Write-down of obsolete inventory.

h) Expropriation of a factory by a foreign government.

NONO

YESYES

YESYESNONO

Are these considered Extraordinary Items?

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

Sustainable Income...

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

• Does not include irregular revenues, expenses, gains, or losses.

Estimating Sustainable Income

When evaluating a company, it generally makes sense to eliminate all irregular items in estimating future sustainable income.

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– Most changes are reported retroactively – improves

comparability

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

• 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

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



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

Complete Income Statement

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

• Intracompany basis

• Intercompany basis

• Industry averages

Financial Statement Analysis

Financial Statement Analysis

Three basic tools are used in financial statement analysis :

1. Horizontal analysis

2. Vertical analysis

3. Ratio analysis

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Analysts should look beyond the ratios.

Economic factors

Consumer tastes

Industry trends

Technological changes

Changes within the firm

Limitations of Financial Statement Analysis

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.

Limitations of Financial Statement Analysis

Statements in Comparative and Common-Size Form

Dollar and percentage changes on statements

Common-size statements

Ratios

Analytical techniques used to examine

relationships among financial statement

items

Dollar and Percentage Changes on Statements

Comparing statements underscores movements and trends and may provide valuable clues about

what to expect in the future.

Horizontal analysis

Trendanalysis

Horizontal Analysis

Horizontal analysis shows the changes between years in the financial data in

both dollar and percentage form.

Horizontal Analysis

CLOVER CORPORATIONComparative Balance SheetsDecember 31, 2011 and 2010

Increase (Decrease)2011 2010 Amount %

AssetsCurrent assets: Cash 12,000$ 23,500$ Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200

Total current assets 155,000 164,700

Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000

Total property and equipment 160,000 125,000

Total assets 315,000$ 289,700$

Horizontal Analysis

Calculating Change in Dollar Amounts

DollarChange

Current YearFigure

Base YearFigure

= –

The dollar amounts for 2007 become

the “base” year figures.

Horizontal Analysis

Calculating Change as a Percentage

PercentageChange

Dollar Change Base Year Figure

100%= ×

Horizontal AnalysisCLOVER CORPORATION

Comparative Balance SheetsDecember 31, 2011 and 2010


AssetsCurrent assets: Cash 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200

Total current assets 155,000 164,700

Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000

Total property and equipment 160,000 125,000

Total assets 315,000$ 289,700$

($11,500 ÷ $23,500) × 100% = 48.9%

$12,000 – $23,500 = $(11,500)


Comparative Balance SheetsDecember 31, 2011 and 2010


AssetsCurrent assets: Cash 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 20,000 50.0 Inventory 80,000 100,000 (20,000) (20.0) Prepaid expenses 3,000 1,200 1,800 150.0

Total current assets 155,000 164,700 (9,700) (5.9)

Property and equipment: Land 40,000 40,000 - 0.0 Buildings and equipment, net 120,000 85,000 35,000 41.2

Total property and equipment 160,000 125,000 35,000 28.0

Total assets 315,000$ 289,700$ 25,300$ 8.7


Comparative Income StatementsFor the Years Ended December 31, 2011 and 2010

Increase (Decrease)

2011 2010 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3

Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1

Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)

Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)

Net income 17,500$ 22,400$ (4,900)$ (21.9)



Increase (Decrease)





Net income 17,500$ 22,400$ (4,900)$ (21.9)

Sales increased by 8.3% yet net income decreased by 21.9%.



Increase (Decrease)





Net income 17,500$ 22,400$ (4,900)$ (21.9)

There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the

increase in sales, yielding an overall decrease in net income.

Trend Percentages

Trend percentages state several years’

financial data in terms of a base year, which equals 100 percent.

Trend Analysis

Example

Look at the income information for Berry Products for the years 2007 through 2011. We will do a trend

analysis on these amounts to see what we can learn about the company.

Trend Analysis

Berry ProductsIncome Information

For the Years Ended December 31,

The baseyear is 2007, and its amounts

will equal 100%.

YearItem 2011 2010 2009 2008 2007

Sales 400,000$ 355,000$ 320,000$ 290,000$ 275,000$ Cost of goods sold 285,000 250,000 225,000 198,000 190,000 Gross margin 115,000 105,000 95,000 92,000 85,000

Trend Analysis


For the Years Ended December 31, Year

Item 2011 2010 2009 2008 2007Sales 105% 100%Cost of goods sold 104% 100%Gross margin 108% 100%

2008 ÷ 2007 ( $290,000 ÷ $275,000 ) × 100% = 105%( $198,000 ÷ $190,000 ) × 100% = 104%( $ 92,000 ÷ $ 85,000 ) × 100% = 108%

Trend Analysis


For the Years Ended December 31,

By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing

faster than sales, which is slowing the increase in gross margin.

YearItem 2011 2010 2009 2008 2007

Sales 145% 129% 116% 105% 100%Cost of goods sold 150% 132% 118% 104% 100%Gross margin 135% 124% 112% 108% 100%

Trend AnalysisWe can use the trend

percentages to construct a graph so we can see the

trend over time.

Common-Size Statements

Common-sizeCommon-size statements use

percentages to express the relationship of

individual components to a total within a singlesingle

period. This is also known as vertical vertical

analysisanalysis.


Example

Let’s take another look at the information from the comparative

income statements of Clover Corporation for 2011 and 2010.

This time let’s prepare common-size

statements.


Net sales 520,000$ 100.0% 480,000$ 100.0%

Cost of goods sold 360,000 315,000

Gross margin 160,000 165,000 Operating expenses 128,600 126,000

Net operating income 31,400 39,000 Interest expense 6,400 7,000

Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600

Net income 17,500$ 22,400$

2011 2010

CLOVER CORPORATIONComparative Income Statements

For the Years Ended December 31, 2011 and 2010

Net sales Net sales is usually the base and is expressed as 100%.


Net sales 520,000$ 100.0% 480,000$ 100.0%

Cost of goods sold 360,000 69.2% 315,000 65.6%

Gross margin 160,000 165,000 Operating expenses 128,600 126,000

Net operating income 31,400 39,000 Interest expense 6,400 7,000

Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600

Net income 17,500$ 22,400$

2011 2010



2011 COGS ÷ 2011 Net Sales ( $360,000 ÷ $520,000 ) = 69.2%

2010 COGS ÷ 2010 Net Sales ( $315,000 ÷ $480,000 ) = 65.6%


Net sales 520,000$ 100.0% 480,000$ 100.0%

Cost of goods sold 360,000 69.2% 315,000 65.6%

Gross margin 160,000 30.8% 165,000 34.4%

Operating expenses 128,600 24.8% 126,000 26.2%

Net operating income 31,400 6.0% 39,000 8.2%

Interest expense 6,400 1.2% 7,000 1.5%

Net income before taxes 25,000 4.8% 32,000 5.7%

Less income taxes (30%) 7,500 1.4% 9,600 2.0%

Net income 17,500$ 3.4% 22,400$ 4.7%

2011 2010



What conclusions

can we draw?

ReviewReviewReviewReview

In horizontal analysis, each item is In horizontal analysis, each item is expressed as a percentage of the:expressed as a percentage of the:

a.a. net income amount.net income amount.

d.d. base-year amount.base-year amount.c. c. total assets amount.total assets amount.b.b. stockholders’ equity amount.stockholders’ equity amount.

In horizontal analysis, each item is In horizontal analysis, each item is expressed as a percentage of the:expressed as a percentage of the:

a.a. net income amount.net income amount.

d.d. base-year amount.base-year amount.c. c. total assets amount.total assets amount.b.b. stockholders’ equity amount.stockholders’ equity amount.


In vertical analysis, the base amount In vertical analysis, the base amount for depreciation expense is for depreciation expense is generally:generally:a.a. net sales.net sales.

d.d. fixed assets.fixed assets.c. c. gross profit.gross profit.b.b. depreciation expense in a previous year.depreciation expense in a previous year.


Ratio Analysis

11 6

Ratios Three types:

Liquidity ratios

Solvency 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

Liquidity Ratios

Solvency Ratios

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

WHO CARES?Long-term creditors and stockholders

Solvency Ratios

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 financing its liquidity position its ability to grow

Profitability Ratios

Quality of Earnings

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.

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.

Pro Forma Income

A measure of the net income generated that usually excludes items that the company thinks are unusual or nonrecurring.

Improper Recognition

• Offering big discounts (channel stuffing) to companies to get them to buy early- Often leads to disaster in subsequent periods.

• Improper capitalization of operating expenses

Price Earnings Ratio

The P/E ratio reflects the investors’ assessment of a company’s future earnings.

Earnings Per Share and Price Earnings Ratio

what we do now determines the future. james m. sugden – (right now)

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