CHAPTER18

Financial Statement Analysis

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Basics of Financial Statement Analysis

Analyzing financial statements involves:
Comparison Bases

Characteristics

Tools of Analysis

Liquidity
Profitability Solvency

Intracompany
Industry averages Intercompany

Horizontal
Vertical Ratio

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SO 1 SO 2

Discuss the need for comparative analysis. Identify the tools of financial statement analysis.

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

Purpose is to determine the increase or decrease that

has taken place.

Commonly applied to the balance sheet, income statement, and statement of retained earnings.

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SO 3 Explain and apply horizontal analysis.

Horizontal Analysis
Illustration 18-5 Horizontal analysis of balance sheets

Changes suggest that the company expanded its asset base during 2009 and financed this expansion primarily by retaining income rather than assuming additional long-term debt.

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SO 3 Explain and apply horizontal analysis.

Horizontal Analysis
Illustration 18-6 Horizontal analysis of Income statements

Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Qualitys profit trend appears favorable.

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SO 3 Explain and apply horizontal analysis.

Horizontal Analysis

Illustration 18-7 Horizontal analysis of retained earnings statements

In the horizontal analysis of the balance sheet the ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities.
SO 3 Explain and apply horizontal analysis.

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Vertical 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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SO 4 Describe and apply vertical analysis.

Vertical Analysis
Illustration 18-8 Vertical analysis of balance sheets

These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt.
SO 4 Describe and apply vertical analysis.

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Vertical Analysis
Illustration 18-9 Vertical analysis of Income statements

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

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SO 4 Describe and apply vertical analysis.

Vertical Analysis
Enables a comparison of companies of different sizes.

Illustration 18-10 Intercompany income statement comparison

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SO 4 Describe and apply vertical analysis.

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

Financial Ratio Classifications

Liquidity
Measures shortterm ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
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Profitability
Measures the income or operating success of a company for a given period of time.

Solvency
Measures the ability of the company to survive over a long period of time.

SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
A single ratio by itself is not very meaningful.
The discussion of ratios will include the following types of comparisons.

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SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
Liquidity 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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SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
1. Current Ratio

Liquidity Ratios

Illustration 18-12

Ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets.
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SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
2. Acid-Test Ratio

Liquidity Ratios

Illustration 18-13

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SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
2. Acid-Test Ratio

Liquidity Ratios

Illustration 18-14

Acid-test ratio measures immediate liquidity.

SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

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Ratio Analysis
3. Receivables Turnover

Liquidity Ratios

Illustration 18-15

Measures the number of times, on average, the company collects receivables during the period.
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SO 5

Ratio Analysis
$2,097,000

Liquidity Ratios

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

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

365 days / 10.2 times = every 35.78 days

Receivables are collected on average every 36 days.

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SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
4. Inventory Turnover

Liquidity Ratios

Illustration 18-16

Measures the number of times, on average, the inventory is sold during the period.
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SO 5

Ratio Analysis
$1,281,000

Liquidity Ratios

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

A variant of inventory turnover is the days in inventory.

365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among industries.

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SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for a given period of time.

Income, or the lack of it, affects the companys 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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SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
5. Profit Margin

Profitability Ratios

Illustration 18-17

Measures the percentage of each dollar of sales that results in net income.
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SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
6. Asset Turnover

Profitability Ratios

Illustration 18-18

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

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SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
7. Return on Asset

Profitability Ratios

Illustration 18-19

An overall measure of profitability.

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SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis

Profitability Ratios

8. Return on Common Stockholders Equity

Illustration 18-20

Shows how many dollars of net income the company earned for each dollar invested by the owners.
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SO 5

Ratio Analysis
9. Earnings Per Share (EPS)

Profitability Ratios

Illustration 18-22

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

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SO 5

Ratio Analysis
10. Price-Earnings Ratio

Profitability Ratios

Illustration 18-23

Measures the net income earned on each share of common stock.

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SO 5

Ratio Analysis
11. Payout Ratio

Profitability Ratios

Illustration 18-24

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

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SO 5

Ratio Analysis
Solvency 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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SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
12. Debt to Total Assets Ratio

Solvency Ratios

Illustration 18-25

Measures the percentage of the total assets that creditors provide.

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SO 5

Ratio Analysis
13. Times Interest Earned

Solvency Ratios

Illustration 18-26

Provides an indication of the companys ability to meet interest payments as they come due.
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SO 5

Ratio Analysis
Summary of Ratios
Illustration 18-27

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SO 5

Summary of Ratios
Illustration 18-27

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SO 5

Earning 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. Irregular items are reported net of income taxes.

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

Earning Power and Irregular Items

Discontinued Operations
(a) 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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SO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items

Illustration: During 2012 BD Inc. has income before income taxes of $79,000,000. During 2012, BD discontinued and sold its unprofitable chemical division. The loss in 2012 from

chemical operations (net of $135,000 taxes) was $315,000. The

loss on disposal of the chemical division (net of $81,000 taxes) was $189,000. Assuming a 30% tax rate on income.

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SO 6

Earning Power and Irregular Items

Income Statement (in thousands)

Discontinued Operations are reported after Income from continuing operations.

Sales Cost of goods sold

Other revenue (expense): Interest revenue Interest expense Total other Income before taxes Income tax expense Income from continuing operations Discontinued operations: Loss from operations, net of tax Loss on disposal, net of tax

$ 285,000 149,000

Previously labeled as Net Income.

17,000 (21,000) (4,000) 79,000 24,000 55,000 315 189 504 $ 54,496

Moved to
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Total loss on discontinued operations Net income

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

Earning Power and Irregular Items

Extraordinary Items
Nonrecurring material items that differ significantly from a companys typical business activities.

Must be both of an

Unusual Nature and

Occur Infrequently.

Must consider the environment in which it operates.

Amounts reported net of tax.

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

Earning Power and Irregular Items

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

YES

NO

frost.
(c) Loss from sale of temporary investments. (d) Loss attributable to a labor strike.
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NO
NO

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

Earning Power and Irregular Items

Are these considered Extraordinary Items?
(d) Loss from flood damage. (The nearby Black River floods every 2 to 3 years.)

NO

(e) An earthquake destroys one of the oil refineries

owned by a large multi-national oil company. Earthquakes are rare in this geographical location.

YES
NO YES

(f)

Write-down of obsolete inventory.

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

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

Earning Power and Irregular Items

Illustration: In 2012 a foreign government expropriated property held as an investment by DB Inc. If the loss is $770,000 before

applicable income taxes of $231,000, the income statement will

report a deduction of $539,000.

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

Earning Power and Irregular Items

Income Statement (in thousands)

Extraordinary Items are reported after Income from continuing operations.

Sales Cost of goods sold

$ 285,000 149,000

Previously labeled as Net Income. Moved to

Other revenue (expense): Interest revenue Interest expense Total other Income before taxes Income tax expense Income from continuing operations Extraordinary loss, net of tax Net income $

17,000 (21,000) (4,000) 79,000 24,000 55,000 539 54,461

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

Earning Power and Irregular Items

Reporting when both Discontinued Operations and Extraordinary Items are present.
Income Statement (in thousands) Sales Cost of goods sold
Interest expense Total other Income before taxes Income tax expense Income from continuing operations Discontinued operations: Loss from operations, net of tax Loss on disposal, net of tax Total loss on discontinued operations Income before extraordinary item

$ 285,000 149,000
(21,000) (4,000) 79,000 24,000 55,000 315 189 504 54,496 539 $ 53,957

Discontinued Operations

Extraordinary Item

Extraordinary loss, net of tax Net income

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

Earning Power and Irregular Items

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

Earning Power and Irregular Items

Comprehensive Income
Income Statement (in thousands) Sales Cost of goods sold Gross profit Operating expenses: Advertising expense Depreciation expense Total operating expense Income from operations Other revenue: Interest revenue Total other Income before taxes Income tax expense Net income $ 285,000 149,000 136,000 10,000 43,000 53,000 83,000 17,000 17,000 100,000 24,000 $ 76,000

All changes in stockholders equity except those resulting from investments by stockholders and distributions to stockholders.
Reported in Stockholders Equity

Unrealized gains and losses on available-forsale securities. Plus other items

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

Earning Power and Irregular Items

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

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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. 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.

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SO 7 Understand the concept of quality of earnings.

Quality of Earnings
Comprehensive Income

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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SO 7 Understand the concept of quality of earnings.

Quality of Earnings
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).

SO 7 Understand the concept of quality of earnings.

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