14-1 chapter 14 financial statement analysis learning objectives after studying this chapter, you...
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14-1
Chapter 14
Financial Statement Analysis
Learning Objectives
After studying this chapter, you should be able to:
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.
14-2
Analyzing financial statements involves:
CharacteristicsCharacteristics Comparison Bases
Comparison Bases
Tools of AnalysisTools of Analysis
Liquidity
Profitability
Solvency
Intracompany
Industry averages
Intercompany
Horizontal
Vertical
Ratio
LO 1 Discuss the need for comparative analysis.LO 2 Identify the tools of financial statement
analysis.
Basics of Financial Statement Analysis
14-3 LO 3 Explain and apply horizontal 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.
14-4 LO 3 Explain and apply horizontal analysis.
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.
Illustration 14-5Horizontal analysis ofbalance sheets
Horizontal Analysis
14-5 LO 3 Explain and apply horizontal analysis.
Overall, gross profit
and net income were
up substantially.
Gross profit
increased
17.1%, and net
income, 26.5%.
Quality’s profit trend
appears favorable.
Illustration 14-6Horizontal analysis ofIncome statements
Horizontal Analysis
14-6 LO 3 Explain and apply horizontal analysis.
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.
Illustration 14-7Horizontal analysis ofretained earnings statements
Horizontal Analysis
14-7 LO 4 Describe and apply 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.
Vertical Analysis
14-8
These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt.
Illustration 14-8Vertical analysis ofbalance sheets
LO 4 Describe and apply vertical analysis.
Vertical Analysis
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Quality appearsto be a profitable enterprise that is becoming even more successful.
Illustration 14-9Vertical analysis ofIncome statements
LO 4 Describe and apply vertical analysis.
Vertical Analysis
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Enables a comparison of companies of different sizes.
Illustration 14-10Intercompany income statement comparison
LO 4 Describe and apply vertical analysis.
Vertical Analysis
14-11LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
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.
Ratio Analysis
14-12LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
The discussion of ratios will include the following types of comparisons.
A single ratio by itself is not very meaningful.
Ratio Analysis
14-13LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
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,
Receivable turnover, and inventory turnover.
Ratio Analysis
14-14LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets.
Ratio Analysis Liquidity RatiosLiquidity Ratios
1. Current RatioIllustration 14-12
14-15LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
2. Acid-Test Ratio
Liquidity RatiosLiquidity Ratios
Illustration 14-13
14-16LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Illustration 14-14
Ratio Analysis
2. Acid-Test Ratio
Acid-test ratio measures immediate liquidity.
Liquidity RatiosLiquidity Ratios
14-17 LO 5
Illustration 14-15
Ratio Analysis
3. Receivable Turnover
Measures the number of times, on average, the company collects receivables during the period.
Liquidity RatiosLiquidity Ratios
14-18LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
A variant of the Receivable turnover ratio is to convert it to an average collection period in terms of days.
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
Receivable Turnover
Ratio Analysis Liquidity RatiosLiquidity Ratios
14-19 LO 5
Illustration 14-16
Ratio Analysis
4. Inventory Turnover
Measures the number of times, on average, the inventory is sold during the period.
Liquidity RatiosLiquidity Ratios
14-20LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
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
Ratio Analysis Liquidity RatiosLiquidity Ratios
14-21LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
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.
Ratio Analysis
14-22
Illustration 14-17
Ratio Analysis
5. Profit Margin
Measures the percentage of each dollar of sales that results in net income.
LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Profitability RatiosProfitability Ratios
14-23
Illustration 14-18
Ratio Analysis
6. Asset Turnover
Measures how efficiently a company uses its assets to generate sales.
LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Profitability RatiosProfitability Ratios
14-24
Illustration 14-19
Ratio Analysis
7. Return on Asset
An overall measure of profitability.
LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Profitability RatiosProfitability Ratios
14-25
Illustration 14-20
Ratio Analysis
8. Return on Common Stockholders’ Equity
Shows how many dollars of net income the company earned for each dollar invested by the owners.
LO 5
Profitability RatiosProfitability Ratios
14-26
Illustration 14-21
Ratio Analysis
9. Earnings Per Share (EPS)
A measure of the net income earned on each share of common stock.
LO 5
Profitability RatiosProfitability Ratios
14-27
Illustration 14-22
Ratio Analysis
10. Price-Earnings Ratio
Measures the net income earned on each share of common stock.
LO 5
Profitability RatiosProfitability Ratios
14-28
Illustration 14-23
Ratio Analysis
11. Payout Ratio
Measures the percentage of earnings distributed in the form of cash dividends.
LO 5
Profitability RatiosProfitability Ratios
14-29LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
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.
Ratio Analysis
14-30
Illustration 14-24
Ratio Analysis
12. Debt to Total Assets Ratio
Measures the percentage of the total assets that creditors provide.
LO 5
Solvency RatiosSolvency Ratios
14-31
Illustration 14-25
Ratio Analysis
13. Times Interest Earned
Provides an indication of the company’s ability to meet interest payments as they come due.
LO 5
Solvency RatiosSolvency Ratios
14-34LO 6 Understand the concept of earning power,
and how irregular items are presented.
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.
Earning Power and Irregular Items
14-35
(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).
LO 6 Understand the concept of earning power, and how irregular items are presented.
Earning Power and Irregular Items
Discontinued Operations
14-36
Illustration: During 2014 BD Inc. has income before income
taxes of $79,000,000. During 2014, BD discontinued and sold
its unprofitable chemical division. The loss in 2014 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 $189,000. Assuming a 30% tax rate on income.
LO 6
Earning Power and Irregular Items
14-37
Discontinued Operations are reported
after “Income from continuing operations.”
Previously labeled as “Net Income”.
Previously labeled as “Net Income”.
Moved to
LO 6 Understand the concept of earning power, and how irregular items are presented.
Earning Power and Irregular Items
Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations 55,000
Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Net income 54,496$
Income Statement (in thousands)
Sales 285,000$
Cost of goods sold 149,000
Gross profit 136,000
14-38
Nonrecurring material items that differ significantly from a
company’s 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.”
LO 6 Understand the concept of earning power, and how irregular items are presented.
Earning Power and Irregular Items
Extraordinary Items
14-39
Illustration: In 2014 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 $539,000.
Earning Power and Irregular Items
LO 6 Understand the concept of earning power, and how irregular items are presented.
14-40
Extraordinary Items are reported after “Income
from continuing operations.”
Previously labeled as “Net Income”.
Previously labeled as “Net Income”.
Moved to
LO 6 Understand the concept of earning power, and how irregular items are presented.
Earning Power and Irregular Items
Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations 55,000
Extraordinary loss, net of tax 559
Net income 54,441$
Income Statement (in thousands)
Sales 285,000$
Cost of goods sold 149,000
Gross profit 136,000
14-41
Reporting when both
Discontinued
Operations and
Extraordinary Items
are present.
Discontinued Operations
Discontinued Operations
Extraordinary ItemExtraordinary Item
LO 6 Understand the concept of earning power, and how irregular items are presented.
Earning Power and Irregular Items
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Income 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
Income before extraordinary item 54,496
Extraordinary loss, net of tax 559
Net income 53,937$
Income Statement (in thousands)
Sales 285,000$
Cost of goods sold 149,000
Gross profit 136,000
14-42
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.
LO 6 Understand the concept of earning power, and how irregular items are presented.
Earning Power and Irregular Items
Change in Accounting Principle
14-43
Income Statement (in thousands)
Sales 285,000$
Cost of goods sold 149,000
Gross profit 136,000
Operating expenses:
Advertising expense 10,000
Depreciation expense 43,000
Total operating expense 53,000
Income from operations 83,000
Other revenue:
Interest revenue 17,000
Total other 17,000
Income before taxes 100,000
Income 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
LO 6 Understand the concept of earning power, and how irregular items are presented.
All changes in stockholders’
equity except those resulting
from investments by
stockholders and distributions
to stockholders.
Earning Power and Irregular Items
14-44
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.
LO 6 Understand the concept of earning power, and how irregular items are presented.
Earning Power and Irregular Items
Comprehensive Income
14-45
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.
LO 7 Understand the concept of quality of earnings.
Quality of Earnings
14-46
Variations among companies in the application of GAAP
may hamper comparability and reduce quality of earnings.
LO 7 Understand the concept of quality of earnings.
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.
Quality of Earnings
Alternate Accounting Methods
Pro Forma Income
14-47
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).
LO 7 Understand the concept of quality of earnings.
Quality of Earnings
Improper Recognition