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.

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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

14-9

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

14-10

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

14-32

Illustration 14-26

Ratio Analysis

LO 5

Summary of Ratios

14-33

Illustration 14-26

Summary of Ratios

LO 5

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