financial statement comparability chapter 4. chapter 4 objectives explain the advantage of common...
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FINANCIAL FINANCIAL STATEMENT STATEMENT COMPARABILITYCOMPARABILITY
Chapter 4Chapter 4
CHAPTER 4 OBJECTIVESCHAPTER 4 OBJECTIVES
Explain the advantage of common size Explain the advantage of common size financial statements compared to those financial statements compared to those disclosed on a monetary basis. disclosed on a monetary basis.
Compute vertical and horizontal common Compute vertical and horizontal common size income statements and balance size income statements and balance sheets.sheets.
Calculate compound annual growth rates Calculate compound annual growth rates and explain why this method provides and explain why this method provides better information than alternative better information than alternative methods of horizontal analysis.methods of horizontal analysis.
CHAPTER 4 OBJECTIVES CHAPTER 4 OBJECTIVES (CONT.)(CONT.)
Determine financial statement Determine financial statement vertical profiles and moving vertical profiles and moving averages.averages.
Use good judgment when reconciling Use good judgment when reconciling financial statement inconsistencies, financial statement inconsistencies, rounding numbers, computing ratios, rounding numbers, computing ratios, scaling numerical amounts and scaling numerical amounts and making qualitative assessments.making qualitative assessments.
BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONSCONSIDERATIONS
Enables valid comparisons over Enables valid comparisons over time or against competitiontime or against competition
BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)
Vertical common size financial Vertical common size financial statementsstatements
Disclosures are a percentage of another Disclosures are a percentage of another account in the same reporting periodaccount in the same reporting period Income statement: accounts reported as a Income statement: accounts reported as a
percentage of revenues (revenues = 100%)percentage of revenues (revenues = 100%) Balance sheet: accounts reported as a Balance sheet: accounts reported as a
percentage of total assets (or liabilities plus percentage of total assets (or liabilities plus shareholders’ equity)shareholders’ equity)
VERTICAL COMMON SIZE VERTICAL COMMON SIZE EXAMPLEEXAMPLE
eXTREMESTUFF.com, Inc.Income StatementsVertical Common Size 2003 2002 2001 2000Sales revenues 100.0% 100.0% 100.0% 100.0%Cost of goods sold 61.1% 58.0% 55.0% 60.0%Gross profit 38.9% 42.0% 45.0% 40.0%Selling expenses 27.1% 25.2% 29.3% 25.0%Administrative expenses 11.5% 12.1% 11.1% 8.5%Income from continuing operations 0.4% 4.8% 4.6% 6.5%Financial expenses 1.5% 1.6% 1.7% 1.0%Pretax income -1.1% 3.1% 2.9% 5.5%Income tax expense / benefit -0.5% 1.3% 1.2% 2.2%Net income -0.7% 1.9% 1.8% 3.3%
BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)
Horizontal common size financial Horizontal common size financial statementsstatements
Disclosures are a percentage of the Disclosures are a percentage of the same account from a previous reporting same account from a previous reporting period period Income statement: e.g., this year’s revenues Income statement: e.g., this year’s revenues
as a percentage of last year’s revenuesas a percentage of last year’s revenues Balance sheet: e.g., this year’s cash balance Balance sheet: e.g., this year’s cash balance
as a percentage of last year’s cash balanceas a percentage of last year’s cash balance
BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)
Alternative disclosures of Alternative disclosures of horizontal analysishorizontal analysis
AnchoringAnchoring Uses the earliest year’s data as the Uses the earliest year’s data as the
base year (100%)base year (100%) Subsequent observations are a Subsequent observations are a
percentage of the base year’s amountpercentage of the base year’s amount
HORIZONTAL COMMON HORIZONTAL COMMON SIZE EXAMPLESIZE EXAMPLE
eXTREMESTUFF.com, Inc.Income StatementsHorizontal Common Size-Base Year 2003 2002 2001 2000Sales revenues 131.0% 124.0% 120.0% 100.0%Cost of goods sold 133.3% 119.8% 110.0% 100.0%Gross profit 127.5% 130.3% 135.0% 100.0%Selling expenses 142.0% 124.8% 140.8% 100.0%Administrative expenses 176.5% 176.5% 156.5% 100.0%Income from continuing operations 7.7% 90.8% 84.6% 100.0%Financial expenses 200.0% 200.0% 200.0% 100.0%Pretax income -27.3% 70.9% 63.6% 100.0%Income tax expense / benefit -27.3% 72.7% 63.6% 100.0%Net income -27.3% 69.7% 63.6% 100.0%
BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)
Alternative disclosures of Alternative disclosures of horizontal analysishorizontal analysis
Rolling forwardRolling forward Uses the previous year’s observation Uses the previous year’s observation
as 100%as 100% Subsequent year’s observations are a Subsequent year’s observations are a
percentage of the previous year’s percentage of the previous year’s base amountbase amount
HORIZONTAL COMMON HORIZONTAL COMMON SIZE EXAMPLESIZE EXAMPLE
eXTREMESTUFF.com, Inc.Income StatementsRolling Forward 2003 2002 2001 2000Sales revenues 105.6% 103.3% 120.0% 100.0%Cost of goods sold 111.3% 108.9% 110.0% 100.0%Gross profit 97.9% 96.5% 135.0% 100.0%Selling expenses 113.8% 88.6% 140.8% 100.0%Administrative expenses 100.0% 112.8% 156.5% 100.0%Income from continuing operations 8.5% 107.3% 84.6% 100.0%Financial expenses 100.0% 100.0% 200.0% 100.0%Pretax income -38.5% 111.4% 63.6% 100.0%Income tax expense / benefit -37.5% 114.3% 63.6% 100.0%Net income -39.1% 109.5% 63.6% 100.0%
BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)
Types of disclosures: reported as aTypes of disclosures: reported as a Percentage of the base year amountPercentage of the base year amount Percentage change from the base Percentage change from the base
year amountyear amount Illustrated in Exhibit 4-4 (p. 88)Illustrated in Exhibit 4-4 (p. 88)
BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)
Mathematical properties of Mathematical properties of common size statementscommon size statements Vertical common sizing is appropriate Vertical common sizing is appropriate
for intraperiod benchmarksfor intraperiod benchmarks Horizontal common sizing is Horizontal common sizing is
appropriate for interperiod appropriate for interperiod benchmarksbenchmarks
Illustrated in Exhibit 4-5 (p. 89)Illustrated in Exhibit 4-5 (p. 89)
COMMON SIZE COMMON SIZE EXTENSIONSEXTENSIONS
Compound annual growth rates—Compound annual growth rates— better method of horizontal analysis than better method of horizontal analysis than
anchoring or rolling the data forwardanchoring or rolling the data forward Mathematically valid: considers the affect of Mathematically valid: considers the affect of
percentage changes on previous periods’ percentage changes on previous periods’ numbersnumbers
Superiority illustrated in Exhibit 4-6 (p. 90) Superiority illustrated in Exhibit 4-6 (p. 90) Internal rate of return command on Internal rate of return command on
spreadsheet application facilitates spreadsheet application facilitates computationscomputations
COMPOUND ANNUAL COMPOUND ANNUAL GROWTH RATE EXAMPLEGROWTH RATE EXAMPLE
eXTREMESTUFF.com, Inc.Income StatementsCompound Annual Growth 2000 2002 2001 2003 GrowthSales revenues (1000.00) 0 0 1310.00 9.4%Cost of goods sold (600.00) 0 0 800.00 10.1%Gross profit (400.00) 0 0 510.00 8.4%Selling expenses (250.00) 0 0 355.00 12.4%Administrative expenses (85.00) 0 0 150.00 20.8%Income from continuing operations (65.00) 0 0 5.00Financial expenses (10.00) 0 0 20.00 26.0%Pretax income (55.00) 0 0 (15.00)Income tax expense / benefit (22.00) 0 0 (6.00)Net income (33.00) 0 0 (9.00)
COMMON SIZE COMMON SIZE EXTENSIONS (CONT.)EXTENSIONS (CONT.)
Financial statement profilesFinancial statement profiles Condenses a vertical common size Condenses a vertical common size
statement into one “average” statement into one “average” reporting periodreporting period
Measures variability over timeMeasures variability over time See Exhibit 4-7 (p. 91)See Exhibit 4-7 (p. 91)
COMMON SIZE COMMON SIZE EXTENSIONS (CONT.)EXTENSIONS (CONT.)
Moving averagesMoving averages Condenses three, five, or seven year Condenses three, five, or seven year
vertical common size statements into vertical common size statements into an average for that period of timean average for that period of time
Moves the average period forward by Moves the average period forward by dropping the earliest observation and dropping the earliest observation and replacing with the most recent replacing with the most recent period’s dataperiod’s data
See Exhibit 4-8 (p. 93)See Exhibit 4-8 (p. 93)
DATA CONSIDERATIONS DATA CONSIDERATIONS
Observation quantityObservation quantity Analyzing sufficient reporting Analyzing sufficient reporting
disclosures to reach valid conclusionsdisclosures to reach valid conclusions Usually between five and 10 years of Usually between five and 10 years of
data sufficedata suffice
DATA CONSIDERATIONS DATA CONSIDERATIONS (CONT.)(CONT.)
Financial statement Financial statement inconsistenciesinconsistencies Format of reported data change over Format of reported data change over
time and differ among companiestime and differ among companies Use judgment to reduce differences in Use judgment to reduce differences in
disclosure setsdisclosure sets Use most recent data available if Use most recent data available if
options existoptions exist
DATA CONSIDERATIONS DATA CONSIDERATIONS (CONT.)(CONT.)
Scaling disclosuresScaling disclosures Companies report financial Companies report financial
statements in thousands or millions of statements in thousands or millions of dollarsdollars
Be aware of the scale or you will fail Be aware of the scale or you will fail to grasp the entity’s sizeto grasp the entity’s size
DATA CONSIDERATIONS DATA CONSIDERATIONS (CONT.)(CONT.)
Numerical roundingNumerical rounding Done to avoid insignificant data Done to avoid insignificant data
disclosuresdisclosures Reduces “clutter” of data disclosures Reduces “clutter” of data disclosures Should only be done when it does not Should only be done when it does not
alter analysts’ decisionsalter analysts’ decisions
DATA CONSIDERATIONS DATA CONSIDERATIONS (CONT.)(CONT.)
Qualitative statementsQualitative statements Analysts’ Analysts’ opinionsopinions about data (e.g. about data (e.g.
one company has a better profit one company has a better profit margin than another) should be made margin than another) should be made with care and after sufficient analysiswith care and after sufficient analysis
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