chapter 18. accounting principles

18-1

CHAPTER18Financial Statement

Analysis

18-2

Analyzing financial statements involves:

CharacteristicsComparison

BasesTools of Analysis

Liquidity

Profitability

Solvency

Intracompany

Industry averages

Intercompany

Horizontal

Vertical

Ratio

SO 1 Discuss the need for comparative analysis.SO 2 Identify the tools of financial statement

analysis.

Basics of Financial Statement Analysis

18-3 SO 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.


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 18-5Horizontal analysis ofbalance sheets

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 18-6Horizontal analysis ofIncome statements

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 18-7Horizontal analysis ofretained earnings statements

Horizontal Analysis

18-7 SO 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

18-8

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 18-8Vertical analysis ofbalance sheets

SO 4 Describe and apply vertical analysis.

Vertical Analysis

18-9

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

Illustration 18-9Vertical analysis ofIncome statements


Vertical Analysis

18-10

Enables a comparison of companies of different sizes.

Illustration 18-10Intercompany income statement comparison


Vertical Analysis

18-11SO 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



The discussion of ratios will include the following types of comparisons.

A single ratio by itself is not very meaningful.

Ratio Analysis



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,

receivables turnover, and inventory turnover.

Ratio Analysis



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 18-12



Illustration 18-13

Ratio Analysis

2. Acid-Test Ratio




Illustration 18-14

Ratio Analysis

2. Acid-Test Ratio


Acid-test ratio measures immediate liquidity.

18-17 SO 5

Illustration 18-15

Ratio Analysis

3. Receivables Turnover


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



A variant of the receivables 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

Receivables Turnover


18-19 SO 5

Illustration 18-16

Ratio Analysis

4. Inventory Turnover


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



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




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

18-22

Illustration 18-17

Ratio Analysis

5. Profit Margin

Measures the percentage of each dollar of sales that results in net income.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.


18-23

Illustration 18-18

Ratio Analysis

6. Asset Turnover

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



18-24

Illustration 18-19

Ratio Analysis

7. Return on Asset

An overall measure of profitability.



18-25

Illustration 18-20

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.


SO 5

18-26

Illustration 18-22

Ratio Analysis

9. Earnings Per Share (EPS)

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


SO 5

18-27

Illustration 18-23

Ratio Analysis

10. Price-Earnings Ratio

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


SO 5

18-28

Illustration 18-24

Ratio Analysis

11. Payout Ratio

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


SO 5



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

18-30

Illustration 18-25

Ratio Analysis

12. Debt to Total Assets Ratio

Measures the percentage of the total assets that creditors provide.

SO 5


18-31

Illustration 18-26

Ratio Analysis

13. Times Interest Earned

Provides an indication of the company’s ability to meet interest payments as they come due.

SO 5


18-32

Illustration 18-27

Ratio Analysis

SO 5

Summary of Ratios

18-33

Illustration 18-27

Summary of Ratios

SO 5

18-34SO 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

18-35

(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).

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


Discontinued Operations

18-36

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.

SO 6


18-37

Other revenue (expense):

I nterest revenue 17,000 I nterest expense (21,000)

Total other (4,000) I ncome bef ore taxes 79,000 I ncome tax expense 24,000 I ncome 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$

I ncome Statement (in thousands)

Sales 285,000$

Cost of goods sold 149,000 Discontinued

Operations are reported after “Income from

continuing operations.”

Previously labeled as “Net Income”.


Moved to



18-38

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.”



Extraordinary Items

18-39

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

NONO


NONO


18-40

(d) Loss from flood damage. (The nearby Black River

floods every 2 to 3 years.)

(e) An earthquake destroys one of the oil refineries

owned by a large multi-national oil company.

Earthquakes are rare in this geographical location.

(f) Write-down of obsolete inventory.

(g) Expropriation of a factory by a foreign

government.

NONO

YESYES

YESYES


NONO

Are these considered Extraordinary Items?


18-41

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.



18-42

Other revenue (expense):

I nterest revenue 17,000 I nterest expense (21,000)

Total other (4,000) I ncome bef ore taxes 79,000 I ncome tax expense 24,000 I ncome from continuing operations 55,000

Extraordinary loss, net of tax 539

Net income 54,461$

Extraordinary Items are reported after “Income

from continuing operations.”



Moved to




Sales 285,000$

Cost of goods sold 149,000

18-43

I nterest expense (21,000) Total other (4,000)

I ncome bef ore taxes 79,000 I ncome tax expense 24,000 I ncome 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

I ncome before extraordinary item 54,496

Extraordinary loss, net of tax 539

Net income 53,957$


Sales 285,000$

Cost of goods sold 149,000

Reporting when both

Discontinued

Operations and

Extraordinary Items

are present.



Extraordinary ItemExtraordinary Item



18-44

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.



Change in Accounting Principle

18-45


Sales 285,000$

Cost of goods sold 149,000 Gross profi t 136,000

Operating expenses:

Advertising expense 10,000 Depreciation expense 43,000

Total operating expense 53,000 I ncome from operations 83,000

Other revenue:

I nterest revenue 17,000 Total other 17,000

I ncome bef ore taxes 100,000 I ncome 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


All changes in stockholders’

equity except those resulting

from investments by

stockholders and distributions

to stockholders.


18-46

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.




18-47

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.

SO 7 Understand the concept of quality of earnings.

Quality of Earnings

18-48

Variations among companies in the application of GAAP

may hamper comparability and reduce 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


Pro Forma Income

18-49

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).


Quality of Earnings

Improper Recognition

chapter 18. accounting principles

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