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14-1
Chapter
14
Financial Statement
Analysis
Financial Accounting, IFRS Edition
Weygandt Kimmel Kieso
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14-2
Study Objectives
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
discontinued operations are presented.
7. Understand the concept of quality of earnings.
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14-3
Financial Statement Analysis
Basics of
Financial
Statement
Analysis
Horizontal and
Vertical
Analysis
Need for
comparative
analysis
Statement of
financial
position
Tools of
analysis
Income
statement
Retained
earnings
statement
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14-4
Ratio Analysis
Liquidity
Profitability
Solvency
Summary
Earning
Power and
Irregular Items
Discontinued
operations
Changes in
accounting
principle
Comprehensive
income
Quality of
Earnings
Alternative
accounting
methods
Pro forma
income
Improper
recognition
Basics of Financial Statement Analysis
Analyzing financial statements involves:
Comparison
Bases
Characteristics
Tools of
Analysis
Liquidity
Intracompany
Horizontal
Profitability
Industry
averages
Vertical
Solvency
Ratio
Intercompany
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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
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 statement of financial position,
income statement, and statement of retained earnings.
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SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Statement of
Financial
Position
These changes
suggest that the
company expanded
its asset base during
2011 and financed
this expansion
primarily by
retaining income
rather than assuming
additional long-term
debt.
Illustration 14-5
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SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Income
Statement
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 14-6
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14-8
SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Retained
Earnings
Statement
Illustration 14-7
We saw in the horizontal analysis of the statement of financial position that
ending retained earnings increased 38.6%. As indicated earlier, the company
retained a significant portion of net income to finance additional plant facilities.
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SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Illustration: Summary financial information for
Rosepatch Company is as follows.
Compute the amount and percentage changes in 2011 using
horizontal analysis, assuming 2010 is the base year.
Solution
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SO 4 Describe and apply horizontal analysis.
Vertical Analysis
Vertical analysis, also called common-size analysis
Expresses each financial statement item as a percent of
a base amount.
For example, selling expenses could be expressed as
16% of net sales.
Commonly applied to the statement of financial position
and the income statement.
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SO 4 Describe and apply vertical analysis.
Vertical Analysis
Statement of
Financial
Position
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 14-8
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SO 4 Describe and apply vertical analysis.
Vertical Analysis
Income
Statement
Quality appears
to be a profitable
enterprise that is
becoming even
more successful.
Illustration 14-9
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SO 4 Describe and apply vertical analysis.
Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 14-10
Intercompany income
statement comparison
Park Street earned net income more than 4,208 times larger than Quality’s, Park
Street’s net income as a percent of each sales euro (5.6%) is only 44% of
Quality’s (12.6%).
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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
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Liquidity
Profitability
Solvency
Measures shortterm ability of the
company to pay its
maturing
obligations and to
meet unexpected
needs for cash.
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.
SO 5 Identify and compute ratios used in analyzing a
firm’s 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
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
Measures short-term ability of the company to pay its
maturing obligations and to meet 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
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
The 2011 ratio of 2.96:1 means that for every euro of current
liabilities, Quality has €2.96 of current assets.
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
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Ratio Analysis
Liquidity Ratios
Compute the Acid-Test Ratio for 2011.
Illustration 14-13
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
The acid-test ratio measures immediate liquidity.
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
It measures the number of times, on average, the company
collects receivables during the period.
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
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
This means that receivables are collected on average every
36 days.
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
Inventory turnover measures the number of times, on average,
the inventory is sold during the period.
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14-24
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
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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14-25
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
Illustration 14-27
Summary of liquidity ratios
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14-26
SO 5 Identify and compute ratios used in analyzing a
firm’s 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 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 ordinary shareholders’
equity, earnings per share, price-earnings, and
payout ratio.
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
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
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Measures how efficiently a company uses its assets to
generate sales.
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14-29
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
An overall measure of profitability.
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14-30
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Shows how many euros of net income the company earned
for each dollar invested by the owners.
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
A measure of the amount of net income applicable to each
ordinary share.
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
The price-earnings (PE) ratio reflects investors’ assessments
of a company’s future earnings.
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Measures the percentage of earnings distributed in the form of
cash dividends.
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Illustration 14-27
Summary of profitability ratios
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
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
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Solvency Ratios
Measures the percentage of the total assets that creditors
provide.
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Solvency Ratios
Provides an indication of the company’s ability to meet
interest payments as they come due.
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Solvency Ratios
Illustration 14-27
Summary of solvency ratios
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SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
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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 as Discontinued Operations.
These “irregular” items are reported net of income taxes.
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SO 6 Understand the concept of earning power, and how
discontinued operations are presented.
Earning Power and Irregular Items
Discontinued Operations
(a) Refers to the 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
discontinued operations are presented.
Earning Power and Irregular Items
Illustration: During 2011 Acro Energy Inc. has income before
taxes of $800,000. During 2011 Acro discontinued and sold its
unprofitable chemical division. The loss in 2011 from chemical
operations (net of $60,000 taxes) was $140,000. The loss on
disposal of the chemical division (net of $30,000 taxes) was
$70,000. Assuming a 30% tax rate.
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SO 6 Understand the concept of earning power, and how
discontinued operations are presented.
Earning Power and Irregular Items
Income Statement (in thousands)
Discontinued Operations
are reported after
“Income from continuing
operations.”
Previously labeled as
“Net Income”.
Moved to
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Sales
Cost of goods sold
$ 285,000
149,000
Other revenue (expense):
Interest revenue
Interest expense
Total other
Income before taxes
Income tax expense
Income from continuing operations
17,000
(21,000)
(4,000)
79,000
24,000
55,000
Discontinued operations:
Loss from operations, net of tax
315
Loss on disposal, net of tax
189
Total loss on discontinued operations
Net income
504
$
54,496
SO 6
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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
discontinued operations are presented.
Earning Power and Irregular Items
Comprehensive Income
All changes in equity except
those resulting from
investments by shareholders
and distributions to
shareholders.
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
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$ 285,000
149,000
136,000
10,000
43,000
53,000
83,000
Reported in Stockholders’
Equity
17,000
17,000
100,000
24,000
$ 76,000
Unrealized gains and
losses on available-forsale securities.
Plus other items
+
SO 6 Understand the concept of earning power, and how
discontinued operations 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.
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SO 6 Understand the concept of earning power, and how
discontinued operations are presented.
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 the shares increase and
the value of share options increase.
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SO 7 Understand the concept of quality of earnings.
Quality of Earnings
Alternative Accounting Methods
Variations among companies in the application of IFRS
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).
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SO 7 Understand the concept of quality of earnings.
Understanding U.S. GAAP
Key Differences
Financial Statement
Analysis
Under GAAP, items that are considered to be both unusual in
nature and infrequent in occurrence are reported as
“extraordinary items” in a separate line item at the bottom of
the income statement, net of tax. Under IFRS, there is no
classification for extraordinary items. In other words,
extraordinary item treatment is prohibited under IFRS. In recent
years, the types of items that can receive extraordinary item
treatment under GAAP has been reduced to the point where the
classification is rarely used.
The accounting for changes in accounting principles and
changes in accounting estimates are the same for both GAAP
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and IFRS.
Understanding U.S. GAAP
Key Differences
Financial Statement
Analysis
Under IFRS, comprehensive income is either presented in a
single statement, combined with net income, or as a separate
statement, immediately after the income statement. GAAP also
permits the one-statement or two-statement approach as well.
In addition, GAAP permits a third alternative, which is to show
the computation of comprehensive income in the statement of
shareholders’ equity.
The issues related to quality of earnings are the same under
both GAAP and IFRS. It is hoped that by adopting a more
principles-based approach as found in IFRS that many of the
earnings quality issues will be reduced.
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Understanding U.S. GAAP
Looking to the Future
Financial Statement
Analysis
FASB and the IASB are working on a project that would rework the
structure of financial statements. Recently, the IASB decided to
require a statement of comprehensive income similar to what was
required under GAAP. In addition, another part of this project
addresses the issue of how to classify various items in the income
statement. A main goal of this new approach is to provide
information that better represents how businesses are run. In
addition, the approach draws attention away from one number—net
income. Instead, this approach provides more information about the
components of net income and comprehensive income.
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Copyright
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