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 Preview of Chapter 14 Financial Accounting Eighth Edition Weygandt Kieso Kimmel 14-3 Basics of Financial Statement Analysis Analyzing financial statements involves: Comparison Bases Characteristics Liquidity Intracompany Horizontal Profitability Vertical Solvency Industry averages Ratio 14-4 Tools of Analysis LO 1 LO 2 Intercompany Discuss the need for comparative analysis. Identify the tools of financial statement 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. 14-5 LO 3 Explain and apply horizontal analysis. Horizontal Analysis Illustration 14-5 Horizontal analysis of balance sheets 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. 14-6 LO 3 Explain and apply horizontal analysis. Horizontal Analysis Illustration 14-6 Horizontal analysis of Income statements 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. 14-7 LO 3 Explain and apply horizontal analysis. Horizontal Analysis Illustration 14-7 Horizontal analysis of retained earnings statements 14-8 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. LO 3 Explain and apply horizontal analysis. 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. 14-9 LO 4 Describe and apply vertical analysis. Vertical Analysis Illustration 14-8 Vertical analysis of balance sheets These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt. 14-10 LO 4 Describe and apply vertical analysis. Vertical Analysis Illustration 14-9 Vertical analysis of Income statements Quality appears to be a profitable enterprise that is becoming even more successful. 14-11 LO 4 Describe and apply vertical analysis. Vertical Analysis Enables a comparison of companies of different sizes. Illustration 14-10 Intercompany income statement comparison 14-12 LO 4 Describe and apply vertical analysis. Ratio Analysis Ratio analysis expresses the relationship among selected items of financial statement data. Financial Ratio Classifications 14-13 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. LO 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. 14-14 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. 14-15 Ratio Analysis Liquidity Ratios Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. 14-16 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. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio Analysis Liquidity Ratios 1. Current Ratio Illustration 14-12 Ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets. 14-17 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio Analysis Liquidity Ratios 2. Acid-Test Ratio Illustration 14-13 14-18 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio Analysis Liquidity Ratios 2. Acid-Test Ratio Illustration 14-14 Acid-test ratio measures immediate liquidity. 14-19 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. 14-20 Ratio Analysis Liquidity Ratios 3. Receivable Turnover Illustration 14-15 Measures the number of times, on average, the company collects receivables during the period. 14-21 LO 5 Ratio Analysis Liquidity Ratios $2,097,000 Receivable Turnover = 10.2 times ($180,000 + $230,000) / 2 A variant of the Receivable turnover ratio is to convert it to an average collection period in terms of days. 365 days / 10.2 times = every 35.78 days Receivables are collected on average every 36 days. 14-22 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio Analysis Liquidity Ratios 4. Inventory Turnover Illustration 14-16 Measures the number of times, on average, the inventory is sold during the period. 14-23 LO 5 Ratio Analysis Liquidity Ratios Inventory Turnover = 2.3 times ($500,000 + $620,000) / 2 $1,281,000 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. 14-24 LO 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 common stockholders’ equity, earnings per share, price-earnings, and payout ratio. 14-25 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio Analysis Profitability Ratios 5. Profit Margin Illustration 14-17 Measures the percentage of each dollar of sales that results in net income. 14-26 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio Analysis Profitability Ratios 6. Asset Turnover Illustration 14-18 Measures how efficiently a company uses its assets to generate sales. 14-27 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio Analysis Profitability Ratios 7. Return on Asset Illustration 14-19 An overall measure of profitability. 14-28 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio Analysis Profitability Ratios 8. Return on Common Stockholders’ Equity Illustration 14-20 Shows how many dollars of net income the company earned for each dollar invested by the owners. 14-29 LO 5 Ratio Analysis Profitability Ratios 9. Earnings Per Share (EPS) Illustration 14-21 A measure of the net income earned on each share of common stock. 14-30 LO 5 Ratio Analysis Profitability Ratios 10. Price-Earnings Ratio Illustration 14-22 Measures the net income earned on each share of common stock. 14-31 LO 5 Ratio Analysis Profitability Ratios 11. Payout Ratio Illustration 14-23 Measures the percentage of earnings distributed in the form of cash dividends. 14-32 LO 5 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. 14-33 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio Analysis Solvency Ratios 12. Debt to Total Assets Ratio Illustration 14-24 Measures the percentage of the total assets that creditors provide. 14-34 LO 5 Ratio Analysis Solvency Ratios 13. Times Interest Earned Illustration 14-25 Provides an indication of the company’s ability to meet interest payments as they come due. 14-35 LO 5 Ratio Analysis Summary of Ratios Illustration 14-26 14-36 LO 5 Summary of Ratios Illustration 14-26 14-37 LO 5 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. Two types are: 1. Discontinued operations. 2. Extraordinary items. “Irregular” items are reported net of income taxes. 14-38 LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items Discontinued Operations (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). 14-39 LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items 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. 14-40 LO 6 Earning Power and Irregular Items Income Statement (in thousands) Discontinued Operations are reported after “Income from continuing operations.” Sales $ Cost of goods sold 149,000 Gross profit 136,000 Other revenue (expense): Interest revenue Previously labeled as “Net Income”. Moved to 14-41 285,000 17,000 Interest expense Total other Income before taxes Income tax expense Income from continuing operations (21,000) (4,000) 79,000 24,000 55,000 Discontinued operations: Loss from operations, net of tax Loss on disposal, net of tax Total loss on discontinued operations Net income 315 $ 189 504 54,496 LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items Extraordinary Items Nonrecurring material items that differ significantly from a company’s typical business activities. 14-42 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 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 YES manufacturer grows tobacco is rare. (b) A citrus grower's Florida crop is damaged by NO frost. (c) Loss from sale of temporary investments. NO (d) Loss attributable to a labor strike. NO 14-43 LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items Are these considered Extraordinary Items? (d) Loss from flood damage. (The nearby Black River floods every 2 to 3 years.) NO (e) An earthquake destroys one of the oil refineries owned by a large multi-national oil company. YES Earthquakes are rare in this geographical location. (f) Write-down of obsolete inventory. (g) Expropriation of a factory by a foreign government. 14-44 NO YES LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items 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. 14-45 LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items Income Statement (in thousands) Extraordinary Items are reported after “Income from continuing operations.” Sales $ 285,000 Cost of goods sold 149,000 Gross profit 136,000 Other revenue (expense): Previously labeled as “Net Income”. Interest revenue 17,000 Interest expense Total other (21,000) (4,000) Income before taxes Income tax expense Income from continuing operations Extraordinary loss, net of tax Net income $ 79,000 24,000 55,000 559 54,441 Moved to 14-46 LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items Reporting when both Discontinued Operations and Extraordinary Items are present. Discontinued Operations Extraordinary Item 14-47 Income Statement (in thousands) Sales $ 285,000 Cost of goods sold 149,000 Gross profit 136,000 Interest expense Total other (21,000) (4,000) Income before taxes Income tax expense Income from continuing operations Discontinued operations: Loss from operations, net of tax 79,000 24,000 55,000 315 Loss on disposal, net of tax Total loss on discontinued operations Income before extraordinary item Extraordinary loss, net of tax Net income 189 504 $ 54,496 559 53,937 LO 6 Understand the concept of earning power, and how irregular items are presented. 14-48 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. 14-49 LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items Comprehensive Income All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders. 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 14-50 $ 285,000 149,000 136,000 10,000 43,000 53,000 83,000 17,000 17,000 100,000 24,000 $ 76,000 Reported in Stockholders’ Equity + Unrealized gains and losses on available-forsale securities. Plus other items LO 6 Understand the concept of earning power, and how irregular items 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. 14-51 LO 6 Understand the concept of earning power, and how irregular items 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 14-52 the market price of stock increases and the value of stock options increase. LO 7 Understand the concept of quality of earnings. Quality of Earnings Alternate Accounting Methods Variations among companies in the application of GAAP 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. 14-53 LO 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: 14-54 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. Key Points The tools of financial statement analysis covered in this chapter are universal and therefore no significant differences exist in the analysis methods used. The basic objectives of the income statement are the same under both GAAP and IFRS. Thus, both the IASB and the FASB are interested in distinguishing normal levels of income from irregular items in order to better predict a company’s future profitability. The basic accounting for discontinued operations is the same under IFRS and GAAP. 14-55 Key Points Under IFRS, there is no classification for extraordinary items. In other words, extraordinary item treatment is prohibited under IFRS. All revenue and expense items are considered ordinary in nature. The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS. Both IFRS and GAAP follow the same approach in reporting comprehensive income. The statement of comprehensive income can be prepared under the one-statement approach or the two statement approach. 14-56 Key Points The issues related to quality of earnings are the same under both GAAP and IFRS. It is hoped that by adopting a more principlesbased approach, as found in IFRS, many of the earnings’ quality issues will disappear. 14-57 Looking to the Future The 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. 14-58 IFRS Self-Test Questions The basic tools of financial analysis are the same under both GAAP and IFRS except that: 14-59 a) horizontal analysis cannot be done because the format of the statements is sometimes different. b) analysis is different because vertical analysis cannot be done under IFRS. c) the current ratio cannot be computed because current liabilities are often reported before current assets in IFRS statements of position. d) None of the above. IFRS Self-Test Questions Under IFRS: a) the reporting of discontinued items is different than GAAP. b) the reporting of extraordinary items is prohibited. c) the reporting of changes in accounting principles is different than under GAAP. d) 14-60 None of the above. IFRS Self-Test Questions Presentation of comprehensive income must be reported under IFRS in: 14-61 a) the statement of stockholders’ equity. b) the income statement ending with net income. c) the notes to the financial statements. d) a statement of comprehensive income. Copyright “Copyright © 2012 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.” 14-62