Slide
14-1
Chapter
14
Financial Statement
Analysis
Financial Accounting,
Seventh Edition
Slide
14-2
Study Objectives
Slide
14-3
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.
Financial Statement Analysis
Basics of
Financial
Statement
Analysis
Need for
comparative
analysis
Tools of
analysis
Horizontal and
Vertical
Analysis
Ratio Analysis
Balance
sheet
Liquidity
Income
statement
Solvency
Retained
earnings
statement
Profitability
Summary
Earning
Power and
Irregular Items
Discontinued
operations
Extraordinary
items
Changes in
accounting
principle
Comprehensive
income
Slide
14-4
Quality of
Earnings
Alternative
accounting
methods
Pro forma
income
Improper
recognition
Basics of Financial Statement Analysis
Analyzing financial statements involves:
Comparison
Bases
Characteristics
Liquidity
Intracompany
Horizontal
Profitability
Industry
averages
Vertical
Solvency
Slide
14-5
Tools of
Analysis
Intercompany
SO 1
SO 2
Ratio
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.
Its purpose is to determine the increase or decrease
that has taken place.
Horizontal analysis is commonly applied to the balance
sheet, income statement, and statement of retained
earnings.
Slide
14-6
SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Balance
Sheet
Illustration 14-5
These changes
suggest that the
company expanded
its asset base
during 2007 and
financed this
expansion primarily
by retaining income
rather than
assuming additional
long-term debt.
Slide
14-7
SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Income
Statement
Illustration 14-6
14-5
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.
Slide
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 balance sheet that ending retained
earnings increased 38.6%. As indicated earlier, the company retained a
significant portion of net income to finance additional plant facilities.
Slide
14-9
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
Slide
14-10
Solution on notes page
2011
SO 4 Describe 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.
Slide
14-11
SO 4 Describe and apply vertical analysis.
Vertical Analysis
Balance
Sheet
Illustration 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.
Slide
14-12
SO 4 Describe and apply vertical analysis.
Vertical Analysis
Income
Statement
Illustration 14-9
Quality appears
to be a profitable
enterprise that is
becoming even
more successful.
Slide
14-13
SO 4 Describe and apply vertical analysis.
Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 14-10
Intercompany income
statement comparison
J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C.
Penney’s net income as a percent of each sales dollar (5.6%) is only 4% of
Quality’s (12.6%).
Slide
14-14
SO 4 Describe and apply vertical analysis.
Ratio Analysis
Ratio analysis expresses the relationship among
selected items of financial statement data.
Financial Ratio Classifications
Slide
14-15
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.
Slide
14-16
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for
cash.
Slide
14-17

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.
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
Compute the Current Ratio for 2007.
Current Assets
Current Liabilities
$1,020,000
$344,500
= Current Ratio
= 2.96 : 1
The ratio of 2.96:1 means that for every dollar of
current liabilities, Quality has $2.96 of current assets.
Slide
14-18
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
Compute the Acid-Test Ratio for 2007.
Illustration 14-13
Slide
14-19
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
Compute the Acid-Test Ratio for 2007.
Cash + Short-Term Investments + Receivables (Net)
Current Liabilities
$100,000 + $20,000 + $230,000
$344.500
= Acid-Test
Ratio
= 1.02 : 1
The acid-test ratio measures immediate liquidity.
Slide
14-20
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
Compute the Receivables Turnover ratio for 2007.
Net Credit Sales
Average Net Receivables
$2,097,000
($180,000 + $230,000) / 2
=
Receivables
Turnover
= 10.2 times
It measures the number of times, on average, the
company collects receivables during the period.
Slide
14-21
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
Receivables Turnover
= 10.2 times
($180,000 + $230,000) / 2
$2,097,000
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.
Slide
14-22
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
Compute the Inventory Turnover ratio for 2007.
Cost of Good Sold
Average Inventory
$1,281,000
($500,000 + $620,000) / 2
=
Inventory
Turnover
= 2.31 times
Inventory turnover measures the number of times, on
average, the inventory is sold during the period.
Slide
14-23
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
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.
Slide
14-24
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.
Slide
14-25

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.
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Compute the Profit Margin ratio for 2007.
Net Income
Net Sales
$263,800
$2,097,000
=
Profit
Margin
= 12.6%
Measures the percentage of each dollar of sales that
results in net income.
Slide
14-26
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Compute the Asset Turnover ratio for 2007.
Net Sales
Average Assets
$2,097,000
($1,95,000 + $1,835,000) / 2
=
Asset
Turnover
= 1.22 times
Measures how efficiently a company uses its assets to
generate sales.
Slide
14-27
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Compute the Return on Assets ratio for 2007.
Net Income
Average Assets
$263,800
($1,595,000 + $1,835,000) / 2
=
Return
on Assets
= 15.4%
An overall measure of profitability.
Slide
14-28
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Compute the Return on Common Stockholders’
Equity ratio for 2007.
Return on
Net Income – Preferred Dividends
Common
=
Stockholders’
Average Common Stockholders’ Equity
Equity
$263,000 - $0
($795,000 + $1,003,000) / 2
= 29.3%
Shows how many dollars of net income the company
earned for each dollar invested by the owners.
Slide
14-29
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Compute the Earnings Per Share for 2007.
Net Income
Weighted Average Common
Shares Outstanding
$263,800
270,000 + 275,400 / 2
=
Earnings
Per Share
= $0.97 per share
A measure of the net income earned on each share of
common stock.
Slide
14-30
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Compute the Price Earnings Ratio for 2007.
Market Price per Share of Stock
Earnings Per Share
$12.00
$0.97
=
Price
Earnings
Ratio
= 12.4 times
The price-earnings (PE) ratio reflects investors’
assessments of a company’s future earnings.
Slide
14-31
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Compute the Payout Ratio for 2007.
Cash Dividends
Net Income
$61,200 *
$263,800
=
Payout
Ratio
= 23.2%
Measures the percentage of earnings distributed in the
form of cash dividends.
* From analysis of retained earnings.
Slide
14-32
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Slide
14-33
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.
Slide
14-34
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Solvency Ratios
Compute the Debt to Total Assets Ratio for 2007.
Total Debt
Total Assets
$832,000
$1,835,000
Debt to
= Total Assets
Ratio
= 45.3%
Measures the percentage of the total assets that
creditors provide.
Slide
14-35
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
Solvency Ratios
Compute the Times Interest Earned ratio for 2007.
Income before Income Taxes and
Interest Expense
Interest Expense
$468,000
$36,000
=
Times
Interest
Earned
= 13 times
Provides an indication of the company’s ability to meet
interest payments as they come due.
Slide
14-36
SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Slide
14-37
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.
These “irregular” items are reported net of income
taxes.
Slide
14-38
SO 6 Understand the concept of earning power,
and how irregular items 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).
Slide
14-39
SO 6 Understand the concept of earning power,
and how irregular items 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.
Slide
14-40
Solution on
notes page
SO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
Discontinued Operations
are reported after
“Income from continuing
operations.”
Previously labeled as
“Net Income”.
Moved to
Slide
14-41
Income Statement (in thousands)
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 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
Extraordinary items are nonrecurring material
items that differ significantly from a company’s
typical business activities.
An extraordinary item must be both of an
Unusual Nature and
Occur Infrequently
Company must consider the environment in which it
operates.
Amounts reported “net of tax.”
Slide
14-42
SO 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 manufacturer grows tobacco is rare.
YES
(b) A citrus grower's Florida crop is damaged by
frost.
NO
(c) Loss from sale of temporary investments.
NO
(d) Loss attributable to a labor strike.
NO
Slide
14-43
SO 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. Earthquakes are rare in this
geographical location.
YES
(f) Write-down of obsolete inventory.
NO
(g) Expropriation of a factory by a foreign
government.
YES
Slide
14-44
SO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
Illustration: In 2011 a foreign government expropriated
property held as an investment by Acro Energy Inc. If the
loss is $70,000 before applicable income taxes of $21,000,
the income statement will report a deduction of $49,000.
Illustration 14-30
Slide
14-45
Earning Power and Irregular Items
Extraordinary Items
are reported after
“Income from continuing
operations.”
Previously labeled as
“Net Income”.
Moved to
Slide
14-46
Income Statement (in thousands)
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
Extraordinary loss, net of tax
Net income
539
$
54,461
SO 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
Income Statement (in thousands)
Sales
Cost of goods sold
$ 285,000
149,000
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
315
Loss on disposal, net of tax
189
Total loss on discontinued operations
Extraordinary Item
Slide
14-47
504
Income before extraordinary item
54,496
Extraordinary loss, net of tax
Net income
539
$
53,957
SO 6 Understand the concept of earning power,
and how irregular items are presented.
Slide
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.
Slide
14-49
SO 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
Slide
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 availablefor-sale securities.
Plus other items
SO 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.
Slide
14-51
SO 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
the market price of stock increases and
the value of stock options increase.
Slide
14-52
SO 7 Understand the concept of quality of earnings.
Quality of Earnings
Alternative 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.
Slide
14-53
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).
Slide
14-54
SO 7 Understand the concept of quality of earnings.
Should I Play the Market?
 83.4 million Americans own stock investments, either through
mutual funds or individual stocks; 89% of stock investors own
stock mutual funds.
 44% of the people who own stock bought their first stock
before 1990.
 The typical equity investor is in his or her late 40s, is married,
is employed, and has a household income in the low $60,000s.
Slide
14-55
 58% of people who own stock said that they rely on
professional financial advisors when making decisions regarding
the purchase and sale of stock.
 46% of people who own stock used the Internet to check stock
prices, and 38% use it to read online financial publications.
Slide
14-56
The percentage of Americans who buy stock, either through
mutual funds or individual shares, has increased significantly in
recent years. A big
part of this
increase is due to
the increasing
prevalence of
employer-sponsored
retirement plans,
such as 401(k)
plans.
Source: “Equity Ownership in
America,” Investment Company
Institute and the Securities
Industry
Association, 2002, p. 1.
Slide
14-57
Rachael West has been working at her new job for six months. She
has a good salary, with lots of opportunities for growth. She has
already accumulated $8,000 in savings, which right now is sitting in a
bank savings account earning very little interest. She has decided to
take $7,000 out of this savings account and buy common stock of
her employer, a young company that has been in business for two
years. Rachael’s liquid assets, including her savings account, total
$10,000. Her monthly expenses are approximately $3,000. Should
Rachael make this investment?
YES: She has a good income, and this is a great opportunity for her
to get in on the ground floor of her employer’s fast-growing
company.
NO: She shouldn’t invest all of her money in one company,
particularly the company at which she works.
Slide
14-58
Copyright
“Copyright © 2010 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.”
Slide
14-59