Chapter 2
Accounting Information, Regression
Analysis
By
Cheng Few Lee
Joseph Finnerty
John Lee
Alice C Lee
Donald Wort
Chapter Outline
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2.1 Introduction
2.2 Financial Statement: A Brief Review
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2.3 Critique of Accounting Information
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2.4.1 Static Determination of Financial Ratios
2.4.2 Dynamic Analysis of Financial Ratios
2.4.3 Statistical Distribution of Financial Ratios
2.5 Cost-Volume-Profit Analysis and its Applications
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2.3.1 Criticism
2.3.2 Methods for Improvement
2.4 Static ratio analysis and its extension
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2.2.1 Balance Sheet
2.2.2 Statement of Earnings
2.2.3 Statement of Equity
2.2.4 Statement of Cash Flows
2.2.5 Interrelationship Among Four Financial Statements
2.2.6 Annual vs. Quarterly Financial Data
2.5.1 Deterministic Analysis
2.5.2 Stochastic Analysis
2.6 Accounting Income vs. Economic Income
2.2 Financial statement: A brief review
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Balance sheet
Income statement
Cash flow statement
Equity statement
Annual vs. quarterly financial data
2.2.1 Balance Sheet
Table 2-1 Consolidated Balance Sheets of Johnson & Johnson Inc & Consolidated Subsidiaries (2004–2009)
(Dollars in Millions)
2004
2005
2006
2007
Assets
Current Assets
Cash and Cash Equivalent ($)
Marketable Securities
Account Receivable
Inventory
Deferred Taxes on Income
Prepaid Expenses and Other Receivable
Total Current Assets
9,203
3,681
6,831
3,744
1,737
2,124
27,320
16,055
83
7,010
3,959
1,845
2,442
31,394
4,083
1
8,712
4,889
2,094
3,196
22,975
7,770
1,545
9,444
5,110
2,609
3,467
29,945
10,768
2,041
9,719
5,052
3,430
3,367
34,377
15,810
3,615
9,646
5,180
2,793
2,497
39,541
Marketable Securities — Non-current
Property, Plant and Equipment, Net
Intangible Assets, Net
Deferred Taxes on Income
Other Assets
Total Assets
46
10,436
11,842
551
3,122
53,317
20
10,830
12,175
385
3,221
58,025
16
13,044
28,688
3,210
2,623
70,556
2
14,185
28,763
4,889
3,170
80,954
14,365
27,695
5,841
2,634
84,912
14,759
31,185
5,507
3,690
94,682
Liabilities and Shareholder’s Equity
Current Liabilities
Loans and Notes Payable
Account Payable
Accrued Liabilities
Accrued Rebates, Returns, and Promotion
Accrued Salaries, Wages, and Commissions
Taxes on Income
Total Current Liabilities
280
5,227
3,523
2,297
1,094
1,506
13,927
668
4,315
3,529
2,017
1,166
940
12,635
4,579
5,691
4,587
2,189
1,391
724
19,161
2,463
6,909
6,412
2,318
1,512
223
19,837
3,732
7,503
5,531
2,237
1,432
417
20,852
6,318
5,541
5,796
2,028
1,606
442
21,731
2,565
403
2,631
1,978
2,017
211
3,065
2,226
2,014
1,319
5,584
3,160
7,074
1,493
5,402
3,829
8,120
1,432
7,791
4,206
8,223
1,424
6,769
5,947
Long-term Debt
Deferred Tax liability
Employee Related Obligations
Other Liabilities
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2008
2009
2.2.1 Balance Sheet
Table 2-1 Consolidated Balance Sheets of Johnson & Johnson Inc & Consolidated Subsidiaries (2004–2009)
(continued)
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Shareowners’ Equity
Preferred Stock-without Par Value
Common Stock-Par Value $1.00
Net Receivable from Employee Stock Plan
Accumulated Other Comprehensive Income
Retained Earnings
Less: Common Stock Held in Treasury
Total Shareowners’ Equity
—
—
—
—
—
—
3,120
−11
−515
35,223
6,004
31,813
3,120
—
−755
41,471
5,965
37,871
3,120
—
−2,118
49,290
10,974
39,318
3,120
—
−693
55,280
14,388
43,319
3,120
—
−4,955
63,379
19,033
42,511
3,120
—
−3,058
70,306
19,780
50,588
Total Liabilities and Shareholders’ Equity
53,317
58,025
70556
80954
84912
94682
2.2.2 Income Statement
Table 2-2 Consolidated Statements of Earnings of JNJ Inc. & Subsidiaries (2004-09)
(dollars in millions)
(Dollars in Millions
Except Per Share
2004
2005
2006
2007
2008
2009
Figures)
Sales to Customers ($)
47,348
50,514
53,324
61,095
63,747
61,897
Cost of Products Sold
Gross Profit
Selling, Marketing and
administrative expenses
Research Expense
Purchased in-process
research and
development
Interest Income
Interest Expense, net of
portion capitalized
Other (income) expense,
Net
Earnings before
Provision for Taxes on
Income
Provision for Taxes on
Income
Net Earnings
Basic Net Earnings per
Share ($)
Diluted Net Earnings
per Share ($)
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13,422
33,926
13,954
36,560
15,057
38,267
17,751
43,344
18,511
45,236
18,447
43,450
15,860
16,877
17,433
20,451
21,490
19,801
5,203
6,312
7,125
7,680
7,577
6,986
18
362
559
807
181
—
−195
−487
−829
−452
−361
90
187
54
63
296
435
451
15
−214
−671
1,279
−1,015
547
21,088
22,904
23,680
30,061
26,307
27,695
12,838
13,656
14,587
13,283
16,929
15,755
4,329
3,245
3,534
2,707
3,980
3,489
8,509
10,411
11,053
10,576
12,949
12,266
2.87
3.5
3.76
3.67
4.62
4.45
2.84
3.46
3.73
3.63
4.57
4.4
2.2.3 Statement of
Equity
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2.2.3 Statement of
Equity
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2.2.3 Statement
of Equity
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2.2.4 Statement of Cash
Flows
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2.2.4 Statement of Cash
Flows
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2.3
Critique of accounting information
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Criticism
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Methods for improvement
a) Use of Alternative Information
b) Statistical Adjustments
c) Application of Finance and Economic
Theories
2.4
Static ratio analysis and its extension
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Static determination of financial ratios
Dynamic analysis of financial ratios
Statistical distribution of financial ratios
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Static determination of financial ratios
Table 2.5: Company ratios period 2003-2004
Ratio Classification
Formula
J&J
Industry
2008
2009
2008
2009
Liquidity Ratio
Current Ratio
Current asset
Current liabilities
1.65
1.82
2.18
2.06
Quick Ratio
CA  inventory other CA
Current liabilities
0.61
0.89
1.61
1.51
0.48
0.45
0.48
0.49
0.96
0.84
1.02
1.04
2.00
1.87
2.10
2.12
27.78
30.39
26.49
27.16
Leverage Ratio
Debt-to-Asset
Debt-to-Equity
Equity Multiplier
Times Interest Paid
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Total debt
Total asset
Total debt
Total equity
Total asset
Total equity
EBIT
Interest expenses
Static determination of financial ratios
Table 2.5: Company ratios period 2003-2004 (Continued)
Ratio Classification
Formula
J&J
Industry
2008
2009
2008
2009
54.11
56.32
72.73
73.14
6.65
6.39
5.81
5.88
3.09
3.04
2.40
2.38
1.26
1.12
3.82
3.82
0.75
0.65
0.67
0.71
20.30%
19.80%
19.47%
19.43%
15.25%
12.95%
12.41%
12.38%
30.20%
26.40%
25.07%
24.51%
12.95
14.47
17.32
20.99
3.90
3.51
3.63
4.27
Activity Ratios
Average collection period
Accounts receivable Turnover
Inventory Turnover
Fixed Asset Turnover
Total Asset Turnover
Profitability Ratios
Profit margin
Return on assets
Return on equity
Account Re ceivable
Sales / 365
Sales
AcountsRe ceivable
Cost of Good Sold
Inventory
Sales
Fixed assets
Sales
Total assets
Net income
Sales
Net incom e
Total assets
Net Incom e
Total equity
Market value
Price/earnings
Price-to-book-value
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Market price per share
Earning per share
Market price per share
Book value per share
Dynamic Analysis of Financial Ratios
Basic Model
Yj,t=Yj,t-1+δj(Yj,t*-Yj,t-1)
where 0≤δj≤1, and
δj = A partial adjustment coefficient;
Yj,t = Firm’s jth financial ratio period t;
Yj,t-1 = Firm’s jth financial ratio period t-1; and
Y*j,t = Firm’s jth financial ratio target in period t,
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(2.1)
Dynamic Analysis of Financial Ratios
Basic Model
Y*j,t = CXj,t-1 + τj,t,
(2.2)
Yj,t -Yj,t-1 =δj[Xj,t-1-Yj,t-1]
(2.3)
Zj,t =Aj+BjWj,t-1+εj,t
(2.4)
where
Zj,t = Yj,t - Yj,t-1;
Wj,t-1 = Xj,t-1 - Yj,t-1;
Aj and Bj = Regression parameters, and
εjj,t = The error term.
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Dynamic Analysis of Financial Ratios
Extensions of Basic Model
Z′j,t = A′j + B′jW′j,t-1 + εj′j,t,
where
Z′j,t = log (Yj,t) - log (Yj,t-1);
W′j,t-1 = log (Xj,t-1) - log (Yj,t-1); and
εj′j,t = The Error term.
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(2.5)
Dynamic Analysis of Financial Ratios
Extension of Basic Model
 log(Y j ,t / Y j ,t 1 )
Bj 
 log( X j ,t 1 / Y j ,t 1 )
% change in [Yj,t / Y j ,t 1 ]

% change in [X j,t-1 / Y j ,t 1 ]
Yj,t*  CX j ,t 1
(2.7)
Yj ,t  Aˆ  Bˆ1 X j ,t 1  Bˆ2Yj ,t 1   j ,t
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(2.6)
(2.8)
Dynamic Analysis of Financial Ratios
Empirical Data
Table 2.6: Dynamic adjustment ratio regression results
Variable
Current Ratio
Leverage Ratio
Mean Z
0.0075
-0.03083
Mean W
-0.14583
0.361666667
Var(Z)
0.013039
0.006099
Cov(Z,W)
0.074
0.009
Bj`
0.810*
0.259
t-Statistics
[3.53]
[1.06]
Aj`
0.032
-0.042
* Partial adjustment coefficient significant at 95% level
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Dynamic Analysis of Financial Ratios
Empirical Data
Table 2.7: Ratio correlation coefficient matrix
CR
CR
AT
GPM
LR
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AT
GPM
LR
1.0
-0.443841
1.0
0.363273
0.381393
1.0
-0.51175
0.21961
-0.05028
1.0
Dynamic Analysis of Financial Ratios
Empirical Data
Z1,t = A0 +A1Z2,t + A2W1 + εj1,t, (2.9a)
Z2,t = B0 + B1Z1,t + B2W2 + εj2,t. (2.9b)
where
Ai, Bi (i = 0, 1, 2) are coefficients, εj1 and εj2 are error terms,
and
Z1,t = Individual firm’s current ratio in period t individual firm’s current ratio in period t-1;
Z2,t = Individual firm’s leverage ratio in period t individual firm’s leverage ratio period t-1;
W1,t = Industry average current ratio in period t-1 individual firm’s current ratio period t-1;
W2,t = Industry average leverage ratio in period t-1 individual firm’s leverage ratio in period t-1.
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Dynamic Analysis of Financial Ratios
Empirical Data
Table 2.8: Johnson & Johnson empirical results for the simultaneous equation
system
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A0(B0)
A1(B1)
A2(B2)
(2.9a)
-0.071
[-1.80]
-0.378
[-5.52]
0.080
[1.20]
(2.9b)
-0.0577
[-1.59]
-0.842
[-6.07]
0.074
[0.91]
Statistical Distribution of Financial Ratios
1
 ( X   )2 / 2 2
F[ X ] 
e
 2
(    X  ),
(2.10)
where μ and σ2 are the population mean and variance, respectively, and e and π
are given constants; that is, π= 3.14159 and e = 2.71828.
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Statistical Distribution of Financial Ratios
There is a direct relationship between the normal distribution and
the log-normal distribution. If Y is log-normally distributed, then
X = log Y is normally distributed. Following this definition, the
mean and the variance of Y can be defined as:
1 2
Y  exp(x   x ),
2
Y2  exp(2x   x2 )(exp( x2 )  1),
(2.11a)
(2.11b)
where exp represents an exponential with base e.
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Deterministic
Analysis
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2.5 COST-VOLUME-PROFIT ANALYSIS AND ITS
APPLICATIONS
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Deterministic analysis
Stochastic analysis
Deterministic Analysis
Operating Profit = EBIT = Q(P－V)－F,
where
Q = Quantity of goods sold;
P = Price per unit sold;
V = Variable cost per unit sold;
F = Total amount of fixed costs; and
P - V = Contribution margin.
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(2.12)
Deterministic Analysis
F
Q 
(P  V )
*
(2.13)
% Change in profits
Q( P  V )
Fixed Costs
DOL 

=1 
% Change in sales Q( P  V )  F
Profits
DOL 
1
.
*
[1  (Q / Q)]
(2.15)
Operating profit = EBIT = Qπ(Pπ － Vπ) －F.
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(2.16)
(2.14)
Deterministic Analysis
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2.6 ACCOUNTING INCOME VS. ECONOMIC
INCOME
Et = At + Pt,
where
Et = Economic income,
At = Accounting earnings,
and
Pt = Proxy errors.
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(2.17)
2.7 SUMMARY
In this chapter, the usefulness of accounting information in financial
analysis is conceptually and analytically evaluated. Both statistical
methods and regression analysis techniques are used to show how
accounting information can be used to perform active financial analysis
for the pharmaceutical industry.
In these analyses, static ratio analysis is generalized to dynamic ratio
analysis. The necessity of using simultaneous-equation technique in
conducting dynamic financial ratio analysis is also demonstrated in
detail. In addition, both deterministic and stochastic CVP analyses are
examined. The potential applications of CVP analysis in financial
analysis and planning are discussed in some detail. Overall, this chapter
gives readers a good understanding of basic accounting information and
econometric methods, which are needed for financial analysis and
planning.
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