CHAPTER18
Financial Statement
Analysis
Acct202 - 5
18-1
PreviewofCHAPTER18
18-2
Basics of Financial Statement Analysis
Analyzing financial statements involves:
Comparison
Bases
Characteristics

Liquidity

Intracompany

Horizontal

Profitability


Vertical

Solvency
Industry
averages

Ratio

18-3
Tools of
Analysis
SO 1
SO 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.
18-4

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.
SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Illustration 18-5
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.
18-5
SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Illustration 18-6
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.
18-6
SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Illustration 18-7
Horizontal analysis of
retained earnings
statements
18-7
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.
SO 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.
18-8

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.
SO 4 Describe and apply vertical analysis.
Vertical Analysis
Illustration 18-8
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.
18-9
SO 4 Describe and apply vertical analysis.
Vertical Analysis
Illustration 18-9
Vertical analysis of
Income statements
Quality appears
to be a profitable
enterprise that is
becoming even
more successful.
18-10
SO 4 Describe and apply vertical analysis.
Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 18-10
Intercompany income
statement comparison
18-11
SO 4 Describe and apply vertical analysis.
Ratio Analysis
Ratio analysis expresses the relationship among selected
items of financial statement data.
Financial Ratio Classifications
18-12
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.
18-13
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.
18-14

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
1. Current Ratio
Liquidity Ratios
Illustration 18-12
Ratio of 2.96:1 (or 2.96) means that for every dollar of current
liabilities, Quality has $2.96 of current assets.
18-15
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
2. Acid-Test Ratio
Illustration 18-13
18-16
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
2. Acid-Test Ratio
Illustration 18-14
Acid-test ratio measures immediate liquidity.
18-17
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
18-18
Ratio Analysis
Liquidity Ratios
3. Receivables Turnover
Illustration 18-15
Measures the number of times, on average, the company collects
receivables during the period.
18-19
SO 5
Liquidity Ratios
Ratio Analysis
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
Receivables are collected on average every 36 days.
18-20
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
4. Inventory Turnover
Illustration 18-16
Measures the number of times, on average, the inventory is sold
during the period.
18-21
SO 5
Liquidity Ratios
Ratio Analysis
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.
18-22
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 common stockholders’ equity,
earnings per share, price-earnings, and payout ratio.
18-23
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
5. Profit Margin
Illustration 18-17
Measures the percentage of each dollar of sales that results in
net income.
18-24
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
6. Asset Turnover
Illustration 18-18
Measures how efficiently a company uses its assets to generate
sales.
18-25
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Profitability Ratios
Ratio Analysis
7. Return on Asset
Illustration 18-19
An overall measure of profitability.
18-26
SO 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 18-20
Shows how many dollars of net income the company earned for
each dollar invested by the owners.
18-27
SO 5
Ratio Analysis
Profitability Ratios
9. Earnings Per Share (EPS)
Illustration 18-22
A measure of the net income earned on each share of common
stock.
18-28
SO 5
Ratio Analysis
Profitability Ratios
10. Price-Earnings Ratio
Illustration 18-23
Measures the net income earned on each share of common stock.
18-29
SO 5
Ratio Analysis
Profitability Ratios
11. Payout Ratio
Illustration 18-24
Measures the percentage of earnings distributed in the form of
cash dividends.
18-30
SO 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.
18-31
SO 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 18-25
Measures the percentage of the total assets that creditors provide.
18-32
SO 5
Ratio Analysis
Solvency Ratios
13. Times Interest Earned
Illustration 18-26
Provides an indication of the company’s ability to meet interest
payments as they come due.
18-33
SO 5
Ratio Analysis
Summary of Ratios
Illustration 18-27
18-34
SO 5
Summary of Ratios
Illustration 18-27
18-35
SO 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.
18-36
SO 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).
18-37
SO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
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.
18-38
SO 6
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
18-39
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
Nonrecurring material items that differ significantly from a
company’s typical business activities.

18-40
Must be both of an
►
Unusual Nature and
►
Occur Infrequently.

Must consider the environment in which it operates.

Amounts reported “net of tax.”
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
NO
frost.
(c) Loss from sale of temporary investments.
NO
(d) Loss attributable to a labor strike.
NO
18-41
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
18-42
SO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
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.
18-43
SO 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.”
Previously labeled as
“Net Income”.
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
Moved to
18-44
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.
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:
Discontinued
Operations
Loss from operations, net of tax
315
Loss on disposal, net of tax
189
Total loss on discontinued operations
504
Income before extraordinary item
Extraordinary Item
Extraordinary loss, net of tax
Net income
18-45
54,496
539
$
53,957
SO 6 Understand the concept of earning power,
and how irregular items are presented.
18-46
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.
18-47

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.
SO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
All changes in stockholders’
equity except those resulting
from investments by
stockholders and distributions
to stockholders.
Comprehensive Income
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
18-48
$ 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
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.
18-49
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
18-50

the market price of stock increases and

the value of stock options increase.
SO 7 Understand the concept of quality of earnings.
Quality of Earnings
Comprehensive Income

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.
18-51
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:
18-52

Improper recognition of revenue (channel stuffing).

Improper capitalization of operating expenses
(WorldCom).

Failure to report all liabilities (Enron).
SO 7 Understand the concept of quality of earnings.