BA213: Chapter 15—Financial Statement Analysis
Study Objectives:
1.
2.
3.
4.
5.
Discuss the need for comparative analysis.
Identify the tools of financial statement analysis.
Explain and apply horizontal analysis.
Describe and apply vertical analysis.
Identify and compute ratios and describe their purpose and use 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.
1. BASIC OF FINANCIAL STATEMENT ANALYSIS
A. Introduction: The definition of accounting which is introduced in the first chapter
of the accounting textbook accounting process involves identifying and analyzing
business transactions; classifying the transactions according to the section(s) of the
accounting equation involved and if a particular account is increased or decreased;
recording transactions in the permanent record; summarizing the transactions in the
form of financial statements; and finally interpreting where conclusions and
decisions are made from the financial statements. Throughout the chapters in the
textbook, ratios have been computed to analyze financial statements or sections of the
financial statements. This chapter brings the entire process together of “Financial
Statement Analysis” where we look for relationships among the many figures on the
financial statements.
B. Analyzing financial statements involves evaluating three characteristics
of a company: its liquidity, its solvency, and its profitability.
1. Define liquidity: the ability of a business to pay its debts when they fall due. It
is the ability of a business to convert its assets into cash, which is the most liquid
asset. In this chapter, this topic will be covered under the heading RATIO
ANALYSIS and under the subheading LIQUIDITY RATIOS.
2. Define solvency: the ability of a business to survive over a long period of time.
In this chapter, this topic will be covered under the heading RATIO ANALYSIS
and under the subheading SOLVENCY RATIOS.
3. Define profitability: the ability of a business to earn a reasonable return on the
owners’ investments. It measures the income or operating success of an enterprise
for a given period of time. Income, or the lack of it, affects the company’s ability
to obtain debt and equity financing. In this chapter, this topic will be covered
under the heading RATIO ANALYSIS and the subheading PROFITABILITY
RATIOS.
C. NEED FOR COMPARATIVE ANALYSIS
1. Financial statements are analyzed to gain greater insights into the firm to
provide information from which the users of that information can make good
judgments and decisions. The accounting process involves transforming the
data into useful information for decision-making and communicating information
to users. Users include owners and managers of the business, creditors, tax agencies,
governmental bodies, and others.
2. Users of the financial statements are interested in the characteristics of a
company’s liquidity, its solvency, and its profitability.
a) A short-term creditor, such as a bank, is primarily interested in the ability
of the borrower to pay obligations when they come due. The liquidity of the
borrower is extremely important is evaluating the safety of a loan.
b) A long-term creditor, such as a bondholder, however looks to profitability
and solvency measures that indicate the company’s ability to survive over a
long period of time. Long-term creditors consider such measures as the amount
of debt in the company’s capital structure and its ability to meet interest
payments.
c) Owners/stockholders are interested in profitability and solvency of the
company. They want to access the likelihood of dividends and the growth
potential of the stock.
3. In order to obtain information as to whether the amount of cash a company
reports such as Sears, Roebuck and Co. (1) represents an increase over
prior years or (2) is adequate in relation to the company’s need for
cash, the amount of cash must be compared with other financial
statement data. Comparisons can be made on a number of different
bases such as the following:
4. Intracompany basis compares an item or financial relationship within a company
in the current year with the same item or relationship in one or more prior years.
Intracompany comparisons are useful in detecting changes in financial
relationships and significant trends.
5. Industry averages compares an item or financial relationship of a company with
industry averages (or norms) published by financial ratings. Industry averages
comparisons are useful to provide information as to a company’s relative
performance within the industry.
6. Intercompany basis compares an item or financial relationship of one company
with the same item or relationship in one or more competing companies.
Intercompany comparisons are useful in determining a company’s competitive
position.
D. TOOLS OF FINANCIAL STATEMENT ANALYSIS
1. Three commonly used tools are utilized to evaluate the significance of
financial statement data.
a) Horizontal analysis (trend analysis) evaluates a series of financial
statement data over a period of time.
b) Vertical analysis evaluates financial statement data expressing each item in
a financial statement as a percent of a base amount.
c) Ratio analysis expresses the relationship among selected items of financial
statement data.
2. Horizontal analysis is used primarily in intracompany comparisons.
Published financial statements facilitate this type of comparison because:
a) Each of the basic financial statements shows a minimum of 2
years.
b) Summary of selected data will show 5 – 10 years or more.
3. Vertical analysis is used in both intra- and intercompany
comparisons.
4. Ratio analysis is used in all three types of comparisons.
II. HORIZONTAL ANALYSIS
A. Horizontal analysis is the comparison of each item in a company’s financial
statements in the current period with the same item from a previous accounting period or
periods. Horizontal analysis compares one year to another and is also called trend
analysis.
B. The purpose of horizontal analysis is to determine the increase or decrease that
has taken place this change may be expressed as either an amount or a percentage.
The recent net sales figures of J.C. Penney Company.
1. Given that 2013 is the base year, we can measure all percentage
increases or decreases from this base period amount as follows where CY is
Current Year and BY is Base Year or can use PY for Prior year:
CY
- BY or PY
÷
BY or PY = “CHANGE” since BY or PY
An easy way to remember how to calculate change is using IS and WAS as follows:
IS
WAS
÷
WAS
=
“CHANGE” since WAS
Applying the formula to JC. Penney’s net sales from 2013 to 2014:
$18,096
- $17,513 ÷
$17,513
= 3.3% increase from 2013 to 2014
HORIZONTAL ANALYSIS example:
$150,000
- $100,000 ÷
$100,000
= 50% increase in 2013 from 2015
CY
BY
÷
BY
“CHANGE” since BY
IS
WAS
÷
WAS
“CHANGE” since WAS
2. Alternatively, we can express current year sales as a percentage of the
base period. This is done by dividing the current year amount. Part of
horizontal analysis is determining, “Trend Percentages” which are measures
used to compare financial data over a period of years, in which one year is selected as
the base year, and every other year’s amount is expressed as a percent of the base
year’s amount. In horizontal analysis, the earlier year is always the base year in
calculating percent increase or percent decrease. Percentage expressions are
more meaningful than dollar amounts.
CY Amount ÷
BY Amount
=
CY results in relation to BY
3. The percentage of the base period for each of the 3 years, assuming 2013 as the
base period, is shown where 2015 is calculated as follows:
CY Amount ÷
BY Amount
=
CY results in relation to BY
$18,781
÷
$`17,513
= 107.24% for 7.24% inc. (change)
C. BALANCE SHEET
1. The two-year condensed balance sheet of Quality Department Store Inc. for 2015
and 2014 would show dollar and percentage changes.
2. The comparative balance sheets show a number of significant changes that
occurred in Quality Department Store’s financial structure from 2014 to 2015:
a) In the asset section, plant assets (net) increased $167,500 or 26.5%.
b) In the liabilities section, current liabilities increased $41,500 or 13.7%.
c) In the stockholders’ equity section, retained earnings increased
$202,600 or 38.6%.
d) ANALYSIS: It appears the company expanded its asset base during
2015 and financed the expansion by retaining income in the firm .
D. INCOME STATEMENT
1. The two-year comparative income statements of Quality Department Store Inc.
for 2015 and 2014.
2. HORIZONTAL ANALYSIS of the comparative income statement shows the
following changes:
a) Net sales increased $260,000, or 14.2% ($260,000 ÷ $1,837,000).
b) Cost of goods sold increased $141,000, or 12.4% ($141,000 ÷ $1,140,000).
c) Total operating expenses increased $37,000, or 11.6% ($37,000 ÷ $320,000).
d) ANALYSIS: Overall, gross profit and net income were up
substantially. Gross profit increased 17.1%, and net income, 26.5%.
Quality’s profit trend appears favorably.
E. RETAINED EARNINGS STATEMENT
1. A horizontal analysis of Quality Department Store’s comparative retained
earnings statements.
2. Analyzed horizontally:
a) Net income increased $55,300, or 26.5%.
b) Common dividends increased only $1,200, or 2%.
c) Ending retained earnings increased 38.6%.
3. ANALYSIS: As indicated above the company retained a significant portion
of net income to finance additional plant facilities.
F. COMMENTS ON HORIZONTAL ANALYSIS:
1. When using horizontal analysis, both dollar amount changes and
percentage changes need to be examined.
a) It is not necessarily bad if a company’s earnings are growing at a
declining rate.
b) The amount of increase may be the same as or more than the base
year.
c) The percentage change may be less because the base is greater each
year.
2. Complications can occur in making the computations:
a) If an item has no value in a base year and a value in the next year, no
percentage change can be computed.
b) If a negative amount appears in the base or preceding period, and a
positive amount exists the following year (or vice versa), no
percentage change can be computed
III.
VERTICAL ANALYSIS
A. Describe and apply vertical analysis, also called common size analysis.
Vertical analysis compares each item on the statement to an item
considered to be the base. VERTICAL ANALYSIS of the income
statement reflects the size of each item relative to a base amount (Net
Sales) where each item is divided by Net Sales. The COMMON
SIZE ANALYSIS restates each item on a financial statement in
terms of percentage of a base amount which enables the comparison
of companies of different sizes (BIG COMPANY vs. SMALL
COMPANY).
1. For the income statement, net sales is the base.
2. For the balance sheet, total assets (or total liabilities and owner’s
equity) is the base.
3. Once percents are calculated for one year, they can be compared to
the same calculations for another year to see if the relative
importance of an item has changed.
B. BALANCE SHEET
1. The two-year comparative balance sheet of Quality Department Store Inc.
for 2015 and 2014.
2. The base for asset items is total assets and the base for the liability and
stockholders’ equity items are total liabilities and owner’s equity.
Vertical analysis shows the relative size of each category in the
balance sheet as well as percentage change in the individual asset,
liability, and stockholders’ equity items.
a) The formula to compute the percentage with Vertical Analysis:
Asset item
or Asset
section
÷
Total Assets
= “PERCENT” of Base for relative importance
÷
Total Assets
= “PERCENT” of Base for relative importance
For Quality Department stores:
Current
Assets
$945,000
$1,020,000
÷
÷
÷
b)
c)
d)
e)
Total Assets = “PERCENT” of Base for relative importance
$1,595,000
=
59.25%
$1,835,000
=
55.59%
Current assets increased $75,000 from 2014 to 2015; but they decreased
from 59.2% to 55.6% of total assets.
Plant assets (net) increased from 39.7% to 43.6% of total assets.
Retained earnings increased from 32.9% to 39.7% of total liabilities and
stockholders’ equity.
ANALYSIS: These results reinforce earlier observations that Quality is
financing its growth through retention of earnings rather than
from issuing additional debt.
C. INCOME STATEMENT
1. Vertical analysis of the two-year comparative income statement of Quality
Department Store Inc. for 2015 and 2014.
2. For the income statement, net sales is the base.
a) of goods sold as a percentage of net sales declined 1% (62.1% versus
61.1%).
b) Total operating expenses declined 0.4% (17.4% versus 17.0%).
c) Net income as a percent of net sales therefore increased from 11.4% to
12.6%.
3. ANALYSIS: Quality appears to be a profitable enterprise that is
becoming more successful.
4. An associated benefit of vertical analysis is that Vertical analysis
enables you to compare companies of different sizes.
a) Quality’s major competitor is a JC Penney store in a nearby town.
b) Using vertical analysis, the small Quality Department Store Inc. can be
meaningfully compared to the much larger J.C.
Penney.Intercompany income statement comparison where
Vertical Analysis eliminates this difference in size:
1) Gross profit rates were somewhat comparable at 38.9% and
39.3%.
2) Income from operations percentages were significantly different at
21.9% and 8.4%.
3) Quality’s selling and administrative expense percentage (17%) is
much lower than JC Penney’s (30.9%).
4) JC Penney’s net income as a percentage of sales (percent of each
sales dollar) was much lower than Quality’s (5.8% to 12.6 %.)
IV.
RATIO ANALYSIS
A. INTRODUCTION—Ratio analysis expresses the relationship among
selected items of the financial statement data. A ratio expresses a
mathematical relationship between one quantity and another. The relationship is
expressed in terms of either a percentage, a rate, or a simple proportion. A
single ratio by itself is not very meaningful, in the illustrations that
will be used. Therefore the following types of comparisons will be
used:
1. Intracompany comparisons for two years for the Quality Department
Store.
2. Industry average comparisons based on median ratios for department
stores from Dun & Bradstreet and Robert Morris Associates’ median ratios.
3. Intercompany comparisons based on the J.C. Penney Company, as
Quality Department Store’s principal competitor.
4. The three financial ratio classifications: Liquidity Ratios;
Profitability Ratios; and Solvency Ratios.
B. LIQUIDITY RATIOS.
1. Introduction: Liquidity is the ability of a business to pay its debts
when they fall due Liquidity ratios measure the short-term ability
of the enterprise to pay its maturity obligations and to meet
unexpected needs for cash.
2. Current Ratio
a) The current ratio (working capital ratio) is a widely used measure
for evaluating a company’s liquidity and short-term debt-paying ability.
Working capital = current assets - current liabilities. The current
ratio is a more dependable indicator of liquidity than working capital.
b) A standard or benchmark for this ratio is 2 to 1 or $2.00 in
current assets for every $1.00 in current liabilities.
c) It is computed by dividing current assets by current liabilities and
is a more dependable indicator of liquidity than working capital where
formula shown below applying it to Quality and compared to the
Industry average and to J.C. Penney (NOTE: the ratio is taken two
places which indicated in dollars and cents the amount of current
assets to current liabilities):
Current Assets
÷ Current Liabilities
=
Current Ratio
Quality Department Store for 2015
$1,020,000
÷
$344,500
=
2.96:1
J.C. Penney Company
=
5.72:1
Industry average
=
1.28:1
d) ANALYSIS:
1) For 2015, the current ratio of 2.96:1 means that there is $2.96
of current assets for every $1.00 of current liabilities.
2) The current ratio for 2015 has decreased from 2014.
3) But compared to the benchmark of 2:1 and the industry
average, Quality appears to be reasonably liquid. J.C.
Penney has an unusually high current ratio which means it
has considerable current assets to current liabilities.
3. Acid-Test Ratio
a) A disadvantage of the current ratio is that it does not take into
account the composition of the current assets. For example, a
satisfactory current ratio does not disclose the fact that a
portion of the current assets may be tied up in slow-moving
inventory.
b) The acid-test ratio (quick ratio) is a measure of a company’s shortterm liquidity. Since the current ratio does not deal with the
composition of current assets, the quick ratio shows the ability of
the firm to convert current assets to cash to pay the current
liabilities so this ratio shows the immediate debt-paying ability
of the company.
c) A standard or benchmark for this ratio is 1 to 1 or $1.00 of
quick assets to every $1.00 of current liabilities.
d) It is computed by dividing the sum of cash, marketable securities,
and net receivables by current liabilities:
Cash + S/T Investments +”Net” Rec.
÷ C. Liabilities =
Acid-Test Ratio
e) The acid-test ratios for Quality Department Store and comparative data
shows this ANALYSIS:
1) The ratio has declined in 2015.
2) But when compared with the industry average and JC
Penney’s, Quality’s acid-test ratio seems adequate.
4. Receivables Turnover
a) The receivables turnover ratio is used to assess the liquidity of the
receivables. It measures the number of times, on average;
receivables are collected during the period.
b) The ratio is computed by dividing net credit sales by average
net receivables shown as follows for Quality Department Store for
2015:
Net Credit Sales ÷
$2,097,000
÷
Average “NET” Receivables
$180,000
+
$230,000
2
=
Receivables Turnover
=
10.2 Times
c) The receivables turnover for Quality Department Store and
comparative data shows this ANALYSIS:
1) The ratio has increased from 2014 to 2015.
2) Even though it is substantially lower than JC Penney’s
ratio, it is similar to the department store’s industry’s
average of 10.8 times.
d) The average collection period converts the receivables turnover
in terms of days by dividing the receivables turnover ratio into
365 days.
For example the above receivables turnover of 10.2 times is
converted into the average collection period as follows:
365 days.
÷ Receivables Turnover = Average Collection Period
10.2
365
÷
=
35.8 days or 36 days
The average collection period is frequently used to assess the
effectiveness of a company’s credit and collection policies.
The general rule is that the collection period should NOT
greatly exceed the credit term period (the time allowed for
payment).
5. Inventory Turnover
a) The inventory turnover ratio measures the number of times, on
average; the inventory is sold during the period. Its purpose is
to measure the liquidity of the inventory.
b) It is computed by dividing cost of goods sold by average
inventory during the year shown as follows for Quality Department
Store for 2015:
÷
= Inventory Turnover
COGS
Average Inventory
$500,000
+
$620,000
$1,281,000
÷
=
2.3 Times
2
c) The inventory turnover is showing forQuality Department Store
and comparative data this ANALYSIS:
1) The ratio has declined slightly in 2015.
2) It is relatively low compared to the industry average and JC
Penney’s.
3) Generally, the faster the inventory turnover, the less cash
that is tied up in inventory and the less chance of inventory
obsolescence.
d) The average days to sell inventory converts the inventory
turnover in term of days and is calculated by dividing the
inventory turnover into 365 days.
1) For example the above receivables turnover of 10.2 days is
converted into the average collection period as follows:
Inventory Turnover
365 days.
÷
= Ave. Days to Sell Inventory
2.3
365
÷
=
158.7 days or 159 days
2) ANALYSIS: This is relatively high compared to the
industry average of 54.5 days and Sears’s of 79.3 days.
C. PROFITABILITY RATIOS:
1. Introduction—Profitability ratios measure the income and
operating success of an enterprise for a given period of time.
a) Without income (profit), the company’s ability to obtain debt
and equity financing.
b) The company’s liquidity position and the company’s ability to
grow is also affected by the amount of income or profit.
c) Therefore, both creditors and investors are interested in
evaluating earning power—profitability and often used as the
ultimate test of management’s operating effectiveness.
2. Profit Margin
a) The profit margin ratio is a measure of the percentage of each
dollar of sales that results in net income.
b) It is computed by dividing net income by net sales shown as
follows for Quality Department Store for 2015:
Net Income
$263,800
÷
÷
Net Sales
$2,097,000
=
=
Profit Margin on Sales
12.6%
c) The profit margin on sales is showing for Quality Department
Store and comparative data this ANALYSIS:
Quality experienced an increase in its profit margin from 2014
to 2015.
Its profit margin is unusually high in comparison with the
industry average of 3.6% and JC Penney’s 3.7%.
3. Asset Turnover
a) Asset turnover measures how efficiently a company uses its
assets to generate sales.
b) It is determined by dividing net sales by average assets shown as
follows for Quality Department Store for 2015.
÷
=
Average Assets
Asset Turnover
$1,595,000 +
$1,835,000
÷
=
1.22 Times
2
Net Sales
$2,097,000
c) The asset turnover is showing for Quality Department Store and
comparative data this ANALYSIS:
Asset turnover shows that in 2015 Quality generated sales of
$1.22 for each dollar it had invested in assets. The ratio
changed little from 2014 to 2015.
Quality’s asset turnover is below the industry average and JC
Penney’s ratio.
4. Return on Assets
a) An overall measure of profitability is return on assets.
b) It is computed by dividing net income by average assets for the
period shown as follows for Quality Department Store for 2015:
=
Net Income ÷
Average Assets
Return on Assets
$263,800
÷
$1,595,000
+
$1,835,000
2
=
15.4% Times
c) The return on assets is showing in for Quality Department Store
and comparative data this ANALYSIS:
Quality’s return on assets improved from 2014 to 2015.
Its return is very high compared with the department store
industry average and JC Penney’s.
5. Return on Common Stockholders’ Equity
a) A ratio that measures profitability from the viewpoint of the
common stockholder is return on common stockholders’
equity.
b) It is computed by dividing net income by average common
stockholders’ equity period shown as follows for Quality Department
Store for 2015.
Net Income
÷
$263,800
÷
Average Common S/H’s Equity
$795,000
+
$1,003,000
2
=
Return on Common
S/H’s Equity
=
29.3% Times
c) When preferred stock is present, preferred dividend
requirements are deducted from net income to compute
income available to common stockholders.
d) The par value of preferred stock (or call price – if applicable)
must be deducted from total stockholders’ equity to determine
the amount of common stockholders’ equity used in this ratio.
The ratio then appears as shown below:
Net Income –
Preferred Div.
÷
Average Common S/H’s Equity
=
Rate of Return on
Common S/H’s Equity
e) The return on common stockholders’ equity is showing for
Quality Department Store and comparative data this
ANALYSIS:
1) Quality’s return on common stockholder’s equity improved
from 2014 to 2015.
2) Quality’s rate of return is higher than both the industry
average and JC Penney’s.
3) Quality’s rate of return on stockholder’s equity (29.3%) is
substantially higher that its rate of return on assets (15.4%).
This is because Quality has made effective use of leverage or
trading on the equity at a gain which means that the
company has borrowed money at a lower rate of interest
than it is able to earn by using the borrowed money.
a. Leverage enables Quality to use money supplied by
nonowners (creditors) to increase the return to its
owners.
b. A comparison of the rate of return on total assets with
the rate of interest paid for borrowed money indicates
the profitability of trading on the equity. Quality earns
more on its borrowed funds than it has to pay in interest.
6. Earnings per Share (EPS)
a) Earnings per share (EPS) is a measure of net income earned on
each share of common stock.
b) It is calculated by dividing net income by the number of
weighted average common shares outstanding during the year
Net Income
$263,800
shown as follows for Quality Department Store for 2005:
Wt. Average Common S/H’s O/S
=
Earnings per Share
270,000
+
275,400
÷
=
$.97/ share
2
÷
c) The earnings per share is showing for Quality Department Store
and comparative data this ANALYSIS:
1) Quality’s EPS increased 20 cents per share in 2015 which
represents a 26% increase over the 2014 EPS.
2) Note that no industry or JC Penney’s data presented as
such comparisons are not meaningful because of the wide
variations in the number of shares outstanding stock among
companies. The only meaningful EPS is an intracompany
trend comparison.
3) In computing EPS, preferred dividends declared for the
period, must be deducted from net income to determine
income available to the “common” stockholders.
7. Price-Earnings Ratio
a) The price-earnings (PE) ratio measures the ratio of the market
price of each share of common stock to the earnings per share.
b) It is computed by dividing the market price per share of
common stock by earnings per share shown as follows for Quality
Department Store for 2015.
Mkt Price/Share of Stock ÷
$12.00
÷
EPS
$.97
= Price-Earnings Ratio
=
12.4 times
c) The price-earnings ratio is showing for Quality Department
Store and comparative data this ANALYSIS:
1) In 2015 each share of Quality’s stock sold for 12.4 times the
amount that was earned on each share which was higher
than the 2014 of 10.4 times.
2) Quality’s PE ratio is lower than the industry average and
the ratio for JC Penney.
8. Payout Ratio
a) The payout ratio measures the percentage of earnings
distributed in the form of cash dividends.
b) It is computed by dividing cash dividends by net income shown
as follows for Quality Department Store for 2015.
Cash Dividends
$61,200
÷
÷
Net Income
$263,800
=
=
Payout Ratio
23.2%
c) The payout ratio is showing for Quality Department Store and
comparative data this ANALYSIS:
1) Quality’s payout ratio was lower in 2015 than in 2014.
2) It is much higher than the industry average and JC Penney.
D. SOLVENCY RATIOS:
1. Introduction—Solvency ratios measure the ability of the company
to survive over a long period of time. Long-term creditors and
stockholders are particularly interested in the company’s ability
to pay interest as it comes due and to repay the face value of debt
at maturity.
2. Debt to Total Assets Ratio
a) The debt to total assets ratio measures the percentage of total
assets provided by creditors. This ratio indicates the
company’s degree of leverage and provides some indication of
the company’s ability to withstand losses without impairing the
interests of creditors. The higher the percentage the greater the
risk that the company may be unable to meet its maturity
obligations.
b) The prudent range for the debt to total assets is considered to
be 50 percent or less.
c) It is computed by dividing total debt by total assets shown as
follows for Quality Department Store for 2015.
÷ TOTAL ASSETS =
TOTAL DEBT
Debt to Total Assets
$832,000
÷
$1,835,000
=
45.3%
d) The debt to total assets ratio is showing for Quality Department
Store and comparative data this ANALYSIS:
1) Quality’s 2015 debt to total assets ratio is lower than the
2014 which means that it is improving and below the
prudent range.
2) Quality’s ratio is above the industry average but much
lower that JC Penney’s. The lower the ratio, the more
equity buffer there is available to creditors.
3. Times Interest Earned
a) Times interest earned provides an indication of the company’s
ability to meet interest payments as they come due. The higher
this ratio the better.
b) It is computed by dividing income before income taxes and
interest expense by interest expense shown as follows for Quality
Department Store for 2015:
÷ Interest Expense
Income Before Income Taxes
and Interest Expense
$468,000
÷
$36,000
=
Times Interest Earned
=
13 times
c) The times interest earned is showing for Quality Department
Store and comparative data this ANALYSIS:
1) Quality times interest earned improved from 2014 to 2015
as it is covering its interest more times.
2) Quality’s ratio is above the industry average and JC Penney’s.
V.
EARNING POWER AND IRREGULAR ITEMS
A. Users of financial statements are interested in the concept of
“earning power.”
1. Earning power differs from actual net income by the amount of
irregular revenues, expenses, gains, and losses.
2. Users are interested in earning power because it helps them derive an
estimate of future earnings without irregular items.
B. For users of financial statements to determine “earning power” or
regular income, the “irregular” items are separately identified on the
income statement. Three types of “irregular” items are reported:
1. In studying financial statements, users may ask: (1) Are the results typical of
the company? (2) Are the results a reasonable indicator of the company’s
future earnings? Therefore accountants have concluded that material items
not typical of regular operations should also be reported through additional
sections should be added to the income statement to report material items not
typical of regular operations.
a) Non-typical “irregular” items include:
1) Discontinued operations
2) Extraordinary items
3) Changes in accounting principle
b) Each item should be carefully explained in footnotes to financial
statements, and the income statement should report the income tax
expense or savings applicable to each item.
C. DISCONTINUED OPERATIONS
1. Discontinued operations refer to the disposal of a significant segment of a
business. Examples are the cessation of an entire activity or the elimination
of a major class of customers.
2. Following the disposal, the income statement should report both income from
continuing operations and income (loss) from discontinued operations.
3. The income (loss) from discontinued operations consists of:
a) (1) income (loss) from operations and
b) (2) gain (loss) on disposal of the segment.
4. Both components are reported net of applicable taxes in a section entitled
Discontinued Operations, which follows Income from Continuing
Operations.
5. Examples will show the caption, “Income from continued operations”
is used and that a new section “Discontinued operations” is added.
Within the new section, the two subsections presentation which clearly
indicates the separate effects of the discontinued operations from the
continuing operations:
a) Operating income or loss that occurred during the year from the discontinued
operation net of applicable taxes.
b) The income or the loss on from disposing of the operation net of applicable
taxes.
D. EXTRAORDINARY ITEMS:
1. Extraordinary items are events and transactions that meet two conditions:
a) unusual in nature and
b) infrequent in occurrence.
2. To be unusual, the item should be:
a) abnormal and
b) be only incidentally related to customary activities of the entity.
3. To be infrequent, the item should not be reasonably expected to recur in the
foreseeable future.
4. Extraordinary items are reported net of taxes in a separate section of the
income statement immediately below discontinued operations.
5. Examples of extraordinary and ordinary items Illustration: Assume
that in 2018 a revolutionary 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 presentation will show a
deduction of $49,000 ($70,000 loss - $21,000 applicable tax savings as the loss
will reduce income that would be taxable).
E. CHANGE IN ACCOUNTING PRINCIPLE
1. A change in accounting principle occurs when the principle used in the
current year is different from the one used in the preceding year. When a
change has occurred:
a) The new principle should be used in reporting the results of operations of
the current year and prior years.
b) Companies report most changes in accounting principle retroactively.
1) They report both the current period and previous periods using the
new principle.
2) As a result the same principle applies to all periods. This treatment
improves the ability to compare results across years.
2. A change in accounting principle is permitted when two conditions are met:
a) Management can show that the new principle is preferable to the old
principle, and
b) The effects of the change are clearly disclosed in the income statement.
3. Examples include a change in depreciation methods or inventory costing
methods.
F. COMPREHENSIVE INCOME
1. Comprehensive Income includes all changes in stockholders’ equity
during a period except those resulting from investments by stockholders and
distributions to stockholders.
2. Unrealized gains and losses on available-for-sale securities are not included
in income but instead are reported in the balance sheet as adjustments to
stockholders’ equity. These are excluded from net income because
disclosing them separately:
a) (1) reduces the volatility of net income due to fluctuations in fair value,
yet
b) (2) informs the financial statement user of the gain or loss that would be
incurred if the securities were sold at fair value.
3. Many analysts have expressed concern over the significant increase in the
number of items that bypass the income statement and have reduced the
usefulness of the income statement. Therefore, the FASB now requires that,
in addition to reporting net income, a company must also report
comprehensive income.
VI.
QUALITY OF EARNINGS
a) Study Objective 7: Understanding the concept of quality of earnings.
b) You should be aware of some of the limitations of the three analytical tools
illustrated in the chapter and of the financial statements on which they are
based:
1. ESTIMATES: Financial statements contain numerous estimates; to the
extent that these estimates are inaccurate, the financial ratios and
percentages are inaccurate.
2. COST: Traditional financial statements are based on cost and are not
adjusted for price-level changes. Comparisons of unadjusted financial data
from different periods may be rendered invalid by significant inflation or
deflation.
3. ALTERNATIVE ACCOUNTING METHODS: Variations among
companies in the application of GAAP may hamper comparability. Example
are:
a) Inventory cost methods such as FIFO vs. LIFO. For example if
GM Corporation had used FIFO instead of LIFO in valuing its
inventories, its inventories would have been 26% higher which
would have significantly affected the current ratio as well as
other ratios.
b) Differences in depreciation methods used (straight-line vs.
declining-balance or units or activity or production, etc.), and
reporting of depletion and amortization expense.
c) Differences in accounting methods might be detectable from reading
the notes to the financial statements.
d) But adjusting the financial data to compensate for the different
methods is difficult, if not impossible, in some cases.
4. A TYPICAL DATA: Fiscal year-end data may not be typical of the
financial condition during the year. Firms often establish a fiscal year-end
that coincides with the low point in operating activity or in inventory levels.
Thus, certain account balances may not be representative of the account
balances during the year.
5. DIVERSIFICATION OF FIRMS: Diversification in U.S. industry also
restricts the usefulness of financial analysis. Many firms today are too
diversified to be classified by industry, while others appear to be comparable
when they are not.
6. PRO FORMA INCOME
a) Excludes items that the company thinks are unusual or
nonrecurring.
b) To compute pro forma income, companies generally can exclude
any items they deem inappropriate for measuring their
performance.
c) Many companies have abused the flexibility that pro forma
numbers allow and have used the measure as a way to put their
companies in good light.
7. IMPROPER RECOGNITION
a) The most common abuse is improper recognition of revenue where
one practice is using channel stuffing: Offering deep discounts on
their products to customers to encourage them to buy early.
b) Another is improper capitalization of operating expenses.
VI.
CORPORATION INCOME STATEMENTS with income taxes:
A. Introduction
2. Income statements for corporations are the same as the statements for
proprietorships or partnerships except for one thing: the reporting of income
taxes.
3. For income tax purposes, corporations are a separate legal entity. As a result,
income tax expense is reported in a separate section of the corporation income
statement before net income.
4. Income statement with income taxes showing the Income tax expense after
the Income before income taxes line item.
5. Income tax expense and the related liability for income taxes payable are
recorded as part of the adjusting process where the adjusting for Leads, Inc.
would be entered as followed:
General Journal
Page 1
P.R
Date
Account Title
Debit
Credit
20-Adjusting Entry
Dec.
31 Income Tax Expense
46,800
Income taxes Payable
46,800
VII. EARNINGS PER SHARE (EPS)
A. Earnings per share (EPS) indicate the net income earned by each share of
outstanding common stock.
B. Most companies are required to report earnings per share on the income
statement.
C. EARNINGS PER SHARE CALCULATION:
“Weighted” Average of
Net Income –
Preferred Dividends ÷ Common Shares Outstanding = Earnings per Share
D. To illustrate, assume Rally Inc. reports net income of $211,000 on its 102,500
weighted average common shares (calculation of weighted average is covered in
advanced accounting courses dealing with days during the year with the number
of shares outstanding) and that during the year it also declares a $6,000 dividend
on its preferred stock is calculated as follows:
“Weighted” Average of
Net Income –
Preferred Dividends ÷ Common Shares Outstanding = Earnings per Share
$211,000 - $6,000
÷
102,500
=
$2.00
E. Basic earnings per share disclosure which is simply reported below the net income
on the income statement.
F. Additional earnings per share disclosures are required when the income statement
contains any irregular (non-recurring) items; EPS should be disclosed for each
component. Assuming that Arco Energy had 100,000 shares of common stock
outstanding during the year, the additional EPS disclosures on the income
statement would be shown as follows noting that the dollar amount in parenthesis
are coming from the main part of the income statement:
ARCO ENERGY INC.
Income Statement (partial)
For the Year Ended December 31, 20-Net income
$284,200
Earnings per share:
Income from continuing operations ($560,000 ÷ 100,000)
$5.60
Loss from discontinued operations ($210,000 ÷ 100,000)
(2.10)
Income before extraordinary item and cumulative
Effect of change in accounting principle ($350,000 ÷ 100,000)
3.50
Extraordinary loss ($49,000 ÷ 100,000)
(.49)
Cumulative effect of change in accounting principle ($16,800÷100,000)
(.17)
Net income
$2.84