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13
Financial Analysis: The Big
Picture
Kimmel ● Weygandt ● Kieso
Financial Accounting, Eighth Edition
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CHAPTER OUTLINE
LEARNING OBJECTIVES
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1
Apply the concepts of sustainable income and
quality of earnings.
2
Apply horizontal analysis and vertical
analysis.
3
Analyze a company’s performance using ratio
analysis.
LEARNING
OBJECTIVE
1
Apply the concepts of sustainable income
and quality of earnings.
SUSTAINABLE INCOME
The most likely level of income to be obtained by a company
in the future.
Unusual Items
Separately identified on the income statement.

Discontinued operations.

Other comprehensive income.
These “irregular” items are reported net of income tax.
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SUSTAINABLE INCOME
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ILLUSTRATION 13-1
Statement of comprehensive
income
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SUSTAINABLE INCOME
Discontinued Operations
(a) Disposal of a significant component of a business.
(b) Income statement should report a gain (or loss) from
discontinued operations, net of tax.
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Discontinued Operations
Illustration: Assume that during 2017 Acro Energy Inc. has
income before income taxes of $800,000. During 2017, Acro
discontinued and sold its unprofitable chemical division. The
loss in 2017 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
on income.
Prepare Acro’s statement of comprehensive income for the
year ended December 31, 2017.
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Discontinued Operations
ILLUSTRATION 13-2
Statement presentation of discontinued operations
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INVESTOR INSIGHT
What Does “Non-Recurring” Really Mean
Many companies incur restructuring charges as they attempt to reduce
costs. They often label these items in the income statement as “nonrecurring” charges, to suggest that they are isolated events, unlikely to
occur in future periods. The question for analysts is, are these costs
really one-time, “nonrecurring events” or do they reflect problems that
the company will be facing for many periods in the future? If they are
one-time events, then they can be largely ignored when trying to predict
future earnings. But, some companies report “one-time” restructuring
charges over and over again. For example, Procter & Gamble reported
a restructuring charge in 12 consecutive quarters, and Motorola had
“special” charges in 14 consecutive quarters. On the other hand, other
companies have a restructuring charge only once in a 5- or 10-year
period. There appears to be no substitute for careful analysis of the
numbers that comprise net income.
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SUSTAINABLE INCOME
Comprehensive Income
All changes in stockholders’ equity except those resulting
from

investments by stockholders and

distributions to stockholders.
Certain gains and losses bypass net income and instead
are reported as direct adjustments to stockholders’ equity.

Example – Unrealized gain or loss on Available-forsale securities.
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Comprehensive Income
ILLUSTRATION OF COMPREHENSIVE INCOME
Accounting standards require companies to adjust most
investments in stocks and bonds up or down to their market
value at the end of each accounting period.
Illustration: During 2017 Stassi Company purchased IBM stock for
$10,000 as an investment. At the end of 2017 Stassi was still
holding the investment, but the stock’s market value was now
$8,000.
How should Stassi account for the $2,000 unrealized loss?
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Comprehensive Income
ILLUSTRATION OF COMPREHENSIVE INCOME
How should Stassi account for the $2,000 unrealized loss?
Answer: Depends on whether Stassi classifies the IBM stock as
a


Trading security or an
Available for-sale security.
Unrealized gains and
losses
(Income Statement)
Unrealized gains and losses
(Comprehensive Income - Stockholders’ Equity)
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Comprehensive Income
Format One
Combined statement of income and comprehensive income.
Illustration 13-5
ILLUSTRATION 13-3
Lower portion of combined statement of
income and comprehensive income
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Comprehensive Income
Format Two
Separate component of Stockholders’ Equity.
ILLUSTRATION 13-4
Unrealized loss in stockholders’ equity section
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ILLUSTRATION 13-5
Complete statement of
comprehensive income
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SUSTAINABLE INCOME
Changes in Accounting Principle

Principle used in the current year is different from one
used in the preceding year.

Example - change from FIFO to average cost.

Permissible when management can show new principle is
preferable.

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Most changes are reported retroactively.
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INVESTOR INSIGHT
United Parcel Service (UPS)
More Frequent Ups and Downs
In the past, U.S. companies used a method to account for their pension
plans that smoothed out the gains and losses on their pension portfolios by
spreading gains and losses over multiple years. Many felt that this
approach was beneficial because it reduced the volatility of reported net
income. However, recently some companies have opted to adopt a method
that comes closer to recognizing gains and losses in the period in which
they occur. Some of the companies that have adopted this approach are
United Parcel Service (UPS), Honeywell International, IBM, AT&T, and
Verizon Communications. The CFO at UPS said he favored the new
approach because “events that occurred in prior years will no longer distort
current-year results. It will result in better transparency by eliminating the
noise of past plan performance.” When UPS switched, it resulted in a
charge of $827 million from the change in accounting principle.
Source: Bob Sechler and Doug Cameron, “UPS Alters Pension-Plan Accounting,”
Wall Street Journal (January 30, 2012).
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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.
Recent accounting scandals suggest that some
companies are spending too much time managing their
income and not enough time managing their business.
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QUALITY OF EARNINGS
Alternative Accounting Methods

Variations among companies in the application of GAAP
may hamper comparability and reduce quality of
earnings (FIFO vs. LIFO).
Pro Forma Income

Usually excludes items that are unusual or nonrecurring.

Some companies have abused the flexibility that pro
forma numbers allow to put their companies in a more
favorable light.
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QUALITY OF EARNINGS
Improper Recognition
Some managers have felt pressure to continually increase
earnings.
Abuses include:

Improper recognition of revenue (channel stuffing).

Improper capitalization of operating expenses
(WorldCom).

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Failure to report all liabilities (Enron).
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DO IT!
1
Unusual Items
In its proposed 2017 income statement, AIR Corporation
reports income before income taxes $400,000, unrealized gain
on available-for-sale securities $100,000, income taxes
$120,000 (not including unusual items), loss from operation of
discontinued flower division $50,000, and loss on disposal of
discontinued flower division $90,000. The income tax rate is
30%.
Prepare a correct statement of comprehensive income,
beginning with “Income before income taxes.”
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DO IT!
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1
Unusual Items
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LEARNING
OBJECTIVE
2
Apply horizontal analysis and vertical
analysis.
Analyzing financial statements involves:
Comparison
Bases
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Basic Tools

Intracompany

Horizontal analysis

Intercompany

Vertical analysis

Industry averages

Ratio Analysis
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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 increase or decrease that has
taken place.

Commonly applied to the balance sheet and income
statement.
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ILLUSTRATION 13-9
Horizontal analysis of
balance sheets
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ILLUSTRATION 13-10
Horizontal analysis of income statements
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VERTICAL ANALYSIS
Also called common-size analysis, is a technique that
expresses each financial statement item as a percent of a
base amount.
Vertical analysis is commonly applied to the balance sheet
and the income statement.
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ILLUSTRATION 13-11
Vertical analysis of
balance sheets
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ILLUSTRATION 13-12
Vertical analysis of income statements
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ILLUSTRATION 13-13
Intercompany comparison by vertical analysis
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ANATOMY OF A FRAUD
This final Anatomy of a Fraud box demonstrates that sometimes relationships
between numbers can be used to detect fraud. Financial ratios that appear
abnormal or statistical abnormalities in the numbers themselves can reveal
fraud. For example, the fact that WorldCom’s line costs, as a percentage of
either total expenses or revenues, differed very significantly from its competitors
should have alerted people to the possibility of fraud. Or, consider the case of a
bank manager, who cooperated with a group of his friends to defraud the bank’s
credit card department. The manager’s friends would apply for credit cards and
then run up balances of slightly less than $5,000. The bank had a policy of
allowing bank personnel to write-off balances of less than $5,000 without seeking
supervisor approval. The fraud was detected by applying statistical analysis
based on Benford’s Law. Benford’s Law states that in a random collection of
numbers, the frequency of lower digits (e.g., 1, 2, or 3) should be much higher
than higher digits (e.g., 7, 8, or 9). In this case, bank auditors analyzed the first
two digits of amounts written off. There was a spike at 48 and 49, which was not
consistent with what would be expected if the numbers were random.
Total take: Thousands of dollars
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(continued)
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ANATOMY OF A FRAUD
Total take: Thousands of dollars
The Missing Control
Independent internal verification. While it might be efficient to allow employees
to write off accounts below a certain level, it is important that these write-offs
be reviewed and verified periodically. Such a review would likely call attention
to an employee with large amounts of write-offs, or in this case, write-offs that
were frequently very close to the approval threshold.
Source: Mark J. Nigrini, “I’ve Got Your Number,” Journal of Accountancy Online (May
1999).
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DO IT!
2
Horizontal Analysis
Summary financial information for Rosepatch Company is as
follows.
Compute the amount and percentage changes in 2017 using
horizontal analysis, assuming 2016 is the base year.
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LEARNING
OBJECTIVE
3
Analyze a company’s performance using
ratio analysis.
PRICE-EARNINGS RATIO
Reflects investors’ assessment of a company’s future
earnings.

Will be higher if investors think that earnings will
increase substantially in the future.

Will be lower when there is the belief that a company
has poor-quality earnings.
ILLUSTRATION 13-14
Formula for price-earnings (P-E) ratio
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LO 3
PRICE-EARNINGS RATIO
ILLUSTRATION 13-14
Formula for price-earnings (P-E) ratio
ILLUSTRATION 13-15
Earnings per share and P-E ratios of various companies
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LO 3
LIQUIDITY RATIOS
ILLUSTRATION 13-16
Summary of liquidity ratios
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LO 3
INVESTOR INSIGHT
How to Manage the Current Ratio
The apparent simplicity of the current ratio can have real-world
limitations because adding equal amounts to both the numerator
and the denominator causes the ratio to decrease.
Assume, for example, that a company has $2,000,000 of current
assets and $1,000,000 of current liabilities. Its current ratio is 2:1. If
it purchases $1,000,000 of inventory on account, it will have
$3,000,000 of current assets and $2,000,000 of current liabilities. Its
current ratio decreases to 1.5:1. If, instead, the company pays off
$500,000 of its current liabilities, it will have $1,500,000 of current
assets and $500,000 of current liabilities. Its current ratio increases
to 3:1. Thus, any trend analysis should be done with care because
the ratio is susceptible to quick changes and is easily influenced by
management.
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SOLVENCY RATIOS
ILLUSTRATION 13-17
Summary of solvency ratios
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PROFITABILITY RATIOS
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ILLUSTRATION 13-18
Summary of profitability ratios
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INVESTOR INSIGHT
High Ratings Can Bring Low Returns
Moody’s, Standard & Poor’s, and Fitch are three big firms that perform
financial analysis on publicly traded companies and then publish ratings of
the companies’ creditworthiness. Investors and lenders rely heavily on
these ratings in making investment and lending decisions. Some people
feel that the collapse of the financial markets was worsened by inadequate
research reports and ratings provided by the financial rating agencies.
Critics contend that the rating agencies were reluctant to give large
companies low ratings because they feared that by offending them they
would lose out on business opportunities. For example, the rating agencies
gave many so-called mortgage-backed securities ratings that suggested
that they were low risk. Later, many of these very securities became
completely worthless. Steps have been taken to reduce the conflicts of
interest that lead to these faulty ratings.
Source: Aaron Lucchetti and Judith Burns, “Moody’s CEO Warned Profit Push
Posed a Risk to Quality of Ratings,” Wall Street Journal Online (October 23, 2008).
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LEARNING
OBJECTIVE
4
APPENDIX 13A: Evaluate a company
comprehensively using ratio analysis.
Analyzing financial statements involves:
Comparison
Bases
Characteristics

Liquidity

Intracompany

Profitability

Industry averages

Solvency

Intercompany
The financial information in Illustrations 13A-1 through 13A-4 will be used to
calculate Chicago’s 2014 ratios.
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ILLUSTRATION 13A-1
Chicago Cereal Company’s balance sheets
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ILLUSTRATION 13A-2
Chicago Cereal Company’s income statements
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ILLUSTRATION 13A-3
Chicago Cereal Company’s
statements of cash flows
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RATIO ANALYSIS
Ratio analysis expresses the relationship among selected
items of financial statement data.
Financial Ratio Classifications
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Liquidity
Solvency
Profitability
Measures shortterm ability of the
company to pay
its maturing
obligations and to
meet unexpected
needs for cash.
Measures the
ability of the
company to
survive over a
long period of
time.
Measures the
income or
operating success
of a company for
a given period of
time.
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LIQUIDITY RATIOS
Measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for
cash.

Short-term creditors such as bankers and suppliers are
particularly interested in assessing liquidity.

Ratios include the current ratio, the current cash debt
coverage, the accounts receivables turnover, the
average collection period, the inventory turnover, and
days in inventory.
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Current Ratio
Expresses the relationship of current assets to current
liabilities.
ILLUSTRATION 13A-5
Current ratio
What do the measures tell us?
A current ratio of .67 means that for every dollar of current
liabilities, the company has $0.67 of current assets.
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Accounts Receivable Turnover
Measures the number of times, on average, a company
collects receivables during the period.
ILLUSTRATION 13A-6
Accounts receivable turnover
How does Chicago’s turnover compare to General Mills’s?
The turnover of 11.9 times is higher than the industry
average of 11.2 times, and slightly lower than General Mills’
turnover of 12.2 times.
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Average Collection Period
Converts the receivable turnover ratio into days.
ILLUSTRATION 13A-7
Average collection period
How effective is Chicago’s credit and collection policies?
General rule - collection period should not greatly exceed
the credit term period (i.e., the time allowed for payment).
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Inventory Turnover
Measures the number of times average inventory was sold
during the period.
ILLUSTRATION 13A-8
Inventory turnover
How does Chicago’s turnover compare to General Mills’s?
The ratio of 7.5 times is higher than the industry average of
6.7 times and similar to that of General Mills.
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Days in Inventory
Measures the average number of days inventory is held.
ILLUSTRATION 13A-9
Days in inventory
How does Chicago’s days compare to General Mills’s?
An average selling time of 49 days is faster than the industry
average and faster than that of General Mills.
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SOLVENCY RATIOS
Measure the ability of a company to survive over a long
period of time.

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Debt-Paying Ability
►
Debt to total assets ratio
►
Times interest earned
►
Free cash flow
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Debt to Assets Ratio
Indicates the degree of financial leveraging. Provides some
indication of the company’s ability to withstand losses.
ILLUSTRATION 13A-10
Debt to assets ratio
Has Chicago’s solvency improved during the year?
Yes. The ratio of 78% says that Chicago would have to
liquidate 78% of its assets at their book value in order to pay
off all of its debts.
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LO 4
Times Interest Earned
Also called interest coverage, indicates the company’s
ability to meet interest payments as they come due.
ILLUSTRATION 13A-11
Times interest earned
Is Chicago able to service its’ debt?
Yes, the ratio indicates that income before interest and taxes
was 5.8 times the amount needed for interest expense.
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Free Cash Flow
Ability to pay dividends or expand operations.
ILLUSTRATION 13A-12
Free cash flow
Cash provided by operations was more than enough to
allow Chicago to acquire additional productive assets and
maintain dividend payments.
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PROFITABILITY RATIOS
Measure the income or operating success of a company for
a given period of time.
ILLUSTRATION 13A-13
Relationships among
profitability measures
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LO 4
Return on Common Stockholders’ Equity
Shows how many dollars of net income the company
earned for each dollar invested by the owners.
ILLUSTRATION 13A-14
Return on common
stockholders’ equity
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Chicago’s 2014 rate of return on common
stockholders’ equity is unusually high at
48%, considering an industry average of
19% and General Mills’s return of 25%.
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Return on Assets
Measures the overall profitability of assets in terms of the
income earned on each dollar invested in assets.
ILLUSTRATION 13A-15
Return on assets
Note that Chicago’s rate of return on common stockholders’
equity (48%) is substantially higher than its rate of return on
assets (10%). Chicago has made effective use of leverage.
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Profit Margin
Or rate of return on sales, is a measure of the percentage of
each dollar of sales that results in net income.
ILLUSTRATION 13A-16
Profit margin
High-volume (high inventory turnover) businesses such as
grocery stores and pharmacy chains generally have low
profit margins.
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Asset Turnover
Measures how efficiently a company uses its assets to
generate sales.
ILLUSTRATION 13A-17
Asset turnover
The average asset turnover for utility companies is .45, for
example, while the grocery store industry has an average
asset turnover of 3.49.
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LO 4
Return on Assets
You can analyze the combined effects of profit margin and
asset turnover on return on assets for Chicago as shown.
ILLUSTRATION 13A-18
Composition of return on assets
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Gross Profit Rate
Indicates a company’s ability to maintain an adequate
selling price above its cost of goods sold.
ILLUSTRATION 13A-19
Gross profit rate
As an industry becomes more competitive, this ratio
declines.
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Earnings Per Share (EPS)
A measure of the net income earned on each share of
common stock.
ILLUSTRATION 13A-20
Earnings per share
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Price-Earnings (P-E) Ratio
Reflects investors’ assessments of a company’s future
earnings.
ILLUSTRATION 13A-21
Price-earnings ratio
A lower P-E ratio suggests that the market is less optimistic
about Chicago cereal than about General Mills. It might also
signal that its stock is underpriced.
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Payout Ratio
Measures the percentage of earnings distributed in the form
of cash dividends.
ILLUSTRATION 13A-22
Payout ratio
This ratio should be calculated over a longer period of time to
evaluate any trends.
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A Look at IFRS
LEARNING
OBJECTIVE
5
Compare financial statement analysis
and income statement presentation
under GAAP and IFRS.
RELEVANT FACTS
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
The tools of financial statement analysis covered in this chapter
are universal and therefore no significant differences exist in the
analysis methods used.

The accounting for changes in accounting principles and
changes in accounting estimates are the same for both GAAP
and IFRS.

Both GAAP and IFRS follow the same approach in reporting
comprehensive income.
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A Look at IFRS
RELEVANT FACTS
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
The basic objectives of the income statement are the same
under both GAAP and IFRS. A very important objective is to
ensure that users of the income statement can evaluate the
sustainable income of the company. Thus, both the IASB and
the FASB are interested in distinguishing normal levels of
income from unusual items in order to better predict a
company’s future profitability.

The basic accounting for discontinued operations is the same
under IFRS and GAAP.
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A Look at IFRS
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.
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A Look at IFRS
IFRS Practice
The basic tools of financial analysis are the same under both GAAP
and IFRS except that:
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.
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A Look at IFRS
IFRS Practice
Presentation of comprehensive income must be reported under
IFRS in:
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.
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A Look at IFRS
IFRS Practice
In preparing its income statement for 2017, Parmalane assembles
the following information.
Sales revenue
Cost of goods sold
Operating expenses
Loss on discontinued operations
$500,000
300,000
40,000
20,000
Ignoring income taxes, what is Parmalane’s income from continuing
operations for 2017 under IFRS?
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a) $260,000.
c) $240,000.
b) $250,000.
d) $160,000.
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