Financial Accounting:
Tools for Business Decision Making, 2nd Ed.
Kimmel, Weygandt, Kieso
Chapter
14
`
Chapter 14
Financial Analysis:
The Big Picture
After studying Chapter 14, you should
be able to:
 Understand the concept of earning power
and indicate how irregular items are
presented.
 Discuss the need for comparative analysis
and identify the tools of financial statement
analysis.
 Explain and apply horizontal analysis.
 Describe and apply vertical analysis.
3
Chapter 14
Financial Analysis:
The Big Picture
After studying Chapter 14, you should
be able to:
 Identify and compute ratios and describe
their purpose and use in analyzing a firm's
liquidity, solvency, and profitability.
 Discuss the limitations of financial
statement analysis.
4
Earning Power
The value of a company is a
function of its future cash
flows.
5
Earning Power...
 Is net income adjusted for
irregular items.
 Is the most likely level of
income to be obtained in the
future.
6
Irregular Items
Three types of irregular items
are reported -- (all net of taxes)
 discontinued operations
 extraordinary items
 changes in accounting principle
7
Discontinued Operations...
Refers to the disposal of a
significant segment of a
business...
 the elimination of a major class
of customers or an entire
activity.
8
Discontinued Operations
 Assume Rozek Inc. has revenues of $2.5 million
and expenses of $1.7 million or net income of
$800,000 from continuing operations in 2001.
 During 2001 the company discontinued and sold
its unprofitable chemical division. The loss in
2001 from chemical operations (net of $60,000
taxes) was $140,000, and the loss on disposal of
the chemical division (net of $30,000 taxes) was
$70,000.
9
Illustration 14-1
Rozek Inc.
Income Statement (Partial)
For the Year Ended December 31, 2001
Income before income taxes
$800,000
Income tax expense (30% Tax Rate)
240,000
Income from continuing operations
560,000
Discontinued operations
Loss from operations of chemical
division, net of $60,000 income
tax saving
$140,000
Loss from disposal of chemical
division, net of $30,000 income
tax saving
70,000 210,000
Net income before extraordinary item
350,000
Extraordinary Items...
Are events and
transactions
that meet two
conditions:
 Unusual in
nature
 Infrequent in
occurrence
11
Extraordinary Items
Illustration 14-2
Ordinary Items
Illustration 14-2
Extraordinary Items
 In 2001 a revolutionary foreign
government expropriated property
held as an investment by Rozek
Inc.
 The loss is $70,000 before
applicable income taxes of
$21,000, the income statement
presentation will show a deduction
of $49,000.
14
Illustration 14-3
Rozek Inc.
Income Statement(Partial)
For the Year Ended December 31, 2001
Income before income taxes
$800,000
Income tax expense
240,000
Income from continuing operations
560,000
Discontinued operations
Loss from operations of chemical
division, net of $60,000 income
tax saving
$140,000
Loss from disposal of chemical
division, net of $30,000 income
tax saving
70,000 210,000
Net income before extraordinary item
350,000
Extraordinary item
Expropriation of investment, net of
$21,000 income tax saving
49,000
Net income
$301,000
Change in
Accounting Principle
 Occur when the principle used in the current year
is different from the one used in the preceding
year.
 Is permitted, when
 management can show that the new principle is
preferable to the old and
 the effects of the change are clearly disclosed in
the income statement.
 Examples:
 a change in depreciation methods (such as
declining-balance to straight-line)
 a change in inventory costing methods (such as
FIFO to average cost).
16
Change in
Accounting Principle
 The new principle should be used in
reporting the results of operations of the
current year.
 The cumulative effect of the change on all
prior-year income statements should be
disclosed net of applicable taxes in a
special section immediately preceding Net
Income.
17
Changes in
Accounting Principle
 Rozek Inc. changes from the straight-line
method to the declining-balance method for
equipment purchased on January 1, 1998.
 The cumulative effect on prior-year income
statements (statements for 1998-2000) is to
increase depreciation expense and
decrease income before income taxes by
$24,000.
 If there is a 30% tax rate, the net-of-tax
effect of the change is $16,800 ($24,000 x
70%).
18
Illustration 14-4
Rozek Inc.
Partial Income Statement
For the Year Ended December 31, 2001
Income before income taxes
$800,000
Income tax expense
240,000
Income from continuing operations
560,000
Discontinued operations
Loss from operations of chemical
division, net of $60,000 income
tax saving
$140,000
Loss from disposal of chemical
division, net of $30,000 income
tax saving
70,000 210,000
Net income before extraordinary item
350,000
Extraordinary item
Expropriation of investment, net of
$21,000 income tax saving
49,000
Cumulative effect of change in accounting
principle
Effect on prior years of change in
depreciation method, net of $ 7,200 tax
16,800
Net Income
284,200
Comprehensive Income
 Most revenues, expenses, gains,
and losses recognized during the
period are included in net income.
 Specific exceptions to this practice
have developed - these items
bypass income and are reported
directly in stockholders’ equity.
20
Comprehensive Income
Unrealized gains and losses on
available-for-sale securities are
excluded from net income because
disclosing them separately  reduces the volatility of net income
due to fluctuations in fair value, yet
 informs the financial statement user
of the gain or loss that would be
incurred if the securities were sold
at fair value.
21
Comprehensive Income
 The FASB now requires that, in
addition to reporting net
income, a company must also
report comprehensive income.
22
Comprehensive Income...
Includes all changes in
stockholders' equity during a
period except those resulting
from investments by
stockholders and distributions
to stockholders.
23
Comparative Analysis
 Any item reported in a financial statement
has significance:
 Its inclusion indicates that the item
exists at a given time and in a certain
quantity.
 For example, when Kellogg Company
reports $136.4 million on its balance sheet
as cash, we know that Kellogg did have
cash and that the quantity was $136.4
million.
24
Comparative Analysis
 Whether the amount represents an
increase over prior years, or
whether it is adequate in relation
to the company's needs, cannot be
determined from the amount
alone.
 The amount must be compared
with other financial data to
provide more information.
25
Comparative Analysis
There are three types of
comparisons to provide decision
usefulness of financial information:
 Intracompany basis
 Intercompany basis
 Industry averages
26
Intracompany Basis
 Comparisons within a company are often
useful to detect changes in financial
relationships and significant trends.
 A comparison of Kellogg's current year's
cash amount with the prior year's cash
amount shows either an increase or a
decrease.
 A comparison of Kellogg's year-end cash
amount with the amount of total assets at
year-end shows the proportion of total
assets in the form of cash.
27
Intercompany Basis
 Comparisons with other companies
provide insight into a company's
competitive position.
 Kellogg's total sales for the year can
be compared with the total sales of
its competitors such as Quaker Oats
and General Mills.
28
Industry Averages
 Comparisons with industry averages
provide information about a
company's relative position within
the industry.
 Kellogg's financial data can be
compared with the averages for its
industry compiled by financial
ratings organizations such as Dun &
Bradstreet, Moody's, and Standard &
Poor's.
29
Financial Statement Analysis
Three basic tools are used in financial
statement analysis :
1.
Horizontal analysis
2.
Vertical analysis
3.
Ratio analysis
30
Horizontal Analysis
 Is a technique for evaluating a series
of financial statement data over a
period of time.
 Purpose is to determine whether an
increase or decrease has taken
place.
 The increase or decrease can be
expressed as either an amount or a
percentage.
31
Illustration 14-7
Horizontal Analysis
KELLOGG COMPANY
Net Sales (in millions)
Base Period 1994
1998
1997
1996
6,762.1 6,830.1 6,676.6
1995
1994
7,003.7 6,562.0
32
Illustration 14-6
Horizontal Analysis
CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT
BASE-YEAR AMOUNT
7,003.7 - 6,562.0 = 6.7%
6,562.0
Net sales for Kellogg company increased
approximately 6.7% from 1994 to 1995.
33
Illustration 14-7
Percentage Change in Sales
The percentage change in sales for each of
the 5 years, assuming 1994 as the base
period is:
Kellogg Company
Net Sales (in millions)
Base Period 1994
1998
1997
1996
1995
1994
6,762.1 6,830.1 6,676.6
7,003.7 6,562.0
103.0% 104.1% 101.7%
106.7% 100.0%
34
Illustration 14-8
Horizontal Analysis
of a Balance Sheet
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Increase (Decrease)
during 1998
1998
1997 Amount
Percent
Assets
Current Assets $1,496.5 $1,467.7 $ 28.8
Plant assets
2,888.8
2,773.3 115.5
Other assets
666.2
636.6
27.6
Total assets
$5,051.5 $4,877.6 $173.9
2.0
4.2
4.6
3.6
35
Horizontal Analysis
of a Balance Sheet
Illustration 14-8
1998
Liabilities and
Stockholders' Equity
Current liabilities
$1,718.5
Long-term liabilities
2,443.2
Total liabilities
4,161.7
Stockholders' equity
Common stock
208.8
Retained earnings
and other
1,075.3
Treasury stock
(394.3)
Total stockholders'
equity
889.8
Total liabilities and
stockholders' equity $5,051.5
Increase (Decrease)
during 1998
1997
Amount Percent
$1,657.3
2,222.8
3,880.1
61.2
220.4
281.6
3.7
9.9
7.3
196.3
12.5
6.4
958.5
(157.3)
116.8
12.2
237.0 (150.7)
997.5
(107.7)
(10.8)
$4,877.6
$173.9
3.6
KELLOGG COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
1998
Net sales
$6,762.1
Cost of goods sold
3,282.6
Gross profit
3,479.5
Selling & Admin.
2,513.9
Nonrecurring charges
70.5
Income from operations 895.1
Interest expense
119.5
Other income
(expense), net
6.9
Income before taxes
782.5
Income tax expense
279.9
Net income
$502.6
1997
$6,830.1
3,270.1
3,560.0
2,366.8
184.1
1,009.1
108.3
3.7
904.5
340.5
$564.0
Illustration 14-9
Increase (Decrease)
during 1998
Amount Percent
($68.0) (1.0)
12.5
0.4
(80.5) (2.3)
147.1
6.2
(113.6) (61.7)
(114.0) (11.3)
11.2
10.3
3.2
86.5
(122.0) (13.5)
(60.6) (17.8)
($61.4) (10.9)
Vertical Analysis
 Is a technique for evaluating financial
statement data that expresses each item
in a financial statement as a percent of
a base amount.
 Total assets is always the base amount
in vertical analysis of a balance sheet.
 Net sales is always the base amount in
vertical analysis of an income
statement.
38
Illustration 14-10
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Assets
Current Assets
Plant assets
Other assets
Total assets
1998
1997
Amount
Percent
Amount
Percen
$1,496.5
29.6
$1,467.7
30.1
2,888.8
57.2
2,733.3
56.9
666.2
13.2
636.6
13.0
$5,051.5
100.0%
$4,877.6
100.0%
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Liabilities and
Stockholders' Equity
Current liabilities
Long-term liabilities
Total liabilities
Stockholders' equity
Common stock
Retained earnings
and other
Treasury stock
Total stockholders'
equity
Total liabilities and
stockholders' equity
1998
Amount
Percent
$1,718.5
2,443.2
4,161.7
34.0
48.4
82.4
208 8
4.1
1,075.3
(394.3)
889.8
$5,051.5
21.3
( 7.8)
17.6
Illustration 14-10
1997
Amount Percent
$1,657.3 34.0
2,222.8 45.5
3,880.1 79.5
196.3
4.0
958.5 19.7
(157.3) (3.2)
997.5
20.5
100.0% $4,877.6 100.0%
KELLOGG COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
1998
Amount
Percent
$6,762.1
100.0
Net sales
Cost of goods sold 3,282.6
Gross profit
3,479.5
Selling & Admin.
2,513.9
Nonrecurring Chgs
70.5
Income operations
895.1
Interest expense
119.5
Other income
(expense),net
6.9
Income before
income taxes
782.5
Income tax expense 279.9
Net income
$502.6
48.6
51.4
37.2
1.0
13.2
1.8
Illustration 14-11
1997
Amount
Percent
$6,830.1
100.0
3,270.1
3,560.0
2,366.8
184.1
1,009.1
108.3
47.9
52.1
34.6
2.7
14.8
1.6
0.1
3.7
0.1
11.5
4.1
7.4
904.5
340.5
$564.0
13.3
5.0
8.3
Illustration 14-12
Condensed Income Statements
For the Year Ended December 31,1998
(in millions)
Kellogg Company, Inc.
Amount Percent
Net sales
$6,762.1 100.0
Cost of goods sold
3,282.6 48.6
Gross profit
3,479.5 51.4
Selling and administrative
expenses
2,513.9 37.2
Nonrecurring charges
70.5
1.0
Income from operations
895.1 13.2
Other expenses and
revenues (including
income taxes)
392.5
5.8
Net income
$502.6
7.4
The Quaker
Oats Company
Amount Percent
$4,842.5 100.0
2,374.4 49.0
2,468.1 51.0
1,872.5
128.5
467.1
38.7
2.6
9.7
182.6
$284.5
3.8
5.9
42
Ratio Analysis
Ratios
Three types:
Liquidity ratios
Solvency ratios
Profitability ratios
Can provide clues to underlying conditions
that may not be apparent from an
inspection of the individual components.
Single ratio by itself is not very meaningful
44
Liquidity Ratios
Measure the short-term
ability of the enterprise to
pay its maturing obligations
and to meet unexpected
needs for cash.
WHO CARES?
Short-term creditors such as
bankers and suppliers
45
Liquidity Ratios







Current ratio
Acid-test ratio
Current cash debt coverage ratio
Receivables turnover ratio
Average collection period
Inventory turnover
Average days in inventory
46
Illustration 14-17
Current Ratio
Indicates short-term debtpaying ability
Current Assets
Current Liabilities
47
Illustration 14-18
Acid-Test Ratio
Indicates immediate shortterm debt-paying ability
Cash + Short-term Investments
+ Net Receivable
Current Liabilities
48
Current Cash Debt
Coverage Ratio
Illustration 14-19
Indicates short-term debtpaying ability (cash basis)
Cash provided by operations
Average current liabilities
49
Illustration 14-20
Receivables Turnover Ratio
Indicates liquidity of
receivables
Net Credit Sales
Average Net Receivables
50
Illustration 14-21
Average Collection Period
Indicates liquidity of
receivables and collection
success
365 days
Receivables Ratio Turnover
51
Illustration 14-22
Inventory Turnover Ratio
Indicates liquidity of inventory
Cost of Goods Sold
Average Inventory
52
Illustration 14-23
Average Days in Inventory
Indicates liquidity of
inventory and inventory
management
365 days
Inventory Turnover Ratio
53
Solvency Ratios
Measure the ability of the
enterprise to survive over a
long period of time
WHO CARES?
Long-term creditors and
stockholders
54
Solvency Ratios
 Debt to total assets ratio
 Times interest earned ratio
 Cash debt coverage ratio
 Free cash flow
55
Illustration 14-24
Debt to Total Assets Ratio
Indicates % of total assets
provided by creditors
Total Liabilities
Total Assets
56
Illustration 14-25
Times Interest Earned Ratio
Indicates company’s ability to
meet interest payments as they
come due
Interest Before Interest
Expense & Income Tax
Interest Expense
57
Illustration 14-26
Cash Debt Coverage Ratio
Indicates long-term debtpaying ability (cash basis)
Cash provided by operations
Average total liabilities
58
Illustration 14-27
Free Cash Flow
Indicates cash available for
paying dividends or expanding
operations
Cash Provided By Operations
-
Capital Expenditures
-
Dividends Paid
Free Cash Flow
59
Profitability Ratios
Measure the income or operating
success of an enterprise for a given
period of time
WHO CARES? Everybody
WHY? A company’s income affects:
its ability to obtain debt and equity
financing
its liquidity position
its ability to grow
60
Profitability Ratios
 Return on common stockholders’
equity ratio
 Return on assets ratio
 Profit margin ratio
 Assets turnover ratio
 Gross profit rate
 Operating expenses to sales ratio
 Cash return on sales ratio
 Earnings per share (EPS)
 Price-earnings ratio
 Payout ratio
61
Illustration 14-28
Relationships Among
Profitability Measures
Return on Common
Stockholders’ Equity Ratio
Illustration 14-29
Indicates profitability of common
stockholders’ investment
Net income -preferred stock dividends
Average common stockholders’ equity
63
Illustration 14-30
Return On Assets Ratio
Reveals the amount of net
income generated by each
dollar invested
Net income
Average total assets
Higher value suggests favorable
efficiency.
64
Illustration 14-31
Profit Margin Ratio
Indicates net income
generated by each dollar of
sales
Net income
Net sales
Higher value suggests favorable
return on each dollar of sales.
65
Illustration 14-32
Asset Turnover Ratio
Indicates how efficiently
assets are used to
generate sales
Net sales
Average total assets
66
Illustration 14-34
Gross Profit Rate
Indicates margin between
selling price and cost of
good sold
Gross profit
Net sales
67
Operating Expenses
to Sales Ratio
Illustration 14-35
Indicates the cost incurred
to support each dollar of
sales
Operating expenses
Net sales
68
Illustration 14-36
Cash Return on Sales Ratio
Indicates net cash flow
generated by each dollar of
sales
Cash provided by operations
Net sales
69
Illustration 14-37
Earnings Per Share (EPS)
Indicates net income earned on
each share of common stock
sales
Income available to common
stockholders
Average number of outstanding
common shares
70
Illustration 14-38
Price Earnings Ratio
Indicates relationship between
market price per share and
earnings per share
Stock Price
Earnings Per Share
71
Illustration 14-39
Payout Ratio
Indicates % of earnings
distributed in the form of cash
dividends
Cash Dividends
Net Income
72
Limitations Of
Financial Analysis
 Horizontal, vertical, and ratio analysis are
frequently used in making significant
business decisions.
 One should be aware
of the limitations of
these tools and the
financial statements.
73
Estimates
 Financial statements are based on
estimates.




allowance for uncollectible accounts
depreciation
costs of warranties
contingent losses
To the extent that these estimates are
inaccurate, the financial ratios and
percentages are also inaccurate.
74
Cost
 Traditional financial statements are based
on historical 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.
75
Alternative Accounting
Methods
 One company may use the FIFO method,
while another company in the same
industry may use LIFO.
 If the inventory is significant for both
companies, it is unlikely that their current
ratios are comparable.
 In addition to differences in inventory
costing methods, differences also exist in
reporting such items as depreciation,
depletion, and amortization.
76
Atypical Data
Fiscal year-end data may not be typical
of a company's financial condition
during the year.
77
Diversification
 Diversification in American industry
also limits the usefulness of financial
analysis.
 Many firms are so diverse they cannot
be classified by industry.
78
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79