Slide 14 -1 Chapter 14 Financial Statement

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Chapter 14 Financial Statement Analysis Financial Accounting, Seventh Edition Slide 14 -2

Study Objectives 1. 2. Identify the tools of financial statement analysis. 3. Explain and apply horizontal analysis. 4. Describe and apply vertical analysis. 5. Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. 6. Understand the concept of earning power, and how irregular items are presented. 7. Slide 14 -3 Discuss the need for comparative analysis. Understand the concept of quality of earnings.

Financial Statement Analysis Basics of Financial Statement Analysis Need for comparative analysis Tools of analysis Horizontal and Vertical Analysis Balance sheet Income statement Retained earnings statement Ratio Analysis Liquidity Profitability Solvency Summary Earning Power and Irregular Items Quality of Earnings Discontinued operations Extraordinary items Changes in accounting principle Alternative accounting methods Pro forma income Improper recognition Comprehensive income Slide 14 -4

Basics of Financial Statement Analysis Analyzing financial statements involves: Comparison Bases Characteristics Tools of Analysis Liquidity Intracompany Horizontal Profitability Industry averages Vertical Solvency Slide 14 -5 Intercompany SO 1 SO 2 Ratio 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. Its purpose is to determine the increase or decrease that has taken place. Horizontal analysis is commonly applied to the balance sheet, income statement, and statement of retained earnings. Slide 14 -6 SO 3 Explain and apply horizontal analysis.

Horizontal Analysis Balance Sheet Illustration 14 -5 These changes suggest that the company expanded its asset base during 2007 and financed this expansion primarily by retaining income rather than assuming additional long-term debt. Slide 14 -7 SO 3 Explain and apply horizontal analysis.

Horizontal Analysis Income Statement Illustration 14 -5 14 -6 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. Slide 14 -8 SO 3 Explain and apply horizontal analysis.

Horizontal Analysis Retained Earnings Statement Illustration 14 -7 We saw in the horizontal analysis of the balance sheet that ending retained earnings increased 38. 6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities. Slide 14 -9 SO 3 Explain and apply horizontal analysis.

Horizontal Analysis Illustration: Summary financial information for Company is as follows. Rosepatch Compute the amount and percentage changes in 2011 using horizontal analysis, assuming 2010 is the base year. Solution Slide 14 -10 Solution on notes page 2011 SO 4 Describe 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. 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. Slide 14 -11 SO 4 Describe and apply vertical analysis.

Vertical Analysis Balance Sheet Illustration 14 -8 These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt. Slide 14 -12 SO 4 Describe and apply vertical analysis.

Vertical Analysis Income Statement Illustration 14 -9 Quality appears to be a profitable enterprise that is becoming even more successful. Slide 14 -13 SO 4 Describe and apply vertical analysis.

Vertical Analysis Enables a comparison of companies of different sizes. Illustration 14 -10 Intercompany income statement comparison J. C. Penney earned net income more than 4, 208 times larger than Quality’s, J. C. Penney’s net income as a percent of each sales dollar (5. 6%) is only 4% of Quality’s (12. 6%). Slide 14 -14 SO 4 Describe and apply vertical analysis.

Ratio Analysis Ratio analysis expresses the relationship among selected items of financial statement data. Financial Ratio Classifications Liquidity Solvency Measures shortterm ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Slide 14 -15 Profitability 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. Slide 14 -16 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. Ø Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. Ø Ratios include the current ratio, the acid-test ratio, receivables turnover, and inventory turnover. Slide 14 -17 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios Compute the Current Ratio for 2007. Current Assets Current Liabilities $1, 020, 000 $344, 500 = Current Ratio = 2. 96 : 1 The ratio of 2. 96: 1 means that for every dollar of current liabilities, Quality has $2. 96 of current assets. Slide 14 -18 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios Compute the Acid-Test Ratio for 2007. Illustration 14 -13 Slide 14 -19 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios Compute the Acid-Test Ratio for 2007. Cash + Short-Term Investments + Receivables (Net) Current Liabilities $100, 000 + $230, 000 $344. 500 = Acid-Test Ratio = 1. 02 : 1 The acid-test ratio measures immediate liquidity. Slide 14 -20 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios Compute the Receivables Turnover ratio for 2007. Net Credit Sales Average Net Receivables $2, 097, 000 ($180, 000 + $230, 000) / 2 = Receivables Turnover = 10. 2 times It measures the number of times, on average, the company collects receivables during the period. Slide 14 -21 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios 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 This means that receivables are collected on average every 36 days. Slide 14 -22 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios Compute the Inventory Turnover ratio for 2007. Cost of Good Sold Average Inventory $1, 281, 000 ($500, 000 + $620, 000) / 2 = Inventory Turnover = 2. 31 times Inventory turnover measures the number of times, on average, the inventory is sold during the period. Slide 14 -23 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios 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. Slide 14 -24 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. Ø Income, or the lack of it, affects the company’s ability to obtain debt and equity financing, liquidity position, and the ability to grow. Ø Ratios include the profit margin, asset turnover, return on assets, return on common stockholders’ equity, earnings per share, price-earnings, and payout ratio. Slide 14 -25 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Profitability Ratios Compute the Profit Margin ratio for 2007. Net Income Net Sales $263, 800 $2, 097, 000 = Profit Margin = 12. 6% Measures the percentage of each dollar of sales that results in net income. Slide 14 -26 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Profitability Ratios Compute the Asset Turnover ratio for 2007. Net Sales Average Assets $2, 097, 000 ($1, 95, 000 + $1, 835, 000) / 2 = Asset Turnover = 1. 22 times Measures how efficiently a company uses its assets to generate sales. Slide 14 -27 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Profitability Ratios Compute the Return on Assets ratio for 2007. Net Income Average Assets $263, 800 ($1, 595, 000 + $1, 835, 000) / 2 = Return on Assets = 15. 4% An overall measure of profitability. Slide 14 -28 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Profitability Ratios Compute the Return on Common Stockholders’ Equity ratio for 2007. Return on Net Income – Preferred Dividends Common = Stockholders’ Average Common Stockholders’ Equity $263, 000 - $0 ($795, 000 + $1, 003, 000) / 2 = 29. 3% Shows how many dollars of net income the company earned for each dollar invested by the owners. Slide 14 -29 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Profitability Ratios Compute the Earnings Per Share for 2007. Net Income Weighted Average Common Shares Outstanding $263, 800 270, 000 + 275, 400 / 2 = Earnings Per Share = $0. 97 per share A measure of the net income earned on each share of common stock. Slide 14 -30 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Profitability Ratios Compute the Price Earnings Ratio for 2007. Market Price per Share of Stock Earnings Per Share $12. 00 $0. 97 = Price Earnings Ratio = 12. 4 times The price-earnings (PE) ratio reflects investors’ assessments of a company’s future earnings. Slide 14 -31 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Profitability Ratios Compute the Payout Ratio for 2007. Cash Dividends Net Income $61, 200 * $263, 800 = Payout Ratio = 23. 2% Measures the percentage of earnings distributed in the form of cash dividends. * From analysis of retained earnings. Slide 14 -32 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

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Ratio Analysis Solvency Ratios Solvency ratios measure the ability of a company to survive over a long period of time. Ø Debt to total assets and times interest earned are two ratios that provide information about debt-paying ability. Slide 14 -34 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Solvency Ratios Compute the Debt to Total Assets Ratio for 2007. Total Debt Total Assets $832, 000 $1, 835, 000 Debt to = Total Assets Ratio = 45. 3% Measures the percentage of the total assets that creditors provide. Slide 14 -35 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Solvency Ratios Compute the Times Interest Earned ratio for 2007. Income before Income Taxes and Interest Expense $468, 000 $36, 000 = Times Interest Earned = 13 times Provides an indication of the company’s ability to meet interest payments as they come due. Slide 14 -36 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

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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. These “irregular” items are reported net of income taxes. Slide 14 -38 SO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Discontinued Operations (a) Refers to the 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). Slide 14 -39 SO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Illustration: During 2011 Acro Energy Inc. has income before taxes of $800, 000. During 2011 Acro discontinued and sold its unprofitable chemical division. The loss in 2011 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. Slide 14 -40 Solution on notes page SO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Discontinued Operations are reported after “Income from continuing operations. ” Previously labeled as “Net Income”. Moved to Slide 14 -41 SO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Extraordinary items are nonrecurring material items that differ significantly from a company’s typical business activities. An extraordinary item must be both of an Unusual Nature and Occur Infrequently Company must consider the environment in which it operates. Amounts reported “net of tax. ” Slide 14 -42 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 frost. NO (c) Loss from sale of temporary investments. NO (d) Loss attributable to a labor strike. NO Slide 14 -43 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 Slide 14 -44 SO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Illustration: In 2011 a 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 will report a deduction of $49, 000. Illustration 14 -30 Slide 14 -45

Earning Power and Irregular Items Extraordinary Items are reported after “Income from continuing operations. ” Previously labeled as “Net Income”. Moved to Slide 14 -46 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. Discontinued Operations Extraordinary Item Slide 14 -47 SO 6 Understand the concept of earning power, and how irregular items are presented.

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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. 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. Slide 14 -49 SO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Comprehensive Income All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders. Reported in Stockholders’ Equity + Slide 14 -50 Unrealized gains and losses on available-for -sale 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. Slide 14 -51 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 the market price of stock increases and the value of stock options increase. Slide 14 -52 SO 7 Understand the concept of quality of earnings.

Quality of Earnings Alternative Accounting Methods 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. Slide 14 -53 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: Improper recognition of revenue (channel stuffing). Improper capitalization of operating expenses (World. Com). Failure to report all liabilities (Enron). Slide 14 -54 SO 7 Understand the concept of quality of earnings.

Should I Play the Market? v 83. 4 million Americans own stock investments, either through mutual funds or individual stocks; 89% of stock investors own stock mutual funds. v 44% of the people who own stock bought their first stock before 1990. v The typical equity investor is in his or her late 40 s, is married, is employed, and has a household income in the low $60, 000 s. Slide 14 -55

v 58% of people who own stock said that they rely on professional financial advisors when making decisions regarding the purchase and sale of stock. v 46% of people who own stock used the Internet to check stock prices, and 38% use it to read online financial publications. Slide 14 -56

The percentage of Americans who buy stock, either through mutual funds or individual shares, has increased significantly in recent years. A big part of this increase is due to the increasing prevalence of employer-sponsored retirement plans, such as 401(k) plans. Source: “Equity Ownership in America, ” Investment Company Institute and the Securities Industry Association, 2002, p. 1. Slide 14 -57

Rachael West has been working at her new job for six months. She has a good salary, with lots of opportunities for growth. She has already accumulated $8, 000 in savings, which right now is sitting in a bank savings account earning very little interest. She has decided to take $7, 000 out of this savings account and buy common stock of her employer, a young company that has been in business for two years. Rachael’s liquid assets, including her savings account, total $10, 000. Her monthly expenses are approximately $3, 000. Should Rachael make this investment? YES: She has a good income, and this is a great opportunity for her to get in on the ground floor of her employer’s fast-growing company. NO: She shouldn’t invest all of her money in one company, particularly the company at which she works. Slide 14 -58

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