Financial accounting 7e harmon chapter 14 financial analysis the big picture

Appendix 13A Appendix 13A Comprehensive Ratio Analysis LO 8 Evaluate a company comprehensively using ratio analysis... Appendix 13A Appendix 13A Comprehensive Ratio Analysis LO 8 Eva

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13-1

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FINANCIAL

ANALYSIS:

THE BIG PICTURE

Financial Accounting, Seventh Edition

13

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After studying this chapter, you should be able to:

1. Understand the concept of sustainable income

2. Indicate how irregular items are presented

3. Explain the concept of comprehensive income

4. Describe and apply horizontal analysis

5. Describe and apply vertical analysis

6. Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability

7. Understand the concept of quality of earnings

Learning Objectives

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Preview of Chapter 13

Financial Accounting Seventh Edition Kimmel Weygandt Kieso

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13-5 LO 2 Indicate how irregular items are presented.

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.

LO 1 Understand the concept of sustainable income.

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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.

Sustainable Income

LO 2 Indicate how irregular items are presented.

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Illustration: Rozek Inc has revenues of $2.5 million and expenses

of $1.7 million from continuing operations in 2014 The company

therefore has income before income taxes of $800,000 During

2014 the company discontinued and sold its unprofitable chemical

division at a loss of $210,000 (net of $90,000 tax savings)

LO 2

Illustration 13-2

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Extraordinary items are events and transactions that

meet two conditions:

Both

 Unusual in nature and

 Infrequent in occurrenceCompany must consider the environment in which it operates Amounts reported “net of tax.”

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Illustration: In 2014 a revolutionary foreign government

expropriated property held as an investment by Rozek Inc If the

loss is $70,000 before applicable income tax savings of $21,000,

how will the loss be presented in the income statement?

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Are these considered Extraordinary Items ?

YES NO NO YES

 Effects of major natural casualties, if rare in

the area.

 Effects of major natural casualties, not

uncommon in the area.

 Write-down of inventories or write-off of

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NO YES NO

 Losses attributable to labor strikes.

 Effects of a newly enacted law or regulation,

such as a condemnation action.

 Gains or losses from sales of property, plant,

or equipment.

Are these considered Extraordinary Items ?

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13-13

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 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.

 Most changes are reported retroactively.

Changes in Accounting Principle

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13-15

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LO 3 Explain the concept of 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.

securities

Comprehensive Income

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Illustration of Comprehensive Income

Accounting standards require companies to adjust most

investments in stocks and bonds up or down to their market

price at the end of each accounting period

Illustration: During 2014 Stassi Company purchased IBM stock

for $10,000 as an investment At the end of 2014 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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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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Format One – Comprehensive Income

Combined statement of income and comprehensive income.

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Format Two - Comprehensive Income

Separate component of Stockholders’ Equity.

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AIR CORPORATION Income Statement (partial)

Income before income taxes $400,000

Income before irregular items 280,000

Discontinued operations

Loss on disposal of discontinued flower division, net of $42,000 tax savings (98,000) Extraordinary earthquake loss, net of $30,000 tax savings (70,000)

Illustration: In its draft 2014 income statement, AIR Corporation reports income before income taxes

$400,000, extraordinary loss due to earthquake $100,000, income

taxes $120,000 (not including irregular items), and loss on disposal of discontinued flower division $140,000 The income tax rate is 30%

Prepare a correct income statement, beginning with income before

income taxes

Advance slide in presentation mode to reveal solution. LO 3

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13-24 LO 4 Describe and apply 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

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Helpful Hint:

When using horizontal analysis, be sure

to examine both dollar amount changes and percentage changes.

Illustration 13-11 Horizontal analysis

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Illustration 13-12 Horizontal analysis

of Income statements

Comparative Analysis

Helpful Hint: In horizontal analysis, while the amount column is additive (the

total is $99 million), the percentage column is not additive (9.9% is not a total).

LO 4 Describe and apply horizontal analysis.

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Summary financial information for Rosepatch Company

is as follows.

Solution

LO 4 Describe and apply horizontal analysis.

Compute the amount and percentage changes in 2012 using horizontal

analysis, assuming 2011 is the base year.

Advance slide in presentation mode to reveal solution.

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13-28 LO 5 Describe and apply 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.

Vertical Analysis

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13-29 LO 5 Describe and apply vertical analysis.

These results indicate the company shifted toward equity financing by relying less on debt and by increasing the amount

of retained earnings.

Illustration 13-13 Vertical analysis of Income statements

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an income statements

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Illustration 13-15 Intercompany comparison by vertical analysis

LO 5 Describe and apply vertical analysis.

Although Chicago Cereal’s net sales are less than those of General Mills,

vertical analysis eliminates the impact of this size difference for our analysis.

Vertical analysis also enables a comparison of companies of different sizes.

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Profitability

Measures the income or operating success

of a company for a given period of

time

Solvency

Measures the ability of the company to survive over a long period of time

LO 6 Identify and compute ratios used in analyzing a

company’s liquidity, solvency, and profitability.

Ratio Analysis

Ratio analysis expresses the relationship among selected

items of financial statement data.

Liquidity

Measures

short-term ability of the

company to pay its

maturing obligations and to

meet unexpected

needs for cash

Financial Ratio Classifications

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Ratio Analysis

Liquidity Ratios

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13-34

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Ratio Analysis

Solvency Ratios

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13-37

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Recent accounting scandals suggest that some companies

are spending too much time managing their income and

not enough time managing their business.

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.

Quality of Earnings

LO 7 Understand the concept of quality of earnings.

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 Variations among companies in the application of GAAP

may hamper comparability and reduce quality of earnings (FIFO vs LIFO)

 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

Alternative Accounting Methods

Pro Forma Income

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Some managers have felt pressure to continually increase

earnings.

Abuses include:

 Improper recognition of revenue (channel stuffing).

 Improper capitalization of operating expenses (WorldCom).

 Failure to report all liabilities (Enron).

Alternative Accounting Methods

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Reflects investors’ assessment of a company’s future

earnings.

 P-E ratio will be higher if investors think that earnings will

increase substantially in the future

 P-E ratio will be lower when there is the belief that a company

has poor-quality earnings

Price-Earnings Ratio

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Earnings per share and P-E

ratios of various companies

Price-Earnings Ratio

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Match each of the following terms with the phrase that

it best matches.

1 Measures the ability of the company to survive

over a long period of time.

2 Usually excludes items that a company thinks are

unusual or non-recurring.

3 Includes all changes in stockholders’ equity during

a period except those resulting from investments

by stockholders and distributions to stockholders.

Comprehensive income Vertical analysis

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Match each of the following terms with the phrase that

it best matches.

4 Indicates the level of full and transparent

information provided to users of the financial

statements.

5 Describes events and transactions that are

unusual in nature and infrequent in occurrence.

6 Expresses each item within a financial statement

as a percent of a base amount.

Extraordinary

Items

Vertical Analysis

Comprehensive income Vertical analysis

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The financial information in Illustrations 13A-1 through 13A-4 will be used to

calculate Chicago Cereal Company’s 2011 ratios.

Appendix 13A

Appendix 13A Comprehensive Ratio Analysis

LO 8 Evaluate a company comprehensively using ratio analysis.

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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.

Appendix 13A

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Current Ratio - Expresses the relationship of current assets to

current liabilities

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

Illustration 13A-5

Appendix 13A

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Current Cash Debt Coverage - Because it uses cash provided by operating activities, it may provide a better representation of

liquidity

Is the coverage adequate?

Probably so Chicago’s coverage is less than that of General

Mills, but it approximates a commonly accepted threshold of 40

Appendix 13A

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Accounts Receivables Turnover – Measures the number of

times, on average, a company collects receivables during the

period

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 12.4 times

Appendix 13A

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Average Collection Period – Converts the receivable turnover

ratio into days

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)

Appendix 13A

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Inventory Turnover - Measures the number of times average

inventory was sold during the period

The ratio of 7.5 times is higher than the industry average of 6.7

times and better than General Mills’s 6.5 times

How does Chicago’s turnover compare to General Mills’s?

Appendix 13A

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Days in Inventory - Measures the average number of days

inventory is held

An average selling time of 49 days is faster than the industry

average and faster than that of General Mills

How does Chicago’s days compare to General Mills’s?

Appendix 13A

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Solvency Ratios

Solvency ratios measure the ability of a company to survive over

a long period of time

 Debt-Paying Ability

► Debt to assets ratio

► Times interest earned

► Cash debt coverage

 Free cash flow provides information about solvency and

ability to pay additional dividends or invest in capital expenditures

Appendix 13A

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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

Yes, slightly 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

Has Chicago’s solvency improved during the year?

Appendix 13A

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