Accounting principles 9e willey kieso chapter 18

Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.. Chapter 18-4 Balance sheet Income statement Retained earnings statement Horizontal and Ver

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Chapter 18-1

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Chapter

18-3

1. Discuss the need for comparative analysis

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. Understand the concept of quality of earnings

Study Objectives

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Chapter

18-4

Balance sheet Income statement Retained earnings statement

Horizontal and Vertical Analysis

Ratio Analysis

Earning Power and Irregular Items

Quality of Earnings

Discontinued operations Extraordinary items

Changes in accounting principle

Comprehensive

income

Alternative accounting methods Pro forma income Improper recognition

Financial Statement Analysis

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Chapter

18-5

Analyzing financial statements involves:

Basics of Financial Statement Analysis

Characteristics Comparison Bases Tools of Analysis

Liquidity Profitability Solvency

Intracompany Industry

averages Intercompany

Horizontal Vertical Ratio

SO 1 Discuss the need for comparative analysis.

SO 2 Identify the tools of financial statement analysis.

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Chapter

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

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Chapter

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.

Illustration 18-5

Horizontal analysis of balance sheets

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Chapter

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.

Horizontal analysis of Income statements

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Chapter

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.

Horizontal analysis of retained earnings statements

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Chapter

18-10 SO 4 Describe and apply vertical 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

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Chapter

18-11

These results reinforce the earlier

observations that

Quality is choosing to finance its growth through retention

of earnings rather than through

issuing additional debt.

Vertical analysis of balance sheets

SO 4 Describe and apply vertical analysis.

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Chapter

18-12

Quality appears

to be a profitable enterprise that is becoming even more successful.

Vertical analysis of Income statements

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Chapter

18-14 SO 5 Identify and compute ratios used in analyzing

a firm’s liquidity, profitability, and solvency.

Ratio Analysis

Ratio analysis expresses the relationship among

selected items of financial statement data

needs for cash.

Financial Ratio Classifications

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.

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Chapter

Ratio Analysis

The discussion of ratios will include the following types of comparisons

A single ratio by itself is not very meaningful

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Chapter

Ratio Analysis

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 acid-test

ratio, receivables turnover, and inventory turnover.

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Chapter

Ratio Analysis

Compute the Current Ratio for 2007.

The ratio of 2.96:1 means that for every dollar of

current liabilities, Quality has $2.96 of current

assets

Current AssetsCurrent Liabilities = Current Ratio

$1,020,000

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Chapter

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Chapter

Ratio Analysis

Compute the Acid-Test Ratio for 2007.

The acid-test ratio measures immediate liquidity

Cash + Short-Term Investments + Receivables (Net)

Current Liabilities

Acid-Test Ratio

$100,000 + $20,000 + $230,000

=

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Chapter

Ratio Analysis

Compute the Receivables Turnover ratio for 2007.

It measures the number of times, on average, the

company collects receivables during the period

$2,097,000($180,000 + $230,000) / 2 = 10.2 times

Net Credit SalesAverage Net Receivables

Receivables Turnover

=

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Chapter

Ratio Analysis

A variant of the receivables turnover ratio is to convert

it to an average collection period in terms of days.

This means that receivables are collected on average

every 36 days.

$2,097,000($180,000 + $230,000) / 2 = 10.2 times

365 days / 10.2 times = every 35.78 days

Receivables Turnover

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Chapter

Ratio Analysis

Compute the Inventory Turnover ratio for 2007.

Inventory turnover measures the number of times,

on average, the inventory is sold during the period

$1,281,000($500,000 + $620,000) / 2 = 2.31 times

Cost of Good SoldAverage Inventory

Inventory Turnover

=

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Chapter

Ratio Analysis

A variant of inventory turnover is the days in inventory.

Inventory turnover ratios vary considerably among

industries.

365 days / 2.3 times = every 159 days

$1,281,000($500,000 + $620,000) / 2 = 2.3 times

Inventory Turnover

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Chapter

Ratio Analysis

Profitability Ratios

Measure the income or operating success of a company

for a given period of time

 Income, or the lack of it, affects the company’s

ability to obtain debt and equity financing, liquidity position, and the ability to grow.

 Ratios include the profit margin, asset turnover,

return on assets, return on common stockholders’ equity, earnings per share, price-earnings, and

payout ratio.

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Chapter

Ratio Analysis

Compute the Profit Margin ratio for 2007.

Measures the percentage of each dollar of sales

that results in net income

$263,800

Net IncomeNet Sales

Profit Margin

=

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Chapter

Ratio Analysis

Compute the Asset Turnover ratio for 2007.

Measures how efficiently a company uses its assets

to generate sales

$2,097,000($1,95,000 + $1,835,000) / 2 = 1.22 times

Net SalesAverage Assets

Asset Turnover

=

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Chapter

Ratio Analysis

Compute the Return on Assets ratio for 2007.

An overall measure of profitability

$263,800 ($1,595,000 + $1,835,000) / 2 = 15.4%

Net IncomeAverage Assets

Return

on Assets

=

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Chapter

Ratio Analysis

Compute the Return on Common Stockholders’

Equity ratio for 2007.

Shows how many dollars of net income the company

earned for each dollar invested by the owners

$263,000 - $0($795,000 + $1,003,000) / 2 = 29.3%

Net Income – Preferred DividendsAverage Common Stockholders’ Equity

Return on Common Stockholders’

Equity

=

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Chapter

Ratio Analysis

Compute the Earnings Per Share for 2007.

A measure of the net income earned on each share

of common stock

$263,800 270,000 + 275,400 / 2 = $0.97 per share

Net IncomeWeighted Average Common

Shares Outstanding

Earnings Per Share

=

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Chapter

Ratio Analysis

Compute the Price Earnings Ratio for 2007.

The price-earnings (PE) ratio reflects investors’

assessments of a company’s future earnings

$12.00

Market Price per Share of Stock

Earnings Per Share

Price Earnings Ratio

=

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Chapter

Ratio Analysis

Compute the Payout Ratio for 2007.

Measures the percentage of earnings distributed in

the form of cash dividends

$61,200

Cash DividendsNet Income

Payout Ratio

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Chapter

Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a company to

survive over a long period of time.

 Debt to total assets and times interest earned

are two ratios that provide information about debt-paying ability.

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Chapter

Ratio Analysis

Compute the Debt to Total Assets Ratio for 2007.

Measures the percentage of the total assets that

creditors provide

$832,000

Total DebtTotal Assets

Debt to Total Assets

Ratio

=

Solvency Ratios

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Chapter

Ratio Analysis

Compute the Times Interest Earned ratio for 2007.

Provides an indication of the company’s ability to

meet interest payments as they come due

$468,000

Income before Income Taxes and

Interest ExpenseInterest Expense

Times Interest Earned

=

Solvency Ratios

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Chapter

18-35 SO 6 Understand the concept of earning power,

and how irregular items are presented.

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

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(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)

SO 6 Understand the concept of earning power,

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Chapter

18-37

Illustration: During 2010 Acro Energy Inc has income from

continuing operations of $560,000 During 2010 Acro

discontinued and sold its unprofitable chemical division The

loss in 2010 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.

Illustration: During 2010 Acro Energy Inc has income from

continuing operations of $560,000 During 2010 Acro

discontinued and sold its unprofitable chemical division The

loss in 2010 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.

Income from continuing operations $560,000

Discontinued operations:

Loss from operations, net of $60,000 tax 140,000 Loss on disposal, net of $30,000 tax 70,000

Total loss on discontinued operations 210,000

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Chapter

18-38

Other revenue (expense):

Interest revenue 17,000 Interest expense (21,000) Total other (4,000) Income before taxes 79,000 Income tax expense 24,000

Income from continuing operations 55,000

Discontinued operations:

Loss from operations, net of tax 315 Loss on disposal, net of tax 189 Total loss on discontinued operations 504

are reported after

“Income from continuing

operations.”

Previously labeled as

“Net Income”

Moved to

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Chapter

18-39

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.”

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Chapter

18-40

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.

(b) A citrus grower's Florida crop is damaged by

frost

(c) Loss from sale of temporary investments.

(d) Loss attributable to a labor strike.

YES

NO NO

NO

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