Lecture Issues in financial accounting – Lecture 27: Financial statement analysis

The contents of this chapter include all of the following: 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, explain and apply vertical analysis,...

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Financial Statement

Analysis

PART III: Decision Tools

Lecture 27

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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.

Learning Objectives

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Balance sheet Income statement Retained earnings statement

Ratio Analysis

Earning Power and Irregular Items

Quality of Earnings

Discontinued operations Extraordinary items

Changes in accounting principle Comprehensiv

e income

Alternative accounting methods Pro forma income Improper recognition

Financial Statement Analysis

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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

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Horizontal Analysis

technique for evaluating a series of financial statement

data over a period of time

has taken place

Horizontal analysis is commonly applied to the balance

sheet, income statement, and statement of retained

earnings

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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.

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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.

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We saw in the horizontal analysis of the balance sheet that ending retained

earnings increased 38.6% As indicated earlier, the company retained a

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Vertical Analysis

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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These results reinforce the earlier observations that

Quality is choosing to finance its growth through retention

of earnings rather than through

issuing additional debt.

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Quality appears

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

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Enables a comparison of companies of different sizes.

J.C Penney earned net income more than 4,208 times larger than Quality’s, J.C

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Ratio Analysis

selected items of financial statement data

Liquidity Profitability Solvency

Measures

short-term ability of the

company to pay its

maturing obligations and to

meet unexpected

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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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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Ratio Analysis

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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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

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Ratio Analysis

Compute the Acid-Test Ratio for 2007

Liquidity Ratios

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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

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Ratio Analysis

It measures the number of times, on average, the

company collects receivables during the period

$2,097,000($180,000 + $230,000) / 2

Net Credit SalesAverage Net Receivables

Receivables Turnover

=

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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

$2,097,000($180,000 + $230,000) / 2

365 days / 10.2 times = every 35.78 days

Receivables Turnover

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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

Cost of Good SoldAverage Inventory

Inventory Turnover

=

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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

Inventory Turnover

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Ratio Analysis

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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Ratio Analysis

Compute the Profit Margin ratio for 2007.

Measures the percentage of each dollar of sales that

$263,800

$2,097,000

Net IncomeNet Sales

Profit Margin

=

Profitability Ratios

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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

Net SalesAverage Assets

Asset Turnover

=

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Ratio Analysis

An overall measure of profitability

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

Net IncomeAverage Assets

Return on Assets

=

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Ratio Analysis

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

Net Income – Preferred Dividends

Average Common Stockholders’ Equity

Return on Common Stockholders’

Equity

=

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Ratio Analysis

A measure of the net income earned on each share of

$263,800 270,000 + 275,400 / 2

=

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Ratio Analysis

The price-earnings (PE) ratio reflects investors’

assessments of a company’s future earnings

$12.00

$0.97

Market Price per Share of Stock

Earnings Per Share

Price Earnings Ratio

=

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Ratio Analysis

Measures the percentage of earnings distributed in the

form of cash dividends

$61,200

Cash DividendsNet Income

Payout Ratio

=

*

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Dividend Yield

Dividends per Share of

Common Stock Market Price per Share of

Common Stock

=

Dividend yield on common stock 2.0% 2.2%

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Operating Profitability Ratios

Assets

Total

EBIT Assets

Total

Sales Sales

EBIT

This is the operating profit return on total

assets To consider the negative effects of

financial leverage, we examine the effect of

interest expense as a percentage of total

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Assets

Total

EBIT Assets

Total

Sales Sales

EBIT

Assets

Total

Tax

Before

Net Assets

Total

Expense

Interest Assets

Total

EBIT

We consider the positive effect of financial

leverage with the financial leverage multiplier

Ratio Analysis

Du Pont

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Assets

Total

EBIT Assets

Total

Sales Sales

EBIT

Assets

Total

Tax

Before

Net Assets

Total

Expense

Interest Assets

Total

EBIT

Equity Common

(NBT) Tax

Before

Net Equity

Common

Assets

Total Assets

Total

(NBT) Tax

Before

Net

This indicates the pretax return on equity To arrive

Ratio Analysis

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Assets

Total

EBIT Assets

Total

Sales Sales

EBIT

Assets

Total

Tax

Before

Net Assets

Total

Expense

Interest Assets

Total

EBIT

Equity Common

(NBT) Tax

Before

Net Equity

Common

Assets

Total Assets

Total

(NBT) Tax

Before

Net

Equity Common

Income Net

Tax

Before Net

Taxes

Income

%

100 Equity

Common

Tax

Before

Net

Ratio Analysis

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 Debt to total assets and times interest earned are

two ratios that provide information about debt-paying ability.

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Ratio Analysis

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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Ratio Analysis

Compute the Times Interest Earned ratio for 2007.

Provides an indication of the company’s ability to meet

$468,000

$36,000 = 13 times

Income before Income Taxes and

Interest ExpenseInterest Expense

Times Interest Earned

=

Solvency Ratios

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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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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)

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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.

Discontinued operations:

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I nc om e f r om c ont inuing ope r a t ions 5 5 ,0 0 0

Dis c ont inue d ope r a t ions : Los s f r om ope r a t ions , ne t of t a x 3 1 5 Los s on d is pos a l, ne t of t a x 1 8 9

T ot a l los s on d is c ont inue d ope r a t ions 5 0 4

I nc om e S t a t e m e nt (in thous and s )

Cos t of good s s old 14 9 ,0 0 0

Discontinued Operations

are reported after

“Income from continuing

operations.”

Previously labeled as

“Net Income”

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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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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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(d) Loss from flood damage (The nearby Black

River floods every 2 to 3 years.)

(e) An earthquake destroys one of the oil refineries

owned by a large multi-national oil company

Earthquakes are rare in this geographical

location.

(f) Write-down of obsolete inventory.

(g) Expropriation of a factory by a foreign

government.

NO

YES

YES NO

Are these considered Extraordinary Items?

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Illustration: In 2010 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: In 2010 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.

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Extraordinary Items are

reported after “Income

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Reporting when both

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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

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Reported in Stockholders’

Equity

Comprehensive Income

All changes in stockholders’ equity except those resulting from investments by

stockholders and distributions to stockholders.

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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

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Companies have incentives to manage income to

meet or beat Wall Street expectations, so that

the market price of stock increases andthe value of stock options increase

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

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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

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