18 Financial Statement Analysis Learning Objectives After studying

18 Financial Statement Analysis Learning Objectives After studying this chapter, you should be able to: [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. 18 -1

Preview of Chapter 18 18 -2

Basics of Financial Statement Analysis Analyzing financial statements involves: Comparison Bases Characteristics u Liquidity u Intracompany u Horizontal u Profitability u u Vertical u Solvency Industry averages u Ratio u 18 -3 Tools of Analysis Intercompany LO 1 Discuss the need for comparative analysis. LO 2 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. 18 -4 u Purpose is to determine the increase or decrease that has taken place. u Commonly applied to the balance sheet, income statement, and statement of retained earnings. LO 3 Explain and apply horizontal analysis.

Horizontal Analysis Illustration 18 -5 Horizontal analysis of balance sheets Changes suggest that the company expanded its asset base during 2011 and financed this expansion primarily by retaining income rather than assuming additional long-term debt. 18 -5 LO 3 Explain and apply horizontal analysis.

Horizontal Analysis Illustration 18 -6 Horizontal analysis of Income statements 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. 18 -6 LO 3 Explain and apply horizontal analysis.

Horizontal Analysis Illustration 18 -7 Horizontal analysis of retained earnings statements 18 -7 In the horizontal analysis of the balance sheet the ending retained earnings increased 38. 6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities. LO 3 Explain 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. 18 -8 u On an income statement, we might say that selling expenses are 16% of net sales. u Vertical analysis is commonly applied to the balance sheet and the income statement. LO 4 Describe and apply vertical analysis.

Vertical Analysis Illustration 18 -8 Vertical analysis of balance sheets These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt. 18 -9 LO 4 Describe and apply vertical analysis.

Vertical Analysis Illustration 18 -9 Vertical analysis of Income statements Quality appears to be a profitable enterprise that is becoming even more successful. 18 -10 LO 4 Describe and apply vertical analysis.

Vertical Analysis Enables a comparison of companies of different sizes. Illustration 18 -10 Intercompany income statement comparison 18 -11 LO 4 Describe and apply vertical analysis.

Ratio Analysis Ratio analysis expresses the relationship among selected items of financial statement data. Financial Ratio Classifications 18 -12 Liquidity Profitability Solvency Measures shortterm ability of the company to pay its maturing obligations and to meet unexpected needs for cash. 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. LO 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. 1. Intracompany comparisons for two years for Quality Department Store. 2. Industry average comparisons based on median ratios for department stores. 3. Intercompany comparisons based on Macy’s, Inc. as Quality Department Store’s principal competitor. 18 -13 LO 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. u Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. u Ratios include the current ratio, the acid-test ratio, accounts receivable turnover, and inventory turnover. 18 -14 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 Illustration 18 -12 18 -15 Advance slide in presentation mode to reveal solution. LO 5

Ratio Analysis Current Ratio Liquidity Ratios Illustration 18 -12 Ratio of 2. 96: 1 means that for every dollar of current liabilities, Quality has $2. 96 of current assets. 18 -16 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios Acid-Test Ratio Illustration 18 -13 18 -17 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets For the Years Ended December 31 Balance Sheet (partial) For the Years Ended December 31 Illustration 18 -12 18 -18 LO 5

Ratio Analysis Liquidity Ratios Acid-Test Ratio Illustration 18 -14 Acid-test ratio measures immediate liquidity. 18 -19 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

18 -20 QUALITY DEPARTMENT STORE INC. Balance Sheet (partial) For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 LO 5

Ratio Analysis Accounts Receivable Turnover Liquidity Ratios Illustration 18 -15 Measures the number of times, on average, the company collects receivables during the period. 18 -21 LO 5

Ratio Analysis Liquidity Ratios $2, 097, 000 Accounts Receivable Turnover = 10. 2 times ($180, 000 + $230, 000) / 2 A variant of the accounts receivable turnover ratio is to convert it to an average collection period in terms of days. 365 days / 10. 2 times = every 35. 78 days Accounts receivable are collected on average every 36 days. 18 -22 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC. Balance Sheet (partial) For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 Illustration 18 -12 18 -23 LO 5

Ratio Analysis Liquidity Ratios Inventory Turnover Illustration 18 -16 Measures the number of times, on average, the inventory is sold during the period. 18 -24 LO 5

Ratio Analysis Liquidity Ratios $1, 281, 000 Inventory Turnover = 2. 3 times ($500, 000 + $620, 000) / 2 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. 18 -25 LO 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. 18 -26 u Income, or the lack of it, affects the company’s ability to obtain debt and equity financing, liquidity position, and the ability to grow. u Ratios include the profit margin, asset turnover, return on assets, return on common stockholders’ equity, earnings per share, price-earnings, and payout ratio. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

18 -27 QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 LO 5

Ratio Analysis Profitability Ratios Profit Margin Illustration 18 -17 Measures the percentage of each dollar of sales that results in net income. 18 -28 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 Illustration 18 -12 18 -29 LO 5

Ratio Analysis Profitability Ratios Asset Turnover Illustration 18 -18 Measures how efficiently a company uses its assets to generate sales. 18 -30 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 Illustration 18 -12 18 -31 LO 5

Ratio Analysis Profitability Ratios Return on Asset Illustration 18 -19 An overall measure of profitability. 18 -32 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 Illustration 18 -12 18 -33 LO 5

Ratio Analysis Profitability Ratios Return on Common Stockholders’ Equity Illustration 18 -20 Shows how many dollars of net income the company earned for each dollar invested by the owners. 18 -34 LO 5

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 Illustration 18 -12 18 -35 LO 5

Ratio Analysis Profitability Ratios Earnings Per Share (EPS) Illustration 18 -22 A measure of the net income earned on each share of common stock. 18 -36 LO 5

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 Illustration 18 -12 18 -37 LO 5

Ratio Analysis Profitability Ratios Price-Earnings Ratio Illustration 18 -23 Measures the net income earned on each share of common stock. 18 -38 LO 5

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 Illustration 18 -12 18 -39 LO 5

Ratio Analysis Profitability Ratios Payout Ratio Illustration 18 -24 Measures the percentage of earnings distributed in the form of cash dividends. 18 -40 LO 5

Ratio Analysis Solvency Ratios Solvency ratios measure the ability of a company to survive over a long period of time. u Debt to Assets and u Times Interest Earned are two ratios that provide information about debt-paying ability. 18 -41 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 Illustration 18 -12 18 -42 LO 5

Ratio Analysis Solvency Ratios Debt to Total Assets Ratio Illustration 18 -25 Measures the percentage of the total assets that creditors provide. 18 -43 LO 5

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets For the Years Ended December 31 Condensed Income Statements For the Years Ended December 31 Illustration 18 -12 18 -44 LO 5

Ratio Analysis Solvency Ratios Times Interest Earned Illustration 18 -25 Provides an indication of the company’s ability to meet interest payments as they come due. 18 -45 LO 5

Ratio Analysis Summary of Ratios Illustration 18 -27 18 -46 LO 5

Summary of Ratios Illustration 18 -27 18 -47 LO 5

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. “Irregular” items are reported net of income taxes. 18 -48 LO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Discontinued Operations (a) 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). 18 -49 LO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Illustration: During 2014 BD Inc. has income before income taxes of $79, 000. During 2014, BD discontinued and sold its unprofitable chemical division. The loss in 2014 from chemical operations (net of $135, 000 taxes) was $315, 000. The loss on disposal of the chemical division (net of $81, 000 taxes) was $189, 000. Assuming a 30% tax rate on income. 18 -50 LO 6

Earning Power and Irregular Items Discontinued Operations are reported after “Income from continuing operations. ” Previously labeled as “Net Income”. Moved to 18 -51 LO 6

Earning Power and Irregular Items Extraordinary Items Nonrecurring material items that differ significantly from a company’s typical business activities. u 18 -52 Must be both of an ► Unusual Nature and ► Occur Infrequently. u Must consider the environment in which it operates. u Amounts reported “net of tax. ” LO 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. (b) A citrus grower's Florida crop is damaged by frost. YES NO (c) Loss from sale of temporary investments. (d) Loss attributable to a labor strike. NO NO 18 -53 LO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Are these considered Extraordinary Items? (e) Loss from flood damage. (The nearby Black River floods every 2 to 3 years. ) (f) An earthquake destroys one of the oil refineries owned by a large multi-national oil company. Earthquakes are rare in this geographical location. NO YES (g) Write-down of obsolete inventory. NO (h) Expropriation of a factory by a foreign government. YES 18 -54 LO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Illustration: In 2014 a foreign government expropriated property held as an investment by DB Inc. If the loss is $770, 000 before applicable income taxes of $231, 000, the income statement will report a deduction of $539, 000. 18 -55 LO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Extraordinary Items are reported after “Income from continuing operations. ” Previously labeled as “Net Income”. Moved to 18 -56 LO 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 18 -57 LO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular Items Change in Accounting Principle u Occurs when the principle used in the current year is different from the one used in the preceding year. 18 -58 u Accounting rules permit a change if justified. u Changes are reported retroactively. u Example would include a change in inventory costing method such as FIFO to average cost. LO 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 + 18 -59 Unrealized gains and losses on available-forsale securities. Plus other items LO 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. 18 -60 LO 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. The issue of quality of earnings has taken on increasing importance because recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business. 18 -61 LO 7 Understand the concept of quality of earnings.

Quality of Earnings Alternative Accounting Methods u Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings. Pro Forma Income u Pro forma income usually excludes items that the company thinks are unusual or nonrecurring. u Some companies have abused the flexibility that pro forma numbers allow. 18 -62 LO 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: 18 -63 u Improper recognition of revenue (channel stuffing). u Improper capitalization of operating expenses (World. Com). u Failure to report all liabilities (Enron). LO 7 Understand the concept of quality of earnings.