Financial Accounting 5 e Weygandt Kieso Kimmel Prepared

Financial Accounting, 5 e Weygandt, Kieso, & Kimmel Prepared by Kurt M. Hull, MBA CPA California State University, Los Angeles John Wiley & Sons, Inc.

CHAPTER 15 FINANCIAL STATEMENT ANALYSIS STUDY OBJECTIVES After studying this chapter, you should understand: Comparative analysis Tools used in financial statement analysis Horizontal analysis Vertical analysis Liquidity, profitability, & solvency ratios Earnings power Limitations of financial statement analysis

STUDY OBJECTIVE 1 COMPARATIVE ANALYSIS

STUDY OBJECTIVE 2 ANALYSIS TOOLS HORIZONTAL (TREND) ANALYSIS evaluates a series of financial statement data over a period of time. VERTICAL ANALYSIS expresses each item in a financial statement as a percent of a base amount RATIO ANALYSIS expresses the relationship among selected items of financial statement data.

STUDY OBJECTIVE 3 HORIZONTAL ANALYSIS Changes are measured against a base year with the following formula. Change since base period

HORIZONTAL ANALYSIS OF BALANCE SHEET

HORIZONTAL ANALYSIS OF INCOME STATEMENT

HORIZONTAL ANALYSIS OF RETAINED EARNINGS STATEMENT The change in January 1 retained earnings is calculated as follows 39. 4% = 525, 000 -376, 500 QUALITY DEPARTMENT STORE INC. Retained Earnings Statement ILLUSTRATION 15 -7 For the Years Ended December 31 Retained earnings, January 1 Add: Net income Deduct: Dividends Retained earnings, December 31 2003 2002 $ 525, 000 $ 376, 500 263, 800 208, 500 788, 800 585, 000 61, 200 60, 000 $ 727, 600 $ 525, 000 Increase or (Decrease) during 1999 Amount Percentage $ 148, 500 39. 4% 55, 300 26. 5% 203, 800 1, 200 2. 0% $ 202, 600 38. 6%

STUDY OBJECTIVE 4 VERTICAL ANALYSIS Financial statement elements are measured as a percent of the total. Balance Sheet Income Statement Elements are a percent of total assets Elements are a percent of total sales

VERTICAL ANALYSIS OF BALANCE SHEET QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets December 31 2003 Amount Percent 2002 Amount Percent Assets Current assets Plant assets (net) Intangible assets Total assets $ 1, 020, 000 800, 000 15, 000 $ 1, 835, 000 55. 6% $ 945, 000 43. 6% 632, 500 0. 8% 17, 500 100. 0% $ 1, 595, 000 59. 2% 39. 7% 1. 1% 100. 0% Liabilities Current liabilities Long-term liabilities Total liabilities Stockholders’ Equity Common stock, $1 par Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity $ 344, 500 487, 500 832, 000 275, 400 727, 600 1, 003, 000 $ 1, 835, 000 18. 8% $ 26. 5% 45. 3% 15. 0% 39. 7% 54. 7% 100. 0% 303, 000 497, 000 800, 000 19. 0% 31. 2% 50. 2% 270, 000 525, 000 795, 000 $1, 595, 000 16. 9% 32. 9% 49. 8% 100. 0%

VERTICAL ANALYSIS OF BALANCE SHEET QUALITY DEPARTMENT STORE INC. Condensed Income Statements For the Years Ended December 31 Sales returns and allowances Net sales Cost of goods sold Gross profit Selling expenses Administrative expenses Total operating expenses Income from operations Other revenues and gains Interest and dividends Other expenses and losses Interest expense Income before income taxes Income tax expense Net income 2003 2002 Amount Percent $ 2, 195, 000 104. 7% $ 1, 960, 000 106. 7% 98, 000 4. 7% 123, 000 6. 7% 2, 097, 000 100. 0% 1, 837, 000 100. 0% 1, 281, 000 61. 1% 1, 140, 000 62. 1% 816, 000 38. 9% 697, 000 37. 9% 253, 000 12. 0% 211, 500 11. 5% 104, 000 5. 0% 108, 500 5. 9% 357, 000 17. 0% 320, 000 17. 4% 459, 000 21. 9% 377, 000 20. 5% 9, 000 $ 36, 000 432, 000 168, 200 263, 800 0. 4% 1. 7% 20. 6% 8. 0% 12. 6% $ 11, 000 0. 6% 40, 500 347, 500 139, 000 208, 500 2. 2% 18. 9% 7. 5% 11. 4%

INTERCOMPANY COMPARISION OF INCOME STATEMENT

REVIEW QUESTION Sammy Corporation reported net sales of $300, 000 and $330, 000 for 2004 and 2005. Calculate the percentage increase. 10% = 330, 000 - 300, 000 Another way to express this change: 2005 sales are 110% of 2004 sales

STUDY OBJECTIVE 5 RATIO ANALYSIS

CURRENT RATIO A LIQUIDITY RATIO Evaluates liquidity and short-term debt-paying ability. CURRENT ASSETS CURRENT RATIO = —————— CURRENT LIABILITIES Quality Department Store 2003 $1, 020, 000 ————— = 2. 96: 1 $344, 500 Industry average ———— 1. 28: 1 2002 $945, 000 ———— = 3. 12: 1 $303, 000 Sears, Roebuck and Co. —————— 1. 32: 1

ACID-TEST/QUICK RATIO A LIQUIDITY RATIO Measures short-term liquidity. CASH + MARKETABLE SECURITIES + RECEIVABLES (NET) ACID-TEST RATIO = —————————————— CURRENT LIABILITIES

ACID-TEST/QUICK RATIO Quality Department Store 2003 2002 $100, 000 + $230, 000 $155, 000 + $70, 000 + $180, 000 ——————— = 1. 02: 1 ——————— = 1. 3: 1 $344, 500 $303, 000 Industry average ———— 0. 33: 1 Sears, Roebuck and Co. —————— 0. 85: 1

RECEIVABLES TURNOVER A LIQUIDITY RATIO • Measures the liquidity of receivables. • Measures the number of times, on average, receivables are collected during the period. NET CREDIT SALES RECEIVABLES TURNOVER = ———————— AVERAGE NET RECEIVABLES

RECEIVABLES TURNOVER Quality Department Store 2003 2002 $2, 097, 000 ————— = 10. 2 times $180, 000 + $230, 000 ————— 2 [ ] Industry average ———— 10. 8 times [ $1, 837, 000 ————— = 9. 7 times $200, 000 + $180, 000 ————— 2 ] Sears, Roebuck and Co. —————— 2. 4 times

INVENTORY TURNOVER A LIQUIDITY RATIO • Measures the number of times, on average, the inventory is sold during the period. • Measures the liquidity of the inventory. COST OF GOODS SOLD INVENTORY TURNOVER = —————— AVERAGE INVENTORY

INVENTORY TURNOVER Quality Department Store 2003 2002 $1, 281, 000 $1, 140, 000 ————— = 2. 3 times ————— = 2. 4 times —————————— [ ] $500, 000 + $620, 000 2 Industry average ———— 6. 7 times [ $450, 000 + $500, 000 2 ] Sears, Roebuck and Co. —————— 5. 0 times

PROFIT MARGIN A PROFITABILITY RATIO • Measures the percentage of each dollar of sales that results in net income. • Measures how profitable the company is NET INCOME PROFIT MARGIN ON SALES = —————— NET SALES

PROFIT MARGIN Quality Department Store 2003 $263, 800 ————— = 12. 6% $2, 097, 000 Industry average ———— 3. 57% 2002 $208, 500 ————— = 11. 4% $1, 837, 000 Sears, Roebuck and Co. —————— 8. 26%

ASSET TURNOVER A PROFITABILITY RATIO Measures how efficiently a company uses its assets to generate sales. NET SALES ASSET TURNOVER = ————— AVERAGE ASSETS

ASSET TURNOVER Quality Department Store 2003 [ 2002 $2, 097, 000 —————— = 1. 22 times $1, 595, 000 + $1, 835, 000 —————— 2 ] Industry average 2. 37 times [ $1, 837, 000 —————— = 1. 21 times $1, 446, 000 + $1, 595, 000 —————— 2 Sears, Roebuck and Co. 1. 05 times ]

RETURN ON ASSETS A PROFITABILITY RATIO An overall measure of profitability. NET INCOME RETURN ON ASSETS = ————— AVERAGE ASSETS

RETURN ON ASSETS Quality Department Store 2003 $263, 800 —————— $1, 595, 000 + $1, 835, 000 —————— 2 [ Industry average ———— 8. 29% 2002 ] = 15. 4% $208, 500 —————— = 13. 7% $1, 446, 000 + $1, 595, 000 —————— 2 [ Sears, Roebuck and Co. —————— 8. 7% ]

RETURN ON COMMON EQUITY A PROFITABILITY RATIO Measures profitability from the viewpoint of the common stockholder. RETURN ON COMMON NET INCOME STOCKHOLDERS’ EQUITY = ———————————— AVERAGE COMMON STOCKHOLDERS’ EQUITY

RETURN ON COMMON EQUITY Quality Department Store 2003 2002 $263, 800 [ —————— = 29. 3% $795, 000 + $1, 003, 000 —————— 2 ] $208, 500 [ —————— = 28. 5% $667, 000 + $795, 000 —————— 2 ]

EARNINGS PER SHARE A PROFITABILITY RATIO EPS measures net income earned on each share of common stock. EARNINGS NET INCOME PER SHARE = —————————————— WEIGHTED AVERAGE COMMON SHARES OUTSTANDING

EARNINGS PER SHARE Quality Department Store 2003 2002 $263, 000 ————— = $. 97 270, 000 + 275, 400 ————— 2 [ ] $208, 500 ————— = $. 77 270, 000

PRICE TO EARNINGS A PROFITABILITY RATIO Measures the ratio of the market price of each share of common stock to the earnings per share. MARKET PRICE PER SHARE OF COMMON STOCK PRICE-EARNINGS RATIO = ————————————— EARNINGS PER SHARE

PRICE TO EARNINGS Quality Department Store 2003 $12. 00 ——— = $. 97 12. 4 times 2002 $ 8. 00 ——— = $. 77 10. 4 times Industry average Sears, Roebuck and Co. 26 times 3. 8 times ———————————

PAYOUT RATIO A PROFITABILITY RATIO Measures the percentage of earnings distributed in the form of cash dividends. CASH DIVIDENDS PAYOUT RATIO = ————————————— NET INCOME

PAYOUT RATIO A PROFITABILITY RATIO Quality Department Store 2003 $61, 200 ————— $263, 800 = 23. 2% Industry average ———— 16. 0% 2002 $60, 000 ————— $208, 500 = 28. 8% Sears, Roebuck and Co. —————— 9. 6%

TIMES INTEREST EARNED A SOLVENCY RATIO Measures ability to meet interest payments as they come due. Income before Income Taxes and Interest Expense Quality Department Store 2003 $468, 000 ———— = 13 times $36, 000 2002 $388, 000 ———— = 9. 6 times $40, 500

DEBT TO TOTAL ASSETS A SOLVENCY RATIO Measures % of total assets provided by creditors Total Debt Total Assets Quality Department Store 2003 $832, 000 = 45. 30% $1, 835, 000 Industry average ———— 40. 1% 2002 $800, 000 = 50. 20% $1, 595, 000 Sears, Roebuck and Co. —————— 76. 9%

REVIEW QUESTION Ace Ventura Pet Detective, Inc. reported the following: Cash Marketable Securities Accounts Receivable Inventory Prepaid Insurance Prepaid Rent Total Assets Current Liabilities $125, 000 $342, 500 $780, 000 $56, 000 $3, 600 $4, 900 $1, 729, 000 $562, 000 Calculate the Quick Ratio. 2. 22 = (125000+342500+780000) / 562000

STUDY OBJECTIVE 6 EARNINGS POWER & IRREGULAR ITEMS Earnings power is the NORMAL LEVEL OF INCOME to be obtained in the future. Earnings power is affected by irregular items. Three types of “Irregular” items: 1) Discontinued operations 2) Extraordinary items 3) Changes in accounting principle

DISCONTINUED OPERATIONS • The disposal of a significant segment of a business. – The income or (loss) form discontinued operations consists of two parts: • The income or (loss) form operations and • The gain/loss on the disposal of the segment • The results are shown “net of tax”

DISCONTINUED OPERATIONS STATEMENT PRESENTATION For the year ended December 31, 2006

EXTRAORDINARY ITEMS • Extraordinary items are events and transactions that meet two conditions. – unusual in nature and – infrequent in occurrence – the results are shown “net of tax”

EXTRAORDINARY ITEMS STATEMENT PRESENTATION For the year ended December 31, 2006

ORDINARY VS. EXTRAORDINARY

CHANGE IN ACCOUNTING PRINCIPLE • Occurs when the principle used in the current year is different form the one used last year. When this happens: – The new principle is used to report the results of operations for current year – The cumulative effect of the change on all prior year income statements should be disclosed “net of tax”

CHANGE IN PRINCIPLE STATEMENT PRESENTATION For the year ended December 31, 2006

STUDY OBJECTIVE 7 LIMITATIONS OF F/S ANALYSIS Estimates Depreciation, allowances, contingencies Cost Historical data not adjusted for inflation/deflation Alternative methods FIFO, LIFO, Average Cost. Completed contract, percentage of completion Seasonal accounting data may not be representative Atypical data Firm Conglomerates hard to identify with single diversification industry.

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