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CHAPTER 14 Financial Statement Analysis: The Big Picture ASSIGNMENT CLASSIFICATION TABLE Study Objectives Questions Brief Exercises Discuss the need for comparative analysis 1, 2, 3, Identify the tools of financial statement analysis 2, 3, 5, Explain and apply horizontal analysis 3, 4, 2, 3, 5, 6, 1, 3, 4 Describe and apply vertical analysis 3, 4, 2, 4, 2, 3, Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency 5, 6, 7, 8, 9, 2, 9, 10, 11, 5, 6, 7, 8, 10, 11,12, 13, 12, 13 9, 10, 11 14, 15, 16, 17, 18, 19 1, 2, 3, 4, 5, 6, Understand the concept of earning power, and how irregular items are presented 20, 21, 22, 23 8, Understand the concept of quality of earnings 24 14-1 14, 15 Exercises 12, 13 Problems ASSIGNMENT CHARACTERISTICS TABLE Problem Number Description Difficulty Level Time Allotted (min.) Prepare vertical analysis and comment on profitability Simple 20–30 Compute ratios from balance sheet and income statement Simple 20–30 Perform ratio analysis, and evaluate financial position and operating results Simple 20–30 Compute ratios, and comment on overall liquidity and profitability Moderate 30–40 Compute selected ratios, and compare liquidity, profitability, and solvency for two companies Moderate 50–60 Compute numerous ratios Simple 30–40 Compute missing information given a set of ratios Complex 30–40 Prepare income statement with discontinued operations and extraordinary loss Moderate 30–40 Prepare income statement with nontypical items Moderate 30–40 14-2 Q14-3 Q14-5 BE14-2 Describe and apply vertical analysis E14-8 E14-9 E14-10 P14-2 P14-3 P14-6 E14-13 P14-8 P14-9 Q14-23 BE14-14 BE14-15 E14-12 Q14-20 Q14-21 Q14-22 Q14-24 Communication Decision Making Across the Organization Understand the concept of earning power, and how irregular items are presented Understand the concept of quality of earnings Broadening Your Perspective E14-2 E14-3 E14-4 BE14-7 E14-1 E14-3 E14-4 Q14-19 BE14-2 BE14-9 BE14-10 E14-6 E14-7 Q14-4 BE14-2 BE14-4 BE14-8 Q14-4 BE14-2 BE14-3 BE14-5 BE14-6 BE14-2 Q14-13 Q14-14 Q14-15 Q14-16 Q14-17 Q14-18 Q14-5 Application Q14-5 Q14-7 Q14-9 Q14-10 Q14-11 Q14-12 Q14-6 Q14-8 BE14-2 Q14-3 Q14-5 BE14-2 Explain and apply horizontal analysis Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency Q14-2 Q14-3 Q14-6 BE14-2 Identify the tools of financial statement analysis Q14-5 BE14-1 Comprehension Q14-1 Q14-2 Q14-3 Knowledge Discuss the need for comparative analysis Study Objective 14-3 P14-2 P14-3 P14-4 P14-5 P14-7 Financial Reporting Comp Analysis Exploring the Web BE14-11 BE14-12 BE14-13 E14-5 E14-11 P14-1 P14-1 Analysis Synthesis Comp Analysis Financial Reporting Decision Making Across the Organization Ethics Case All About You Evaluation Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems BLOOM’S TAXONOMY TABLE STUDY OBJECTIVES DISCUSS THE NEED FOR COMPARATIVE ANALYSIS IDENTIFY THE TOOLS OF FINANCIAL STATEMENT ANALYSIS EXPLAIN AND APPLY HORIZONTAL ANALYSIS DESCRIBE AND APPLY VERTICAL ANALYSIS IDENTIFY AND COMPUTE RATIOS USED IN ANALYZING A FIRM’S LIQUIDITY, PROFITABILITY, AND SOLVENCY UNDERSTAND THE CONCEPT OF EARNING POWER, AND INDICATE HOW IRREGULAR ITEMS ARE PRESENTED UNDERSTAND THE CONCEPT OF QUALITY OF EARNINGS 14-4 CHAPTER REVIEW Characteristics Financial statement analysis enables the financial statement user to make informed decisions about a company When analyzing financial statements, three major characteristics of a company are generally evaluated: (a) liquidity, (b) profitability, and (c) solvency (S.O 1) Comparative analysis may be made on a number of different bases a Intracompany basis—Compares an item or financial relationship within a company in the current year with the same item or relationship in one or more prior years b Industry averages—Compares an item or financial relationship of a company with industry averages c Intercompany basis—Compares an item or financial relationship of one company with the same item or relationship in one or more competing companies Tools of Financial Analysis (S.O 2) There are three basic tools of analysis: (a) horizontal, (b) vertical, and (c) ratio Horizontal Analysis (S.O 3) Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage In horizontal analysis, a base year is selected and changes are expressed as percentages of the base year amount Vertical Analysis (S.O 4) Vertical analysis, also called common size analysis, expresses each item within a financial statement as a percent of a base amount Generally, the base amount is total assets for the balance sheet, and net sales for the income statement For example, it may be determined that current assets are 22% of total assets, and selling expenses are 15% of net sales Ratio Analysis (S.O 5) A ratio expresses the mathematical relationship between one quantity and another as either a percentage, rate, or proportion Ratios can be classified as: a Liquidity ratios—measures of the short-term debt-paying ability b Profitability ratios—measures of the income or operating success of an enterprise for a given period of time c Solvency ratios—measures of the ability of the enterprise to survive over a long period of time There are four liquidity ratios: the current ratio, the acid test ratio, receivables turnover, and inventory turnover 14-5 The current ratio expresses the relationship of current assets to current liabilities It is a widely used measure for evaluating a company’s liquidity and short-term debt paying ability The formula for this ratio is: Current ratio = 10 The acid-test or quick ratio relates cash, short-term investments, and net receivables to current liabilities This ratio indicates a company’s immediate liquidity It is an important complement to the current ratio The formula for the acid-test ratio is: Acid-test ratio = 11 Current assets Current liabilities Cash + short-term investments + receivables (net) Current liabilities The receivables turnover ratio is used to assess the liquidity of the receivables This ratio measures the number of times, on average, receivables are collected during the period The formula for the ratio is: Receivables turnover = Net credit sales Average net receivables Average net receivables can be computed from the beginning and ending balances of the net receivables A popular variant of the receivables turnover ratio is to convert it into an average collection period in terms of days This is done by dividing the turnover ratio into 365 days 12 Inventory turnover measures the number of times, on average, the inventory is sold during the period It indicates the liquidity of the inventory The formula for the ratio is: Inventory turnover = Cost of goods sold Average inventory Average inventory can be computed from the beginning and ending inventory balances A variant of the inventory turnover ratio is to compute the average days to sell the inventory This is done by dividing the inventory turnover ratio into 365 days 13 The profitability ratios are explained in review points 14 to 23 14 The profit margin ratio is a measure of the percentage of each sales dollar that results in net income The formula is: Profit margin on sales = 15 Asset turnover measures how efficiently a company uses its assets to generate sales The formula for this ratio is: Asset turnover = 16 Net income Net sales Net sales Average assets Return on assets is an overall measure of profitability It measures the rate of return on each dollar invested in assets The formula is: Return on assets = 14-6 Net income Average assets 17 Return on common stockholders’ equity measures profitability from the common stockholders’ viewpoint The ratio shows the dollars of income earned for each dollar invested by the owners The formula is: Net income Return on common = stockholders’ equity Average common stockholders’ equity 18 a When preferred stock is present, preferred dividend requirements are deducted from net income to compute income available to common stockholders Similarly, the par value of preferred stock (or call price, if applicable) must be deducted from total stockholders’ equity to arrive at the amount of common stock equity used in this ratio b Leveraging or trading on the equity at a gain means that the company has borrowed money through the issuance of bonds or notes at a lower rate of interest than it is able to earn by using the borrowed money A comparison of the rate of return on total assets with the rate of interest paid for borrowed money indicates the profitability of trading on the equity Earnings per share measures the amount of net income earned on each share of common stock The formula is: Earnings per share = Net income Weighted average common shares outstanding Any preferred dividends declared for the period must be subtracted from net income 19 The price-earnings ratio measures the ratio of market price per share of common stock to earnings per share It is an oft-quoted statistic that reflects investors’ assessments of a company’s future earnings The formula for the ratio is: Price-earnings ratio = 20 Market price per share of stock Earnings per share The payout ratio measures the percentage of earnings distributed in the form of cash dividends The formula is: Payout ratio = Cash dividends Net income Companies with high growth rates generally have low payout ratios because they reinvest most of their income into the business 21 There are two solvency ratios: debt to total assets and times interest earned 22 The debt to total assets ratio measures the percentage of total assets provided by creditors The formula for this ratio is: Debt to total assets = Total debt Total assets The adequacy of this ratio is often judged in the light of the company’s earnings Companies with relatively stable earnings, such as public utilities, have higher debt to total assets ratios than cyclical companies with widely fluctuating earnings, such as many high-tech companies 14-7 23 The times interest earned ratio measures a company’s ability to meet interest payments as they become due The formula is: Income before income taxes and interest expense Times interest earned = Interest expense Discontinued Operations 24 (S.O 6) Discontinued operations refers to the disposal of a significant component of a business, such as eliminating an entire activity or eliminating a major class of customers a When the disposal occurs, the income statement should report both income from continuing operations and income (loss) from discontinued operations b The income (loss) from discontinued operations consists of (1) income (loss) from operations and (2) gain (loss) on disposal of the segment c Both components are reported net of applicable taxes in a section entitled Discontinued Operations, which follows income from continuing operations Extraordinary Items 25 Extraordinary items are events and transactions that meet two conditions: (a) unusual in nature and (b) infrequent in occurrence a To be “unusual,” the item should be abnormal and only incidentally related to customary activities of the entity b To be “infrequent,” the item should not be reasonably expected to recur in the foreseeable future c Extraordinary items are reported net of taxes in a separate section of the income statement immediately below discontinued operations Changes in Accounting Principle 26 A change in an accounting principle occurs when the principle used in the current year is different from the one used in the preceding year Companies report most changes in accounting principle retroactively That is, they report both the current period and previous periods using the new principle Income Statement with Nontypical Items 27 A partial income statement showing the additional sections and the material items not typical of regular operations is as follows: Income Statement (partial) Income before income taxes Income tax expense Income from continuing operations Discontinued operations: Loss from operations of discontinued segment, net of $XXX income tax savings Gain on disposal of segment, net of $XXX income taxes Income before extraordinary item Extraordinary item: Gain or loss, net of $XXX income taxes Net Income 14-8 $XXX XXX XXX $XXX XXX XXX XXX XXX $XXX 28 Comprehensive income includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders Quality of Earnings 29 (S.O 7) In evaluating the financial performance of a company, the quality of a company’s earnings is of extreme importance to analysts A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of financial statements 30 Variations among companies in the application of generally accepted accounting principles— alternative accounting methods—may hamper comparability and reduce quality of earnings 31 In recent years, many companies have been also reporting a second measure of income called pro forma income—which excludes items that the company thinks are unusual or nonrecurring Because many companies have abused the flexibility that pro forma numbers allow, it is an area that will probably result in new rule-making 14-9 LECTURE OUTLINE A Basics of Financial Statement Analysis Analyzing financial statements involves evaluating three characteristics: a company’s liquidity, profitability, and solvency a A short-term creditor (a bank) is primarily interested in liquidity—the ability of the borrower to pay obligations when they come due b A long-term creditor (a bondholder) looks to profitability and solvency measures that indicate the company’s ability to survive over a long period of time c Stockholders look at the profitability and solvency of the company They want to assess the likelihood of dividends and the growth potential of the stock Comparison of financial information can be made on a number of different bases B a Intracompany basis: compares an item or financial relationship within a company in the current year with the same item or relationship in prior years b Industry averages: compares an item or financial relationship of a company with industry averages (norms) published by Dun & Bradstreet, Moody’s, and Standard & Poor’s c Intercompany basis: compares an item or financial relationship of one company with the same item or relationship in one or more competing companies Tools of Financial Statement Analysis Horizontal analysis (trend analysis) is a technique for evaluating a series of financial statement data over a period of time to determine the increase or decrease that has taken place The change can be expressed as either an amount or a percentage 14-10 Liquidity ratios TEACHING TIP ILLUSTRATION 14-3 provides a listing of the liquidity ratios; the formulas for calculation; and their major purpose or use a The current ratio is a widely used measure for evaluating a company’s liquidity and short-term debt paying ability It is computed by dividing current assets by current liabilities b The acid-test (quick) ratio is a measure of a company’s immediate short-term liquidity One computes this ratio by dividing the sum of cash, short-term investments, and net receivables by current liabilities c Receivables turnover is used to assess the liquidity of the receivables Companies compute this ratio by dividing net credit sales by the average net receivables during the year One computes the average collection period in days by dividing the receivables turnover ratio into 365 days d Inventory turnover measures the number of times, on average, the inventory is sold during the period Companies compute the inventory turnover by dividing cost of goods sold by the average inventory during the year One computes the average days in inventory by dividing the inventory turnover into 365 days Profitability ratios TEACHING TIP ILLUSTRATION 14-4 provides a listing of the profitability ratios; the formulas for calculation; and their major purpose or use a Profit margin is a measure of the percentage of each dollar of sales that results in net income Companies compute it by dividing net income by net sales 14-12 b Asset turnover measures how efficiently a company uses its assets to generate sales It is computed by dividing net sales by average assets c An overall measure of profitability is return on assets One computes this ratio by dividing net income by average assets d Return on common stockholders’ equity shows how many dollars of net income the company earned for each dollar invested by the owners Companies compute it by dividing net income by average common stockholders’ equity (1) When a company has preferred stock, it must deduct preferred dividend requirements from net income to compute income available to common stockholders (2) Companies deduct the par value of preferred stock (or call price) from total stockholders’ equity to determine the amount of common stockholders equity used in the denominator (3) Leveraging or trading on the equity at a gain means the company is borrowing money at a lower rate of interest than it can earn by using the borrowed money e Earnings per share is a measure of the net income earned on each share of common stock It is computed by dividing net income by the number of weighted average common shares outstanding during the year f The price-earnings ratio is a measure of the ratio of the market price of each share of common stock to the earnings per share One computes it by dividing the market price per share of the stock by earnings per share g The payout ratio measures the percentage of earnings distributed in the form of cash dividends Companies compute it by dividing cash dividends by net income 14-13 Solvency ratios TEACHING TIP ILLUSTRATION 14-5 provides a listing of the solvency ratios, the formulas for calculation, and their major purpose or use C a The debt to total assets ratio measures the percentage of the total assets that creditors provide One computes it by dividing total debt (both current and long-term liabilities) by total assets b Times interest earned (interest coverage ratio) provides an indication of the company’s ability to meet interest payments as they come due Companies compute it by dividing income before interest expense and income taxes by interest expense Earning Power and Irregular Items Earning power means the normal level of income to be obtained in the future Irregular items include (a) discontinued operations, and (b) extraordinary items Discontinued operations refers to the disposal of a significant component of a business Examples involve stopping an entire activity or eliminating a major class of customers a The income (loss) from discontinued operations consists of the income (loss) from operations and the gain (loss) on disposal of the segment b The discontinued operations section reports both the operating income (loss) and the gain (loss) on disposal net of applicable income taxes Extraordinary items are events and transactions that are: a Unusual in nature, and 14-14 b Infrequent in occurrence (1) To be “unusual,” the item should be abnormal and only incidentally related to the company’s customary activities (2) To be “infrequent,” the item should not be reasonably expected to recur in the foreseeable future TEACHING TIP Use ILLUSTRATION 14-6 to distinguish between extraordinary and ordinary items Emphasize the location of each item in the income statement and point out that extraordinary items should be reported net of taxes c Companies report extraordinary items net of taxes in a separate section of the income statement, immediately below discontinued operations A 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 when management can show that the new principle is preferable to the old principle Companies report most changes in accounting principle retroactively They report both the current period and previous periods using the new principle TEACHING TIP ILLUSTRATION 14-7 presents a partial income statement that includes intraperiod tax allocation and separate sections for discontinued operations and extraordinary items Emphasize that the items that are not typical of regular operations are reported net of taxes 14-15 Comprehensive income includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders D Quality of Earnings In evaluating the financial performance of a company, the quality of a company’s earnings is of extreme importance to analysts A high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements Factors affecting to quality of earnings are: a Alternative accounting methods Variations among companies in the application of generally accepted accounting principles may hamper comparability and reduce quality of earnings b Pro forma income Pro forma income usually excludes items that the company thinks are unusual or nonrecurring Many analysts are critical of using pro forma income because these numbers often make companies look better than they really are c Improper recognition Because some managers have felt pressure from investors to continually increase earnings, they have manipulated the earnings numbers to meet these expectations The most common abuse is the improper recognition of revenue 14-16 20 MINUTE QUIZ Circle the correct answer True/False Intercompany comparison refers to comparison with other companies to provide insight into competitive position True Vertical analysis determines the percentage increase or decrease that has taken place over a period of time True False Extraordinary gains and losses should be disclosed in the income statement immediately below discontinued operations net of taxes True 10 False The debt to total assets ratio measures the percentage of total assets provided by longterm creditors True False The formula for computing times interest earned is income before income taxes and interest expense divided by interest expense True False Profit margin, return on assets, and return on common stockholders’ equity are profitability ratios True False Receivables turnover, inventory turnover, and asset turnover are all common measures of liquidity True False Liquidity ratios measure the ability of an enterprise to survive over a long period of time True False A base year is determined when performing horizontal analysis True False False To compute pro forma income, companies generally can exclude any items they deem inappropriate for measuring their performance True False 14-17 Multiple Choice Sales (in millions) for a three year period are: Year $6, Year $6.9, and Year $7.5 Using Year as the base year the percentage increase in sales in Years and are, respectively a 115% and 125% b 115% and 109% c 115% and 130% d 87% and 80% An incorrect formula is a current ratio = current assets ÷ current liabilities b receivables turnover = net credit sales ÷ average net receivables c asset turnover = net income ÷ average assets d payout ratio = cash dividends ÷ net income The acid-test ratio a is a solvency ratio b measures immediate short-term liquidity c includes inventory in the numerator of the formula d includes total liabilities in the denominator of the formula The ratio that measures the overall profitability of assets is a profit margin b asset turnover c return on common stockholders’ equity d return on assets Which of the following would least likely be considered an extraordinary item? a Loss from fire destruction b Loss from meteorite destruction c Gain on sale of company vehicle d Gain on property taken over by a foreign government 14-18 ANSWERS TO QUIZ True/False True False True False False 10 True True False True True Multiple Choice a c b d c 14-19 ILLUSTRATION 14-1 HORIZONTAL ANALYSIS HORIZONTAL ANALYSIS Sales 2009 $150,000 2008 $125,000 2007 $100,000 Base year 150% 125% 100% 25% increase 50% increase Percentage increase or decrease from base year formula: Current year amount – Base year amount Base year amount Example: Percent increase in sales in 2009 from 2007 $150,000 – $100,000 = 50% $100,000 14-20 ILLUSTRATION 14-2 VERTICAL ANALYSIS SAME COMPANY 2009 2008 Amount Percent Amount Percent Sales $120,000 105.73% $80,000 106.67% 6.67% 5,000 5.73% 6,500 Sales returns 75,000 100.00% 113,500 100.00% Net sales 40,000 53.33% 65,000 57.27% Cost of goods sold 35,000 46.67% 48,500 42.73% Gross profit 15,000 20.00% 18,000 15.86% Selling expenses 8,000 10.67% 8.81% 10,000 Administrative expenses 23,000 30.67% 28,000 24.67% Total operating expenses $20,500 18.06% $12,000 16.00% Net income V E R T I C A L A N A L Y S I S Reflects the size of each item relative to a base amount (Net sales) COMMON SIZE ANALYSIS Restating each item on a financial statement in terms of a percentage of a base amount enables the comparison of companies of different sizes BIG COMPANY SMALL COMPANY 2008 2008 Amount Percent Amount Percent $1,200,000 105.73% $80,000 106.67% Sales 6.67% 5,000 5.73% 65,000 Sales returns 75,000 100.00% 1,135,000 100.00% Net sales 40,000 53.33% 650,000 57.27% Cost of goods sold 35,000 46.67% 485,000 42.73% Gross profit 15,000 20.00% 180,000 15.86% Selling expenses 8,000 10.67% 8.81% 100,000 Administrative expenses 23,000 30.67% 24.67% Total operating expenses 280,000 $205,000 18.06% $12,000 16.00% Net income 14-21 V E R T I C A L A N A L Y S I S ILLUSTRATION 14-3 LIQUIDITY RATIOS Ratio Formula Purpose or Use Liquidity Ratios Current assets Current liabilities Measures short-term debt-paying ability Acid-test (quick) ratio Cash + short-term investments + receivables (net) Current liabilities Measures immediate short-term liquidity Receivables turnover Net credit sales Average net receivables Measures liquidity of receivables Inventory turnover Cost of goods sold Average inventory Measures liquidity of inventory Current ratio 14-22 ILLUSTRATION 14-4 PROFITABILITY RATIOS Ratio Formula Purpose or Use Net income Net sales Measures net income generated by each dollar of sales Profitability Ratios Profit margin Asset turnover Net sales Average assets Measures how efficiently assets are used to generate sales Return on assets Net income Average assets Measures overall profitability of assets Return on common stockholders' equity Net income Average common stockholders' equity Measures profitability of owner's investment Earnings per share Net income Weighted average common shares outstanding Measures net income earned on each share of common stock Price-earnings ratio Market price per share of stock Earnings per share Measures the ratio of the market price per share to earnings per share Payout ratio Cash dividends Net income Measures percentage of earnings distributed in the form of cash dividends 14-23 ILLUSTRATION 14-5 SOLVENCY RATIOS Ratio Formula Purpose or Use Total debt Total assets Measures the percentage of total assets provided by creditors Income before income taxes and interest expense Interest expense Measures ability to meet interest payments as they come due Solvency Ratios Debt to total assets ratio Times interest earned 14-24 ILLUSTRATION 14-6 EXTRAORDINARY ITEMS • Events and transactions that are (1) unusual in nature, and (2) infrequent in occurrence • Reported net of taxes in a separate section of the income statement immediately below discontinued operations, if any Extraordinary Examples of appropriate classification for extraordinary and ordinary items Ordinary Effects of major, natural casualties, if rare in the area Effects of major, natural casualties, not uncommon in the area Expropriation (takeover) of property by a foreign goverment Write-down of inventories or write-off of receivables Effects of newly enacted law or regulation, such as a condemnation action Losses attributable to labor strikes Destruction of property by fire or explosion 14-25 Gains or losses from sales of property, plant, or equipment ILLUSTRATION 14-7 PARTIAL INCOME STATEMENT Income Tax Expense from Continuing Operations Discontinued Operations (net of taxes) Extraordinary Items (net of tax) DEVINE, INC Income Statement (partial) For the Year Ended December 31, 2008 Income before Income Taxes $190,000 Income Tax Expense 57,000 Income from Continuing Operations 133,000 Discontinued Operations: Loss from Operations of Video Division, Net of $12,000 Tax Savings $(28,000) Loss on Disposal of Video Division, Net of $27,000 Tax Savings (63,000) (91,000) Income before Extraordinary Item 42,000 Extraordinary Item: Gain from Expropriation of Investment, Net of $15,000 Income Taxes 35,000 Net Income $ 77,000 14-26 ... It is computed by dividing current assets by current liabilities b The acid -test (quick) ratio is a measure of a company’s immediate short-term liquidity One computes this ratio by dividing the... Companies compute it by dividing net income by net sales 14-12 b Asset turnover measures how efficiently a company uses its assets to generate sales It is computed by dividing net sales by average assets... Companies compute the inventory turnover by dividing cost of goods sold by the average inventory during the year One computes the average days in inventory by dividing the inventory turnover into
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