2. Accounting Principles, Ninth Edition
Chapter 18
Financial Statement
Analysis
Accounting Principles, Ninth Edition

3. 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 how irregular items are presented.
Understand the concept of quality of earnings.
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

4. Financial Statement Analysis
Basics of Financial Statement Analysis
Horizontal and Vertical Analysis
Ratio Analysis
Earning Power and Irregular Items
Quality of Earnings
Need for comparative analysis
Tools of analysis
Balance sheet
Income statement
Retained earnings statement
Liquidity
Profitability
Solvency
Summary
Discontinued operations
Extraordinary items
Changes in accounting principle
Comprehensive income
Alternative accounting methods
Pro forma income
Improper recognition
Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation.
Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt.
Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets.
Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees.
Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss:
difference between the actual return and the expected return on plan assets and,
amortization of the unrecognized net gain or loss from previous periods

5. Basics of Financial Statement Analysis
Analyzing financial statements involves:
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.

6. 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.
SO 3 Explain and apply horizontal analysis.

7. Horizontal Analysis
Illustration 18-5
Horizontal analysis of
balance sheets
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.
SO 3 Explain and apply horizontal analysis.

8. 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.
SO 3 Explain and apply horizontal analysis.

9. Horizontal Analysis
Illustration 18-7
Horizontal analysis of
retained earnings statements
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.
SO 3 Explain and apply horizontal analysis.

10. 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.
SO 4 Describe and apply vertical analysis.

11. 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.
SO 4 Describe and apply vertical analysis.

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

13. Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 18-10
Intercompany income statement comparison
J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C. Penney’s net income as a percent of each sales dollar (5.6%) is only 4% of Quality’s (12.6%).
SO 4 Describe and apply vertical analysis.

14. Financial Ratio Classifications
Ratio Analysis
Ratio analysis expresses the relationship among selected items of financial statement data.
Financial Ratio Classifications
Liquidity
Profitability
Solvency
Measures short-term 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.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

15. Ratio Analysis A single ratio by itself is not very meaningful.
The discussion of ratios will include the following types of comparisons.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

16. 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.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

17. Ratio Analysis Liquidity Ratios Compute the Current Ratio for 2007.
Current Assets
= Current Ratio
Current Liabilities
$1,020,000
= : 1
$344,500
The ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

18. Ratio Analysis Liquidity Ratios Compute the Acid-Test Ratio for 2007.
Illustration 18-13
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

19. Ratio Analysis Liquidity Ratios Compute the Acid-Test Ratio for 2007.
Cash + Short-Term Investments + Receivables (Net)
Acid-Test Ratio =
Current Liabilities
$100,000 + $20,000 + $230,000
= : 1 $
The acid-test ratio measures immediate liquidity.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

20. Average Net Receivables
Liquidity Ratios
Ratio Analysis
Compute the Receivables Turnover ratio for 2007.
Net Credit Sales
Receivables Turnover =
Average Net Receivables
$2,097,000
= times
($180,000 + $230,000) / 2
It measures the number of times, on average, the company collects receivables during the period.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

21. 365 days / 10.2 times = every 35.78 days
Liquidity Ratios
Ratio Analysis
Receivables Turnover
$2,097,000
= times
($180,000 + $230,000) / 2
A variant of the receivables turnover ratio is to convert it to an average collection period in terms of days.
365 days / 10.2 times = every days
This means that receivables are collected on average every 36 days.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

22. Ratio Analysis Liquidity Ratios
Compute the Inventory Turnover ratio for 2007.
Cost of Good Sold
Inventory Turnover =
Average Inventory
$1,281,000
= times
($500,000 + $620,000) / 2
Inventory turnover measures the number of times, on average, the inventory is sold during the period.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

23. 365 days / 2.3 times = every 159 days
Liquidity Ratios
Ratio Analysis
Inventory Turnover
$1,281,000
= 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.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

24. 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.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

25. Ratio Analysis Profitability Ratios
Compute the Profit Margin ratio for 2007.
Net Income
Profit Margin =
Net Sales
$263,800
= 12.6%
$2,097,000
Measures the percentage of each dollar of sales that results in net income.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

26. Ratio Analysis Profitability Ratios
Compute the Asset Turnover ratio for 2007.
Net Sales
Asset Turnover =
Average Assets
$2,097,000
= times
($1,95,000 + $1,835,000) / 2
Measures how efficiently a company uses its assets to generate sales.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

27. Ratio Analysis Profitability Ratios
Compute the Return on Assets ratio for 2007.
Net Income
Return on Assets =
Average Assets
$263,800
= 15.4%
($1,595,000 + $1,835,000) / 2
An overall measure of profitability.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

28. Return on Common Stockholders’ Equity
Profitability Ratios
Ratio Analysis
Compute the Return on Common Stockholders’ Equity ratio for 2007.
Return on Common Stockholders’ Equity
Net Income – Preferred Dividends =
Average Common Stockholders’ Equity
$263,000 - $0
= 29.3%
($795,000 + $1,003,000) / 2
Shows how many dollars of net income the company earned for each dollar invested by the owners.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

29. Weighted Average Common Shares Outstanding
Profitability Ratios
Ratio Analysis
Compute the Earnings Per Share for 2007.
Net Income
Earnings Per Share =
Weighted Average Common Shares Outstanding
$263,800
= $0.97 per share
270, ,400 / 2
A measure of the net income earned on each share of common stock.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

30. Market Price per Share of Stock
Profitability Ratios
Ratio Analysis
Compute the Price Earnings Ratio for 2007.
Price Earnings Ratio
Market Price per Share of Stock =
Earnings Per Share
$12.00
= times
$0.97
The price-earnings (PE) ratio reflects investors’ assessments of a company’s future earnings.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

31. Ratio Analysis Profitability Ratios Compute the Payout Ratio for 2007.
Cash Dividends
Payout Ratio =
Net Income *
$61,200
= 23.2%
$263,800
Measures the percentage of earnings distributed in the form of cash dividends.
* From analysis of retained earnings.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

32. 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.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

33. Debt to Total Assets Ratio
Solvency Ratios
Ratio Analysis
Compute the Debt to Total Assets Ratio for 2007.
Debt to Total Assets Ratio
Total Debt =
Total Assets
$832,000
= 45.3%
$1,835,000
Measures the percentage of the total assets that creditors provide.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

34. Income before Income Taxes and Interest Expense
Solvency Ratios
Ratio Analysis
Compute the Times Interest Earned ratio for 2007.
Income before Income Taxes and Interest Expense
Times Interest Earned =
Interest Expense
$468,000
= 13 times
$36,000
Provides an indication of the company’s ability to meet interest payments as they come due.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

35. 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:
Discontinued operations.
Extraordinary items.
These “irregular” items are reported net of income taxes.
SO 6 Understand the concept of earning power, and how irregular items are presented.

36. Earning Power and Irregular Items
Discontinued Operations
Refers to the disposal of a significant component of a business.
Report the income (loss) from discontinued operations in two parts:
income (loss) from operations (net of tax) and
gain (loss) on disposal (net of tax).
SO 6 Understand the concept of earning power, and how irregular items are presented.

37. Earning Power and Irregular Items
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
Net income $350,000
SO 6 Understand the concept of earning power, and how irregular items are presented.

38. Previously labeled as “Net Income”.
Earning Power and Irregular Items
Discontinued Operations are reported after “Income from continuing operations.”
Previously labeled as “Net Income”.
Moved to
SO 6 Understand the concept of earning power, and how irregular items are presented.

39. Earning Power and Irregular Items
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.”
SO 6 Understand the concept of earning power, and how irregular items are presented.

40. 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.
A citrus grower's Florida crop is damaged by frost.
Loss from sale of temporary investments.
Loss attributable to a labor strike.
YES NO NO NO
SO 6 Understand the concept of earning power, and how irregular items are presented.

41. Earning Power and Irregular Items
Are these considered Extraordinary Items?
(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.
Write-down of obsolete inventory.
Expropriation of a factory by a foreign government. NO
YES NO
YES
SO 6 Understand the concept of earning power, and how irregular items are presented.

42. Earning Power and Irregular Items
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 18-30

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

44. Discontinued Operations
Earning Power and Irregular Items
Reporting when both Discontinued Operations and Extraordinary Items are present.
Discontinued Operations
Extraordinary Item
SO 6 Understand the concept of earning power, and how irregular items are presented.

45. Earning Power and Irregular Items
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.
SO 6 Understand the concept of earning power, and how irregular items are presented.

46. Reported in Stockholders’ Equity
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
Unrealized gains and losses on available-for-sale securities.
Plus other items +
SO 6 Understand the concept of earning power, and how irregular items are presented.

47. 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
reduces the volatility of net income due to fluctuations in fair value,
yet informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value.
SO 6 Understand the concept of earning power, and how irregular items are presented.

48. 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.
Companies have incentives to manage income to meet or beat Wall Street expectations, so that
the market price of stock increases and
the value of stock options increase.
SO 7 Understand the concept of quality of earnings.

49. Quality of Earnings Alternative Accounting Methods Pro Forma Income
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.
SO 7 Understand the concept of quality of earnings.

50. 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:
Improper recognition of revenue (channel stuffing).
Improper capitalization of operating expenses (WorldCom).
Failure to report all liabilities (Enron).
SO 7 Understand the concept of quality of earnings.

51. Copyright
“Copyright © 2009 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”