Chapter 18 Financial Statement Analysis Prepared by: Debbie Musil Kwantlen University College

Agenda Learning goals Vocabulary Tools for Financial Statement Analysis Horizontal Analysis Vertical Analysis Ratio Analysis Limitation of Financial Analysis

Learning Goals Explain and apply horizontal analysis Explain an apply vertical analysis Identify and use ratios to analyze a company’s liquidity, profitability and solvency Recognize and illustrate the limitations of financial statement analysis

Vocabulary Discontinued operations Identifiable business segment Liquidity ratios Earnings power Profitability ratios Horizontal analysis Ratio analysis Solvency ratios Vertical analysis

Tools of Financial Statement Analysis Comparing financial statement information of a company can be done: On an intracompany basis: compare current year with prior years On an intercompany basis: with other competing companies Based on industry averages: the averages are determined and published by financial ratings organizations, such as Bloomberg…

Tools of Financial Statement Analysis Important to also review other financial and non-financial information Company's mission statement, objectives and goals It’s market positions, people, and products. Economic situation

Tools of Financial Statement Analysis Three commonly used tools follow: Horizontal analysis: this tool evaluates a series of financial statement data over a period of time. Vertical analysis: This tool evaluates financial statement data by expressing each item in a financial statement as a percentage of a based amount that covers the same period of time as the items Ratio analysis: this tool expresses the relationship among selected items of financial statement data

Horizontal Analysis (Trend Analysis) Compares a series of financial data over a period of time Use financial statements/annual reports: provide comparison data for one or more years To determine the increase or decrease that has taken place in specific accounts Comparisons can also be made between accounts For example, the change in sales to the change in accounts receivable over the same time period Indicates where further analysis is required Such as vertical or ratio analysis

Horizontal Analysis: Balance Sheet

Horizontal Analysis : Income Statement

Check for understanding Selected, condensed information (in thousands) from Bonora Ltd.’s income statement for four years ended June 30 follows: (pg927) Calculate the percentage of the base-year amount for each year, assuming that 2005 is the base year Calculate the percentage change between the following years: 2005 & 2006; 2006 & 2007; 2007& 2008 2008 2007 2006 2005 Revenue $5,035 $6,294 $9,468 $8,646 Gross profit 936 1,077 2,146 1,900 Net Income 251 110 546 428

Vertical Analysis (Common Size Analysis) Expresses financial statement data as a percentage of a base amount Commonly used base amounts are: Balance sheet: total assets; total liabilities and shareholders’ equity Income statement: net sales Useful for intracompany and intercompany comparisons

Vertical Analysis: Balance Sheet

Vertical Analysis: Income Statement

Vertical Analysis: Intercompany Comparison A benefit of vertical analysis is that it makes it possible to compare companies of different sizes.

Check for understanding Summary financial information for Boyko Corporation at May 31 is as follows: (pg931) Calculate the percentage size of each category, for each year, using vertical analysis 2008 2007 Current Assets $234,000 $180,000 Property, plan and equipment 756,000 420,000 Total Assets $990,000 $600,000

Practice Questions Self study questions 1, 2, 3 Questions: 1, 4 BE 18-1 5 B 18-1  4

Ratio Analysis Expresses the relationship between selected financial statement items Classified into: Liquidity ratios: measure short-term ability to meet obligations and unexpected cash needs Solvency ratios: measure ability to survive over long periods of time Profitability ratios: measure operating success for a specific time period

Ratio Analysis Liquidity Ratios

Ratio Analysis Solvency Ratios

Ratio Analysis Profitability Ratios

Check for understanding Read pages 939-950 Do demonstration problem 951 -952

Practice Questions BE 18-6  11 E 18- 5  11

Limitations of Financial Analysis Inflation: Revenue might show growth from previous year however, prices went up. Estimates: if inaccurate or biased, the financial analysis will also be inaccurate or biased Alternative accounting principles: reduces intercompany comparability. Different companies use different accounting methods.

Limitations of Financial Analysis Diversification: affects classification and intercompany comparability. So many companies these day do more than one thing or sell more than one kind of product Quality of earnings: full and transparent reporting aids in accurate financial analysis. Some companies may limit what they disclose or make it confusing to try to hide information and mislead users of the financial statement.

Earning Power Users are interested in the normal level of income of a company (its “earning power”) Net income must be adjusted for any irregular, non-typical items In order to ensure comparability Therefore, adjust for irregular items: Change in accounting principle (Ch. 14) Discontinued operations Extraordinary items: rare in Canada

Discontinued Operations Disposal of an identifiable operating segment of business Clearly distinguished from the rest of the company for financial reporting and operating purposes A segment can be a separate subsidiary company, an operating division within the company, or even a groups of assets. It has to be a separate business that can be clearly distinguished from the company as a whole

Discontinued Operations Reported separately on the income statement

Check for understanding In its 2008 income statement , Qu Ltd. reported income before income tax of $400,000; a pre-tax loss on discontinued operations of $75,000; and a pre-tax gain on the disposal of the assets from the discontinued operations of $30,000. The company has a 25% income tax rate; Prepare an income statement, beginning with income before income tax (pg 938)

Practice Questions BE 18-12  14 E 18-12 + 13