Financial Statement Analysis Chapter 14 Financial Statement Analysis Financial Accounting, IFRS Edition Weygandt Kimmel Kieso

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 discontinued operations are presented. Understand the concept of quality of earnings.

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 Statement of financial position Income statement Retained earnings statement Liquidity Profitability Solvency Summary Discontinued operations Changes in accounting principle Comprehensive income Alternative accounting methods Pro forma income Improper recognition

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.

Horizontal Analysis Horizontal analysis, also called trend analysis Technique for evaluating a series of financial statement data over a period of time. Purpose is to determine the increase or decrease that has taken place. Commonly applied to the statement of financial position, income statement, and statement of retained earnings. SO 3 Explain and apply horizontal analysis.

Horizontal Analysis Statement of Financial Position These 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. Illustration 14-5 SO 3 Explain and apply horizontal analysis.

Horizontal Analysis Income Statement 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. Illustration 14-6 SO 3 Explain and apply horizontal analysis.

Horizontal Analysis Retained Earnings Statement Illustration 14-7 We saw in the horizontal analysis of the statement of financial position 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.

Horizontal Analysis Solution Illustration: Summary financial information for Rosepatch Company is as follows. Compute the amount and percentage changes in 2011 using horizontal analysis, assuming 2010 is the base year. Solution SO 4 Describe and apply horizontal analysis.

Vertical Analysis Vertical analysis, also called common-size analysis Expresses each financial statement item as a percent of a base amount. For example, selling expenses could be expressed as 16% of net sales. Commonly applied to the statement of financial position and the income statement. SO 4 Describe and apply vertical analysis.

Vertical Analysis Statement of Financial Position These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt. Illustration 14-8 SO 4 Describe and apply vertical analysis.

Vertical Analysis Income Statement Quality appears to be a profitable enterprise that is becoming even more successful. Illustration 14-9 SO 4 Describe and apply vertical analysis.

Vertical Analysis Enables a comparison of companies of different sizes. Illustration 14-10 Intercompany income statement comparison Park Street earned net income more than 4,208 times larger than Quality’s, Park Street’s net income as a percent of each sales euro (5.6%) is only 44% of Quality’s (12.6%). SO 4 Describe and apply vertical analysis.

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.

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.

Ratio Analysis Liquidity Ratios Measures short-term ability of the company to pay its maturing obligations and to meet 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.

Ratio Analysis Liquidity Ratios The 2011 ratio of 2.96:1 means that for every euro 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.

p. 669 How to Manage the Current Ratio Q: How might management influence the company’s current ratio? A: Management can affect the current ratio by speeding up or withholding payments on accounts payable just before the statement of financial position date. Management can alter the cash balance by increasing or decreasing non-current assets or long-term debt, or by issuing or purchasing equity shares.

Ratio Analysis Liquidity Ratios Compute the Acid-Test Ratio for 2011. Illustration 14-13 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios The acid-test ratio measures immediate liquidity. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios 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.

365 days / 10.2 times = every 35.78 days Liquidity Ratios Ratio Analysis 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 35.78 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.

Ratio Analysis Liquidity Ratios 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.

365 days / 2.3 times = every 159 days Liquidity Ratios Ratio Analysis 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.

Ratio Analysis Liquidity Ratios Illustration 14-27 Summary of liquidity ratios SO 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. 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 ordinary shareholders’ 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.

Ratio Analysis Profitability Ratios 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.

Ratio Analysis Profitability Ratios 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.

Ratio Analysis Profitability Ratios An overall measure of profitability. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Profitability Ratios Shows how many euros 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.

Ratio Analysis Profitability Ratios A measure of the amount of net income applicable to each ordinary share. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Profitability Ratios 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.

Ratio Analysis Profitability Ratios Measures the percentage of earnings distributed in the form of cash dividends. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis Profitability Ratios Illustration 14-27 Summary of profitability ratios SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

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.

Ratio Analysis Solvency Ratios 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.

Ratio Analysis Solvency Ratios 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.

Ratio Analysis Solvency Ratios Illustration 14-27 Summary of solvency ratios SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

p. 677 Keeping Up to Date as an Investor Q: If you want to keep current with the financial and operating developments of a company in which you own shares, what are some ways you can do so? A: You can obtain current information on your investments through a company’s website, financial magazines and newspapers, CNBC television programs, and investment letters.

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

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 discontinued operations are presented.

Earning Power and Irregular Items Illustration: During 2011 Acro Energy Inc. has income before taxes of $800,000. During 2011 Acro discontinued and sold its unprofitable chemical division. The loss in 2011 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. SO 6 Understand the concept of earning power, and how discontinued operations are presented.

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

p. 681 What Does “Non-Recurring” Really Mean? Q: If a company takes a large restructuring charge, what is the effect on the company’s current income statement versus future ones? A: The current period’s net income can be greatly diminished by a large restructuring charge, while the net income in future periods can be enhanced because they are relieved of costs (i.e., depreciation and labor expenses) that would have been charged to them.

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 discontinued operations are presented.

Reported in Stockholders’ Equity Earning Power and Irregular Items Comprehensive Income All changes in equity except those resulting from investments by shareholders and distributions to shareholders. 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 discontinued operations 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 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 discontinued operations 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. Companies have incentives to manage income to meet or beat Wall Street expectations, so that the market price of the shares increase and the value of share options increase. SO 7 Understand the concept of quality of earnings.

Quality of Earnings Alternative Accounting Methods Pro Forma Income Variations among companies in the application of IFRS 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.

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.

Understanding U.S. GAAP Key Differences Financial Statement Analysis Under GAAP, items that are considered to be both unusual in nature and infrequent in occurrence are reported as “extraordinary items” in a separate line item at the bottom of the income statement, net of tax. Under IFRS, there is no classification for extraordinary items. In other words, extraordinary item treatment is prohibited under IFRS. In recent years, the types of items that can receive extraordinary item treatment under GAAP has been reduced to the point where the classification is rarely used. The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS.

Understanding U.S. GAAP Key Differences Financial Statement Analysis Under IFRS, comprehensive income is either presented in a single statement, combined with net income, or as a separate statement, immediately after the income statement. GAAP also permits the one-statement or two-statement approach as well. In addition, GAAP permits a third alternative, which is to show the computation of comprehensive income in the statement of shareholders’ equity. The issues related to quality of earnings are the same under both GAAP and IFRS. It is hoped that by adopting a more principles-based approach as found in IFRS that many of the earnings quality issues will be reduced.

Understanding U.S. GAAP Looking to the Future Financial Statement Analysis Looking to the Future FASB and the IASB are working on a project that would rework the structure of financial statements. Recently, the IASB decided to require a statement of comprehensive income similar to what was required under GAAP. In addition, another part of this project addresses the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, the approach draws attention away from one number—net income. Instead, this approach provides more information about the components of net income and comprehensive income.

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