Accounting Fundamentals Dr. Yan Xiong Department of Accountancy CSU Sacramento The lecture notes are primarily based on Reimers (2003). 7/11/03

Chapter 11: Financial Statement Analysis Agenda  Purpose of a Business and Types of Businesses  Ownership Structure of Businesses  Business Processes  The Accounting Equation  Four Basic Financial Statements

Analyzing Financial Statements t Before we discuss financial statement analysis, let’s take a closer look at some of the elements of the income statement. t Then, we’ll talk about several ways to analyze financial statements.

More About The Income Statement t To make the information on the income statement clearer, there are several special items that are separated from the regular earnings of a business: u Gains and losses from discontinued operations, u Extraordinary items, and u Cumulative effect of a change in accounting principle

Discontinued Operations t If a segment or division of a business is eliminated, the gain or loss from the disposal must be shown after income from continuing operations, net of taxes. t Any current gain or loss from the operations of that discontinued segment must also be shown separately.

How Discontinued Operations Are Shown

Extraordinary Items t Events that are unusual in nature and infrequent in occurrence are called extraordinary items. t The accounting rules are very strict about what types of events may be classified as extraordinary. t Any gain or loss from these events are shown, net of taxes, after income from continuing operations and after income from discontinued operations.

Examples Of Actual Extraordinary Occurrences t Volcano eruptions t Take-over of foreign operations by the foreign government t Effects of new laws or regulations that result in a one-time cost to comply E ach situation is unique and must be considered in the environment in which the business operates. E ach situation is unique and must be considered in the environment in which the business operates.

How Extraordinary Items Are Shown

Cumulative Effect Of A Change In Accounting Principal t The cumulative effect of a change in accounting principle is the amount of gain or loss from changing accounting methods. t It must be shown separately on the income statement, net of taxes, after income from continuing operations, discontinued operations, and any extraordinary items.

Example t Suppose the company changed from depreciating equipment using the straight-line method to depreciating the equipment using the double declining balance method. t The equipment was purchased on January 1, 2001, at a cost of $10,000, has a useful life of 10 years, with no salvage value.

Depreciation Schedules t The income for Containers, Inc. would have been lower by $1,600 if double-declining balance had been used from the beginning. t A switch now means the company will have to subtract $1,600, net of any tax effect, as a cumulative effect of a change in accounting principle.

Cumulative Effect t The income for Containers, Inc. would have been lower by $1,600 if double-declining balance had been used from the beginning. t A switch now means the company will have to subtract $1,600, net of any tax effect, as a cumulative effect of a change in accounting principle.

How The Cumulative Effect Is Shown On The Income Statement

Comprehensive Income t The income statement shows all of the effects of revenues, expenses, gains, and losses on net income. t Net income, in turn, affects owners’ equity. t Other items, not included on the income statement, may affect owners’ equity. t The total of all items that affect owners’ equity, not including contributions from owners and dividends, is called comprehensive income.

Diagram Showing the Items that Affect Owners’ Equity

Other Comprehensive Income t Total comprehensive income = net income plus other comprehensive income t Items included in other comprehensive income include: u unrealized gains and losses from foreign currency translation u unrealized gains and losses on certain types of investments.

One More New Financial Statement Item: Investments In Securities t A company may use some of its extra cash to invest in the debt or equity securities of another company. t These investments must be classified as one of three types: p Securities held to maturity p Trading securities p Securities available for sale t A company may use some of its extra cash to invest in the debt or equity securities of another company. t These investments must be classified as one of three types: p Securities held to maturity p Trading securities p Securities available for sale

Securities Held To Maturity t Debt securities t Intent and ability to hold to maturity t Must not be sold in response to changes in interest rates, funding sources, etc. t Measured at cost on the balance sheet

Trading Securities t Debt and equity securities t Readily determinable fair values t Bought and held to sell in the near term t Actively and frequently traded (profit!) t Measured at fair value and classified as a current asset t Unrealized gains and losses, included in determination of net income

Securities Available For Sale t Debt and equity securities t Readily determinable fair values t Not classified as either securities held to maturity or trading securities t Measured at fair value on balance sheet t May be either current or noncurrent t May have holding gains or losses, to be reported net as a separate component of owners’ equity, usually as part of other comprehensive income.

t In addition to the financial statements, annual reports contain the following: u Notes to the financial statements, including a summary of the accounting methods used u Management’s discussion and analysis (MD&A) of the financial results u The auditor’s report u Comparative financial data for a series of years Financial Statement Analysis

t Now that you’ll be able to recognize these new items we’ve just discussed, you’re ready to do some analysis of the financial statements. t First, we’ll talk about horizontal and vertical analysis. t Then, we’ll discuss financial ratios -- standard measures that enable analysts to compare companies of different sizes

Horizontal Analysis Sales$41,500 $37,850 $36,300 $35,000 Horizontal analysis compares one value across several periods. First, a base year must be chosen as the basis for comparison. The difference between each year and the base year is expressed as a percentage of the base year.

Horizontal Analysis Sales$41,500 $37,850 $36,300 $35, % 8.1% 3.7% This shows 2000 as the base year. The base year’s sales are subtracted from each year’s sales. Then, this difference is expressed as a percentage of the base year’s sales. Base year

Horizontal Analysis Sales$41,500 $37,850 $36,300 $35, % 8.1% 3.7% For example, the sales for 2003 represent an increase of 18.6% over the base year Base year

Vertical Analysis – compares each item in a financial statement to a base number set to 100%. t Every item on the financial statement is then reported as a percentage of that base.

Vertical Analysis 2002 % Sales$38, Cost of goods sold 19, Gross margin$18, Total operating expenses 13, Operating income$ 5, Other income 2, Income before taxes$ 7, Income taxes 2, Net income$ 4,

Ratio Analysis Ratios are standard measures that enable analysts to compare companies of different sizes.

Ratio Classification  Liquidity : Can a company pay the bills as they come due? t Solvency: Can the company survive over a long period of time? t Profitability : Can a company earn a satisfactory rate of return? t Market indicators : Is the stock a good investment?

Current ratio = Total current assets ÷ Total current liabilities Liquidity: Measuring Ability to Pay Current Liabilities This ratio measures a company’s ability to pay current liabilities with current assets.

Acid-test ratio = (Cash + Short-term investments + Net current receivables) ÷ Total current liabilities Liquidity: Measuring Ability to Pay Current Liabilities The acid-test ratio shows the company’s ability to pay all current liabilities if they come due immediately.

Working capital = Total current assets Total current liabilities Liquidity: Measuring Ability to Pay Current Liabilities Working capital is not a ratio, but it is often computed to evaluate a the company’s ability to pay its current liabilities.

Inventory turnover = Cost of goods sold ÷ Average inventory Liquidity: Measuring Ability to Sell Inventory This ratio measures how quickly a company is turning over its inventory. A high number indicates an ability to quickly sell inventory.

Accounts receivable turnover = Net credit sales ÷ Average accounts receivable Liquidity: Measuring Ability to Collect Receivables This ratio measure’s a company’s ability to collect the cash from its credit customers.

Solvency: Measuring Ability to Pay Long-term Debt The debt to equity ratio compares the amount of debt a company has with the amount the owners have invested in the company. Debt-to-equity ratio = Total liabilities ÷ Total equity

Solvency: Times interest earned This ratio compares the amount of income that has been earned in an accounting period to the interest obligation for the same period. Times interest earned ratio = Net income + interest expense ÷ Interest expense

Return on assets = Net income + interest expense ÷ Average total assets Measuring Profitability: Return on assets This ratio measures a company’s success in using its assets to earn income for the persons who are financing the business.

Rate of return on common stockholders’ equity = (Net income – preferred dividends) ÷ Average common stockholders’ equity Measuring Profitability: Return on Equity This ratio measures how much income is earned with the common shareholders’ investment in the company.

Gross margin ratio = Gross margin ÷ Sales Measuring Profitability: Gross Margin Ratio This ratio measures percentage of sales price that is gross profit. A small shift usually indicates a big change in the profitability of the company’s sales.

Measuring Profitability: Earnings Per Share Earnings per share of common stock = (Net income – Preferred dividends) ÷ Number of shares of common stock outstanding This ratio gives the amount of net income per share of common stock. It is one of the most widely-used measures of a company’s profitability.

Market Indicators: PE Ratio Price/earning ratio is the ratio of market price per share to earnings per share. This ratio indicates the market price for $1 of earnings. Price/earning ratio is the ratio of market price per share to earnings per share. This ratio indicates the market price for $1 of earnings. Price/Earnings Ratio = Market price per share of common stock ÷ Earnings per share

Dividend per share of common (or preferred) stock ÷ Market price per share of common (or preferred) stock Market Indicators: Dividend Yield Dividend yield gives the percentage of a stock’s market value returned as dividends to stockholders each period.

Making Ratios Useful t A ratio by itself does not give much information.  To be useful, a ratio must be compared to other ratios from previous periods, compared to ratios of other companies in the industry, or compared to industry averages.