What we do now determines the future. James M. Sugden – (right now)

Chapter 14 FINANCIAL STATEMENT ANALYSIS: The Big Picture

Chapter 14 After studying Chapter 14, you should be able to: Understand the concept of sustainable income. Indicate how irregular items are presented. Explain the concept of comprehensive income. Describe and apply horizontal analysis. Describe and apply vertical analysis.

Chapter 14 After studying Chapter 14, you should be able to: Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability. Understand the concept of quality of earnings.

Components of the Income Statement

Irregular Items Two types of irregular items are reported -- (all net of taxes) discontinued operations extraordinary items

Discontinued Operations... The disposal of a significant segment of a business... –the elimination of a major class of customers or –an entire activity.

Rozek net income of $800,000 from continuing operations in During 2007 the company discontinued and sold its unprofitable chemical division. The loss in 2007 from chemical operations (net of $90,000 taxes) was $210,000. The tax rate is 30%. Discontinued Operations

Extraordinary Items... Are events and transactions that meet two conditions: –Unusual in nature –Infrequent in occurrence 9

In 2007 a revolutionary foreign government expropriated property held as an investment by Rozek Inc. The loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000. Extraordinary Items

Presentation of Extraordinary Items...

Extraordinary 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. (b)A citrus grower's Florida crop is damaged by frost. (c)Loss from sale of temporary investments. (d)Loss attributable to a labor strike. YES NO NO NO Earning Power and Irregular Items

(e) Loss from flood damage. (The nearby Black River floods every 2 to 3 years.) (f) An earthquake destroys one of the oil refineries owned by a large multi-national oil company. Earthquakes are rare in this geographical location. g)Write-down of obsolete inventory. h)Expropriation of a factory by a foreign government. NO YES YES NO Are these considered Extraordinary Items? Earning Power and Irregular Items

Sustainable Income... Is the most likely level of income to be obtained in the future. Does not include irregular revenues, expenses, gains, or losses.

Estimating Sustainable Income When evaluating a company, it generally makes sense to eliminate all irregular items in estimating future sustainable income.

Change in Accounting Principle Occur when the principle used in the current year is different from the one used in the preceding year. Is permitted, when –management can show that the new principle is preferable to the old and –Most changes are reported retroactively – improves comparability Example: a change in inventory costing methods (such as FIFO to average cost).

Most revenues, expenses, gains, and losses recognized during the period are included in net income. Specific exceptions to this practice have developed - these items bypass income and are reported directly in stockholders’ equity. Comprehensive Income

The FASB now requires that, in addition to reporting net income, a company must also report comprehensive income. Comprehensive Income

Includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders.

Complete Income Statement

There are three types of comparisons to improve decision usefulness of financial information: Intracompany basis Intercompany basis Industry averages Financial Statement Analysis

Three basic tools are used in financial statement analysis : 1.Horizontal analysis 2.Vertical analysis 3.Ratio analysis 23

Analysts should look beyond the ratios. Economic factors Consumer tastes Industry trends Technological changes Changes within the firm Limitations of Financial Statement Analysis

Financial statements are based on estimates. –allowance for uncollectible accounts –depreciation –costs of warranties –contingent losses To the extent that these estimates are inaccurate, the financial ratios and percentages are also inaccurate. Limitations of Financial Statement Analysis

Statements in Comparative and Common- Size Form Dollar and percentage changes on statements Common-size statements Ratios Analytical techniques used to examine relationships among financial statement items

Dollar and Percentage Changes on Statements Comparing statements underscores movements and trends and may provide valuable clues about what to expect in the future. Horizontal analysis Trend analysis

Horizontal Analysis Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

Horizontal Analysis

Calculating Change in Dollar Amounts Dollar Change Current Year Figure Base Year Figure =– The dollar amounts for 2007 become the “base” year figures.

Horizontal Analysis Calculating Change as a Percentage Percentage Change Dollar Change Base Year Figure 100% = ×

Horizontal Analysis ($11,500 ÷ $23,500) × 100% = 48.9% $12,000 – $23,500 = $(11,500)

Horizontal Analysis

Sales increased by 8.3% yet net income decreased by 21.9%.

Horizontal Analysis There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.

Trend Percentages Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.

Trend Analysis Example Look at the income information for Berry Products for the years 2007 through We will do a trend analysis on these amounts to see what we can learn about the company.

Trend Analysis Berry Products Income Information For the Years Ended December 31, The base year is 2007, and its amounts will equal 100%.

Trend Analysis Berry Products Income Information For the Years Ended December 31, 2008 ÷ 2007 ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108%

Trend Analysis Berry Products Income Information For the Years Ended December 31, By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.

Trend Analysis We can use the trend percentages to construct a graph so we can see the trend over time.

Common-Size Statements Common-size single vertical analysis Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis.

Common-Size Statements Example Let’s take another look at the information from the comparative income statements of Clover Corporation for 2011 and This time let’s prepare common-size statements.

Common-Size Statements Net sales Net sales is usually the base and is expressed as 100%.

Common-Size Statements 2011 COGS ÷ 2011 Net Sales ( $360,000 ÷ $520,000 ) = 69.2% 2010 COGS ÷ 2010 Net Sales ( $315,000 ÷ $480,000 ) = 65.6%

Common-Size Statements What conclusions can we draw?

ReviewReview In horizontal analysis, each item is expressed as a percentage of the: a. net income amount. d. base-year amount. c. total assets amount. b. stockholders’ equity amount.

In horizontal analysis, each item is expressed as a percentage of the: a. net income amount. d. base-year amount. c. total assets amount. b. stockholders’ equity amount. ReviewReview

In vertical analysis, the base amount for depreciation expense is generally: a. net sales. d. fixed assets. c. gross profit. b. depreciation expense in a previous year. ReviewReview

In vertical analysis, the base amount for depreciation expense is generally: a. net sales. d. fixed assets. c. gross profit. b. depreciation expense in a previous year. ReviewReview

Ratio Analysis 11 6

Ratios  Three types:  Liquidity ratios  Solvency ratios  Profitability ratios  Can provide clues to underlying conditions that may not be apparent from an inspection of the individual components.  Single ratio by itself is not very meaningful. 53

Liquidity Ratios Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. WHO CARES? Short-term creditors such as bankers and suppliers

Liquidity Ratios

Solvency Ratios Measure the ability of the enterprise to survive over a long period of time WHO CARES? Long-term creditors and stockholders

Solvency Ratios

Profitability Ratios Measure the income or operating success of an enterprise for a given period of time WHO CARES? Everybody WHY? A company’s income affects:  its ability to obtain debt and equity financing  its liquidity position  its ability to grow é

Profitability Ratios

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.

Alternative Accounting Methods One company may use the FIFO method, while another company in the same industry may use LIFO. If the inventory is significant for both companies, it is unlikely that their current ratios are comparable. In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization.

Pro Forma Income A measure of the net income generated that usually excludes items that the company thinks are unusual or nonrecurring.

Improper Recognition Offering big discounts (channel stuffing) to companies to get them to buy early- Often leads to disaster in subsequent periods. Improper capitalization of operating expenses

Price Earnings Ratio The P/E ratio reflects the investors’ assessment of a company’s future earnings.

Earnings Per Share and Price Earnings Ratio