17 Financial Statement Analysis Accounting 26e C H A P T E R Warren Reeve Duchac human/iStock/360/Getty Images

Horizontal Analysis The analysis of increases and decreases in the amount and percentage of comparative financial statement items is called horizontal analysis. Each item on the most recent statement is compared with the same item on one or more earlier statements in terms of the amount of increase or decrease and the percent of increase or decrease. When comparing statements, the earlier statement is normally used as the base year for computing increases and decreases. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Vertical Analysis The percentage analysis of the relationship of each component in a financial statement to a total within the statement is called vertical analysis. In a vertical analysis of the balance sheet, the percentages are computed as follows: Each asset item is stated as a percent of the total assets. Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity. In a vertical analysis of the income statement, each item is stated as a percent of sales. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Common-Sized Statements In a common-sized statement, all items are expressed as percentages, with no dollar amounts shown. Common-sized statements are useful for comparing one company with another or comparing a company with industry averages. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Liquidity and Solvency Analysis (slide 1 of 2) All users of financial statements are interested in the ability of a company to do the following: Maintain liquidity and solvency Earn income, called profitability The ability of a company to convert assets into cash is called liquidity, while the ability of a company to pay its debts is called solvency. Liquidity, solvency, and profitability are interrelated. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Liquidity and Solvency Analysis (slide 2 of 2) Liquidity and solvency are normally assessed using the following: Current position analysis Working capital Current ratio Quick ratio Accounts Receivable analysis Accounts receivable turnover Number of days’ sales in receivables Inventory analysis Inventory turnover Number of days’ sales in inventory The ratio of fixed assets to long-term liabilities The ratio of liabilities to stockholders’ equity The number of times interest charges are earned ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Current Position Analysis A company’s ability to pay its current liabilities is called current position analysis. Current position analysis is a solvency measure of special interest to short-term creditors and includes the computation and analysis of the following: Working Capital Current ratio Quick ratio ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Profitability Analysis Common profitability analyses include the following: Ratio of sales to assets Rate earned on total assets Rate earned on stockholders’ equity Rate earned on common stockholders’ equity Earnings per share on common stock Price-earnings ratio Dividends per share Dividend yield ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Summary of Analytical Measures (slide 1 of 2) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Summary of Analytical Measures (slide 2 of 2) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Corporate Annual Reports In addition to the financial statements and the accompanying notes, corporate annual reports normally include the following sections: Management discussion and analysis Report on internal control Report on fairness of the financial statements ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Management Discussion and Analysis Management’s Discussion and Analysis (MD&A) is required in annual reports filed with the Securities and Exchange Commission. It includes management’s analysis of current operations and its plans for the future. Typical items included in the MD&A are: Management’s analysis and explanations of any significant changes between the current and prior years’ financial statements. Important accounting principles or policies that could affect interpretation of the financial statements, including the effect of changes in accounting principles or the adoption of new accounting principles. Management’s assessment of the company’s liquidity and the availability of capital to the company. Significant risk exposures that might affect the company. Any “off-balance-sheet” arrangements such as leases not included directly in the financial statements. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Report on Internal Control The Sarbanes-Oxley Act of 2002 requires a report by management. The report states management’s responsibility for establishing and maintaining internal control. In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report. Sarbanes-Oxley also requires a public accounting firm to verify management’s conclusions on internal control. Thus, two reports on internal control, one by management and one by a public accounting firm, are included in the annual report. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Report on Fairness of the Financial Statements All publicly held corporations are required to have an independent audit (examination) of their financial statements. The Certified Public Accounting (CPA) firm that conducts the audit renders an opinion, called the Report of Independent Registered Public Accounting Firm, on the fairness of the statements. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Unusual Items on the Income Statement Generally accepted accounting principles require that unusual items be reported separately on the income statement. This is because such items do not occur frequently and are typically unrelated to current operations. Unusual items on the income statement are classified as one of the following: Affecting the current period income statement Affecting a prior period income statement ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Unusual Items Affecting the Current Period’s Income Statement—Discontinued Operations A company may discontinue a component of its operations by selling or abandoning the component’s operations. If the discontinued component is (1) the result of a strategic shift and (2) has a major effect on the entity’s operations and financial results, any gain or loss on discontinued operations is reported on the income statement as a Gain (or loss) from discontinued operations. A note to the financial statements should describe the operations sold, including the date operations were discontinued, and details about the assets, liabilities, income, and expenses of the discontinued component. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Unusual Items Affecting the Current Period’s Income Statement An extraordinary item is defined as an event or transaction with both of the following characteristics: Unusual in nature Infrequent in occurrence Any gain or loss from extraordinary items is reported on the income statement as Gain (or loss) from extraordinary item. Earnings per common share should be prepared separately in the notes to the financial statements for discontinued operations and extraordinary items. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Appendix: Unusual Items Affecting the Prior Period’s Income Statement An unusual item may occur that affects a prior period’s income statement. Two such items are as follows: Errors in applying generally accepted accounting principles Changes from one generally accepted accounting principle to another ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.