1. 14-1

2. 14-2 Chapter 14 Financial Statement Analysis Learning Objectives After studying this chapter, you should be able to: 1.Discuss the need for comparative analysis. 2.Identify the tools of financial statement analysis. 3.Explain and apply horizontal analysis. 4.Describe and apply vertical analysis. 5.Identify and compute ratios used in analyzing a firm ’ s liquidity, profitability, and solvency. 6.Understand the concept of earning power, and how irregular items are presented. 7.Understand the concept of quality of earnings.

3. 14-3 Preview of Chapter 14 Financial and Managerial Accounting Weygandt Kimmel Kieso

4. 14-4 Analyzing financial statements involves: Characteristics Comparison Bases Comparison Bases Tools of Analysis Tools of Analysis  Liquidity  Profitability  Solvency  Intracompany  Industry averages  Intercompany  Horizontal  Vertical  Ratio LO 1 Discuss the need for comparative analysis. LO 2 Identify the tools of financial statement analysis. Basics of Financial Statement Analysis

5. 14-5 LO 3 Explain and apply horizontal analysis. Horizontal Analysis Horizontal analysis, also called trend analysis, is a 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 balance sheet, income statement, and statement of retained earnings.

6. 14-6 LO 3 Explain and apply horizontal analysis. Changes suggest that the company expanded its asset base during 2009 and financed this expansion primarily by retaining income rather than assuming additional long-term debt. Illustration 14-5 Horizontal analysis of balance sheets Horizontal Analysis

7. 14-7 LO 3 Explain and apply horizontal analysis. 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 Horizontal analysis of Income statements Horizontal Analysis

8. 14-8 LO 3 Explain and apply horizontal analysis. In the horizontal analysis of the balance sheet the ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities. Illustration 14-7 Horizontal analysis of retained earnings statements Horizontal Analysis

9. 14-9 LO 4 Describe and apply vertical analysis. Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount.  On an income statement, we might say that selling expenses are 16% of net sales.  Vertical analysis is commonly applied to the balance sheet and the income statement. Vertical Analysis

10. 14-10 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 Vertical analysis of balance sheets LO 4 Describe and apply vertical analysis. Vertical Analysis

11. 14-11 Quality appears to be a profitable enterprise that is becoming even more successful. Illustration 14-9 Vertical analysis of Income statements LO 4 Describe and apply vertical analysis. Vertical Analysis

12. 14-12 Enables a comparison of companies of different sizes. Illustration 14-10 Intercompany income statement comparison LO 4 Describe and apply vertical analysis. Vertical Analysis

13. 14-13 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio analysis expresses the relationship among selected items of financial statement data. LiquidityProfitabilitySolvency Measures short- term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Financial Ratio Classifications 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. Ratio Analysis

14. 14-14 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. The discussion of ratios will include the following types of comparisons. A single ratio by itself is not very meaningful. Ratio Analysis

15. 14-15

16. 14-16 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Liquidity Ratios Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected 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, Receivable turnover, and inventory turnover. Ratio Analysis

17. 14-17 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets. Ratio Analysis Liquidity Ratios 1. Current Ratio Illustration 14-12

18. 14-18 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio Analysis 2. Acid-Test Ratio Liquidity Ratios Illustration 14-13

19. 14-19 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Illustration 14-14 Ratio Analysis 2. Acid-Test Ratio Acid-test ratio measures immediate liquidity. Liquidity Ratios

20. 14-20

21. 14-21 LO 5 Illustration 14-15 Ratio Analysis 3. Receivable Turnover Measures the number of times, on average, the company collects receivables during the period. Liquidity Ratios

22. 14-22 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. A variant of the Receivable turnover ratio is to convert it to an average collection period in terms of days. Receivables are collected on average every 36 days. $2,097,000 ($180,000 + $230,000) / 2 = 10.2 times 365 days / 10.2 times = every 35.78 days Receivable Turnover Ratio Analysis Liquidity Ratios

23. 14-23 LO 5 Illustration 14-16 Ratio Analysis 4. Inventory Turnover Measures the number of times, on average, the inventory is sold during the period. Liquidity Ratios

24. 14-24 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. A variant of inventory turnover is the days in inventory. Inventory turnover ratios vary considerably among industries. 365 days / 2.3 times = every 159 days $1,281,000 ($500,000 + $620,000) / 2 = 2.3 times Inventory Turnover Ratio Analysis Liquidity Ratios

25. 14-25 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. 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 common stockholders’ equity, earnings per share, price-earnings, and payout ratio. Ratio Analysis

26. 14-26 Illustration 14-17 Ratio Analysis 5. Profit Margin Measures the percentage of each dollar of sales that results in net income. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Profitability Ratios

27. 14-27 Illustration 14-18 Ratio Analysis 6. Asset Turnover Measures how efficiently a company uses its assets to generate sales. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Profitability Ratios

28. 14-28 Illustration 14-19 Ratio Analysis 7. Return on Asset An overall measure of profitability. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Profitability Ratios

29. 14-29 Illustration 14-20 Ratio Analysis 8. Return on Common Stockholders’ Equity Shows how many dollars of net income the company earned for each dollar invested by the owners. LO 5 Profitability Ratios

30. 14-30 Illustration 14-21 Ratio Analysis 9. Earnings Per Share (EPS) A measure of the net income earned on each share of common stock. LO 5 Profitability Ratios

31. 14-31 Illustration 14-22 Ratio Analysis 10. Price-Earnings Ratio Measures the net income earned on each share of common stock. LO 5 Profitability Ratios

32. 14-32 Illustration 14-23 Ratio Analysis 11. Payout Ratio Measures the percentage of earnings distributed in the form of cash dividends. LO 5 Profitability Ratios

33. 14-33 LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. 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. Ratio Analysis

34. 14-34 Illustration 14-24 Ratio Analysis 12. Debt to Total Assets Ratio Measures the percentage of the total assets that creditors provide. LO 5 Solvency Ratios

35. 14-35 Illustration 14-25 Ratio Analysis 13. Times Interest Earned Provides an indication of the company’s ability to meet interest payments as they come due. LO 5 Solvency Ratios

36. 14-36 Illustration 14-26 Ratio Analysis LO 5 Summary of Ratios

37. 14-37 Illustration 14-26 Summary of Ratios LO 5

38. 14-38 LO 6 Understand the concept of earning power, and how irregular items are presented. Earning power means the normal level of income to be obtained in the future. “Irregular” items are separately identified on the income statement. Two types are: 1.Discontinued operations. 2.Extraordinary items. “Irregular” items are reported net of income taxes. Earning Power and Irregular Items

39. 14-39 (a)Disposal of a significant component of a business. (b)Report the income (loss) from discontinued operations in two parts: 1.income (loss) from operations (net of tax) and 2.gain (loss) on disposal (net of tax). LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items Discontinued Operations

40. 14-40 Illustration: During 2014 BD Inc. has income before income taxes of $79,000,000. During 2014, BD discontinued and sold its unprofitable chemical division. The loss in 2014 from chemical operations (net of $135,000 taxes) was $315,000. The loss on disposal of the chemical division (net of $81,000 taxes) was $189,000. Assuming a 30% tax rate on income. LO 6 Earning Power and Irregular Items

41. 14-41 Discontinued Operations are reported after “Income from continuing operations.” Previously labeled as “Net Income”. Moved to LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items

42. 14-42 Nonrecurring material items that differ significantly from a company’s typical business activities.  Must be both of an ► Unusual Nature and ► Occur Infrequently.  Must consider the environment in which it operates.  Amounts reported “net of tax.” LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items Extraordinary Items

43. 14-43 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 LO 6 Understand the concept of earning power, and how irregular items are presented. NO Earning Power and Irregular Items

44. 14-44 (d) Loss from flood damage. (The nearby Black River floods every 2 to 3 years.) (e)An earthquake destroys one of the oil refineries owned by a large multi-national oil company. Earthquakes are rare in this geographical location. (f)Write-down of obsolete inventory. (g)Expropriation of a factory by a foreign government. NO YES YES LO 6 Understand the concept of earning power, and how irregular items are presented. NO Are these considered Extraordinary Items? Earning Power and Irregular Items

45. 14-45 Illustration: In 2014 a foreign government expropriated property held as an investment by DB Inc. If the loss is $770,000 before applicable income taxes of $231,000, the income statement will report a deduction of $539,000. Earning Power and Irregular Items LO 6 Understand the concept of earning power, and how irregular items are presented.

46. 14-46 Extraordinary Items are reported after “Income from continuing operations.” Previously labeled as “Net Income”. Moved to LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items

47. 14-47 Reporting when both Discontinued Operations and Extraordinary Items are present. Discontinued Operations Extraordinary Item LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items

48. 14-48

49. 14-49  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. LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items Change in Accounting Principle

50. 14-50  Unrealized gains and losses on available-for- sale securities.  Plus other items + Reported in Stockholders’ Equity Comprehensive Income LO 6 Understand the concept of earning power, and how irregular items are presented. All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders. Earning Power and Irregular Items

51. 14-51 Why are gains and losses on available-for-sale securities excluded from net income? Because disclosing them separately 1)reduces the volatility of net income due to fluctuations in fair value, 2)yet informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value. LO 6 Understand the concept of earning power, and how irregular items are presented. Earning Power and Irregular Items Comprehensive Income

52. 14-52 Companies have incentives to manage income to meet or beat Wall Street expectations, so that  the market price of stock increases and  the value of stock options increase. 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. LO 7 Understand the concept of quality of earnings. Quality of Earnings

53. 14-53  Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings. LO 7 Understand the concept of quality of earnings.  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. Quality of Earnings Alternate Accounting Methods Pro Forma Income

54. 14-54 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). LO 7 Understand the concept of quality of earnings. Quality of Earnings Improper Recognition

55. 14-55  The tools of financial statement analysis covered in this chapter are universal and therefore no significant differences exist in the analysis methods used.  The basic objectives of the income statement are the same under both GAAP and IFRS. Thus, both the IASB and the FASB are interested in distinguishing normal levels of income from irregular items in order to better predict a company ’ s future profitability.  The basic accounting for discontinued operations is the same under IFRS and GAAP. Key Points

56. 14-56  Under IFRS, there is no classification for extraordinary items. In other words, extraordinary item treatment is prohibited under IFRS. All revenue and expense items are considered ordinary in nature.  The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS.  Both IFRS and GAAP follow the same approach in reporting comprehensive income. The statement of comprehensive income can be prepared under the one-statement approach or the two statement approach. Key Points

57. 14-57  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, many of the earnings ’ quality issues will disappear. Key Points

58. 14-58 The 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. Looking to the Future

59. 14-59 The basic tools of financial analysis are the same under both GAAP and IFRS except that: a)horizontal analysis cannot be done because the format of the statements is sometimes different. b)analysis is different because vertical analysis cannot be done under IFRS. c)the current ratio cannot be computed because current liabilities are often reported before current assets in IFRS statements of position. d)None of the above. IFRS Self-Test Questions

60. 14-60 Under IFRS: a)the reporting of discontinued items is different than GAAP. b)the reporting of extraordinary items is prohibited. c)the reporting of changes in accounting principles is different than under GAAP. d)None of the above. IFRS Self-Test Questions

61. 14-61 Presentation of comprehensive income must be reported under IFRS in: a)the statement of stockholders ’ equity. b)the income statement ending with net income. c)the notes to the financial statements. d)a statement of comprehensive income. IFRS Self-Test Questions

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