1. Financial Statement Analysis
Chapter 12
Financial Statement Analysis
This chapter is divided into 3 parts:
Part A: Comparison of Financial Accounting Information
Part B: Using Ratios to assess Risk and Profitability
Part C: Earnings Persistence and Earnings Quality
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Comparison of Financial Accounting Information
Part A
Comparison of Financial Accounting Information
First, let’s look at how to make comparisons based on financial statements.
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3. Comparison of Financial Accounting Information
We use ratios to make comparisons every day. Likewise, we can use ratios to help evaluate a firm’s performance and financial position.
Ratios are most useful when compared to some standard. That standard of comparison may be the performance of a competing company, last year’s performance by the same company, or an industry average.
Here is a summary of these three different types of comparisons.
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4. LO1 Vertical Analysis
In performing vertical analysis, we express each item in a financial statement as a percentage of the same base amount.
UNDER AMROUR AND NIKE
Common-Size Income Statements
For the Years Ended December 31, 2009 and May 31, 2009
($ in millions)
UNDER ARMOUR
NIKE
For the year ended:
December 31, 2009
May 31, 2009
Amount %
Net Sales
$856.4
100.0
$19,176.1
Cost of goods sold
443.4
51.8
10,571.7
55.1
Gross profit
413.0
48.2
8,604.4
44.9
Operating expenses
327.7
38.3
6,745.9
35.2
Operating income
85.3
9.9
1,858.5
9.7
Other income (expense)
(2.9)
(0.3)
98.0
0.5
Income before tax
82.4
9.6
1,956.5
10.2
Income tax expense
35.6
4.1
469.8
2.4
Net income
46.8
5.5
1,486.7
7.8
In performing vertical analysis, we express each item in a financial statement as a percentage of the same base amount. For instance, we can express each line item in an income statement as a percentage of sales. In a balance sheet, we can express each item as a percentage of total assets.
The Illustration provides common-size income statements for Under Armour and Nike. Notice that the two companies end their fiscal years on different dates. Under Armour’s year-end is December 31 while Nike’s is May 31. Even though the year-ends do not exactly match, we can still make meaningful comparisons between the two companies.
Nike reports net income of almost $1.5 billion while Under Armour reports only $47 million. Does this mean Nike’s operations are nearly 30 times more profitable than Under Armour’s? Not necessarily. Nike is a much larger company, reporting sales over $19 Billion compared to $856.4 million for Under Armour. Because of its greater size, we expect Nike to report a greater amount of net income. To better compare the performance of the two companies, we use vertical analysis to express each income statement item as a percentage of sales.
Under Armour’s gross profit equals 48.2% of sales ($413.0 ÷ $856.4) compared to Nike’s 44.9%. This means that Under Armour earns a higher gross profit for each item sold, consistent with its business strategy of focusing on high-quality performance apparel. However, Under Armour’s higher gross profit is offset almost entirely by its proportionately higher operating expenses, 38.3% of sales compared to only 35.2% for Nike. The net result is that operating income, income before tax, and net income as a percentage of sales are quite similar for the two companies.
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5. LO2 Horizontal Analysis
Analyze trends in financial statement data for a single company over time.
UNDER ARMOUR
Income Statement
For the Years Ended December 31
(in millions)
Year
Increase (Decrease)
2009
2008
Amount %
Sales
$856.4
$725.2
$131.2
18.1
Cost of goods sold
443.4
370.3
73.1
19.7
Gross profit
413.0
354.9
58.1
16.4
Operating expenses
327.7
278.0
49.7
17.9
Operating income
85.3
76.9
8.4
10.9
Other expenses
2.9
7.0
(4.1)
(58.6)
Income before tax
82.4
69.9
12.5
Income tax expense
35.6
31.7
3.9
12.3
Net income
$46.8
$38.2
$8.6
22.5
We use horizontal analysis, to analyze trends in financial statement data for a single company over time.
Consider here the income statements over two years for Under Armour. The final two columns show the dollar amount and percentage changes.
We calculate the amount of the increase or decrease by subtracting the 2008 balance from the 2009 balance. A positive difference indicates the amount increased in A negative amount represents a decrease, which we record in parentheses.
We calculate the percentage increase or decrease based on the following formula:
% Increase (Decrease) = (Current-Year Amount (−) Prior-Year Amount) / Prior-Year Amount
For example, the amount of sales increased $131.2 million—equal to sales of $856.4 million in 2009 minus sales of $725.2 million in We calculate the percentage increase of 18.1% by dividing the $131.2 million increase in sales by 2008 sales of $725.2 million. If the base-year amount (2008 in our example) is ever zero, we can’t calculate a percentage. Also, if the base year is negative and the following year is positive, a percentage change is not meaningful.
The horizontal analysis of Under Armour’s income statement demonstrates steady growth in company operations. Gross profit increased 16.4% ($58.1 ÷ $354.9), operating income increased 10.9% ($8.4 ÷ $76.9), income before tax increased 17.9% ($12.5 ÷ $69.9), and net income increased 22.5% ($8.6 ÷ $38.2). The growth in these income measures definitely is a positive sign.
However, note that gross profit did not grow as quickly as sales. Under Armour did increase sales, but the cost of those sales (cost of goods sold) grew at an even greater rate. The growth in sales came with slightly smaller markups on products costs. Another negative sign is that the company’s operating expenses increased at a faster rate than its gross profit (17.9% vs. 16.4%). While sales are increasing, similar or even larger increases in the cost of goods sold and operating expenses raise some concerns.
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6. Using Ratios to assess Risk and Profitability
Part B
Using Ratios to assess Risk and Profitability
Now, let’s focus on how to use different ratios to assess the risk and return of a company.
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7. LO3 Risk Analysis Liquidity Solvency Risk Ratios Chapter Calculations
Receivable turnover ratio 5
Net Credit sales
Average accounts receivables
Average collection period 5
365 days
Receivable turnover ratio
Inventory turnover ratio 6
Cost of goods sold
Average inventory
A company’s ability to pay its current liabilities
Average days in inventory 6
365 days
Inventory turnover ratio
Current ratio 8
Current assets
Current liabilities
Here, we summarize eight risk ratios, the chapters in which we discussed them, and the way they’re calculated.
We divide the eight risk ratios into six liquidity ratios and two solvency ratios. Liquidity refers to a company’s ability to pay its current liabilities. The accounts used to calculate liquidity ratios are current assets and current liabilities. Solvency refers to a company’s ability to pay its long-term liabilities. Let’s calculate each of the eight risk ratios for Under Armour and compare the results with Nike.
Acid-test ratio 8
Cash + net receivables + current investments
Current liabilities
Solvency
Debt to equity ratio 9
Total liabilities
Total stockholders’ equity
A company’s ability to pay its long-term liabilities
Times interest earned ratio 9
Net income + interest expense + tax expense
Interest expense
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8. LO4 Profitability Analysis
Profitability Ratios
Chapter
Calculations
Gross profit ratio 6
Gross profit
Net Sales
Return on assets 7
Net income
Average total assets
Profit margin
Asset turnover
Return on equity 10
Average stockholders’ equity
Price-earnings ratio
Stock price
Earnings per share
Our next six ratios focus on profitability, the primary measure of company success. Profitability ratios measure the earnings or operating effectiveness of a company. Not only is profitability necessary just to survive as a company, it’s the primary indicator used by investors and creditors in making financial decisions.
Here, we summarize six profitability ratios, the chapters in which we discussed them, and the way we calculate them.
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9. Earnings Persistence and Earnings Quality
Part C
Earnings Persistence and Earnings Quality
Now, lets consider one-time income items. Also, we will focus on different accounting practices and how they affect earnings quality.
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10. LO5 Earnings Persistence and One-Time Income Items
Current earnings that will continue or persist into future years
Certain items are part of net income in the current year but are not expected to persist
To make predictions of future earnings, investors look for the current earnings that will continue or persist into future years. Certain items are part of net income in the current year but are not expected to persist. We refer to these as one-time income items. The prime examples are (1) discontinued operations and (2) extraordinary items.
Discontinued operations
Extraordinary items
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11. Discontinued Operations
The sale or disposal of a significant component of a company’s operations.
FEDERER SPORTS APPAREL
Income Statement
For the Year Ended December 31, 2012
Revenues
15,500,000
Cost of goods sold
Gross Profit
7,000,000
8,500,000
Operating expenses
1,200,000
Depreciation expense
1,000,000
Other revenues and expenses
300,000
Income before tax
6,000,000
Income tax expense
2,000,000
Income from continuing operations
4,000,000
Discontinued operation:
Loss from disposal of tennis shoe segment, net of tax
2,500,000
Net income
$ 1,500,000
A discontinued operation is the sale or disposal of a significant component of a company’s operations. We report any profits or losses on discontinued operations in the current year, separately from profits and losses on the portion of the business that will continue. This allows investors the opportunity to exclude discontinued operations in their estimation of income that will persist into future years.
For an example of accounting for discontinued operations, let’s consider Federer Sports Apparel, which has two business activities: a very profitable line of tennis apparel and a less profitable line of tennis shoes. Let’s say that during 2012, the company decides to sell the tennis shoe business to a competitor and the loss from discontinued operations is $2.5 million. We report the $2.5 million loss “net of tax,” which means the $2.5 million includes the effect of taxes. Here is the income statement presentation of discontinued operations for Federer Sports Apparel.
With discontinued operations reported separately in the income statement, investors can clearly see the reported net income of $1.5 million and the net income excluding the effects of the discontinued tennis shoe segment of $4.0 million. Investors can then use the income excluding discontinued operations, $4.0 million, to estimate income that persists into future periods.
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12. FEDERER SPORTS APPAREL For the Year Ended December 31, 2012
Extraordinary Items
An event that produces a gain or loss; and is
(1) unusual in nature and (2) infrequent in occurrence.
FEDERER SPORTS APPAREL
Income Statement
For the Year Ended December 31, 2012
Revenues
15,500,000
Cost of goods sold
Gross Profit
7,000,000
8,500,000
Operating expenses
1,200,000
Depreciation expense
1,000,000
Other revenues and expenses
300,000
Income before tax
6,000,000
Income tax expense
2,000,000
Income from continuing operations
4,000,000
Discontinued operation:
Loss from disposal of tennis shoe segment, net of tax
Extraordinary item:
Loss from earthquake damage, net of tax
2,500,000
600,000
Net income
$ 900,000
Sometimes, companies have gains or losses that do not reflect normal operations and that are not likely to happen again. Because of the one-time, abnormal nature of these items, we don’t want to combine their effects on net income with those of normal operations. These items are referred to as extraordinary items.
To be an extraordinary item, an event that produces a gain or loss must meet two conditions. It must be (1) unusual in nature and (2) infrequent in occurrence. Unusual in nature means that the event is not normal for the type of company. Infrequent in occurrence means the company does not expect the event to happen again in the near future.
We report extraordinary items separately, net of taxes, near the bottom of the income statement just below discontinued operations. To illustrate, let’s assume Federer Sports Apparel suffers an uninsured loss to property and equipment from an earthquake. This event meets both criteria for an extraordinary item – it is unusual in nature and infrequent in occurrence. If the loss (net of taxes) is $600,000, we would report it separately as an extraordinary item in the income statement in order to allow investors to see that these should be excluded in estimating income that will persist into future periods.
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13. Other Revenues and Expenses
Items that do not meet both the criteria for Extra-ordinary items are reported in the Income statements as “Other Revenues and Expenses”
Examples include: Gain or loss on sale of Long term assets, Losses due to employee strikes or loss due to business restructuring.
The sale or disposal of a significant component of a company’s operations is recorded as discontinued operations. However, the sale or disposal of most assets is reported, not as discontinued operations, but rather as other revenues and expenses.
Many items meet one, but not both, criteria for extraordinary item treatment. In that case, they are correctly excluded from extraordinary items. Common examples include losses due to the write-down of receivables, inventory, or long-term assets; gains or losses on the sale of long-term assets; losses due to an employee strike; or losses due to business restructuring.
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14. Other Revenues and Expenses
Extraordinary Items
“Unusual in nature” and “Infrequent”
Other Revenues and Expenses
“Unusual in nature” or “Infrequent”
Examples
Uninsured losses from a natural disaster such as a flood, earthquake, or hurricane.
Losses due to the write-down of receivables, inventory, or long-term assets.
Takeover of property by a foreign government.
Gains or losses on the sale of long-term assets.
Losses due to an employee strike.
Losses due to business restructuring.
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15. LO6 Quality of Earnings
The ability of reported earnings to reflect the company’s true earnings, as well as the usefulness of reported earnings to predict future earnings.
Conservative
Accounting Practices
Aggressive Accounting Practices
Result in reporting lower income, lower assets, and higher liabilities
Result in reporting higher income, higher assets, and lower liabilities
Quality of earnings refers to the ability of reported earnings to reflect the company’s true earnings, as well as the usefulness of reported earnings to predict future earnings.
Conservative accounting practices. Conservative accounting practices are those that result in reporting lower income, lower assets, and higher liabilities. The larger estimation of the allowance for uncollectible accounts, the write-down of overvalued inventory, the use of a shorter useful life for depreciation, and the recording of a contingent litigation loss are all examples of conservative accounting.
Aggressive accounting practices. Aggressive accounting practices result in reporting higher income, higher assets, and lower liabilities. The lower estimation of the allowance for uncollectible accounts, delay in reporting an inventory write-down, choosing a longer useful life for depreciation, and delay in recording a litigation loss are all examples of aggressive accounting. All executives in the business world, not just accountants, need to be able to recognize the difference between conservative and aggressive accounting practices.
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16. End of chapter 12
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