2. Financial Statement Analysis
Managerial Accounting
Fifth Edition
Weygandt Kimmel Kieso

3. study objectives Discuss the need for comparative analysis.
Identify the tools of financial statement analysis.
Explain and apply horizontal analysis.
Describe and apply vertical analysis.
Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Understand the concept of earning power, and how irregular items are presented.
Understand the concept of quality of earnings.

4. preview of chapter 14

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

6. Horizontal Analysis
Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time.
Its purpose is to determine the increase or decrease that has taken place.
Horizontal analysis is commonly applied to the balance sheet, income statement, and statement of retained earnings.
SO 3 Explain and apply horizontal analysis.

7. Horizontal Analysis Balance Sheet
These changes suggest that the company expanded its asset base during 2007 and financed this expansion primarily by retaining income rather than assuming additional long-term debt.
Illustration 14-5
Horizontal analysis of
balance sheets
SO 3 Explain and apply horizontal analysis.

8. Horizontal Analysis Income Statement
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
SO 3 Explain and apply horizontal analysis.

9. Retained Earnings Statement
Horizontal Analysis
Retained Earnings Statement
Illustration 14-7
Horizontal analysis of
retained earnings statements
We saw in the horizontal analysis of the balance sheet that ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities.
SO 3 Explain and apply horizontal analysis.

10. Horizontal Analysis
Summary financial information for Rosepatch Company is as follows.
Compute the amount and percentage changes in 2011 using horizontal analysis, assuming 2010 is the base year.
Solution on notes page
SO 3 Explain and apply horizontal analysis.

11. 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.
SO 4 Describe and apply vertical analysis.

12. Vertical Analysis Balance Sheet
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
SO 4 Describe and apply vertical analysis.

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

14. Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 14-10
Intercompany income statement comparison
J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C. Penney’s net income as a percent of each sales dollar (5.6%) is only 44% of Quality’s (12.6%).
SO 4 Describe and apply vertical analysis.

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

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

17. Ratio Analysis 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, receivables turnover, and inventory turnover.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

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

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

21. Ratio Analysis 2. Acid-Test Ratio Liquidity Ratios
Illustration 14-14
Measures immediate short-term liquidity.
Solution on notes page
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

22. Ratio Analysis 3. Receivables Turnover Liquidity Ratios
Illustration 14-15
Number of times, on average, the company collects receivables.
Solution on notes page
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

23. 365 days / 10.2 times = every 35.78 days
Liquidity Ratios
Ratio Analysis
Receivables Turnover
$2,097,000
= times
($180,000 + $230,000) / 2
A variant of the receivables turnover ratio is to convert it to an average collection period in terms of days.
365 days / 10.2 times = every days
This means that receivables are collected on average every 36 days.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

24. Ratio Analysis 4. Inventory Turnover Liquidity Ratios
Illustration 14-16
Number of times, on average, the inventory is sold.
Solution on notes page
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

25. 365 days / 2.3 times = every 159 days
Liquidity Ratios
Ratio Analysis
Inventory Turnover
$1,281,000
= 2.3 times
($500,000 + $620,000) / 2
A variant of inventory turnover is the days in inventory.
365 days / 2.3 times = every 159 days
Inventory turnover ratios vary considerably among industries.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

26. Ratio Analysis 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.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

27. Ratio Analysis 5. Profit Margin Profitability Ratios
Illustration 14-17
Measures net income generated by each dollar of sales.
Solution on notes page
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

28. Ratio Analysis 6. Asset Turnover Profitability Ratios
Illustration 14-18
Measures how efficiently assets are used to generate sales.
Solution on notes page
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

29. Ratio Analysis 7. Return on Assets Profitability Ratios
Illustration 14-19
An overall measure of profitability.
Solution on notes page
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

30. Ratio Analysis 8. Return on Common Stockholders’ Equity
Profitability Ratios
Ratio Analysis
8. Return on Common Stockholders’ Equity
Illustration 14-20
Dollars of net income earned for each dollar invested by the owners.
Solution on notes page
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

31. Ratio Analysis 8. Return on Common Stockholders’ Equity
Profitability Ratios
Ratio Analysis
8. Return on Common Stockholders’ Equity
(with preferred stock)
Illustration 14-21
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

32. Ratio Analysis 9. Earnings per Share (EPS) Profitability Ratios
Illustration 14-22
Measures net income earned on each share of common stock.
Solution on notes page
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

33. Ratio Analysis 10. Price-Earnings Ratio Profitability Ratios
Illustration 14-23
The price-earnings (P-E) ratio reflects investors’ assessments of a company’s future earnings.
Solution on notes page
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

34. Ratio Analysis 11. Payout Ratio Profitability Ratios
Illustration 14-24 *
Measures the percentage of earnings distributed in the form of cash dividends.
Solution on notes page
* From analysis of retained earnings.
SO 5

35. Ratio Analysis 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.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

36. Ratio Analysis 12. Debt to Total Assets Ratio Solvency Ratios
Illustration 14-25
Measures the percentage of the total assets provided by creditors.
Solution on notes page
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

37. Ratio Analysis 13. Times Interest Earned Solvency Ratios
Illustration 14-26
Provides an indication of the company’s ability to meet interest payments as they come due.
Solution on notes page
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

39. Earning Power and Irregular Items
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:
Discontinued operations.
Extraordinary items.
These “irregular” items are reported net of income taxes.
SO 6 Understand the concept of earning power, and how irregular items are presented.

40. Earning Power and Irregular Items
Discontinued Operations
Refers to the disposal of a significant component of a business.
Report the income (loss) from discontinued operations in two parts:
income (loss) from operations (net of tax) and
gain (loss) on disposal (net of tax).
SO 6 Understand the concept of earning power, and how irregular items are presented.

41. Earning Power and Irregular Items
Illustration: During 2011 Acro Energy Inc. has income from continuing operations of $560,000. During 2011 Acro discontinued and sold its unprofitable chemical division. The loss in 2011 from chemical operations (net of $60,000 taxes) was $140,000. The loss on disposal of the chemical division (net of $30,000 taxes) was $70,000. Assuming a 30% tax rate.
Income from continuing operations $560,000
Discontinued operations:
Loss from operations, net of $60,000 tax 140,000
Loss on disposal, net of $30,000 tax 70,000
Total loss on discontinued operations 210,000
Net income $350,000
SO 6 Understand the concept of earning power, and how irregular items are presented.

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

43. Earning Power and Irregular Items
Extraordinary items are nonrecurring material items that differ significantly from a company’s typical business activities.
An extraordinary item must be both of an
Unusual Nature and
Occur Infrequently
Company must consider the environment in which it operates.
Amounts reported “net of tax.”
SO 6 Understand the concept of earning power, and how irregular items are presented.

44. Earning Power and Irregular 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.
A citrus grower's Florida crop is damaged by frost.
Loss from sale of temporary investments.
Loss attributable to a labor strike.
YES NO NO NO
Solution on notes page
SO 6 Understand the concept of earning power, and how irregular items are presented.

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

46. Earning Power and Irregular Items
Illustration: In 2011 a foreign government expropriated property held as an investment by Acro Energy Inc. If the loss is $70,000 before applicable income taxes of $21,000, the income statement will report a deduction of $49,000.
Illustration 14-30
SO 6

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

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

49. Earning Power and Irregular Items
In its proposed 2011 income statement, AIR Corporation reports income before income
Taxes $400,000, extraordinary loss due to earthquake $100,000, income taxes $120,000 (not including irregular items), loss on operation of discontinued flower division $50,000, and loss on disposal of discontinued flower division $90,000. The income tax rate is 30%. Prepare a correct income statement, beginning with “Income before income taxes.”
SO 6 Understand the concept of earning power, and how irregular items are presented.

50. Earning Power and Irregular Items
Prepare a correct income statement.
Solution on notes page
SO 6

52. Earning Power and Irregular Items
Change in Accounting Principle
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.
SO 6 Understand the concept of earning power, and how irregular items are presented.

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

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

55. 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.
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.
SO 7 Understand the concept of quality of earnings.

56. Quality of Earnings Alternative Accounting Methods Pro Forma Income
Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings.
Pro Forma Income
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.
SO 7 Understand the concept of quality of earnings.

57. Quality of Earnings Improper Recognition
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).
SO 7 Understand the concept of quality of earnings.

58. Quality of Earnings
Match each of the following terms with the phrase that it best matches.
Comprehensive income
Quality of earnings
Solvency ratio
Vertical analysis
Pro forma income
Extraordinary item
1. ___ Measures the ability of the company to survive over a long period of time.
2. ___ Usually excludes items that a company thinks are unusual or non-recurring. c e
Solution on notes page
SO 7 Understand the concept of quality of earnings.

59. Quality of Earnings
Match each of the following terms with the phrase that it best matches.
Comprehensive income
Quality of earnings
Solvency ratio
Vertical analysis
Pro forma income
Extraordinary item
3. ___ Includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.
4. ___ Indicates the level of full and transparent information provided to users of the financial statements. a b
Solution on notes page
SO 7 Understand the concept of quality of earnings.

60. Quality of Earnings
Match each of the following terms with the phrase that it best matches.
Comprehensive income
Quality of earnings
Solvency ratio
Vertical analysis
Pro forma income
Extraordinary item
5. ___ Describes events and transactions that are unusual in nature and infrequent in occurrence.
6. ___ Expresses each item within a financial statement as a percent of a base amount. f d
Solution on notes page
SO 7 Understand the concept of quality of earnings.

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