Chapter 13-1

Financial Analysis: The Big Picture

Chapter 13-2

Financial Accounting, Fifth Edition

Study Objectives
1. Understand the concept of sustainable income.

2. Indicate how irregular items are presented. 3. Explain the concept of comprehensive income. 4. Describe and apply horizontal analysis. 5. Describe and apply vertical analysis. 6. Identify and compute ratios used in analyzing a companys liquidity, solvency, and profitability. 7. Understand the concept of quality of earnings.

Chapter 13-3

Financial Analysis: The Big Picture

Sustainable Income

Comparative Analysis

Ratio Analysis

Quality of Earnings

Irregular items Changes in accounting principles Comprehensive income

Horizontal analysis Vertical analysis

Liquidity ratios Solvency ratios Profitability ratios

Alternative accounting methods Pro forma income Improper recognition PricePrice-earnings ratio

Chapter 13-4

Sustainable Income
Sustainable Income - Net income adjusted for irregular items. Irregular items are separately identified on the income statement. Two types are: 1. Discontinued operations. 2. Extraordinary items. These irregular items are reported net of income taxes.
SO 1 Understand the concept of sustainable income. SO 2 Indicate how irregular items are presented.

Chapter 13-5

Sustainable Income
Illustration 13-1

Components of the income statement

Chapter 13-6

SO 2 Indicate how irregular items are presented.

Sustainable Income
Discontinued Operations
(a) Disposal of a significant component of a

business.
(b) Income statement should report a gain (or loss)

from discontinued operations, net of tax.

Chapter 13-7

SO 2 Indicate how irregular items are presented.

Sustainable Income
Illustration: Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in 2010. The company therefore has income before income taxes of $800,000. During 2010 the company discontinued and sold its unprofitable chemical division at a loss of $210,000 (net of $90,000 tax savings).
Illustration 13-2

Chapter 13-8

SO 2 Indicate how irregular items are presented.

Sustainable Income
Extraordinary items are events and transactions
that meet two conditions:

Both
Unusual in nature and Infrequent in occurrence Company must consider the environment in which it operates. Amounts reported net of tax.
Chapter 13-9

SO 2 Indicate how irregular items are presented.

Sustainable Income
Illustration: Assume that in 2010 a revolutionary foreign government expropriated property held as an investment by Rozek Inc. If the loss is $70,000 before applicable income tax savings of $21,000, how will the loss be presented in the income statement?
Illustration 13-3 Illustration 13-2

Chapter 13-10

Solution on notes page

Sustainable Income
Are these considered Extraordinary Items?
Effects of major natural casualties, if rare in the area. Effects of major natural casualties, not uncommon in the area. Write-down of inventories or write-off of receivables. Expropriation (takeover) of property by a foreign government.
Chapter 13-11

YES NO NO YES

SO 2 Indicate how irregular items are presented.

Sustainable Income
Are these considered Extraordinary Items?
Losses attributable to labor strikes. Effects of a newly enacted law or regulation, such as a condemnation action. Gains or losses from sales of property, plant, or equipment.

NO YES NO

Chapter 13-12

SO 2 Indicate how irregular items are presented.

Chapter 13-13

Sustainable Income
Changes in Accounting Principle
Principle used in the current year is different from one used in the preceding year. Example - change from FIFO to average cost. Permissible when management can show new principle is preferable. Most changes are reported retroactively.

Chapter 13-14

SO 2 Indicate how irregular items are presented.

Sustainable Income
Comprehensive Income
All changes in stockholders equity except those resulting from
 investments by stockholders and  distributions to stockholders.

Certain gains and losses bypass net income and instead are reported as direct adjustments to stockholders equity.
 Example Unrealized gain or loss on Available-forsale securities
Chapter 13-15

SO 3 Explain the concept of comprehensive income.

Sustainable Income
Illustration of Comprehensive Income
Accounting standards require companies to adjust most investments in stocks and bonds up or down to their market value at the end of each accounting period. Illustration: During 2010 Stassi Company purchased IBM stock for $10,000 as an investment. At the end of 2010 Stassi was still holding the investment, but the stocks market value was now $8,000. How should Stassi account for the $2,000 unrealized loss?

Chapter 13-16

SO 3 Explain the concept of comprehensive income.

Sustainable Income
Illustration of Comprehensive Income
How should Stassi account for the $2,000 unrealized loss? Answer: Depends on whether Stassi classifies the IBM stock as a
 Trading security or an  Available for-sale security.
Unrealized gains and losses (Income Statement)

Unrealized gains and losses (Comprehensive Income - Stockholders Equity)

Chapter 13-17

SO 3 Explain the concept of comprehensive income.

Sustainable Income
Format One Comprehensive Income
Combined statement of income and comprehensive income.
Illustration 13-5

Chapter 13-18

SO 3 Explain the concept of comprehensive income.

Sustainable Income
Format Two - Comprehensive Income
Separate component of Stockholders Equity.
Illustration 13-6

Chapter 13-19

SO 3 Explain the concept of comprehensive income.

Sustainable Income
Illustration 13-7

Format Three Comprehensive Income Complete Income Statement

Chapter 13-20

SO 3 Explain the concept of comprehensive income.

Sustainable Income
Illustration: In its draft 2010 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), and loss on disposal of discontinued flower division $140,000. The income tax rate is 30%. Prepare a correct income statement, beginning with income before income taxes.

Chapter 13-21

Solution on notes page

Comparative Analysis
Analyzing financial statements involves:
Comparison Bases
Intracompany Intercompany Industry averages

Basic Tools
Horizontal analysis Vertical analysis Ratio Analysis

Chapter 13-22

Comparative Analysis
Horizontal Analysis
Also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Purpose - to determine increase or decrease that has taken place. Commonly applied to the balance sheet and income statement.

Chapter 13-23

SO 4 Describe and apply horizontal analysis.

Comparative Analysis
Illustration 13-11 Horizontal analysis of balance sheets

Helpful Hint:
When using horizontal analysis, be sure to examine both dollar amount changes and percentage changes.

Chapter 13-24

SO 4 Describe and apply horizontal analysis.

Comparative Analysis
Illustration 13-12 Horizontal analysis of Income statements

Helpful Hint: In horizontal analysis, while the amount column is

additive (the total is $99 million), the percentage column is not additive (9.9% is not a total).
Chapter 13-25

SO 4 Describe and apply horizontal analysis.

Comparative Analysis
Illustration: Summary financial information for Rosepatch Company is as follows.

Compute the amount and percentage changes in 2010 using horizontal analysis, assuming 2009 is the base year.

Solution

Solution on notes page

Chapter 13-26

SO 4 Describe and apply horizontal analysis.

Comparative Analysis
Vertical Analysis
Also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount. Vertical analysis is commonly applied to the balance sheet and the income statement.

Chapter 13-27

SO 5 Describe and apply vertical analysis.

Comparative Analysis

These results indicate the company shifted toward equity financing by relying less on debt and by increasing the amount of retained earnings.

Chapter 13-28

SO 5 Describe and apply vertical analysis.

Comparative Analysis
Illustration 13-14 Vertical analysis of an income statements

Kelloggs increase in net income as a percentage of sales is due primarily to the decrease in interest expense and income tax expense as a percent of sales.
Chapter 13-29

SO 5 Describe and apply vertical analysis.

Comparative Analysis
Illustration 13-15 Intercompany comparison by vertical analysis

Vertical analysis also enables a comparison of companies of different sizes.

Although Kelloggs net sales are less than those of General Mills, vertical analysis eliminates the impact of this size difference for our analysis.
Chapter 13-30

SO 5 Describe and apply vertical analysis.

Ratio Analysis
Ratio analysis expresses the relationship among selected items of financial statement data. Financial Ratio Classifications
Liquidity
Measures shortterm ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Chapter 13-31

Solvency
Measures the ability of the company to survive over a long period of time.

Profitability
Measures the income or operating success of a company for a given period of time.

SO 6 Identify and compute ratios used in analyzing a companys liquidity, solvency, and profitability.

Ratio Analysis
Liquidity Ratios
Illustration 13-16

Chapter 13-32

SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
Solvency Ratios
Illustration 13-17

Chapter 13-33

SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Ratio Analysis
Profitability Ratios
Illustration 13-18

Chapter 13-34

SO 5 Identify and compute ratios used in analyzing a firms liquidity, profitability, and solvency.

Chapter 13-35

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. Recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business.

Chapter 13-36

SO 7 Understand the concept of quality of earnings.

Quality of Earnings
Alternative Accounting Methods
Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings (FIFO vs. LIFO).

Pro Forma Income

Usually excludes items that are unusual or nonrecurring. Some companies have abused the flexibility that pro forma numbers allow to put their companies in a more favorable light.
SO 7 Understand the concept of quality of earnings.

Chapter 13-37

Quality of Earnings
Improper Recognition
Some managers have felt pressure to continually increase earnings. Abuses include:
Improper recognition of revenue (channel stuffing). Improper capitalization of operating expenses (WorldCom). Failure to report all liabilities (Enron).

Chapter 13-38

SO 7 Understand the concept of quality of earnings.

Quality of Earnings
Price-Earnings Ratio
Reflects investors assessment of a companys future earnings.
 P-E ratio will be higher if investors think that earnings will increase substantially in the future.  P-E ratio will be lower when there is the belief that a company has poor-quality earnings.
Illustration 13-19

Chapter 13-39

SO 7 Understand the concept of quality of earnings.

Quality of Earnings
Price-Earnings Ratio
Illustration 13-19

Illustration 13-20 Earnings per share and P-E ratios of various companies

Chapter 13-40

SO 7 Understand the concept of quality of earnings.

Chapter 13-41

Quality of Earnings
Illustration: Match each of the following with the phrase that it best matches.
Comprehensive income Quality of earnings Solvency ratio 1. Vertical analysis Pro forma income Extraordinary items

terms

Measures the ability of the company to survive over a long period of time.

Solvency Pro forma

Comprehensive income

2. Usually excludes items that a company thinks are unusual or non-recurring. 3. Includes all changes in stockholders equity during a period except those resulting from investments by stockholders and distributions to stockholders.

Chapter 13-42

SO 7 Understand the concept of quality of earnings.

Quality of Earnings
Illustration: Match each of the following with the phrase that it best matches.
Comprehensive income Quality of earnings Solvency ratio Vertical analysis Pro forma income Extraordinary items

terms

4. Indicates the level of full and transparent information provided to users of the financial statements.

Quality of earnings

5. Describes events and transactions that are Extraordinary unusual in nature and infrequent in occurrence. items 6. Expresses each item within a financial statement as a percent of a base amount.
Chapter 13-43

Vertical analysis

SO 7 Understand the concept of quality of earnings.

Comprehensive Illustration of Ratio Analysis

Analyzing financial statements involves:
Characteristics Liquidity Profitability Solvency Comparison Bases Intracompany Industry averages Intercompany

Appendix

The financial information in Illustrations 13A-1 through 13A-4 will be used to calculate Kelloggs 2007 ratios.
Chapter 13-44

Comprehensive Illustration of Ratio Analysis

Illustration 13A-1

Chapter 13-45

Comprehensive Illustration of Ratio Analysis

Illustration 13A-2

Illustration 13A-4

Chapter 13-46

Comprehensive Illustration of Ratio Analysis

Illustration 13A-3

Chapter 13-47

Comprehensive Illustration of 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 current cash debt coverage ratio, the receivables turnover ratio, the average collection period, the inventory turnover ratio, and average days in inventory.
Chapter 13-48

Comprehensive Illustration of Ratio Analysis

Current Ratio - Expresses the relationship of current
assets to current liabilities. Calculate the current ratio for Kellogg for 2007 and 2006.
Illustration 13A-5

.67
What do the measures tell us?

.60

A current ratio of .67 means that for every dollar of current liabilities, Kellogg has $0.67 of current assets.
Chapter 13-49

Comprehensive Illustration of Ratio Analysis

Cash Debt Coverage Ratio - Because it uses cash
provided by operating activities, it may provide a better representation of liquidity. Calculate the ratio for Kellogg for 2007 and 2006

Illustration 13A-6

.37
Is the coverage adequate?

.39

Probably so. Kelloggs coverage is better than that of General Mills, and it approximates a commonly accepted threshold of .40.
Chapter 13-50

Comprehensive Illustration of Ratio Analysis

Receivables Turnover Ratio Measures the number of
times, on average, a company collects receivables during the period. Calculate the ratio for Kellogg for 2007 and 2006.

Illustration 13A-7

11.9 12.0
How does Kelloggs turnover compare to General Millss? The turnover of 11.9 times compares favorably with the industry average of 11.5 times, but is lower than General Millss turnover of 13.3 times.
Chapter 13-51

Comprehensive Illustration of Ratio Analysis

Average Collection Period Converts the receivable
turnover ratio into days. Calculate the collection period for Kellogg for 2007 and 2006.
Illustration 13A-8

30.7 30.4
How effective is Kelloggs credit and collection policies? General rule - collection period should not greatly exceed the credit term period (i.e., the time allowed for payment).
Chapter 13-52

Comprehensive Illustration of Ratio Analysis

Inventory Turnover Ratio - Measures the number of
times average inventory was sold during the period. Calculate the ratio for Kellogg for 2007 and 2006.
Illustration 13A-9

7.5

7.9

How does Kelloggs turnover compare to General Millss? The ratio of 7.5 times is higher than the industry average of 6.6 times and better than General Millss 7.1 times.
Chapter 13-53

Comprehensive Illustration of Ratio Analysis

Days in Inventory - Measures the average number of
days inventory is held. Calculate the days for Kellogg for 2007 and 2006.
Illustration 13A-10

48.7 46.2

How does Kelloggs days compare to General Millss? An average selling time of 49 days is faster than the industry average and faster than that of General Mills.
Chapter 13-54

Comprehensive Illustration of Ratio Analysis

Solvency Ratios
Solvency ratios measure the ability of a company to survive over a long period of time.  Debt-Paying Ability  Debt to total assets ratio  Times interest earned ratio  Cash debt coverage ratio  Free cash flow provides information about solvency and ability to pay additional dividends or invest.
Chapter 13-55

Comprehensive Illustration of Ratio Analysis

Debt to Total Assets Ratio Indicates the degree of
financial leveraging. Provides some indication of the companys ability to withstand losses. Calculate the ratio for Kellogg for 2007 and 2006. Illustration 13A-11

78% 81% Has Kelloggs solvency improved during the year? Yes, slightly. The ratio of 78% says that Kellogg would have to liquidate 78% of its assets at their book value in order to pay off all of its debts.
Chapter 13-56

Comprehensive Illustration of Ratio Analysis

Times Interest Earned Ratio - (also called interest
coverage) indicates the companys ability to meet interest payments as they come due. Calculate the ratio for Kellogg for 2007 and 2006. Illustration 13A-12

5.8 5.8 Is Kellogg better able to service its debt? Yes, the debt to total assets ratio decreased during 2007 and the times interest earned ratio held constant.
Chapter 13-57

Comprehensive Illustration of Ratio Analysis

Cash Debt Coverage Ratio - Indicates a companys
ability to repay its liabilities from cash generated from operating activities without having to liquidate the assets used in its operations. Calculate the ratio for Kellogg.
Illustration 13A-13

.17

.17

One way of interpreting this ratio is to say that net cash generated from one year of operations would be sufficient to pay off 17% of Kelloggs total liabilities.
Chapter 13-58

Comprehensive Illustration of Ratio Analysis

Free Cash Flow - Ability to pay dividends or expand
operations. Calculate the ratio for Kellogg.
Illustration 13A-14

556

507

(in millions)

Cash provided by operations was more than enough to allow Kellogg to acquire additional productive assets and maintain dividend payments.
Chapter 13-59

Comprehensive Illustration of Ratio Analysis

Profitability Ratios
Measure the income or operating success of a company for a given period of time.
Illustration 13A-15 Relationships among profitability measures

Chapter 13-60

Comprehensive Illustration of Ratio Analysis

Return on Common Stockholders Equity Ratio Shows how many dollars of net income the company earned for each dollar invested by the owners. Calculate the ratio for Kellogg.

Illustration 13A-16

48% 46%

Kelloggs 2007 rate of return on common stockholders equity is unusually high at 48%, considering an industry average of 23% and General Millss return of 21%.
Chapter 13-61

Comprehensive Illustration of Ratio Analysis

Return on Assets Ratio - Measures the overall
profitability of assets in terms of the income earned on each dollar invested in assets. Calculate the ratio.
Illustration 13A-17

10% 9.4%

Note that Kelloggs rate of return on common stockholders equity (48%) is substantially higher than its rate of return on assets (10%). Kellogg has made effective use of leverage.
Chapter 13-62

Comprehensive Illustration of Ratio Analysis

Profit Margin Ratio - Or rate of return on sales, is a
measure of the percentage of each dollar of sales that results in net income. Calculate the ratio for Kellogg.
Illustration 13A-18

9.4% 9.2%

High-volume (high inventory turnover) businesses such as grocery stores and pharmacy chains generally have low profit margins.
Chapter 13-63

Comprehensive Illustration of Ratio Analysis

Asset Turnover Ratio - Measures how efficiently a
company uses its assets to generate sales. Calculate the ratio for Kellogg.
Illustration 13A-19

1.07

1.02

The average asset turnover for utility companies is .45, for example, while the grocery store industry has an average asset turnover of 3.49.
Chapter 13-64

Comprehensive Illustration of Ratio Analysis

You can analyze the combined effects of profit margin and asset turnover on return on assets for Kellogg as shown
Illustration 13A-20

Chapter 13-65

Comprehensive Illustration of Ratio Analysis

Gross Profit Rate - Indicates a companys ability to
maintain an adequate selling price above its cost of goods sold. Calculate the ratio for Kellogg.
Illustration 13A-21

44% 44%

As an industry becomes more competitive, this ratio declines.

Chapter 13-66

Comprehensive Illustration of Ratio Analysis

Earnings Per Share - A measure of the net income
earned on each share of common stock. Calculate the ratio for Kellogg.
Illustration 13A-22

$2.63 $2.40

Chapter 13-67

Comprehensive Illustration of Ratio Analysis

Price-Earnings (P-E) Ratio - Reflects investors
assessments of a companys future earnings. Calculate the ratio for Kellogg.
Illustration 13A-23

20.1

20.9

A higher P-E ratio suggests that the market is more optimistic about Kellogg. It might also signal that its stock is overpriced.
Chapter 13-68

Comprehensive Illustration of Ratio Analysis

Payout Ratio - Measures the percentage of earnings
distributed in the form of cash dividends. Calculate the ratio for Kellogg.
Illustration 13A-24

43% 45%

This ratio should be calculated over a longer period of time to evaluate any trends.

Chapter 13-69

Copyright
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Chapter 13-70