13-1. 13-2 FINANCIAL ANALYSIS: THE BIG PICTURE Accounting, Fourth Edition 13.

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FINANCIAL ANALYSIS: FINANCIAL ANALYSIS: THE BIG PICTURETHE BIG PICTURE

Accounting, Fourth Edition

13

13-3

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 company’s

liquidity, solvency, and profitability.

7. Understand the concept of quality of earnings.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

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Sustainable Sustainable IncomeIncome

Sustainable Sustainable IncomeIncome

Irregular itemsIrregular items

Changes in Changes in accounting accounting principlesprinciples

Comprehensive Comprehensive incomeincome

Alternative Alternative accounting accounting methodsmethods

Pro forma Pro forma incomeincome

Improper Improper recognitionrecognition

Price-earnings Price-earnings ratioratio

Liquidity ratiosLiquidity ratios

Solvency ratiosSolvency ratios

Profitability Profitability ratiosratios

Horizontal Horizontal analysisanalysis

Vertical Vertical analysisanalysis

Comparative Comparative AnalysisAnalysis

Comparative Comparative AnalysisAnalysis Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis Quality of Quality of

EarningsEarningsQuality of Quality of EarningsEarnings

Financial Analysis: The Big PictureFinancial Analysis: The Big PictureFinancial Analysis: The Big PictureFinancial Analysis: The Big Picture

13-5 SO 2 Indicate how irregular items are presented.

Sustainable IncomeSustainable IncomeSustainable IncomeSustainable 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.

13-6 SO 2 Indicate how irregular items are presented.


Components of the income statement

Illustration 13-1

13-7

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.


SO 2 Indicate how irregular items are presented.

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Illustration: Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in 2012. The company therefore has income before income taxes of $800,000. During 2012 the company discontinued and sold its unprofitable chemical division at a loss of $210,000 (net of $90,000 tax savings).


SO 2

Illustration 13-2

13-9

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.”



13-10

Illustration: In 2012 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


13-11

Are these considered Extraordinary Items?

YESYES

NONO

NONO

YESYES


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.


13-12

NONO

YESYES

NONO


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.


Are these considered Extraordinary Items?

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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.

Changes in Accounting Principle

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SO 3 Explain the concept of 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-for-sale

securities

Comprehensive Income

13-16

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 2012 Stassi Company purchased IBM stock

for $10,000 as an investment. At the end of 2012 Stassi was still

holding the investment, but the stock’s market value was now

$8,000.

How should Stassi account for the $2,000 unrealized loss?

13-17

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)

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Format One – Comprehensive Income



Combined statement of income and comprehensive income.

Illustration 13-5

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Format Two - Comprehensive Income



Separate component of Stockholders’ Equity.Illustration 13-6

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Complete Income Statement



Illustration 13-7

Format Three - Comprehensive Income

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AIR CORPORATIONIncome Statement (partial)

Income before income taxes $400,000Income tax expense 120,000Income before irregular items 280,000Discontinued operations

Loss on disposal of discontinued flower division, net of $42,000 tax savings (98,000)

Extraordinary earthquake loss, net of $30,000 tax savings (70,000)Net income $112,000


Illustration: In its draft 2012 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.

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Analyzing financial statements involves:

Comparative AnalysisComparative AnalysisComparative AnalysisComparative Analysis

Comparison Bases

Basic Tools

Intracompany

Intercompany

Industry averages

Horizontal analysis

Vertical analysis

Ratio Analysis

13-23 SO 4 Describe and apply 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.


Horizontal Analysis

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Helpful Hint: When using horizontal

analysis, be sure to examine both dollar amountchanges and percentage changes.

Illustration 13-11Horizontal analysis of balance sheets


SO 4 Describe and apply horizontal analysis.

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Illustration 13-12Horizontal 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).


13-26

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


Solution


Compute the amount and percentage changes in 2012 using horizontal analysis, assuming 2011 is the base year.

13-27 SO 5 Describe and apply 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.


Vertical Analysis

13-28 SO 5 Describe and apply vertical analysis.


These results indicate the

company shiftedtoward equity

financing by relying less on debt and by

increasing the amount

of retained earnings.

Illustration 13-13Vertical analysis of Income statements

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The 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.

SO 5 Describe and apply vertical analysis.


Illustration 13-14Vertical analysis of an income statements

13-30

Illustration 13-15Intercompany comparison by vertical analysis

SO 5 Describe and apply vertical analysis.

Although Chicago Cereal’s net sales are less than those of General Mills, vertical analysis eliminates the impact of this size difference for our analysis.


Vertical analysis

also enables a

comparison of

companies of

different sizes.

13-31

ProfitabilityProfitability

Measures the income or

operating success of a company for a

given period of time.

SolvencySolvency

Measures the ability of the company to

survive over a long period of time.

SO 6 Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis

Ratio analysis expresses the relationship among selected items of financial statement data.

LiquidityLiquidity

Measures short-term ability of the

company to pay its maturing

obligations and to meet unexpected needs for cash.

Financial Ratio Classifications

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Illustration 13-16

Liquidity Ratios


13-34


Illustration 13-17

Solvency Ratios


13-35


Illustration 13-18

Profitability Ratios


13-37

Recent accounting scandals suggest that some

companies are spending too much time managing their

income and not enough time managing their

business.

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.

Quality of EarningsQuality of EarningsQuality of EarningsQuality of Earnings

SO 7 Understand the concept of quality of earnings.

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


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.


Alternative Accounting Methods

Pro Forma Income

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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).

Alternative Accounting Methods

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Price-Earnings Ratio



Reflects investors’ assessment of a company’s 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

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Illustration 13-19

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

Price-Earnings Ratio

13-43

Illustration: Match each of the following terms with the phrase that it best matches.


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.

3. Includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.

Solvency


Pro forma

Comprehensive income

Comprehensive income Vertical analysisQuality of earnings Pro forma incomeSolvency ratio Extraordinary items

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Quality of earnings


Extraordinary items

Vertical analysis

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

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.

Illustration: Match each of the following terms with the phrase that it best matches.

Comprehensive income Vertical analysisQuality of earnings Pro forma incomeSolvency ratio Extraordinary items

13-45

Analyzing financial statements involves:

CharacteristicsComparison

Bases

Liquidity

Profitability

Solvency

Intracompany

Industry averages

Intercompany

The financial information in Illustrations 13A-1 through 13A-4 will be used to calculate Chicago’s 2009 ratios.

appendix 13A Comprehensive Ratio Analysis

13-46

Illustration 13A-1


13-47

Illustration 13A-2 & 13A-4


13-48


Illustration 13A-3

13-49

Liquidity RatiosLiquidity 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.


13-50

Current Ratio - Expresses the relationship of current assets to

current liabilities. Calculate the current ratio for 2009 and 2008.

What do the measures tell us?

A current ratio of .67 means that for every dollar of current

liabilities, the company has $0.67 of current assets.

.67 .60

Illustration 13A-5


13-51

Cash Debt Coverage Ratio - Because it uses cash provided by

operating activities, it may provide a better representation of

liquidity. Calculate the ratio for 2009 and 2008.

Is the coverage adequate?

Probably so. Chicago’s coverage is better than that of General

Mills, and it approximates an accepted threshold of .40.

.37 .39

Illustration 13A-6


13-52

Receivables Turnover Ratio – Measures the number of times,

on average, a company collects receivables during the period.

Calculate the ratio for 2009 and 2008.

How does Chicago’s turnover compare to General Mills’s?

The turnover of 11.9 times is lower than the industry average of

14.0 times, and slightly lower than General Mills’s turnover of 12.8

times.

11.9 12.0

Illustration 13A-7


13-53

Average Collection Period – Converts the receivable turnover

ratio into days. Calculate the collection period for 2009 and

2008.

How effective is Chicago’s credit and collection policies?

General rule - collection period should not greatly exceed the

credit term period (i.e., the time allowed for payment).

30.7 30.4

Illustration 13A-8


13-54

Inventory Turnover Ratio - Measures the number of times

average inventory was sold during the period. Calculate the

ratio for Chicago for 2009 and 2008.

The ratio of 7.5 times is higher than the industry average of 6.9 times and better than General Mills’s 6.2 times.

7.5 7.9

How does Chicago’s turnover compare to General Mills’s?

Illustration 13A-9


13-55

Days in Inventory - Measures the average number of days

inventory is held. Calculate the days for Chicago for 2009 and

2008.

An average selling time of 49 days is faster than the industry average and faster than that of General Mills.

48.7 46.2

How does Chicago’s days compare to General Mills’s?

Illustration 13A-10


13-56

Solvency RatiosSolvency 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.


13-57

Debt to Total Assets Ratio – Indicates the degree of financial

leveraging. Provides some indication of the company’s ability to

withstand losses. Calculate the ratio for 2009 and 2008.

Yes, slightly. The ratio of 78% says that Chicago would have to

liquidate 78% of its assets at their book value in order to pay off

all of its debts.

78% 81%

Has Chicago’s solvency improved during the year?

Illustration 13A-11


13-58

Times Interest Earned Ratio - (also called interest coverage)

indicates the company’s ability to meet interest payments as they

come due. Calculate the ratio for Chicago for 2009 and 2008.

Yes, the debt to total assets ratio decreased during 2009 and the

times interest earned ratio held constant.

5.8 5.8

Is Chicago better able to service its’ debt?

Illustration 13A-12


13-59

Cash Debt Coverage Ratio - Indicates a company’s 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 Chicago.

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

Chicago’s total liabilities.

.17 .17

Illustration 13A-13


13-60

Free Cash Flow - Ability to pay dividends or expand operations.


Cash provided by operations was more than enough to allow

Chicago to acquire additional productive assets and maintain

dividend payments.

556 507

Illustration 13A-14

(in millions)


13-61

Profitability RatiosProfitability Ratios

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

Illustration 13A-15Relationships amongprofitability measures


13-62

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 Chicago.

Chicago’s 2009 rate of return on common stockholders’ equity is

unusually high at 48%, considering an industry average of 30%

and General Mills’s return of 29%.

48% 46%

Illustration 13A-16


13-63

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.

Note that Chicago’s rate of return on common stockholders’ equity

(48%) is substantially higher than its rate of return on assets

(10%). Chicago has made effective use of leverage.

10% 9.4%

Illustration 13A-17


13-64

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.


High-volume (high inventory turnover) businesses such as

grocery stores and pharmacy chains generally have low profit

margins.

9.4% 9.2%

Illustration 13A-18


13-65

Asset Turnover Ratio - Measures how efficiently a company

uses its assets to generate sales. Calculate the ratio for

Chicago.

The average asset turnover for utility companies is .45, for

example, while the grocery store industry has an average asset

turnover of 3.49.

1.07 1.02

Illustration 13A-19


13-66

You can analyze the combined effects of profit margin and

asset turnover on return on assets for Chicago as shown

Illustration 13A-20


13-67

Gross Profit Rate - Indicates a company’s ability to maintain

an adequate selling price above its cost of goods sold.


44% 44%

Illustration 13A-21

As an industry becomes more competitive, this ratio declines.


13-68

Earnings Per Share - A measure of the net income earned on

each share of common stock. Calculate the ratio for Chicago.

$2.63 $2.40

Illustration 13A-22


13-69

Price-Earnings (P-E) Ratio - Reflects investors’ assessments of

a company’s future earnings. Calculate the ratio for Chicago.

20.1 20.9

Illustration 13A-23

A higher P-E ratio suggests that the market is more optimistic

about Chicago. It might also signal that its stock is overpriced.


13-70

Payout Ratio - Measures the percentage of earnings distributed

in the form of cash dividends. Calculate the ratio for Chicago.

43% 45%

Illustration 13A-24

This ratio should be calculated over a longer period of time to

evaluate any trends.


13-71

Key Points

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.

13-72

Key Points

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.

The income statement under IFRS is referred to as a statement of comprehensive income. The statement of comprehensive income can be prepared under the one-statement approach or the two-statement approach.

13-73

Key Points

GAAP also permits the one-statement or two-statement approach. In addition, GAAP permits a third alternative, which is to show the computation of comprehensive income in the statement of stockholders’ equity.

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.

13-74

Looking into the Future

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.

13-75

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.

13-76

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.

13-77

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.

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13-1. 13-2 FINANCIAL ANALYSIS: THE BIG PICTURE Accounting, Fourth Edition 13.

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