3rd Lecture FSA

7/30/2019 3rd Lecture FSA

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Chapter18-1

Financial StatementAnalysis


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Chapter18-2

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 afirms liquidity, profitability, and solvency.

6. Understand the concept of earning power, and howirregular items are presented.

7. Understand the concept of quality of earnings.

Study Objectives


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Chapter18-3

Balance

sheet

Income

statement

Retained

earnings

statement

Basics of

Financial

Statement

Analysis

Horizontal and

Vertical

Analysis

Ratio Analysis

Earning

Power and

Irregular Items

Quality of

Earnings

Need for

comparative

analysis

Tools of

analysis

Liquidity

Profitability

Solvency

Summary

Discontinued

operations

Extraordinary

items

Changes in

accounting

principle

Comprehensive

income

Alternative

accounting

methods

Pro forma

income

Improper

recognition

Financial Statement Analysis


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Chapter18-4

Analyzing financial statements involves:

Basics of Financial Statement Analysis

CharacteristicsComparison

BasesTools ofAnalysis

Liquidity

Profitability

Solvency

Intracompany

Industryaverages

Intercompany

Horizontal

Vertical

Ratio

SO 1 Discuss the need for comparative analysis.SO 2 Identify the tools of financial statement analysis.


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Chapter18-5 SO 3 Explain and apply horizontal analysis.

Horizontal Analysis

Horizontal analysis, also called trend analysis, is atechnique for evaluating a series of financialstatement data over a period of time.

Its purpose is to determine the increase or decreasethat has taken place.

Horizontal analysis is commonly applied to the balance

sheet, income statement, and statement of retainedearnings.


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These changessuggest that thecompany expandedits asset baseduring 2007 andfinanced thisexpansion primarily

by retaining incomerather thanassuming additionallong-term debt.

Horizontal Analysis

Illustration 18-5

Horizontal analysis ofbalance sheets


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Overall, grossprofit and netincome were upsubstantially. Grossprofit increased17.1%, and netincome, 26.5%.

Qualitys profittrend appearsfavorable.

Horizontal Analysis

Illustration 18-6

Horizontal analysis ofIncome statements


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We saw in the horizontal analysis of the balance sheet that ending retainedearnings increased 38.6%. As indicated earlier, the company retained asignificant portion of net income to finance additional plant facilities.

Horizontal Analysis

Illustration 18-7Horizontal analysis of

retained earnings

statements


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Chapter18-9 SO 4 Describe and apply vertical analysis.

Vertical Analysis

Vertical analysis, also called common-size analysis, isa technique that expresses each financial statementitem as a percent of a base amount.

On an income statement, we might say that sellingexpenses are 16% of net sales.

Vertical analysis is commonly applied to the balance

sheet and the income statement.


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Chapter18-10

These resultsreinforce the

earlierobservations thatQuality ischoosing tofinance its growththrough retention

of earnings ratherthan throughissuing additionaldebt.

Illustration 18-8

Vertical analysis ofbalance sheets

SO 4 Describe and apply vertical analysis.

Vertical Analysis


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Chapter18-11

Quality appearsto be a profitable

enterprise that isbecoming evenmore successful.

Illustration 18-9

Vertical analysis ofIncome statements

SO 4 Describe and apply vertical analysis.

Vertical Analysis


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Chapter18-12 SO 5 Identify and compute ratios used in analyzinga firms liquidity, profitability, and solvency.

Ratio Analysis

Ratio analysisexpresses the relationship amongselected items of financial statement data.

Liquidity Profitability Solvency

Measures short-term ability of

the company topay its maturingobligations and tomeet unexpectedneeds for cash.

Financial Ratio Classifications

Measures theincome or

operating successof a company fora given period of

time.

Measures theability of the

company tosurvive over along period of

time.


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Ratio Analysis

The discussion of ratios will

include the following types ofcomparisons.

A single ratio by itself is not very meaningful.


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Ratio Analysis

Liquidity Ratios

Measure the short-term ability of the company to payits maturing obligations and to meet unexpected needs

for cash.

Short-term creditors such as bankers andsuppliers are particularly interested in assessingliquidity.

Ratios include the current ratio, the acid-testratio, receivables turnover, and inventoryturnover.


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Ratio Analysis

Compute the Current Ratio for 2007.

The ratio of 2.96:1 means that for every dollar ofcurrent liabilities, Quality has $2.96 of currentassets.

Current Assets

Current Liabilities

= Current Ratio

$1,020,000

$344,500= 2.96 : 1

Liquidity Ratios


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Ratio Analysis

Compute the Acid-Test Ratiofor 2007.

Liquidity Ratios

Illustration 18-13


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Ratio Analysis

Compute the Acid-Test Ratio for 2007.

The acid-test ratio measures immediate liquidity.

Cash + Short-Term Investments + Receivables (Net)

Current Liabilities

Acid-TestRatio

$100,000 + $20,000 + $230,000

$344.500= 1.02 : 1

=

Liquidity Ratios


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Ratio Analysis

Compute the Receivables Turnoverratio for 2007.

It measures the number of times, on average, thecompany collects receivables during the period.

$2,097,000

($180,000 + $230,000) / 2= 10.2 times

Net Credit Sales

Average Net Receivables

ReceivablesTurnover

=

Liquidity Ratios


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Ratio Analysis

A variant of the receivables turnover ratio is to convertit to an average collection periodin terms of days.

This means that receivables are collected on averageevery 36 days.

$2,097,000

($180,000 + $230,000) / 2= 10.2 times

Liquidity Ratios

365 days / 10.2 times = every 35.78 days

Receivables Turnover


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Ratio Analysis

Compute the Inventory Turnoverratio for 2007.

Inventory turnover measures the number of times,on average, the inventory is sold during the period.

$1,281,000

($500,000 + $620,000) / 2= 2.31 times

Cost of Good Sold

Average Inventory

InventoryTurnover

=

Liquidity Ratios


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Ratio Analysis

A variant of inventory turnover is the days in inventory.

Inventory turnover ratios vary considerably amongindustries.

Liquidity Ratios

365 days / 2.3 times = every 159 days

$1,281,000

($500,000 + $620,000) / 2= 2.3 times

Inventory Turnover


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Ratio Analysis

Profitability Ratios

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

Income, or the lack of it, affects the companysability 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 stockholdersequity, earnings per share, price-earnings, andpayout ratio.


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Ratio Analysis

Compute the Profit Marginratio for 2007.

Measures the percentage of each dollar of salesthat results in net income.

$263,800

$2,097,000= 12.6%

Net Income

Net Sales

ProfitMargin

=



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Ratio Analysis

Compute the Asset Turnoverratio for 2007.

Measures how efficiently a company uses its assetsto generate sales.

$2,097,000

($1,95,000 + $1,835,000) / 2= 1.22 times

Net Sales

Average Assets

AssetTurnover

=



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Ratio Analysis

Compute the Return on Assetsratio for 2007.

An overall measure of profitability.

$263,800

($1,595,000 + $1,835,000) / 2= 15.4%

Net Income

Average Assets

Returnon Assets

=



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Ratio Analysis

Compute theReturn on Common Stockholders

Equity ratio for 2007.

Shows how many dollars of net income the companyearned for each dollar invested by the owners.

$263,000 - $0

($795,000 + $1,003,000) / 2

= 29.3%

Net Income Preferred Dividends

Average Common Stockholders Equity

Return onCommon

Stockholders

Equity

=



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Ratio Analysis

Compute the Earnings Per Share for 2007.

A measure of the net income earned on each shareof common stock.

$263,800

270,000 + 275,400 / 2

= $0.97 per share

Net Income

Weighted Average CommonShares Outstanding

EarningsPer Share

=



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Ratio Analysis

Compute the Price Earnings Ratio for 2007.

The price-earnings (PE) ratio reflects investorsassessments of a companys future earnings.

$12.00

$0.97= 12.4 times

Market Price per Share of Stock

Earnings Per Share

PriceEarningsRatio

=



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Ratio Analysis

Compute the Payout Ratio for 2007.

Measures the percentage of earnings distributed inthe form of cash dividends.

$61,200

$263,800= 23.2%

Cash Dividends

Net Income

PayoutRatio

=


*

* From analysis of retained earnings.


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Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a company tosurvive over a long period of time.

Debt to total assets and times interest earnedare two ratios that provide information aboutdebt-paying ability.


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Ratio Analysis

Compute the Debt to Total Assets Ratio for 2007.

Measures the percentage of the total assets thatcreditors provide.

$832,000

$1,835,000= 45.3%

Total Debt

Total Assets

Debt toTotal Assets

Ratio

=

Solvency Ratios


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Ratio Analysis

Compute the Times Interest Earned ratio for 2007.

Provides an indication of the companys ability tomeet interest payments as they come due.

$468,000

$36,000= 13 times

Income before Income Taxes andInterest Expense

Interest Expense

Times

InterestEarned=

Solvency Ratios


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Chapter18-33 SO 6 Understand the concept of earning power,and how irregular items are presented.

Earning Power and Irregular Items

Earning powermeans the normal level of income to beobtained in the future.

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.


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Chapter18-34

The DU PONT EQUATION

In ratio analysis, it is sometimes easy to miss the forest for all the trees. TheDu Pont equation provides a framework that ties together a firms

Profitability, asset efficiency, and use of debt. The return on assets (ROA)

an be expressed as the profit margin multiplied by the total assets turnover

ratio:


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Chapter18-35

The DU PONT EQUATION


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Chapter18-36

Discontinued Operations(a) Refers to the disposal of a significant component

of a business.

(b) Report the income (loss) from discontinuedoperations in two parts:

1. income (loss) from operations (net of tax)

and2. gain (loss) on disposal (net of tax).

SO 6 Understand the concept of earning power,and how irregular items are presented.



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Chapter18-37

Illustration: During 2010 Acro Energy Inc. has income fromcontinuing operations of $560,000. During 2010 Acrodiscontinued and sold its unprofitable chemical division. Theloss in 2010 from chemical operations (net of $60,000 taxes)was $140,000. The loss on disposal of the chemical division (netof $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

Net income $350,000

Total loss on discontinued operations 210,000




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Chapter18-38

Other revenue (expense):

Interest revenue 17,000

Interest expense (21,000)Total other (4,000)

Income before taxes 79,000

Income tax expense 24,000

Income from continuing operations 55,000


Loss from operations, net of tax 315

Loss on disposal, net of tax 189

Total loss on discontinued operations 504

Net income 54,496$

Income Statement (in thousands)

Sales 285,000$

Cost of goods sold 149,000Discontinued Operations

are reported afterIncome from continuing

operations.

Previously labeled asNet Income.

Moved to

SO 6 Understand the concept of earning power,and how irre ular items are resented.



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Chapter18-39

Extraordinary items are nonrecurring materialitems that differ significantly from a companystypical business activities.

An extraordinary item must be both of anUnusual Nature and

Occur Infrequently

Company must consider the environment in which itoperates.

Amounts reported net of tax.




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Chapter18-40

Are these considered Extraordinary Items?(a) A large portion of a tobacco manufacturers

crops are destroyed by a hail storm. Severedamage 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


NO



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Chapter18-41

(d) Loss from flood damage. (The nearby BlackRiver floods every 2 to 3 years.)

(e) An earthquake destroys one of the oil

refineries owned by a large multi-national oilcompany. Earthquakes are rare in thisgeographical location.

(f) Write-down of obsolete inventory.

(g) Expropriation of a factory by a foreigngovernment.

NO

YES

YES


NO

Are these considered Extraordinary Items?



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Chapter18-42

Illustration: In 2010 a foreign government expropriatedproperty held as an investment by Acro Energy Inc. If theloss is $70,000 before applicable income taxes of $21,000,the income statement will report a deduction of $49,000.


Illustration 18-30


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Chapter18-43

Other revenue (expense):

Interest revenue 17,000





Extraordinary loss, net of tax 539Net income 54,461$


Sales 285,000$Cost of goods sold 149,000

Extraordinary Itemsare reported after

Income from continuingoperations.

Previously labeled asNet Income.

Moved to




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Chapter18-44


Income before taxes 79,000Income tax expense 24,000



Loss from operations, net of tax 315

Loss on disposal, net of tax 189

Total loss on discontinued operations 504

Income before extraordinary item 54,496

Extraordinary loss, net of tax 539

Net income 53,957$


Sales 285,000$Cost of goods sold 149,000

Reporting when bothDiscontinued Operations

and

Extraordinary Items

are present.

DiscontinuedOperations

Extraordinary Item




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Chapter18-45

Change in Accounting PrincipleOccurs when the principle used in the currentyear is different from the one used in thepreceding year.

Accounting rules permit a change if justified.

Changes are reported retroactively.

Example would include a change in inventorycosting method such as FIFO to average cost.




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Chapter18-46


Sales 285,000$

Cost of goods sold 149,000

Gross profit 136,000

Operating expenses:Advertising expense 10,000

Depreciation expense 43,000

Total operating expense 53,000

Income from operations 83,000

Other revenue:

Interest revenue 17,000Total other 17,000



Net income 76,000$

Unrealized gains andlosses on available-for-sale securities.

Plus other items

+

Reported inStockholders Equity

Comprehensive Income



All changes in stockholdersequity except thoseresulting from investmentsby stockholders anddistributions to

stockholders.


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Chapter18-47

Comprehensive IncomeWhy are gains and losses on available-for-salesecurities excluded from net income?

Because disclosing them separately1. reduces the volatility of net income due to

fluctuations in fair value,

2. yet informs the financial statement user of thegain or loss that would be incurred if thesecurities were sold at fair value.




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Chapter18-48

Companies have incentives to manage income tomeet 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 earningsprovides full and transparent information that willnot confuse or mislead users of the financialstatements.

Quality of Earnings

SO 7 Understand the concept of quality of earnings.


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Chapter

18-49

Alternative Accounting MethodsVariations among companies in the application ofGAAP may hamper comparability and reducequality of earnings.

Quality of Earnings

SO 7 Understand the concept of 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 thatpro forma numbers allow.


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Chapter

Improper RecognitionSome managers have felt pressure to continuallyincrease earnings and have manipulated the earningsnumbers to meet these expectations.

Abuses include:

Improper recognition of revenue (channel stuffing).

Improper capitalization of operating expenses(WorldCom).

Failure to report all liabilities (Enron).

Quality of Earnings

3rd Lecture FSA

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