Chapter 14

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Principles of AccountingPrinciples of AccountingKimmel • Weygandt • KiesoKimmel • Weygandt • Kieso

Financial Statement Analysis Financial Statement Analysis

Chapter 14Chapter 14

Prepared byAlice Sineath

Forsyth Technical Community CollegeAnd

Ellen Sweat Georgia Perimeter College

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Chapter 14Financial Statement Analysis

After studying Chapter 14, you should be able to: • Understand the concept of sustainable

income.• Indicate how irregular items are presented.• Explain the concept of comprehensive

income.• Describe and apply horizontal analysis.

• Describe and apply vertical analysis.

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After studying Chapter 14, you should be able to: • Identify and compute ratios used in

analyzing a company’s liquidity, solvency, and profitability.

• Understand the concept of quality of earnings.

Chapter 14Financial Statement Analysis

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Sustainable Income

• Is the most likely level of income to be obtained in the future.

• Does not include irregular revenues, expenses, gains, or losses.

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Comprehensive Income

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

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• Most revenues, expenses, gains, and losses recognized during the period are included in net income.

• Specific exceptions to this practice have developed - these items bypass income and are reported directly in stockholders’ equity.

Comprehensive Income

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Irregular Items

Three types of irregular items are reported -- (all net of taxes)

• discontinued operations

• extraordinary items

• changes in accounting principle

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Discontinued Operations...

Refers to the disposal of a significant segment of a business...

• the elimination of a major class of customers or

• an entire activity.

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• Assume Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million or net income of $800,000 from continuing operations in 2005.

• During 2005 the company discontinued and sold its unprofitable chemical division. The loss in 2005 from chemical operations (net of $90,000 taxes) was $210,000. The tax rate is 30%.

Discontinued Operations

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Statement Presentation of Discontinued Operations

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Extraordinary Items...

Are events and transactions that meet two conditions: • Unusual in

nature• Infrequent in

occurrence

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Classification of Extraordinary and Ordinary Items

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• In 2005 a revolutionary foreign government expropriated property held as an investment by Rozek Inc.

• The loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000.

Extraordinary Items

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Statement Presentation of Extraordinary Items

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Change in Accounting Principle

• Occurs when the principle used in the current year is different from the one used in the preceding year.

• Is permitted, when – management can show that the new principle is preferable to

the old and– the effects of the change are clearly disclosed in the income

statement.• Examples:

– a change in depreciation methods (such as declining-balance to straight-line)

– a change in inventory costing methods (such as FIFO to average cost).

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• The new principle should be used in reporting the results of operations of the current year.

• The cumulative effect of the change on all prior-year income statements should be disclosed net of applicable taxes in a special section immediately preceding net income.

Change in Accounting Principle

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• Rozek Inc. changes from the straight-line method to the declining-balance method for equipment purchased on January 1, 2002.

• The cumulative effect on prior-year income statements (statements for 2002-2004) is to increase depreciation expense and decrease income before income taxes by $24,000.

• If there is a 30% tax rate, the net-of-tax effect of the change is ($16,800) ($24,000 x 70%).

Changes in Accounting Principle

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Statement Presentation of a Change in Accounting

Principle

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SUMMARYWhen evaluating a company,it generally makes sense to eliminate all irregular items.

Estimating Sustainable Income

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Comprehensive Income

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

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• Most revenues, expenses, gains, and losses recognized during the period are included in net income.

• Specific exceptions to this practice have developed - these items bypass income and are reported directly in stockholders’ equity.

Comprehensive Income

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Unrealized gains and losses on available-for-sale securities are 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.

Comprehensive Income

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• The FASB now requires that, in addition to reporting net income, a company must also report comprehensive income.

Comprehensive Income

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Comparative Analysis

• Any item reported in a financial statement has significance if: – Its inclusion indicates that the item exists at a given

time and in a certain quantity. • For example, when Kellogg Company reports $136.4

million on its balance sheet as cash, we know that Kellogg did have cash and that the quantity was $136.4 million.

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• Whether the amount represents an increase over prior years, or whether it is adequate in relation to the company's needs, cannot be determined from the amount alone.

• The amount must be compared with other financial data to provide more information.

Comparative Analysis

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There are three types of comparisons to provide decision usefulness of financial information:

• Intracompany basis

• Intercompany basis

• Industry averages

Comparative Analysis

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Intracompany Basis

• Comparisons within a company are often useful to detect changes in financial relationships and significant trends.

• A comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease.

• A comparison of Kellogg's year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash.

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Intercompany Basis

• Comparisons with other companies provide insight into a company's competitive position.

• Kellogg's total sales for the year can be compared with the total sales of its competitors such as Quaker Oats and General Mills.

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• Comparisons with industry averages provide

information about a company's relative position within the industry.

• Kellogg's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's.

Industry Averages

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Financial Statement Analysis

Three basic tools are used in financial statement analysis :• Horizontal analysis• Vertical analysis• Ratio analysis

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Horizontal Analysis

• Is a technique for evaluating a series of financial statement data over a period of time.

• Purpose is to determine whether an increase or decrease has taken place.

• The increase or decrease can be expressed as either an amount or a percentage.

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Horizontal Analysis

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Percentage Change in Sales

The percentage change in sales for each of the 5 years, assuming 1997 as the base period is:

Kellogg Company Net Sales (in millions) Base Period 1997

2001 2000 1999 1998 1997$8,853.3 $6,954.7 $6,984.2 $6762.1 $6,830.1

129.62% 101.82 % 102.26% 99%

100.0%

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Horizontal Analysis of a Balance Sheet

KELLOGG COMPANY, INC.Condensed Balance Sheets

December 31(In millions)

Increase (Decrease) during 2001

2001 2000 Amount Percent

AssetsCurrent Assets $ 1,902.0 $1,617.1 $ 284.9 17.6 Plant assets 2,952.8 2,526.9 425.9 16.9Other assets 5,513.8 742.0 4,771.8 643.1Total assets $10,368.6 $4,886.0 $5,482.6 112.2

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Increase (Decrease)

during 2001

2001 2000 Amount Percent

Liabilities andStockholders' EquityCurrent liabilities $ 2,207.6 $2,482.3 $ (274.7) (11.1)Long-term liabilities 7,289.5 1,506.2 5,783.3 384.0 Total liabilities 9,497.1 3,988.5 5,508.6 138.1Stockholders' equity Common stock 195.3 205.8 (10.5) (5.1) Retained earnings

and other 1,013.3 1,065.7 (52.4) (4.9) Treasury stock (337.1) (374.0) 36.9 9.9Total stockholders'

equity 871.5 897.5 (26.0) (2.9)Total liabilities and stockholders' equity $10,368.6 $4,886.0 $5,482.6 112.2

Horizontal Analysis of a Balance Sheet

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KELLOGG COMPANY, INC.Condensed Income Statement

For the Years Ended December 31(In millions)

Increase (Decrease)

during 2001 2001 2000 Amount Percent

Net sales $ 8,853.3 $6,954.7 $1,898.6 27.3

Cost of goods sold 4,128.5 3,327.0 801.5 24.1Gross profit 4,724.8 3,627.7 1,097.1 30.2Selling & Admin. 3,523.6 2,551.4 972.2 38.1Nonrecurring charges 33.3 86.5 (53.2)

(61.5)Income from operations 1,167.9 989.8 178.1

18.0Interest expense 1351.5 137.5 214.0 155.6Other income

(expense), net (12.3) 15.4 (27.7) (179.9)

Income before taxes 804.1 867.7 (63.6) (7.3)Income tax expense 322.1 280.0 42.1 15.0 Net income $ 482.0 $ 587.7 $ (105.7)

(18.0)

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Let’s ReviewLet’s Review

In horizontal analysis, each item is In horizontal analysis, each item is expressed as a percentage of the:expressed as a percentage of the:

a.a. net income amount.net income amount.

d.d. base-year amount.base-year amount.c. c. total assets amount.total assets amount.

b.b. stockholders’ equity amount.stockholders’ equity amount.

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Let’s ReviewLet’s Review

In horizontal analysis, each item is In horizontal analysis, each item is expressed as a percentage of the:expressed as a percentage of the:

a.a. net income amount.net income amount.

d.d. base-year amount.base-year amount.c. c. total assets amount.total assets amount.

b.b. stockholders’ equity amount.stockholders’ equity amount.

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Vertical Analysis

• Is a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount.

• Total assets is always the base amount in vertical analysis of a balance sheet.

• Net sales is always the base amount in vertical analysis of an income statement.

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KELLOGG COMPANY, INC.

Condensed Balance SheetsDecember 31(In millions)

2001 2000 z Assets Amount Percent Amount PercentCurrent Assets $ 1,902.0 18.3 $1,617.1 33.1Property Assets 2,952.8 28.5 2,526.9 51.7Other assets 5,513.8 53.2 742.0 15.2 Total assets $10,368.6 100.0% $4,886.0 100.0%

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2001 2000 Liabilities and Amount Percent Amount PercentStockholders' EquityCurrent liabilities $ 2,207.6 21.3 $2,482.3 50.8 Long-term liabilities 7,289.5 70.3 1,506.2 30.8 Total liabilities 9,497.1 91.6 3,988.5 81.6Stockholders' equity Common stock 195.3 1.9 205.8 4.2 Retained earnings

and other 1,013.3 9.8 1,065.7 21.8 Treasury stock (337.1) (3.3) (374.0) (7.6) Total stockholders'

equity 871.5 8.4 897.5 18.4 Total liabilities and stockholders' equity $10,368.6 100.0 $4,886.0 100.0

KELLOGG COMPANY, INC.Condensed Balance Sheets

December 31(In millions)

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KELLOGG COMPANY, INC.Condensed Income Statement

For the Years Ended December 31(In millions)

2001 2000 Amount Percent Amount Percent

Net sales $8,853.3 100.0 $6,954.7 100.0

Cost of goods sold 4,128.5 46.6 3,327.0 47.8

Gross profit 4,724.8 53.4 3,627.7 52.2

Selling & admin. 3,523.6 39.8 2,551.4 36.7

Nonrecurring chgs. 33.3 0.4 86.5 1.3

Income operations 1,167.9 13.2 989.8 14.2

Interest expense 351.5 4.0 137.5 2.0 Other income (expense),net (12.3) (0.1) 15.4 0.2

Income before income taxes 804.1 9.1 867.7 12.4

Income tax ex. 322.1 3.6 280.0 4.0

Net income $ 482.0 5.5 $ 587.7 8.4

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Condensed Income StatementsFor the Year Ended December 31, 2001

(in millions)Kellogg Company, Inc. General Mills,Inc Amount Percent Amount Percent

Net sales $8,853.3 100.0 $7,949.0 100.0 Cost of goods sold 4,128.5 46.6 4,767.0 60.0 Gross profit 4,724.8 53.4 3,182.0 40.0Selling and administrative

expenses 3,523.6 39.8 1,909.0 24.0Nonrecurring charges 33.3 0.4 190.0 2.4Income from operations 1,167.9 13.2 1,083.0 13.6Other expenses and

revenues (including income taxes) 685.9 7.7 622.0 7.8

Net income $ 482.0 5.5 $ 461.0 5.8

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Ratio Analysis

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Ratios

• Three types:Liquidity ratios

Solvency ratios

Profitability ratios

• Can provide clues to underlying conditions that may not be apparent from an inspection of the individual components.

• Single ratio by itself is not very meaningful.

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Liquidity Ratios

Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash.

WHO CARES?Short-term creditors such as bankers and suppliers

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• Working capital

• Current ratio

• Current cash debt coverage ratio

• Inventory turnover ratio

• Days in inventory

• Receivables turnover ratio

• Average collection period

Liquidity Ratios

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Working Capital

Indicates immediate short-term debt-paying ability

Current Assets - Current Liabilities

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Current Ratio

Indicates short-term debt-paying ability

Current AssetsCurrent Liabilities

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Current Cash Debt Coverage Ratio

Indicates short-term debt-paying ability (cash basis)

Cash provided by operations Average current liabilities

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Inventory Turnover Ratio

Indicates liquidity of inventory

Cost of Goods SoldAverage Inventory

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Indicates liquidity of inventory and inventory management

365 days

Inventory Turnover Ratio

Days in Inventory

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Receivables Turnover Ratio

Indicates liquidity of receivables

Net Credit SalesAverage Gross Receivables

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Average Collection Period

Indicates liquidity of receivables and collection success.

365 daysReceivables Turnover Ratio

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Solvency Ratios

Measure the ability of the enterprise to survive over a long period of time

WHO CARES?Long-term creditors and stockholders

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• Debt to total assets ratio

• Cash debt coverage ratio

• Times interest earned ratio

• Free cash flow

Solvency Ratios

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Debt to Total Assets Ratio

Indicates % of total assets provided by creditors

Total Liabilities

Total Assets

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Cash Debt Coverage Ratio

Indicates long-term debt-paying ability (cash basis)

Cash provided by operations Average total liabilities

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Times Interest Earned Ratio

Indicates company’s ability to meet interest payments as they come due

Net Income Before Interest

Expense & Income Tax

Interest Expense

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Indicates cash available for paying dividends or expanding operations

Cash Provided By Operations

- Capital Expenditures

- Dividends Paid

Free Cash Flow

Free Cash Flow

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Profitability Ratios

Measure the income or operating success of an enterprise for a given period of time

WHO CARES? Everybody

WHY? A company’s income affects: • its ability to obtain debt and equity financing• its liquidity position• its ability to grow

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• Earnings per share (EPS)• Price-earnings ratio• Gross profit rate• Profit margin ratio• Return on assets ratio• Assets turnover ratio• Payout ratio • Return on common stockholders’ equity ratio

Profitability Ratios

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Earnings Per Share (EPS)

Indicates net income earned on each share of common stock sales

Net Income - Preferred Stock Average common shares outstanding

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Price Earnings Ratio

Indicates relationship between market price per share and earnings per share

Stock Price Per ShareEarnings Per Share

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Gross Profit Rate

Indicates margin between selling price and cost of good sold

Gross profit

Net sales

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Profit Margin Ratio

Indicates net income generated by each dollar of sales

Higher value suggests favorable return on each dollar of sales.

Net incomeNet sales

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Return On Assets Ratio

Reveals the amount of net income generated by each dollar invested

Net incomeAverage total assets

Higher value suggests favorable efficiency.

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Asset Turnover Ratio

Indicates how efficiently assets are used to generate sales

Net sales

Average total assets

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Payout Ratio

Indicates % of earnings distributed in the form of cash dividends

Cash dividends decl. on common stock

Net income

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Return on Common Stockholders’ Equity Ratio

Indicates profitability of common

stockholders’ investment

Net income - preferred stock dividends

Average common stockholders’ equity

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Limitations Of Financial Analysis

• Horizontal, vertical, and ratio analysis are frequently used in making significant business decisions.

• One should be aware of the limitations of these tools and the financial statements.

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Alternative Accounting Methods• One company may use the FIFO method,

while another company in the same industry may use LIFO.

• If the inventory is significant for both companies, it is unlikely that their current ratios are comparable.

• In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization.

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Quality of Earnings

Indicates the level of full and transparent information that is provided to users of the financial statement.

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Pro Forma Income

A measure of the net income generated that usually excludes items that the company thinks are unusual or nonrecurring.

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Relationships among Profitability Measures

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Let’s ReviewLet’s Review

In vertical analysis, the base amount for In vertical analysis, the base amount for depreciation expense is generally:depreciation expense is generally:

a.a. net sales.net sales.

d.d. fixed assets.fixed assets.c. c. gross profit.gross profit.

b.b. depreciation expense in a previous year.depreciation expense in a previous year.

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Let’s ReviewLet’s Review

In vertical analysis, the base amount for In vertical analysis, the base amount for depreciation expense is generally:depreciation expense is generally:

a.a. net sales.net sales.

d.d. fixed assets.fixed assets.c. c. gross profit.gross profit.

b.b. depreciation expense in a previous year.depreciation expense in a previous year.

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