Chapter 14

Financial Statement Analysis

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1. Discuss the need for comparative analysis and identify the tools of financial statement analysis.

2. Explain and apply horizontal and vertical analysis.3. Identify and compute ratios used in analyzing a

firm’s liquidity, profitability, and solvency.4. Understand the concept of earning power, and how

irregular items are presented.5. Understand the concept of quality of earnings.

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Forensic. . . Assessment of Past Performance and Current position

Future. . . Assessment of Future potential and related Risk

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Inside the company Outside the company Really outside the company

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Inside the company – 10K, website, press releases Outside the company – external analysts, Standard

and Poors, Valueline, Hoovers, Dun & Bradstreet, Moody’s, etc.

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Three basic tools are used in financial statement analysis :

1.Horizontal (also called trend)analysis2.Vertical analysis3.Ratio analysis

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Looking at the Trends over time….

In $$$$$$$$$$ or %%%%%%%%%%

From the base year

Shows growth or decline Used with Balance Sheet and Income

Statement

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Kellogg ($ in millions)

Selected Income Statement Items - Horizontal Analysis

Period Ending 2-Jan-10 3-Jan-09 29-Dec-07

Total Revenue (Sales $ 12,575 $ 12,822 $ 11,776

106.78% 108.88% 100.00%

Gross Profit 5,391 5,367 5,179 104.09% 103.63% 100.00%

Total Operating Expenses 3,390 3,414 3,311

102.39% 103.11% 100.00%

Net Income 1,212 1,148 1,103 109.88% 104.08% 100.00%

Analysis: Look at the Trends, all of them

What can you say about them?

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Selected Income Statement Items - Horizontal Analysis


Total Revenue (Sales $ 12,575 $ 12,822 $ 11,776

106.78% 108.88% 100.00%

Gross Profit 5,391 5,367 5,179 104.09% 103.63% 100.00%

Total Operating Expenses 3,390 3,414 3,311

102.39% 103.11% 100.00%

Net Income 1,212 1,148 1,103 109.88% 104.08% 100.00%

Analysis: Sales grew in 2009 compared to 2008, however dipped in 2010. Net income grew each year; reviewing costs, Kellogg’s Operating Expenses grew at a much slower pace, which contributed to the Net Income growth. Also Kellogg’s gross profit improved in 2010, even though its sales did not. This suggests that Kellogg’s is controlling costs.

Note: with more space, you would quote actual numbers and % for evidence.

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CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT BASE-YEAR AMOUNT

12,822.0 – 11,776= 108.88% 11,776.0

Net sales for Kellogg company increased 8.88% in 2011 compared to 2011.

Horizontal Analysis – Income Statement

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Selected Balance Sheet Items - Horizontal Analysis


Current assets $ 2,558 $ 2,521 $ 2,717

94.15% 92.79% 100.00%

Total Assets 11,200 10,946 11,397 98.27% 96.04% 100.00%

Current Liabliities 2,288 3,552 4,044 56.58% 87.83% 100.00%

Long Term Liabilities 8,928 9,498 8,871 100.64% 107.07% 100.00%

Retained Earnings 5,461 4,836 4,217 129.50% 114.68% 100.00%

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Analysis: Total Assets are decreasing; Current Assets are decreasing at a faster rate, suggesting more funds are being dedicated to Long Term Assets. However, Long Term Liabilities are stable, suggesting that the company is maintaining the same debt levels. Retained Earnings has grown by almost 30% over the base year, indicating that the company has been profitable.


Selected Balance Sheet Items - Horizontal Analysis


Current assets $ 2,558 $ 2,521 $ 2,717

94.15% 92.79% 100.00%

Total Assets 11,200 10,946 11,397 98.27% 96.04% 100.00%

Current Liabliities 2,288 3,552 4,044 56.58% 87.83% 100.00%

Long Term Liabilities 8,928 9,498 8,871 100.64% 107.07% 100.00%

Retained Earnings 5,461 4,836 4,217 129.50% 114.68% 100.00%

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BALANCE SHEET: What changed and in what direction? How was it financed?

INCOME STATEMENT: Are sales increasing? Are costs following sales? (growth, decline)

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Tracks changes over time Tracks changes in one area (sales)

compared to other areas (net income)

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Common size analysis What is your basis?

Balance Sheet: Total Assets Income Statement: Net Sales (net

revenues)

Note that Net Sales is always the 100% base figure for Vertical Analysis and all other items are a percentage of this

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Selected Income Statement Items - Vertical Analysis


Amount Percent Amount Percent Amount Percent

Total Revenue (Sales 12,575 100.00% 12,822 100.00% 11,776 100.00%

Gross Profit 5,391 42.87% 5,367 41.86% 5,179 43.98%

Total Operating Expenses 3,390 26.96% 3,414 26.63% 3,311 28.12%

Net Income 1,212 9.64% 1,148 8.95% 1,103 9.37%



Note that Net Sales is always the 100% base figure for Vertical Analysis and all other items are a percentage of this

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Analysis: You can’t analyze Sales much, as it is the 100% number; so talk about the other numbers: Net Income as a percent of sales increased in 2009 compared to 2008. It dipped slightly in 2010 compared to 2009, but is still above 2008’s percentage level.

Analysis: The improvements in Net Income were caused by reduction in Operating Expenses which reduced almost 1.5%, as a percentage of net sales) and Gross Profit (declined in 2008, but improved) in 2010


Selected Income Statement Items - Vertical AnalysisPeriod Ending 2-Jan-10 3-Jan-09 29-Dec-07


Total Revenue (Sales 12,575 100.00% 12,822 100.00% 11,776 100.00%

Cost of Goods Sold 7,184 57.13% 7,455 58.14% 6,597 56.02%

Gross Profit 5,391 42.87% 5,367 41.86% 5,179 43.98%

Total Operating Expenses 3,390 26.96% 3,414 26.63% 3,311 28.12%

Net Income 1,212 9.64% 1,148 8.95% 1,103 9.37%

Note that Total Assets are the 100% base figure and all other items are a percentage of this

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Selected Balance Sheet Items - Vertical Analysis



Current assets 2,558 22.84% 2,521 23.03% 2,717 23.84%

Total Assets 11,200 100.00% 10,946 100.00% 11,397 100.00%

Current Liabliities 2,288 20.43% 3,552 32.45% 4,044 35.48%

Long Term Liabilities 8,928 79.71% 9,498 86.77% 8,871 77.84%

Retained Earnings 5,461 48.76% 4,836 44.18% 4,217 37.00%

The years were 1998 and 1997

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KELLOGG COMPANY, INC.Condensed Income Statement – Vertical AnalysisFor the Years Ended December 31(In millions) 1998 1997

Amount Percent Amount Percent

Net sales $6,762.1 100.0 $6,830.1 100.0Cost of goods sold 3,282.6 48.6 3,270.1 47.9Gross profit 3,479.5 51.4 3,560.0 52.1Selling & Admin. 2,513.9 37.2 2,366.8 34.6Nonrecurring Chgs 70.5 1.0 184.1 2.7 Income operations 895.1 13.2 1,009.1 14.8Interest expense 119.5 1.8 108.3

1.6 Other income (expense),net 6.9 0.1 3.7 0.1

Income before income taxes 782.5 11.5 904.5 13.3

Income tax expense 279.9 4.1 340.5 5.0

Net income $502.6 7.4 $564.0 8.3

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Look at the changes in each year?

What is the trend in Sales?

Does Cost of Goods Sold follow the same trend?

What about other costs?You may not know the

reason, but what are your questions as to WHY things do not look right?

See end of slides for solution

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Relative size of things on the statement. . . .Over time

Allows comparisons between companies

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Estimates Cost Alternative Accounting

Methods Atypical Data Diversification

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Financial statements are based on estimates. allowance for uncollectible accounts depreciation costs of warranties contingent losses To the extent that these estimates are

inaccurate, the financial ratios and percentages are also inaccurate.

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Traditional financial statements are based on historical cost and are not adjusted for price level changes.

Comparisons of unadjusted financial data from different periods may be rendered invalid by significant inflation or deflation.

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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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Fiscal year-end data may not be typical of a company's financial condition during the year.

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Diversification in American industry also limits the usefulness of financial analysis.

Many firms are so diverse they cannot be classified by industry.

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Types: Liquidity ratios Profitability ratios Solvency 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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RATIO Analysis – Galore!

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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 banks, suppliers, employees

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Current ratio Acid-test ratio Receivables turnover ratio Inventory turnover

Liquidity Ratios

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Indicates short-term debt-paying ability

Current AssetsCurrent Liabilities

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Indicates immediate short-term debt-paying ability

Cash + Short-term Investments + Net Receivables Current Liabilities

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Indicates liquidity of receivables

Net Credit SalesAverage Net Receivables

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Indicates liquidity of receivables and collection success

365 daysReceivables Ratio Turnover

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Indicates liquidity of inventory

Cost of Goods SoldAverage Inventory

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Indicates liquidity of inventory and inventory management

365 daysInventory Turnover Ratio

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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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Return on common stockholders’ equity ratio

Return on assets ratio Profit margin ratio Assets turnover ratio Gross profit rate Operating expenses to sales ratio Cash return on sales ratio Earnings per share (EPS) Price-earnings ratio Payout ratio

Profitability Ratios

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Indicates profitability of common stockholders’ investment

Net income -preferred stock dividendsAverage common stockholders’ equity

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Reveals the amount of net income generated by each dollar invested

Net incomeAverage total assets

Higher value suggests favorable efficiency.

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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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Indicates how efficiently assets are used to generate sales

Net salesAverage total assets

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Indicates margin between selling price and cost of good sold

Gross profitNet sales

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Indicates the cost incurred to support each dollar of sales

Operating expensesNet sales

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Indicates net cash flow generated by each dollar of sales

Cash provided by operationsNet sales

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Indicates net income earned on each share of common stock sales

Income available to common stockholdersAverage number of outstanding common shares

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Indicates relationship between market price per share and earnings per share

Stock PriceEarnings Per Share

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Indicates % of earnings distributed in the form of cash dividends

Cash DividendsNet Income

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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 Times interest earned ratio

Solvency Ratios

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Indicates % of total assets provided by creditors

Total Liabilities

Total Assets

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

Income before* Interest Expense &

Income TaxInterest Expense

* Also called Operating Income

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Review and STOP HERE!

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The value of a company is a function of its future cash flows at normal income levels.

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Accounting methods & estimates Industry dependent Requires FULL DISCLOSURE &

CONSISTENCY Non operating items on the Income

Statement Look at the D-E-A

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

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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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Pepsi spun off: Taco Bell, Pizza Hut, and KFC

Quaker Oats spun off: Gatorade Western Wireless spun off: Voicestream PACCAR spun off: Paccar Automotive

and Trico (oil well digging manufacturer)

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Assume a company, Agroworld Inc. During 2001 the company discontinued and sold its chemical division. The income in 2001 from chemical operations

was $200,000, and The loss on disposal of the chemical division

$130,000. Apply a 30% tax rate

Discontinued Operations

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Or, I could word this: During 2001 the company discontinued

and sold its chemical division. The income in 2001 from chemical operations

(net of $60,000 taxes) was $140,000, and The loss on disposal of the chemical division

(net of $39,000 taxes) was $91,000.

Discontinued Operations

Agroworld Inc. Income Statement (Partial)

For the Year Ended December 31, 2001

Income before income taxes $800,000Income tax expense (30% Tax Rate) 240,000Income from continuing operations 560,000Discontinued operations:

1) Income from operations of chemical division, net of taxes, $60,000 $140,000 2) Loss from disposal of chemical division, net of $39,000 income tax saving (91,000) 49,000Net income before extraordinary item 609,000

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

Infrequent in occurrence

Illustration 14-2

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Illustration 14-2

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In 2001 a revolutionary foreign government expropriated property held as an investment by Agroworld 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

Agroworld Inc.Income Statement(Partial)

For the Year Ended December 31, 2001Income before income taxes $800,000Income tax expense 240,000Income from continuing operations 560,000Discontinued operations:

Income from operations of chemical division, net of taxes, $60,000 $140,000 Loss from disposal of chemical division, net of $39,000 income tax saving (91,000) 49,000Net income before extraordinary item 609,000Extraordinary item

Expropriation of investment, net of $21,000 income tax saving 49,000Net income $560,000

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Is permitted, when New principle is PREFERABLE to the old and

Effects are clearly DISCLOSED in the income statement.

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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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Use new principle in 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 below Net Income.

Change in Accounting Principle

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

Plus: Discontinued Operations Extraordinary Items Accounting Changes.

Plus changes in unrealized investment gains and losses

Comprehensive Income

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The substance of earnings And their sustainability into the

future.

Companies have incentives to manage income to meet or beat Wall Street expectations, so that

the market price of stock increases andthe value of stock options increase.

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 Earnings

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Alternative Accounting MethodsVariations among companies in the application of GAAP may hamper comparability and reduce quality of earnings.

Pro Forma IncomePro forma income usually excludes items that the company thinks are unusual or nonrecurring.Some companies have abused the flexibility that pro forma numbers allow.


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Improper RecognitionSome 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).


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Good Bye and Good Luck. – solutions follow

End of Chapter 14End of Chapter 14

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COGS increased, but Sales went down – this is reverse trend as Costs should directly proportional to Sales (when sales go up, COGS should go up, when sales go down, COGS should go down)…what happened?

Selling & Admin dramatically went up 2.6%, why?

Most alarming, Net Income went down a full point (0.9%)

Why????????82

Big, generic bags of cereal hit the supermarkets in 1997 and 1998.

Kellogg’s made the management decision not to participate in the big bags of cereal line Argument: Our corn flake cereal is premium,

fresh, in a box. Customer will pay more for a better product.

It didn’t work. Customers switched to the cheaper cereal.

Kellogg’s spent more on advertising (reflected in growth in Selling & Admin costs).

Kellogg’s finally reduced its prices (reflected in lower sales but no corresponding reduction in Cost of Goods Sold

The end result Lower Net Income

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Chapter 14

Documents

ratio analysis

comparative analysis

kellogg company

net income growth

net sales

current assets

total revenue sales

total operating expenses3