Chapter

2

Accounting Information, Regression Analysis

By Cheng Few Lee Joseph Finnerty John Lee Alice C Lee Donald Wort

2

Chapter Outline

• • • • • • 2.1 Introduction 2.2 Financial Statement: A Brief Review • • • • • • 2.2.1 Balance Sheet 2.2.2 Statement of Earnings 2.2.3 Statement of Equity 2.2.4 Statement of Cash Flows 2.2.5 Interrelationship Among Four Financial Statements 2.2.6 Annual vs. Quarterly Financial Data 2.3 Critique of Accounting Information • • 2.3.1 Criticism 2.3.2 Methods for Improvement 2.4 Static ratio analysis and its extension • • • 2.4.1 Static Determination of Financial Ratios 2.4.2 Dynamic Analysis of Financial Ratios 2.4.3 Statistical Distribution of Financial Ratios 2.5 Cost-Volume-Profit Analysis and its Applications • • 2.5.1 Deterministic Analysis 2.5.2 Stochastic Analysis 2.6 Accounting Income vs. Economic Income

3

• • • • •

2.2 Financial statement: A brief review

Balance sheet Income statement Cash flow statement Equity statement Annual vs. quarterly financial data

2.2.1 Balance Sheet

Table 2-1 Consolidated Balance Sheets of Johnson & Johnson Inc & Consolidated Subsidiaries (2004–2009)

Assets Current Assets

Cash and Cash Equivalent ($) Marketable Securities Account Receivable Inventory Deferred Taxes on Income Prepaid Expenses and Other Receivable

Total Current Assets

(Dollars in Millions)

2004

9,203 3,681 6,831 3,744 1,737 2,124

27,320 2005

16,055 83 7,010 3,959 1,845 2,442

31,394 2006

4,083 1 8,712 4,889 2,094 3,196

22,975 2007

7,770 1,545 9,444 5,110 2,609 3,467

29,945 2008

10,768 2,041 9,719 5,052 3,430 3,367

34,377

Marketable Securities — Non-current Property, Plant and Equipment, Net Intangible Assets, Net Deferred Taxes on Income Other Assets

Total Assets Liabilities and Shareholder’s Equity Current Liabilities

Loans and Notes Payable Account Payable Accrued Liabilities Accrued Rebates, Returns, and Promotion Accrued Salaries, Wages, and Commissions Taxes on Income

Total Current Liabilities

Long-term Debt Deferred Tax liability Employee Related Obligations Other Liabilities

4

46 10,436 11,842 551 3,122

53,317

280 5,227 3,523 2,297 1,094 1,506

13,927

2,565 403 2,631 1,978 20 10,830 12,175 385 3,221

58,025

668 4,315 3,529 2,017 1,166 940

12,635

2,017 211 3,065 2,226 16 13,044 28,688 3,210 2,623

70,556

4,579 5,691 4,587 2,189 1,391 724

19,161

2,014 1,319 5,584 3,160 2 14,185 28,763 4,889 3,170

80,954

2,463 6,909 6,412 2,318 1,512 223

19,837

7,074 1,493 5,402 3,829 14,365 27,695 5,841 2,634

84,912

3,732 7,503 5,531 2,237 1,432 417

20,852

8,120 1,432 7,791 4,206

2009

15,810 3,615 9,646 5,180 2,793 2,497

39,541

14,759 31,185 5,507 3,690

94,682

6,318 5,541 5,796 2,028 1,606 442

21,731

8,223 1,424 6,769 5,947

5

2.2.1 Balance Sheet

Table 2-1 Consolidated Balance Sheets of Johnson & Johnson Inc & Consolidated Subsidiaries (2004–2009) (continued)

Shareowners’ Equity

Preferred Stock-without Par Value Common Stock-Par Value $1.00

Net Receivable from Employee Stock Plan Accumulated Other Comprehensive Income Retained Earnings Less: Common Stock Held in Treasury

Total Shareowners’ Equity

— 3,120 −11 −515 35,223 6,004

31,813

— 3,120 — −755 41,471 5,965

37,871

— 3,120 — −2,118 49,290 10,974

39,318

— 3,120 — −693 55,280 14,388

43,319

— 3,120 — −4,955 63,379 19,033

42,511

— 3,120 — −3,058 70,306 19,780

50,588

Total Liabilities and Shareholders’ Equity

53,317 58,025 70556 80954 84912 94682

6

2.2.2 Income Statement

Table 2-2 Consolidated Statements of Earnings of JNJ Inc. & Subsidiaries (2004-09) (dollars in millions) (Dollars in Millions Except Per Share Figures)

2004 2005 2006 2007 2008 2009 Sales to Customers ($)

47,348 50,514 53,324 61,095 63,747 61,897 Cost of Products Sold Gross Profit Selling, Marketing and administrative expenses Research Expense Purchased in-process research and development Interest Income Interest Expense, net of portion capitalized Other (income) expense, Net 13,422 33,926 15,860 5,203 18 −195 187 15 13,954 36,560 16,877 6,312 362 −487 54 −214 15,057 38,267 17,433 7,125 559 −829 63 −671 17,751 43,344 20,451 7,680 807 −452 296 1,279 18,511 45,236 21,490 7,577 181 −361 435 −1,015 18,447 43,450 19,801 6,986 — 90 451 547 21,088 22,904 23,680 30,061 26,307 27,695 Earnings before Provision for Taxes on Income Provision for Taxes on Income

Net Earnings Basic Net Earnings per Share ($) Diluted Net Earnings per Share ($)

12,838 4,329 8,509 2.87

2.84

13,656 3,245 10,411 3.5

3.46

14,587 3,534 11,053 3.76

3.73

13,283 2,707 10,576 3.67

3.63

16,929 3,980 12,949 4.62

4.57

15,755 3,489 12,266 4.45

4.4

7 2.2.3 Statement of Equity

8 2.2.3 Statement of Equity

9 2.2.3 Statement of Equity

2.2.4 Statement of Cash Flows 10

2.2.4 Statement of Cash Flows 11

12

•

2.3

Critique of accounting information

Criticism

•

Methods for improvement a) Use of Alternative Information b) Statistical Adjustments c) Application of Finance and Economic Theories

13

• • •

2.4

Static ratio analysis and its extension

Static determination of financial ratios Dynamic analysis of financial ratios Statistical distribution of financial ratios

14 Static determination of financial ratios Table 2.5: Company ratios period 2003-2004 Ratio Classification Formula 2008 J&J 2009 Industry 2008 2009 Liquidity Ratio

Current Ratio Quick Ratio

Leverage Ratio

Debt-to-Asset Debt-to-Equity Equity Multiplier Times Interest Paid

Current asset Current liabilitie s CA



inventory



other CA Current liabilitie s Total debt Total asset Total debt Total equity Total asset Total equity EBIT Interest

exp

enses

1.65

0.61

0.48

0.96

2.00

27.78

1.82

0.89

2.18

1.61

0.45

0.84

1.87

0.48

1.02

2.10

30.39

26.49

2.06

1.51

0.49

1.04

2.12

27.16

Static determination of financial ratios Table 2.5: Company ratios period 2003-2004 (Continued) Ratio Classification Formula J&J 2008 2009 Industry 2008 2009 15 Activity Ratios

Average collection period Accounts receivable Turnover Inventory Turnover Fixed Asset Turnover Total Asset Turnover

Profitability Ratios

Profit margin Return on assets Return on equity

Market value

Price/earnings Price-to-book-value

Account

Re

ceivable Sales

/ 365

Sales Acounts

Re

ceivable Cost of Good Sold Inventory Sales Fixed assets Sales Total assets Net income Net Sales income Total assets Net Income Total equity Market price per share Earning Market per price share per share Book value per share

54.11

6.65

3.09

1.26

0.75

20.30% 15.25% 30.20% 12.95

3.90

56.32

6.39

3.04

1.12

0.65

19.80% 12.95% 26.40% 14.47

3.51

72.73

5.81

2.40

3.82

0.67

19.47% 12.41% 25.07% 17.32

3.63

73.14

5.88

2.38

3.82

0.71

19.43% 12.38% 24.51% 20.99

4.27

16 Dynamic Analysis of Financial Ratios

Basic Model Y j,t =Y j,t -1+δ j (Y j,t *-Y j,t-1 ) where 0≤ δ j ≤1, and δ j = A partial adjustment coefficient; Y j,t = Firm’s jth financial ratio period t; Y j,t-1 = Firm’s jth financial ratio period t-1; and Y* j,t = Firm’s jth financial ratio target in period t, (2.1)

17 Dynamic Analysis of Financial Ratios

Basic Model Y* j,t = CX j,t-1 + τ j,t , Y j,t -Y j,t-1 =δ j [X j,t-1 -Y j,t-1 ] Z j,t = A j + B j W j,t-1 + ε j,t where Z j,t = Y j,t - Y j,t-1 ; W j,t-1 = X j,t-1 - Y j,t-1 ; A j and B j = Regression parameters, and ε jj,t = The error term.

(2.2) (2.3) (2.4)

18 Dynamic Analysis of Financial Ratios

Extensions of Basic Model Z′ j,t = A′ j + B′ j W′ j,t-1 + ε j ′ j,t , where Z′ j,t = log (Y j,t ) - log (Y j,t-1 ); W′ j,t-1 = log (X j,t-1 ) - log (Y j,t-1 ); and ε j ′ j,t = The Error term.

(2.5)

19 Dynamic Analysis of Financial Ratios

Extension of Basic Model

B j

    log( log(

X Y

/ /

Y Y

) )  % change in [Y / j,t

Y

% change in [X j,t-1 /

Y

] ] (2.6)

Y

Y

* j,t 

CX

(2.7)

  

(2.8)

20 Dynamic Analysis of Financial Ratios

Empirical Data

Table 2.6: Dynamic adjustment ratio regression results

Variable Current Ratio Mean Z Mean W Var(Z) Cov(Z,W) B j ` t-Statistics A j ` Leverage Ratio 0.0075

-0.14583

0.013039

0.074

0.810* [3.53] 0.032

-0.03083

0.361666667

0.006099

0.009

0.259

[1.06] -0.042

* Partial adjustment coefficient significant at 95% level

21 Dynamic Analysis of Financial Ratios

Empirical Data

Table 2.7: Ratio correlation coefficient matrix

CR AT GPM CR 1.0

AT GPM LR -0.443841

0.363273

-0.51175

1.0

0.381393

0.21961

1.0

-0.05028

LR 1.0

22 Dynamic Analysis of Financial Ratios

Empirical Data Z 1,t = A 0 Z 2,t +A 1 Z 2,t = B 0 + A 2 W 1 + B 1 Z 1,t + ε j 1,t , (2.9a) + B 2 W 2 + ε j 2,t . (2.9b) where A i , B i (i = 0, 1, 2) are coefficients, ε j 1 and ε j 2 are error terms, Z 1,t and = Individual firm’s current ratio in period t individual firm’s current ratio in period t-1; Z 2,t = Individual firm’s leverage ratio in period t individual firm’s leverage ratio period t-1; W 1,t = Industry average current ratio in period t-1 individual firm’s current ratio period t-1; W 2,t = Industry average leverage ratio in period t-1 individual firm’s leverage ratio in period t-1.

23 Dynamic Analysis of Financial Ratios Empirical Data Table 2.8: Johnson & Johnson empirical results for the simultaneous equation system

A 0 (B 0 ) A 1 (B 1 ) A 2 (B 2 ) (2.9a) (2.9b) -0.071

[-1.80] -0.0577

[-1.59] -0.378

[-5.52] -0.842

[-6.07] 0.080

[1.20] 0.074

[0.91]

24 Statistical Distribution of Financial Ratios

  1 2 

e

 (

X

   2 ( ), (2.10) where μ and σ 2 are the population mean and variance, respectively, and e and π are given constants; that is, π= 3.14159 and e = 2.71828.

25 Statistical Distribution of Financial Ratios

There is a direct relationship between the normal distribution and the log-normal distribution. If Y is log-normally distributed, then X = log Y is normally distributed. Following this definition, the mean and the variance of Y can be defined as:  

Y Y

2  

exp(



exp(2

x

 

1 2

  

x

2

x

2

), (2.11a) )(exp(



x

2 where exp represents an exponential with base e.

26 Deterministic Analysis

27 2.5 COST-VOLUME-PROFIT ANALYSIS AND ITS APPLICATIONS

• •

Deterministic analysis Stochastic analysis

Deterministic Analysis

Operating Profit = EBIT = Q(P － V) － F, (2.12)

28

where Q = Quantity of goods sold; P = Price per unit sold; V = Variable cost per unit sold; F = Total amount of fixed costs; and P - V = Contribution margin.

29 Deterministic Analysis

Q

*  (

F

) (2.13) DOL  % Change in profits  % Change in sales

DOL

 1 

Q

* )  )

F

=1  Fixed Costs (2.14) Profits . (2.15) Operating profit = EBIT = Q π (P π － V π ) － F. (2.16)

30 Deterministic Analysis

2.6 ACCOUNTING INCOME VS. ECONOMIC INCOME

E

t

= A

t

+ P

t

, (2.17) where

31

E

t

= Economic income, A

t

= Accounting earnings, and P

t

= Proxy errors.

32

2.7 SUMMARY

In this chapter, the usefulness of accounting information in financial analysis is conceptually and analytically evaluated. Both statistical methods and regression analysis techniques are used to show how accounting information can be used to perform active financial analysis for the pharmaceutical industry.

In these analyses, static ratio analysis is generalized to dynamic ratio analysis. The necessity of using simultaneous-equation technique in conducting dynamic financial ratio analysis is also demonstrated in detail. In addition, both deterministic and stochastic CVP analyses are examined. The potential applications of CVP analysis in financial analysis and planning are discussed in some detail. Overall, this chapter gives readers a good understanding of basic accounting information and econometric methods, which are needed for financial analysis and planning.