Transcript 14-1 Chapter 14 Financial Statement Analysis Learning Objectives After studying this chapter, you should be able to: 1.

14-1
Chapter 14
Financial Statement
Analysis
Learning Objectives
After studying this chapter, you should be able to:
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 a firm’s liquidity, profitability, and
solvency.
6. Understand the concept of earning power, and how irregular items are presented.
7. Understand the concept of quality of earnings.
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Preview of Chapter 14
Managerial Accounting
Sixth Edition
Weygandt Kimmel Kieso
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Basics of Financial Statement Analysis
Analyzing financial statements involves:
Comparison
Bases
Characteristics

Liquidity

Intracompany

Horizontal

Profitability


Vertical

Solvency
Industry
averages

Ratio

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Tools of
Analysis
LO 1
LO 2
Intercompany
Discuss the need for comparative analysis.
Identify the tools of financial statement analysis.
Horizontal Analysis
Horizontal analysis, also called trend analysis:
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
Technique for evaluating a series of financial statement
data over a period of time.

Purpose is to determine the increase or decrease that has
taken place.

Commonly applied to the balance sheet, income statement,
and statement of retained earnings.
LO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Balance Sheet
These changes
suggest that the
company expanded its
asset base during
2009 and financed
this expansion
primarily by retaining
income rather than
assuming additional
long-term debt.
Illustration 14-5
Horizontal analysis of
balance sheets
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LO 3
Horizontal Analysis
Income
Statement
Overall, gross profit
and net income were
up substantially. Gross
profit increased
17.1%, and net
income, 26.5%.
Quality’s profit trend
appears favorable.
Illustration 14-6
Horizontal analysis of
Income statements
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LO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Retained Earnings Statement
Illustration 14-7
Horizontal analysis of
retained earnings statements
Ending retained earnings increased 38.6%. As indicated earlier, the company
retained a significant portion of net income to finance additional plant
facilities.
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LO 3
Financial information for Rosepatch Company is as follows.
Compute the amount and percentage changes in 2014 using
horizontal analysis, assuming 2013 is the base year.
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LO 3
Vertical Analysis
Vertical analysis, also called common-size analysis:
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
Technique that expresses each financial statement item as
a percent of a base amount.

On an income statement, we might say that selling
expenses are 16% of net sales.

Commonly applied to the balance sheet and the income
statement.
LO 4 Describe and apply vertical analysis.
Vertical Analysis
Balance
Sheet
These results
reinforce the earlier
observations that
Quality is
choosing to
finance its growth
through retention
of earnings rather
than through
issuing additional
debt.
Illustration 14-8
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LO 4
Vertical Analysis
Income
Statement
Quality appears
to be a profitable
enterprise that is
becoming even
more successful.
Illustration 14-9
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LO 4
Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 14-10
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LO 4
Ratio Analysis
Ratio analysis expresses the relationship among selected
items of financial statement data.
Financial Ratio Classifications
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Liquidity
Profitability
Solvency
Measures shortterm ability of the
company to pay its
maturing obligations
and to meet
unexpected needs
for cash.
Measures the
income or operating
success of a
company for a
given period of
time.
Measures the ability
of the company to
survive over a long
period of time.
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
A single ratio by itself is not very meaningful.
Ratios will include the following types of comparisons.
1. Intracompany comparisons for two years for Quality
Department Store.
2. Industry average comparisons based on median ratios for
department stores.
3. Intercompany comparisons based on J.C. Penney Company
as Quality Department Store’s principal competitor.
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LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for cash.
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
Short-term creditors such as bankers and suppliers are
particularly interested in assessing liquidity.

Ratios include the current ratio, the acid-test ratio,
receivables turnover, and inventory turnover.
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
1. Current Ratio
Illustration 14-12
The ratio of 2.96:1 means that for every dollar of current liabilities,
Quality has $2.96 of current assets.
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LO 5
Ratio Analysis
Liquidity Ratios
2. Acid-Test Ratio
Illustration 14-13
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LO 5
Ratio Analysis
Liquidity Ratios
2. Acid-Test Ratio
Illustration 14-14
Measures immediate short-term liquidity.
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LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
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Ratio Analysis
Liquidity Ratios
3. Receivables Turnover
Illustration 14-15
Number of times, on average, the company collects receivables.
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LO 5
Ratio Analysis
Liquidity Ratios
$2,097,000
Receivables Turnover
= 10.2 times
($180,000 + $230,000) ÷ 2
A variant of the receivables turnover ratio is to convert it to an
average collection period in terms of days.
365 days ÷ 10.2 times = every 35.78 days
This means that receivables are collected on average every 36
days.
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LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Liquidity Ratios
4. Inventory Turnover
Illustration 14-16
Number of times, on average, the inventory is sold.
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LO 5
Ratio Analysis
Liquidity Ratios
$1,281,000
Inventory Turnover
= 2.3 times
($500,000 + $620,000) ÷ 2
A variant of inventory turnover is the days in inventory.
365 days ÷ 2.3 times = every 159 days
Inventory turnover ratios vary considerably among industries.
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LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for a
given period of time.
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
Income, or the lack of it, affects the company’s ability 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 stockholders’ equity, earnings
per share, price-earnings, and payout ratio.
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Profitability Ratios
5. Profit Margin
Illustration 14-17
Measures net income generated by each dollar of sales.
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LO 5
Ratio Analysis
Profitability Ratios
6. Asset Turnover
Illustration 14-18
Measures how efficiently assets are used to generate sales.
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LO 5
Ratio Analysis
Profitability Ratios
7. Return on Assets
Illustration 14-19
An overall measure of profitability.
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LO 5
Ratio Analysis
Profitability Ratios
8. Return on Common Stockholders’ Equity
Illustration 14-20
Dollars of net income earned for each dollar invested by the owners.
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LO 5
Ratio Analysis
Profitability Ratios
9. Earnings per Share (EPS)
Illustration 14-21
Measures net income earned on each share of common stock.
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LO 5
Ratio Analysis
Profitability Ratios
10. Price-Earnings Ratio
Illustration 14-22
Reflects investors’ assessments of a company’s future earnings.
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LO 5
Ratio Analysis
Profitability Ratios
11. Payout Ratio
Illustration 14-23
*
Measures the percentage of earnings distributed in the form of cash
dividends.
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* From analysis of retained earnings.
LO 5
Ratio Analysis
Solvency Ratios
Solvency ratios measure the ability of a company to survive
over a long period of time.

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Debt to total assets and times interest earned are two
ratios that provide information about debt-paying ability.
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
Solvency Ratios
12. Debt to Total Assets Ratio
Illustration 14-24
Measures the percentage of the total assets provided by creditors.
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LO 5
Ratio Analysis
Solvency Ratios
13. Times Interest Earned
Illustration 14-25
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Provides an indication of the company’s ability to meet interest
payments as they come due.
LO 5
Summary of Ratios
Illustration 14-26
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LO 5
Summary of Ratios
Illustration 14-26
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LO 5
Summary of Ratios
Illustration 14-26
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LO 5
Earning Power and Irregular Items
Earning power means the normal level of income to be
obtained 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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LO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
Discontinued Operations
(a) Refers to the disposal of a significant component of a
business.
(b) Report the income (loss) from discontinued operations in
two parts:
1. income (loss) from operations (net of tax) and
2. gain (loss) on disposal (net of tax).
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LO 6 Understand the concept of earning power,
and how irregular items are presented.
Earning Power and Irregular Items
Illustration: During 2014 Acro Energy Inc. has income before
income taxes of $800,000. During 2014, Acro discontinued and sold its
unprofitable chemical division. The loss in 2014 from chemical operations
(net of $60,000 taxes) was $140,000. The loss on disposal of the chemical
division (net of $30,000 taxes) was $70,000. Assuming a 30% tax rate on
income.
Illustration 14-27
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LO 6
Earning Power and Irregular Items
Discontinued
Operations are reported
after “Income from
continuing operations.”
Previously labeled as
“Net Income”.
Moved to
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Income Statement (in thousands)
Sales
Cost of goods sold
Gross profit
Interest expense
Total other
Income before taxes
Income tax expense
Income from continuing operations
Discontinued operations:
Loss from operations, net of tax
Loss on disposal, net of tax
Total loss on discontinued operations
Net income
$ 285,000
149,000
136,000
(21,000)
(4,000)
79,000
24,000
55,000
315
189
504
$ 54,496
LO 6
Earning Power and Irregular Items
Extraordinary items are nonrecurring material items that differ
significantly from a company’s typical business activities.
Extraordinary Item must be both of an

Unusual Nature and

Occur Infrequently
Company must consider the environment in which it operates.
Amount reported “net of tax.”
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LO 6
Earning Power and Irregular Items
Are these considered Extraordinary Items?
(a) A large portion of a tobacco manufacturer’s
crops are destroyed by a hail storm. Severe
damage from hail storms in the locality where
the manufacturer grows tobacco is rare.
YES
(b) A citrus grower's Florida crop is damaged by
frost.
NO
(c) Loss from sale of temporary investments.
NO
(d) Loss attributable to a labor strike.
NO
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LO 6
Earning Power and Irregular Items
Are these considered Extraordinary Items?
(e) Loss from flood damage. (The nearby Black
River floods every 2 to 3 years.)
(f)
An earthquake destroys one of the oil
refineries owned by a large multi-national oil
company. Earthquakes are rare in this
geographical location.
NO
YES
(g) Write-down of obsolete inventory.
NO
(h) Expropriation of a factory by a foreign
government.
YES
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LO 6
Earning Power and Irregular Items
Illustration: In 2014 a foreign government expropriated property held as
an investment by Acro Energy Inc. If the loss is $70,000 before applicable
income taxes of $21,000, the income statement will report a deduction of
$49,000.
Illustration 14-29
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LO 6
Earning Power and Irregular Items
Extraordinary Items
are reported after
“Income from continuing
operations.”
Previously labeled as
“Net Income”.
Income Statement (in thousands)
Sales
Cost of goods sold
Gross profit
$ 285,000
149,000
136,000
Other revenue (expense):
Interest revenue
Interest expense
Total other
Income before taxes
Income tax expense
Income from continuing operations
Extraordinary loss, net of tax
Net income
17,000
(21,000)
(4,000)
79,000
24,000
55,000
539
$ 54,461
Moved to
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LO 6
Earning Power and Irregular Items
Reporting when both
Discontinued
Operations and
Extraordinary Items
are present.
Discontinued
Operations
Extraordinary Items
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Income Statement (in thousands)
Sales
Cost of goods sold
Gross profit
Income before taxes
Income tax expense
Income from continuing operations
Discontinued operations:
Loss from operations, net of tax
Loss on disposal, net of tax
Total loss on discontinued operations
Income before extraordinary item
Extraordinary loss, net of tax
Net income
$ 285,000
149,000
136,000
79,000
24,000
55,000
315
189
504
54,496
539
$ 54,496
LO 6
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Earning Power and Irregular Items
Change in Accounting Principle
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
Occurs when the principle used in the current year is
different from the one used in the preceding year.

Accounting rules permit a change if justified.

Changes are reported retroactively.

Example would include a change in inventory costing
method such as FIFO to average cost.
LO 6 Understand the concept of earning power,
and how irregular items are presented.
In its proposed 2014 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), loss on operation of discontinued
flower division $50,000, and loss on disposal of discontinued
flower division $90,000. The income tax rate is 30%.
Prepare a correct income statement, beginning with “Income
before income taxes.”
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LO 6 Understand the concept of earning power,
and how irregular items are presented.
Prepare a correct income statement
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LO 6
Comprehensive Income
Income Statement (in thousands)
Sales
$ 285,000
Cost of goods sold
149,000
Gross profit
136,000
Operating expenses:
Selling expenses
10,000
Administrative expenses
43,000
Total operating expense
53,000
Income from operations
83,000
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
Net income
$ 55,000
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+
Other Comprehensive
Income

Unrealized gains and
losses on available-forsale securities.

Translation gains and
losses on foreign
currency.

Plus others
Reported in Stockholders’
Equity
LO 6
Comprehensive Income
Why are gains and losses on available-for-sale securities
excluded from net income?
Because disclosing them separately
1. reduces the volatility of net income due to fluctuations in fair
value,
2. yet informs the financial statement user of the gain or loss that
would be incurred if the securities were sold at fair value.
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LO 6 Understand the concept of earning power,
and how irregular items are presented.
Quality of Earnings
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.
Companies have incentives to manage income to meet or beat
Wall Street expectations, so that
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
the market price of stock increases and

the value of stock options increase.
LO 7 Understand the concept of quality of earnings.
Quality of Earnings
Alternative Accounting Methods

Variations among companies in the application of GAAP
may hamper comparability and reduce quality of earnings.
Pro Forma Income
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
Pro forma income usually excludes items that the company
thinks are unusual or nonrecurring.

Some companies have abused the flexibility that pro forma
numbers allow.
LO 7 Understand the concept of quality of earnings.
Quality of Earnings
Improper Recognition
Some managers have felt pressure to continually increase
earnings and have manipulated the earnings numbers to meet
these expectations. Abuses include:
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
Improper recognition of revenue (channel stuffing).

Improper capitalization of operating expenses (WorldCom).

Failure to report all liabilities (Enron).
LO 7 Understand the concept of quality of earnings.
Match each of the following terms with the phrase that it best
matches.
a. Comprehensive income
b. Quality of earnings
c. Solvency ratio
d. Vertical analysis
e. Pro forma income
f. Extraordinary item
c Measures the ability of the company to survive over a long
1. ___
period of time.
e Usually excludes items that a company thinks are unusual
2. ___
or non-recurring.
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LO 7 Understand the concept of quality of earnings.
Match each of the following terms with the phrase that it best
matches.
a. Comprehensive income
b. Quality of earnings
c. Solvency ratio
d. Vertical analysis
e. Pro forma income
f. Extraordinary item
a Includes all changes in stockholders’ equity during a period
3. ___
except those resulting from investments by stockholders and
distributions to stockholders.
b Indicates the level of full and transparent information
4. ___
provided to users of the financial statements.
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LO 7 Understand the concept of quality of earnings.
Match each of the following terms with the phrase that it best
matches.
a. Comprehensive income
b. Quality of earnings
c. Solvency ratio
d. Vertical analysis
e. Pro forma income
f. Extraordinary item
f Describes events and transactions that are unusual in
5. ___
nature and infrequent in occurrence.
d Expresses each item within a financial statement as a
6. ___
percent of a base amount.
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LO 7 Understand the concept of quality of earnings.
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