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13 - 1
Irregular Items
Comparative Analysis
Horizontal Analysis
Vertical Analysis
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Limitation of Financial Statement Analysiss
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Managerial Accounting Weygandt / Kieso / Kimmel
ELS
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Financial Analysis: the Big Picture
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Earning Power
The value of a company is a function of its future cash flows.
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Earning Power...
• Is net income adjusted for irregular items.
• Is the most likely level of income to be obtained in the future.
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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 2001.
• During 2001 the company discontinued and sold its unprofitable chemical division. The loss in 2001 from chemical operations (net of $60,000 taxes) was $140,000, and the loss on disposal of the chemical division (net of $30,000 taxes) was $70,000.
Discontinued Operations
Rozek 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 560,000 Discontinued operations
Loss from operations of chemical division, net of $60,000 income tax saving $140,000 Loss from disposal of chemical division, net of $30,000 income tax saving 70,000 210,000Net income before extraordinary item $350,000
Illustration 13-1
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Extraordinary Items...
Are events and transactions that meet two conditions: – Unusual in
nature– Infrequent in
occurrence
Illustration 13-3
Extraordinary Items
Illustration 13-3
Ordinary Items
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• In 2001 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
Rozek Inc.Income Statement(Partial)
For the Year Ended December 31, 2001
Income before income taxes $800,000Income tax expense 240,000Income from continuing operations 560,000
Discontinued operationsLoss from operations of chemical division, net of $60,000 income tax saving $140,000
Loss from disposal of chemical division, net of $30,000 income tax saving 70,000 (210,000)Income before extraordinary item 350,000Extraordinary item
Expropriation of investment, net of $21,000 income tax saving ( 49,000)Net income $301,000
Illustration 13-2
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Change in Accounting Principle
• Occur 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, 1998.
• The cumulative effect on prior-year income statements (statements for 1998-2000) 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
Rozek Inc.Partial Income Statement
For the Year Ended December 31, 2001Income before income taxes $800,000Income tax expense 240,000Income from continuing operations 560,000Discontinued operations
Loss from operations of chemical division, net of $60,000 income tax saving $140,000 Loss from disposal of chemical division, net of $30,000 income tax saving 70,000 210,000Income before extraordinary item and cumulative effect of change in accounting principle 350,000Extraordinary item
Expropriation of investment, net of $21,000 income tax saving (49,000)Cumulative effect of change in accounting principle Effect on prior years of change in depreciation method, net of $ 7,200 tax saving (16,800) Net Income 284,200
Illustration 13-4
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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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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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Comparative Analysis
• Any item reported in a financial statement has significance: – 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 :
1. Horizontal analysis
2. Vertical analysis
3. 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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•
KELLOGG COMPANY
Net Sales (in millions)
Base Period 1994
1998 1997 1996 1995 1994
6,762.1 6,830.1 6,676.6 7,003.7 6,562.0
Horizontal AnalysisIllustration 13-7
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• CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT BASE-YEAR AMOUNT
7,003.7 - 6,562.0
6,562.0
Net sales for Kellogg company increased approximately 6.7% from 1994 to 1995.
Horizontal Analysis
= 6.7%
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Percentage Change in Sales
The percentage change in sales for each of the 5 years, assuming 1996 as the base period is:
Kellogg Company Net Sales (in millions)
Base Period 1994
2000 1999 1998 1997 1996 6954.7
6,984.2 6,762.1 6,830.1 6,676.6
104.2% 104.6% 101.3% 102.3% 100.0%
Illustration 13-7
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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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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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• • Current ratio
• Acid-test ratio
• Current cash debt coverage ratio
• Receivables turnover ratio
• Average collection period
• Inventory turnover
• Average days in inventory
Liquidity Ratios
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Current Ratio
Indicates short-term debt-paying ability
Current AssetsCurrent Liabilities
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Acid-Test Ratio
Indicates immediate short-term debt-paying ability
Cash + Short-term Investments + Net Receivable Current 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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Receivables Turnover Ratio
Indicates liquidity of receivables
Net Credit SalesAverage Net Receivables
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Average Collection Period
Indicates liquidity of receivables and collection success
365 daysReceivables Ratio Turnover
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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
Average Days in Inventory
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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
• Times interest earned ratio
• Cash debt coverage 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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Times Interest Earned Ratio
Indicates company’s ability to meet interest payments as they come due
Interest Before Interest
Expense & Income Tax
Interest Expense
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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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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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•
• 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
Relationships Among Profitability MeasuresIllustration 13-28
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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
Illustration 13-29
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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.
Illustration 13-30
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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.
Illustration 13-31
Net incomeNet sales
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Asset Turnover Ratio
Indicates how efficiently assets are used to generate sales
Net sales
Average total assets
Illustration 13-32
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Gross Profit Rate
Indicates margin between selling price and cost of good sold
Gross profit
Net sales
Illustration 13-34
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Operating Expenses to Sales Ratio
Indicates the cost incurred to support each dollar of sales
Operating expenses
Net sales
Illustration 13-35
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Cash Return on Sales Ratio
Indicates net cash flow generated by each dollar of sales
Cash provided by operationsNet sales
Illustration 13-36
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Earnings Per Share (EPS)
Indicates net income earned on each share of common stock sales
Income available to common stockholders
Average number of outstanding common
shares
Illustration 13-37
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Price Earnings Ratio
Indicates relationship between market price per share and earnings per share
Stock PriceEarnings Per Share
Illustration 13-38
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Payout Ratio
Indicates % of earnings distributed in the form of cash dividends
Cash DividendsNet Income
Illustration 13-39
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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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Estimates
• 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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Cost
• 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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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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Atypical Data
Fiscal year-end data may not be typical of a company's financial condition during the year.
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Diversification
• 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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COPYRIGHT
Copyright © 2002, John Wiley & Sons, Inc. All rights reserved.Reproduction or translation of this work beyond that permitted i n Section 117 of the 1976 United States Copyright Act without theexpress written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibilityfor errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.