asics of Financial Statement Analysis the borrower is extremely important in evaluating the safety of a loan. A long-term creditor, such as a bondholder, looks to profitability and solvency measures that indicate the company's ability to survive over a long period of time, Long-term creditors consider such measures as the amount of debt in the company’s capital structure and its ability to meet interest payments. ‘Similarly, shareholders look at the profitability and solvency of the company. They want to assess the likelihood of dividends and the growth potential oftheir investment. Need for Comparative Analysis Every item reported in a financial statement has significance. When Marks and Spencer ple (M&S) (GBR) reports cash and cash equivalents of £422.9 million on its statement of finan- cial position, we know the company had that amount of cash on the report date. But, we do not know whether the amount represents an increase over prior years, or whether it is adequate in relation to the company's need for cash, To obtain such information, we need to compare the amount of cash with other financial statement data ‘Comparisons can be made on a nuunber of different bases. Three are illustrated inthis chapter. 1, Intracompany basis. Comparisons within a company ate often useful to detect changes in financial relationships and significant trends, For example, a comparison of M&S's current year’s cash amount with the prior year's cash amount shows either an increase oF decrease. Likewise, a comparison of M&S's year-end cash amount with the amount of its total assets at yearend shows the proportion of total assets in the form of cash, 2, Industry averages. Comparisons with industry averages provide information about a company's relative position within the industry. For example, financial statement readers can compare M&S's financial data with the averages for its industry compiled by finan- cial rating organizations such as the U.S. companies Dun & Bradstreet, Moody's, and Standard & Poor's, of with information provided on the Internet by organizations such as Yahoo! on its financial site 3. Intercompany basis. Comparisons with other companies provide insight into a com- pany's competitive position, For example, investors can compare M&S's total sales for the year with the total sales of its competitors in retail, such as Carrefour (FRA). Tools of Analysis We use various tools to evaluate the significance of financial statement data, Three commonly used tools are as follows, ‘* Horizontal analysis evaluates a series of financial statement data over a period of time. ‘ Vertical analysis evaluates financial statement data by expressing each item in a financial statement as a percentage of a base amount ‘© Ratio analysis expresses the relationship among selected items of financial statement data, ‘Horizontal analysis is used primarily in intracompany comparisons. Two features in pub- lished financial statements and annual report information facilitate this type of comparison. First, each of the basic financial statements presents comparative financial data for a minimum ‘of two years. Second, a summary of selected financial data is presented for a series of five to 10 years or more. Vertical analysis is used in both intra and intercompany comparisons. Ratio analysis is used in all three types of comparisons. In the following sections, we explain and illustrate each of the thtee types of analysis. Horizontal Analysis Horizontal analysis, also called trend analysis, is a technique for evaluating a series of finan- cial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place, This change may be expressed as either an amount or a percentage. For example, Illustration 15.1 shows recent net sales figures of Dubois SA. Intracompany a 2019.6 2020 Industry Averages DED pof> fF Intercompany @-a 1315-4 CHAPTER 15 Financial Analysis: The Big Picture Dubois SA's net sales Formula for horizontal a of changes since base period Form bral nae a Tort sna Dabi Sten Weer) Horizontal analysis of statements of financial position DIT Porn 2020 203 2018, 19860 -€19.903 18.781 ‘ewe assume that 2018 isthe base year, we can measure all percentage increases or decreases from this base period amount as shown in Illustration 15.2. Change Since _ Current Year Amount - Base Year Amount. Base Period ‘Base Year Amount For example, we can determine that net sales for Dubois increased from 2018 to 2019 approximately 6% ((€19,903 ~ €18,781) + €18,781]. Similarly, we can determine that net sales increased from 2018 to 2020 approximately 5.7% [(€19,860 — €18,781) + €18,781) ‘Alternatively, we can express current year sales as a percentage of the base period, We do this by dividing the current year amount by the base year amount, as shown in Illustration 15.3, Current Results in ‘Current Year Amount Relation to Base “Base Year Amount Illustration 15.4 presents this analysis for Dubois for a three-year period using 2018 as the base period, Pirin. Net Sales (in thousands) Pcie 2020 2019 2018, eigaso £19,903 E1881 105.7% 106.0% 1003: Statement of Financial Position To further illustrate horizontal analysis, we will use the financial statements of Quality Department Store, a fictional retailer. Illustration 15.5 presents a horizontal analysis of its ‘o-year condensed statements of financial position, showing euro and percentage changes, Quality Department Store Condensed Statements of Financial Position Cee Increase or (Decrease) uring 2020 2020 2019 ‘Amount Percent Assets Tntangible asses € 15000 € 17500 € 2500) (44.3%) Plant assets (net) ‘800.000 632500 167,500 268% CCurzent assets 945,000 75000 7.9% “Total assets €1595.000 24000 15.0%Basics of Financial Statement Analysis 15-5 Baty seripisodines ci € 28000 € 200m suo sae | Liabilities Non-curtent liabilities € 487,500 € 497,000 € (9,500) Current liabilities 344,500 303,000 41,500 ‘Tota liabilities 532,000 ‘300,000, 000 ‘Tota equity and Tisbiliies 1,595,000 ‘The comparative statements of financial position in Iustration 15.5 show that a number of significant changes have occurred in Quality Department Store's financial structure from 2019 t0 2020: ‘In the assets section, plant assets (net) increased €167,500, or 26.5%, «* In the equity section, retained earnings increased €202,600, of 38.6%. ‘« In the liabilities section, current liabilities increased €41,500, or 13.7% ‘These changes suggest thatthe company expanded its asset base during 2020 and financed this ‘expansion primarily by retaining income rather than assuming additional long-term debt HELPFUL HINT Income Statement Note that though the amount lusteation 15.6 presents a horizontal analysis f the two-year condensed income statements | column is additive te to of Quality Department Store forthe years 2020 and 2019 (see Helpful Tint). Horizontal | tal is €55,800), the percent analysis ofthe income statements shows the following changes: age column is not additive 26.5% isnot the column to- + Net sales increased €260,000, or 14.2% (€260,000 = €1,837,000) fab. A separate percentage + Cost of goods sold increased €141,000, oF 12.4% (€141,000 + €1,140,000) has been calculated for each ‘+ Total operating expenses increased €37,000, or 11.6% (€37,000 = €320,000), Hem. Ciao Carrere’ Horizontal analysis of income For the Years Ended December 31 statements Increase or (Decrease) uring 2020 2020 2019 Percent Sales revenue 2,195.00 €1,960,000 12.0% Sales retrns and allowances 98,000 5 203%) Net sales 2,097,000 i 142% Cost of goods sold 1.281.000, ‘ nae Gross profit, 816,000 AAs Selling expenses 253.000, 211,500 19.6% ‘Administeative expenses 104,000 108,500 44%) ‘Total operating expenses 357,000 320,000, 116% Income from operations 459.000, 377,000 13% (Other income and expense Interest and dividends 9,000 11,000) as2%) Interest expense 36,000 40,500 LA) Tncome before income taxes 432,000, 347,500 243% Income tax expense 168.200 139,000 210% Net income 263800 € 208500 € 55,300 26.5%15-6 CHAPTER 15 Financial Analysis: The Big Picture Horizontal analysis of ret ‘earnings statements HELPFUL HINT The formula for calculating these statement of financial position percentages is Each item Total assets Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and act income, 26.5%. Quality’s profit tend appears favorable. Retained Earnings Statement Illustration 15.7 presents a horizontal analysis of Quality Department Store's comparative retained carnings statements. Analyzed horizontally, net income increased €55,300, or 26.5%, whereas dividends on the share capital—ordinary increased only €1,200, or 2%. We saw in the horizontal analysis of the statement of financial position that ending retained earnings in- creased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities. CTE ses ce ok once exer east Increase or (Decrease) during 2020 2020 2019 ‘Amount ercent 525,000 €376,500 © €148,500 39.4% ‘Add: Net income 263.800 $8,300 265% 788,800 203,800 Deduet: Dividends 61,200 200 20% Retained earnings. Dec. 31 €727.600 Z 38.6% Horizontal analysis of changes from period to period is relatively straightforward and is quite useful. But, complications can oocut in making the computations, fan item has no value in a base year or preceding year but does have a value in the next year, we cannot compute ‘ percentage change, Similaély. if a negative amount appeats in the base or preceding period and a positive amount exists the following year (or vice versa), no percentage change can be computed. Vertical Analysis Vertical analysis, also called common-size analysis, isa technique that expresses each fnan- cial statement item as a percentage ofa base amount. On a statement of financial position, we right say that current assets are 22% of total assets—totalasets being the base amount, Or on an income statement, we might say that selling expenses are 16% of net sales—net sales being the base amount. Statement of Financial Position Illustration 15.8 presents the vertical analysis of Quality Department Store's comparative statements of financial position, The base for the asset items is total assets, The base for the equity and linbilty items is total equity and liabilities, ‘Vertical analysis shows the relative size of each category in the statement of finan cial position, It also can show the percentage change in the individual asset, libility, and equity items (see Helpful Hint). For example, we can sce that current assets decreased from 59.2% of total assets in 2019 to $5.6% in 2020 (even though the absolute euro amount increased €75,000 in that time). Plant assets (net) have increased from 39.7% to 43.6% of total assets. Retained earnings have increased from 32.9% to 39.7% of total equity and liabilities. These results reinforce the earlier observations that Quality Department Store is choosing to finance its growth through retention of earnings rather than through issuing additional debtBasics of Financial Statement Analysis 15-7 Prepares Coreen etn rien) ‘Vertical analysis of statements Eos of financial posi Intangible assets Plant asset (nt) ‘Share capital ordinary, 1 par Retained earnings ‘Tota equity Lis Non-curtent liabilities € Carrent liabilities 344,500 303,000 Total liabilities 300,000 ‘Total equity and lisiltes 1,595,000 Income Statement HELPFUL HINT Illustration 15.9 shows vertical analysis of Quality Department Store's income statements, | The formula for calculating Cost of goods sold as a percentage of net sales declined 1% (62.1% vs. 61.1%), and total op- | these income statement per- crating expenses declined 0.4% (17.4% vs, 17.0%). As a result, it is not surprising to see net | cemtasesis: income as.a percentage of net sales increase from 11.4% to 12.6% (sce Helpful Hint), Quality | Bach item on US Department Store appears to be a profitable business that is becoming even more successful Net sales CET ec Carrere encores ‘Vertical analysis of income Poe reass statements 2020 2019 ‘Amount ‘Amount Percent Sales revenue 2,195,000 €1,960,000 106.7% Sales returns and allowances 98,000 123,000 67% Net sales 2,097,000 1,837,000 Cost of goods sold 1.281.000 140,000 Gross profit $16,000 697,000 Selling expenses 253,000, 211,500 ‘Administeative expenses 104,000 108,500 ‘Total operating expenses 357.000 320,000 Income from operations 459.000, 377,000 (Other income and expense Interest and dividends 9,000 11,000 Interest expense 36,000 40,500 Income before income taxes “432,000, 347,500 Income tax expense 168,200 139,000 Netincome © 263,800 © 208,50035-8 CHAPTER 15 Financial Analysis: The Big Picture Wee Intercompany income statement comparison ACTION PLAN + Find the percentage change by dividing th amount of the increase by the 2019 amount (hase year). ‘An associated benefit of vertical analysis is that it enables you to compare companies of different sizes. For example, Quality Department Store's main competitor is a Park Steet store in a nearby town. Using vertical analysis, we ean compare the condensed income statements ‘of Quality Department Store (a small retail company) with Park Street (a giant global retailer), as shown in Illustration 15.10. ee Rue oud Fer the Year Ended December 21, 2020 (in thousands) Quality Department Store Park Street Amount Percent ‘Amount Percent Netsales 100.0% 17,556,000 100.0% Cost of goods sold 11% 6% Gross profit 389% 6910,000 3945 Selling and administrative expenses 17.0% 35.6% Income from operations 29% r 38 (Other income and expense ‘including income taxes) 93% 412,000 Netincome 12.6% 251,000 Park Street's net sales are 8,372 times greater than the net sales of relatively tiny Quality Department Store. But vertical analysis eliminates this difference in size. The percentages show that Quality's and Park Street's gross profit rates were comparable at 38.9% and 39.4%. However, the percentages related to income from operations were significantly different at 21.9% and 3.8%. This disparity can be attributed to Quality’s selling and administrative expense percentage (17%), which is much lower than Park Street's (35.6%). Although Park Street earned net income more than 951 times lager than Quality's, Park Street's net income as a percentage of each sales euro (1.4%) is only 11% of Quality’s (12.6%) DOIT!1 | Horizontal Analysis ‘Summary financial information for Rosepatch NV is as follows. December 31, 2020, December 31,2019 Plant assets (net) €756,000, €420,000, Curent assets 234,000 180,000 ‘Tota assets 590,000 £600,000 ‘Compute the amount and percentage changes in 2020 using horizontal analysis, assuming 2019 is the base year Solution Increase in 2020 ‘Amount Pereent Plant assets (et) '€336,000 80% [(€756,000 — €420,000) = €420 000), Current assets 54000 30% [(€234,000 ~ €180,000) = €180,000] Total assets €390,000 65% [(€990,000 — €600,000) = €600,000], Relate exercise materia: BERS.2, BEIS.3, BEAS 6, BE3S.7, DOT! 18.1, F1S., F1S.3, and FIS.4,Ratio Analysis LEARNING OBJECTIVE 2 Analyze a company's performance using ratio analysis. Ratio analysis expresses the relationship among selected items of financial statement data. A rratio expresses the mathematica relationship between one quantity and another. The relation- ship is expressed in terms of either a percentage, a rate, or a simple proportion, To illustrate, ‘Marks and Spencer ple (M&S) recently had current assets of £1,267.9 million and current liabilities of £2,238.3 million, We can find the relationship between these two measures by dividing current assets by current liabilities. The alternative means of expression ate: Percentage: Current assets are $7% of current liabilities, Rate: Current assets are 57 times current liabilities Proportion: The relationship of current assets to liabilities is 57:1 ‘To analyze the primary financial statements, we can use ratios to evaluate liquidity, profit. ability, and solvency. Illustration 15.11 describes these classifications. Liquidity Ratios Measure shore-cerm ability ‘of the company to pay ite maturing obligations and to rreet unexpected need: for cash ofitability Ratios Measure the income or ‘operating success of a company fora given period of me Solvency Ratios Measure the abil of the company to survive ‘over along period of time Ratios can provide clues to underlying conditions that may not be apparent from individ- xual financial statement components. However, a single ratio by itself is not very meaningful. ‘Thus, inthe discussion of ratios we will use 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 Park Street as Quality Department Store's princi- pal competitor. Liquidity Ratios Liquidity ratios measure the short-term ability of the company to pay its maturing obliga- tions and to meet unexpected needs for cash, Short-term creditors such as bankers and sup- pliers are particularly interested in assessing liquidity, The ratios we can use to determine the company's short-term debt-paying ability are the current ratio, the acid-test ratio, accounts receivable turnover, and inventory turnover, Ratio Analysis, Financial ratio classifications 3935-10 CHAPTER 15. Financial Analysis: The Big Picture Current ratio HELPFUL HINT ‘Any company can operate successfully without working capital if thas very predict: able cash flows and solid earnings. A number of US, companies (¢g., Whirlpoot, American Standard, and Campbells Soup) are pur: suing this goal as less money tied up in working capital -means more money to invest inthe business 1. Current Ratio The current ratio is a widely used measure for evaluating a company's liquidity and short-term debt-paying ability. The ratio is computed by dividing current assets by current liabilities. Illustration 15.12 shows the 2020 and 2019 current ratios for Quality Department ‘Store and comparative data, Current assets Current Ratio = —“urrentAssets_ ‘Current Liabilities Quality Department Store 2020 2019 1.020.000 _ 5.95.1 £945,000 51) 344,500 303,000 Tadust e Park Steet 1 205: ‘What does the ratio actually mean? The 2020 ratio of 2.96:1 means that for every euro of current liabilities, Quality has €2.96 of current assets. Quality’s current ratio has decreased in the current year. But, compared to the industry average of 1.70:1, Quality appears to be very liquid. Park Street has a current ratio of 2.05:1, which indicates it has adequate current assets relative to its current Liabilities. ‘The current ratio is sometimes referred to as the working capital ratio. Working capital is current assets minus current liabilities. The current ratio is a more dependable indicator of liquidity than working capital (see Helpful Hint). Two companies with the same amount of ‘working capital may have significantly different current ratios. ‘The current ratio is only one measure of liquidity. It does not take into account the com- position of the current assets. For example, a satisfactory current ratio does not disclose the fact that a portion of the current assets may be tied up in slow-moving inventory, A euro of ceash would be more readily available to pay the bills than a euro of slow-moving inventory. Investor Insight How to Manage the Current ‘of inventory on account, it will have $3,000,000 of current asses Ratio ‘The apparent simplicity of the current abilities it will have $1,500,000 of current asets and $500,000 of ratio can have real-world limitations current liabilities; ite current raio increases to 3:1. Thus, any because adding ogy ‘numerator andthe denominator causes the ceptible to quick changes and is easly influenced by management tatia to deerease if it exceeds 1:1 ‘Assume, for example, ‘has $2,000,000 of current assets and How might management influence @ company's current ra- NomateciSupesiock ¢4.999,000 of current Liabilities: its cur- tio? (Go tothe book's companion website for this answer and rent ratio is 2:1 Iit purchases $1,000,000 and $2,000,000 of eucren abilities; its errent ratio decreases to 5:1 If, instead, the company pays off $500,000 ofits eurrent lt yun to both the wend analysis should be done with caze because the ratio is sus ‘company 2. Acid-Test Ratio The acid-test (quick) ratio is a measure of a company’s immediate short-term liquidity, ‘We compute this ratio by dividing the sum of cash, short-term investments, and net accounts receivable by current liabilities. Thus, it is an important complement to the current ratio.RatioAnalysis 15-22 For example, assume that the current assets of Quality Department Store for 2020 and 2019 consist ofthe items shown in Illustration 15.13. Quality Department Store Secon) Current assets of Quality Department Store Carseat assets repaid expenses Inventory ‘Accounts receivable (et*) Short-term investments Cash ‘Total current assets ‘Allowance for dobifl accounts is €1,000 at he end ofeach yas. Cash, short-term investments, and accounts receivable (net) ae highly liquid compared to inventory and prepaid expenses. The inventory may not be readily saleable, and the prepaid expenses may not be transferable to others. Thus, the acid-test ratio measures immediate liquidity. The 2020 and 2019 acid-test ratios for Quality Department Store and comparative data are as shown in Illustration 15.14, ‘ei ‘Acid-test rat Quality Department Store 2020 2019 £100,000 + €20,000-+ €230.000 _ , 4,., €155,000+€70,000 + €180.000 _ |, 344,500 Industry average 70:1 ‘The ratio has declined in 2020. Is an acid-test ratio of 1.02:1 adequate? This depends on the industry and the economy. When compared with the industry average of 0.70:1 and Park ‘Street's of 1.05:1, Quality’sacid-test ratio seems adequate 3. Accounts Receivable Turnover ‘We can measue liquidity by how quickly a company can convert certain assets to cash. How liquid, for example, ate the accounts receivable? The ratio used to assess the liquidity of the receivables isthe accounts receivable turnover. It measutes the numberof times, on average, the company collects receivables during the period. We compute the accounts receivable tun- over by dividing net credit sales (net sales less cash sales) by the average net accounts receiv- able. Unless seasonal factors aze significant, average net accounts receivable can be computed from the beginning and ending balances of the net accounts receivable.” st, the average accounts receivable balance might be determined by using monthly35-12 CHAPTER 15. Financial Analysis: The Big Picture ‘Accounts receivable turnover Inventory turnover ‘Assume that all Quality Department Store's sales are credit sales. The balance of net accounts receivable atthe beginning of 2019 is €200,000. Illustration 15.15 shows the accounts receivable turnover for Quality Department Store ané comparative data. Quality's accounts receivable turnover improved in 2020. The turnover of 10.2 times is substantially lower than Park Street's 37.2 times, and is also lower than the department store industry's average of 46.4 times, Net credit sales ‘Accounts Receivable Turnover = —___Net Credit Sales __ ‘verage Net Accounts Receivable ‘Quality Department Store 2020 2018 2.097.000 ote £18370 orimes “iso 000 + €230,000 200,000 + «180,000, 2 2 Indasty average Pak Stot aoa times 7a times Average Collection Period. A popular variant of the accounts receivable turnover is to convert it to an average collection period in terms of days. To do so, we divide the accounts receivable tumover into 365 days. For example, the accounts receivable turnover of 10.2 times divided into 365 days gives an average collection period of approximately 36 days. This ‘means that accounts receivable are collected on average every 36 days, or about every S weeks. ‘Analysts frequently use the average collection period to assess the effectiveness of a company’s credit and collection policies. The general rule is thatthe collection period should not greatly exceed the credit term period (the time allowed for payment) 4. Inventory Turnover Inventory turnover measures the number of times, on average, the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory, We compute the inventory turnover by dividing cost of goods sold by the average inventory. Unless seasonal factors are significant, we can use the beginning and ending inventory balances to compute average inventory. Assuming thatthe inventory balance for Quality Department Store atthe beginning of 2019 was €450,000, its inventory turnover and comparative data are as shown in Illustration 15.16. Quality’s inventory turnover declined slightly in 2020, The turnover of 2.3 times is low com- pared with the industry average of 4.3 and Park Street's 3.1. Generally, the faster the inventory c sds Sold Inventory Turnever = ‘Average inventory (Quality Department Store 2020 2019 1,281,000 a suimes 1,140,000 2A times 00,000 + €620,000) 50,000 + €500,000 2 z Industry average Park Street 43 times 3.1 times‘umover, the less cash a company has tied up in inventory and the less chance a company has of inventory obsolescence. Days in Inventory. A variant of inventory turnover is the days in inventory. We calculate it by dividing the inventory turnover into 365. For example, Quality’s 2020 inventory turnover of 2.3 times divided into 365 is approximately 159 days. An average selling time of 159 days is also high compared with the industry average of 84.9 days (365 ~ 4.3) and Park Steet’s 117-7 days (365 + 3.1), Inventory turnovers vary considerably among industries. For example, grocery store chains have a turnover of 17.1 times and an average selling period of 21 days. In contrast, jew clry stores have an average turnover of 0.80 times and an average selling period of 456 days. Profitability Ratios Profitability ratios measure the income or operating success of a company for a given period of time. Income, or the lack of it, affects the company’s ability o obtain debt and equity financing. It also affects the company's liquidity position and the company’s ability to grow. As a consequence, both creditors and investors are interested in evaluating earning power— profitability. Analysts frequently use profitability as theultimate test of management's operating effectiveness. 5. Profit Margin Profit margin is a measure of the percentage of each euro of sales that results in net in- come (see Alternative Terminology). We can compute it by dividing net income by net sales, Illustration 15.17 shows Quality Department Store’s profit margin and compar- ative data. Net Income fie Margin = Nettncome ts (Net Sales. ua Depart Sexe aoa aos eso. y, €208500 4, ezom1.000 Exsy7 000 Indusy neage Park Suc 20% 14s (Quality experienced an increase in its profit margin from 2019 to 2020. Its profit margin is unusually high in comparison with the industry average of 8% and Park Street's 1.4%. High-volume (high inventory turnover) businesses, such as grocery stores and discount stores, generally experience low profit margins. In contrast, low-volume businesses, such as jewelry stores or airplane manufacturers, have high profit margins. 6. Asset Turnover Asset turnover measures how efficiently a company uses its assets to generate sales. It is de- termined by dividing net sales by average total assets. The resulting number shows the curos of sales produced by each euro invested in assets, Unless seasonal factors are significant, we can use the beginning and ending balance of total assets to determine average total assets, Assuming that total assets atthe beginning of 2019 were €1,446,000, the 2020 and 2019 asset turnover for Quality Department Store and comparative data are shown in Illustration 15.18. RatioAnalysis 15-13 ALTERNATIVE TERMINOLOGY Profit margin is also called ‘the rate of return om sales, ures Profit margin15-14 CHAPTER 15, ‘Asset turnover eee) ‘Return on assets Financial Analysis: The Big Picture Net Sales ‘Asset Turnover = ——Net Sales __ ‘Average Total Assets ‘Quality Department Store 2020 2019 €2.097000 sages £48390 yey 1,595,000 + €1,8: 1,446,000 + €1, ; 2 Industry average Park Street 1a times 1.4 times Asset turnover shows that in 2020 Quality generated sales of approximately €1.20 for each ccuro it had invested in assets. The ratio did not change from 2019 to 2020. Quality’s asset turnover is below both the industry average of 1.4 times and Park Street's ratio of 14 times, Asset turnovers vary considerably among industries. For example, a large utility company might have a ratio of 4 times, and a large grocery chain might have a ratio of 3.4 times. 7. Return on Assets An overall measure of profitability is return on assets. We compute this ratio by dividing net income by average total assets. The 2020 and 2019 return on assets for Quality Department Store and comparative data are shown in Tilustration 15.19, Netincome Return on Assets = —_NetIncome __ ‘Average Total Assets ‘Quality Department Store 2020 2019 263.800 misuse £208,500 sie '€1,595,000 + €1,835,000 €1.446,000 + €1,595,000, 2 z Industry average ark Street 39% 24% Quality’s return on assets improved from 2019 to 2020, Its return of 15.4% is very high com- pared with the department store industry average of 8.9% and Park Street's 2.4%. 8, Return on Ordinary Shareholders’ Equity Another widely used profitability ratio is return on ordinary shareholders? equity. It mea sures profitability from the ordinary shareholders’ viewpoint, This ratio shows how many euros of net income the company earned for each euro invested by the owners. We compute it by dividing net income evailable to ordinary shareholders by average ordinary shareholders’ equity. When a company has preference shares, we must deduct preference dividend require- ‘ments from net income to compute income available to ordinary shareholders. Similarly, we deduct the par value of preference shares (or call price, if applicable) from total equity to de termine the amount of ordinary shareholders’ equity used inthis ato. Assuming that ordinary shareholders’ equity atthe beginning of 2019 was €667,000, Illustration 15.20 shows the 2020 and 2019 ratios for Quality Department Store and comparative dataReturn on Ordinary _ Shareholders’ Equity Quality Department Store 2020 2019 £263,800 - €0 a0a8 £208,500 - €0 ase (€795,000 + €1,003 000) £667,000 + €795,000 2 2 Industry average Park Street 13% 6am Quatity’s rate of return on ordinary shareholders’ equity is high at 29.3%, considering an industry average of 18.3% and a rate of 6.4% for Park Street. Note also that Quality’s rate of return on ordinary shareholders’ equity (29.3%) is sub- stantially higher than its rate of return on assets (15.4%). The reason is that Quality has made effective use of leverage. Leveraging or trading on the equity at a gain means that the company has borrowed money at a lower rate of interest than it is able to earn by using the borrowed money. Leverage enables Quality Department Store to use money supplied by non-owners to increase the return to the owners. A comparison of the rate of return on total assets with the rate of interest paid for borrowed money indicates the profitability of trading ‘on the equity. Quality Department Store earns more on its borrowed funds than it has to pay in the form of interest. Thus, the return to shareholders exceeds the return on the assets, due to ‘benefits from the positive leveraging. 9, Earnings per Share (EPS) Earnings per share (EPS) is a measure of the net income earned on each ordinary share. is computed by dividing net income available to ordinary shareholders by the number of weighted-average ordinary shares outstanding during the year. A measure of net income earned on a per share basis provides a useful perspective for determining profitability. Assum- ing that there is no change in the number of outstanding shares during 2019 and that the 2020 increase occurred midyear, Illustration 15.21 shows the net income per share for Quality Department Store for 2020 and 2019. Earnings Net income ~ Preference Dividends PerShare Weighted-Average Ordinary Shares Outstanding Quality Department Store 2020 2019 £263,800 _ gy gy £208,500 60 _ 5.55 [270,000 + 275,400 270,000 2 Note that no industry or specific competitive data are presented. Such comparisons are not meaningful because of the wide variations in the number of shares outstanding among companies. The only meaningful EPS comparison is an intracompany trend comparison. Here, Quality's earnings per share increased 20 cents per share in 2020. This represents a 26% increase over the 2019 earnings per share of 77 cents Ratio Analysis ‘Return on ordinary shareholders’ equity Earnings per share 153s15-16 CHAPTER 15, Price-earnings ratio Financial Analysis: The Big Picture ‘The terms “earnings per share” and “net income per share" refer to the amount of net in- come applicable to each ordinary share. Therefore, in computing EPS, if there are preference dividends declared for the period, we must deduct them from net income to determine income available to the ordinary sharcholders. 10. Price-Earnings Ratio ‘The price-earnings (P-E) ratio is a widely used measure of the ratio of the market price of each ordinary share tothe earnings per share. The price-earnings (P-E) ratio reflects investors’ assessments of a company’s future earnings. We compute it by dividing the market price per share by earnings per share. Assuming that the market price of Quality Department Store shares is €8 in 2019 and €12 in 2020, the price-earnings ratio computation is as shown in Ilustration 15.22. Market Price per Share Price-Earnings Ratio Earnings per Share ‘Quality Deparment Store 2020 2o1g oe = 124 times s = 104 times Indust average Pak Stst 21.3 times 172 times In 2020, each Quality Department Store share sold for 12.4 times the amount thatthe company earned on each share. Quality’sprice-carnings ratio is lower than the industry aver- age of 21.3 times, and also lower than the ratio of 17.2 times for Patk Street 11. Payout Ratio ‘The payout ratio measures the percentage of carnings distributed in the form of cash divi- dends, We compute it by dividing cash dividends declared on ordinary shares by net income. Companies that have high growth rates generally have low payout ratios because they rein- vest most of their net income into the business, The 2020 and 2019 payout ratios for Quality Department Store are computed as shown in Ilustration 15.23, Payout Ratio = £##hDividends Declared on Ordinary Shares Net Income ‘Quality Department Store 2020 £61200 — 55 95 263,800, Industry average Park Street 161% 680% Quality’s payout ratio decreased ftom 2019 to 2020, but is higher than the industry average payout ratio of 16.1%, Park Streets rato is very high because its net income in 2020 was quit low. Solvency Ratios Solvency ratios measure the ability of a company to survive over a long period of time, Long-term creditors and shareholders are particularly interested in a company's ability to payinterest as it comes due and to repay the face value of debt at maturity, Debt to assets and times interest earmed are two ratios that provide information about debt-paying ability. 12. Debt to Assets Ratio ‘The debt (o assets ratio measures the percentage ofthe total assets that creditors provide. We compute it by dividing total liabilities (both current and non-curtent liabilities) by total assets. ‘This ratio indicates the company's degree of leverage. It also provides some indication of the company’s ability to withstand losses without impairing the interests of creditors. The higher the percentage of total liabilities to total assets, the greater the risk that the company may be ‘unable to meet its maturing obligations. The 2020 and 2019 ratios for Quality Department Store and comparative data are as shown in Illustration 15.24. Total Liabilities Total Assets Debt to Assets Rat ‘Quality Department Store 2020 2019 €832.000 go age €£00.000 595, 41,835,000 1€1,595,000 Industry average Pak Street Mae 2.0% A ratio of 45.3% means that creditors have provided 45.3% of Quality Department Store's total assets. Quality's 45.3% is above the industry average of 34.2%. It is consider- ably below the high 62.0% ratio of Park Steet. The lower the ratio, the more equity “bus” there is available tothe creditors. Thus, ftom the creditors’ point of view, alow ratio of debt to assets is usually desirable. Therefore, the decrease in Quality's debt to assets ratio from 2019 to 2020 would be viewed as a favorable trend, “The adequacy ofthis ratio is often judged in the light of the company’s earnings. Generally, ‘companies with elatively stable earings (such as public utes) have higher debt to assets ratios than cyclical companies with widely fluctuating earnings (euch as many high-tech companies). 13. Times Interest Earned ‘Times interest earned provides an indication of the company's ability to meet interest pay- rents as they come due (ee Alternative Terminology). We compute it by dividing the sum ‘of net income, interest expense, and income tax expense by interest expense. Illustration 15.25 shows the 2020 and 2019 ratios for Quality Department Store and comparative data. Note that times interest earned uses net income before interest expense and income tax expense. This tep- resents the amount availabe to cover interest. For Quality Department Store, the 2020 amount ‘of €468,000 is computed by taking net income of €263,800 and adding back the €36,000 of interest expense and the €168,200 of income tax expense. Times Interest _ NetIncome + Interest Ex Earned Interest Expense (Quality Department Store 2020 2019 £263,800 4 €36,000 + €168,200 _, ..,, €208,500 + €40,500-+ €139,000 _g 6 “€36,000 40,500 Industry average Park Street 16.1 times 29 times RatioAnalysis 15-37 LUSTRATION 15.24 Debt to assets ratio ALTERNATIVE TERMINOLOGY ‘Times interest earned is also called interest coverage inure) ‘Times interest earned.35-18 CHAPTER 15 Financial Analysis: The Big Picture ‘Quality’s interest expense is well covered at 13 times. It is less than the industry average of 16.1 times but significantly exceeds Park Steer’ 2.9 times and is an improvement over the 2019 ratio of 9.6 times. Summary of Ratios Illustration 15.26 summarizes the ratios discussed in this chapter. The summary includes the formula and purpose or use of each ratio, Sammary of gut, profit Ratio Formula Purpose or Use Liquidity Ratios lity, and solvency ratios Current ase 1, Current ratio ee ‘Measures short-term debt-paying ability, Cash + Short-term investments + Accounts receivable (net) Cartent Liabilities 4, Accounts receivable Net ere sales umover ‘Rverage net accounts eosivable Cost of goods sold ‘Average inventory 2, cides (quick) ratio ‘Measures immediate short-term liquidity ‘Measures liquidity of accounts receivable. 4, Inventory turnover “Measures liquidity of inventory Net income Measures net income generated by each 5: rotit margin Net sales ‘currency unit of sales. bs Ansett Netales Measures how elicently assets are used eset turnover ‘Rrerage total asses to generate sales Net income 7, Return on assets ‘Measures overall profitability of ase. ‘Rverage (lal aseis Netincome ~ Preference 8, Return on ordinary dividends tee acy [= — ‘Measures profitability of owners investment shareholders’ equity Netincome ~ Preference ve os ‘iis open os sper share (EPS) ‘Weighted-average ordinary ordinary share. Shaw ooo Mee 10, Price uings ao pais Mearns thr th mat pee Bal a Save ang peran wh pow Cub views ayes pemtge of eng tbe Saison Soren Rati ie Seen eee 12, Debt to assets ratio “Total assets ‘provided by creditors. Ree eee vest 13, Times interest earned + Income tax expense eee oe Daa as they come due Tterest expenseDOIT!2 | Ratio Analysis ‘The condensed financial statements of John Cully Group, for the years ended June 30, 2020 and 2019, are presented below. ear) Pease entry ed (én thousands) Assets 0 2019 Intangibles and other assets € 8767 € 893 Property, plant nd equipment (at) 6942 6470 Investments 123 126 ‘Curent assets Prepaid expenses and other current assets €2044 €269.2 Inventory 768.3 6535 Accounts receivable (net) 7766 6649 Cash 5533 616 2,199.2 Total assets 67081 Equity and Liabilities, ‘Shareholders’ equity—ordinary €1,708.6 €1,7490 ‘Non-curreat liabilities DS 637.1 ‘Current liabilities 1497.7 1,322.0 708.1 ‘Total equity and lisiltes Peco eles Forthe Year Ended June 30 (Gn thousands) 2020 2019 Sales revenue €6,3363, 5.7904 ‘Coste and expenses Cost of goods sold Leia 1.4763 Selling and administrative expenses 40076 3.6790 Interest expense 9 m1 ‘Total costs and expenses 56389 51824 Income before income taxes ora Income tax expense 2913 Net income ©4061 ‘Compute the following ratios for 2020 and 2019. a. Curent ratio. '. Inventory turnover Inventory on 6/30/18 was €599.0) «. Profit margin 4d. Return on asses. (Assets on 6/30/18 were €3,349.9.) ‘. Return on ordinary shareholders’ equity, (Equity on 6/30/18 was €1,795.9.) f. Debt to asses ratio. a, Times interest earned, RatioAnalysis 15-29 ACTION PLAN + Remember that the current ratio includes: current assets, The acd test ratio uses only cash, short-term investments, and net accounts receivable, + Use average balances inventory, accounts receivable, as well as return on assets35-20 CHAPTER 15 Financial Analysis: The Big Picture Solution 2020 2019 a. Current ratio: €2,302.6 + €1,497. 1s 2,199.2 = €1,322, ana bi, Inventory tumover; €1.6174 = [(€768.3 + €653.5) +2] 23 times €1,86.3 = [(€653 5 + €599.0) +2] 24 times Profit margin +€406,1 = £6,335, am €375.4 + €5.790, 65% 4, Return on assets €406,1 + [(€3,885,8 + €3,708.1) = 2 107% €3754 + [(€3,708.1 + €3,349.9)=2] = 10.6% fe, Return on ordinary shareholders’ equity (€406.1 ~ €0) + [(€1,708.6 + €1,749.0) = 2) 235% (€375.4 ~ €0) + [(€1,749.0 + €1,7959) = 2) 212% £, Debt asses ratio: (€1,497.7 + €6795) = €3,885.8 560% (€1.322.0 + €637.1) = €3,708.1 = 528% a. Times interest earned: (€406.1 + €291.3 4 €13.9) + €139= 51.2 mee (€375.4 + €232.6 4 €27.1) = E271 23.4 times ‘elated exerise material: BEIS.9, BEIS.10, BEIS.11, BEIS.12, BEIS.13, DOITI15.2, EIS.5, 15.6, IS, FASS, F159, B1S10, and FAS.11 Sustainable Income LEARNING OBJECTIVE 3 Apply the concept of sustainable income. ‘The value of a company like Google (USA) is a function of the amount, timing, and uncer tainty ofits future cash flows. Google's current and past income statements are particularly ‘useful in helping analysts predict these future cash flows. In using this approach, analysts must make sure that Google's past income numbers reflect its sustainable income, that is, do not include unusual (out-of-the-ordinary) revenues, expenses, gains, and losses. Sustainable income is, therefore, the most likely level of income to be obtained by a company in the future Sustainable income differs from actual net income by the amount of unusual revenues, expenses, gains, and losses included in the current year's income. Analysts are interested in sustainable income because it helps them derive an estimate of future earnings without the “noise” of unusual items Fortunately, an income statement provides information on sustainable income by sepa- rating operating transactions from non-operating transactions. This statement also highlights intermediate components of income such as income from operations, income before income taxes, and income from continuing operations. In addition, information on unusual items such as gains or losses on discontinued items and components of other comprehensive income ate disclosed,Mustration 15.27 presents a statement of comprehensive income for Cruz Textiles for the year 2020. A statement of comprehensive income includes not only net income but a broader measure of income called comprehensive income. The two major unusual items in this statement ate discontinued operations and other comprehensive income (highlighted in red), When estimating future cash flows, analysts must consider the implications of each of these components po ad Sa Forthe Year Ended 2020, Sales revenue $900,000 Cost of goods sold 650,000 Gross profit 250,000, ‘Operaing expenses 100,000 Tneome from operations 150,000 (Other revenues (expenses) and gains (losses) 20,000 Income before income taxes Taeome tax expense Income from continuing operations Discontinued operations (net of tax) [Net income Other comprehensive income items (net of tax) Comprehensive income In looking at Ilustration 15.27, note that Cruz Textiles’ two major types of unusual items, discontinued operations and other comprehensive income, are reported net of tax. ‘That is, Cruz first calculates income tax expense before income from continuing opera- tions. Then, it calculates income tax expense related to the discontinued operations and other comprehensive income. The general concept is, “Let the tax follow the income or loss.” We discuss discontinued operations and other comprehensive income in more detail next. Discontinued Operations Discontinued operations refers to the disposal of significant component of a business, such as the elimination of a major class of customers or an entire activity. For example, to downsize its operations, General Dynamies Corp. (USA) sold its missile business to Hughes Aircraft Co. (USA) for $450 million. In its income statement, General Dynamics reported the sale in 2 separate section entitled “Discontinued operations Following the disposal of a significant component, the company should report on its ‘income statement both income from continuing operations and income (or loss) from discon- tinued operations. The income (loss) from discontinued operations consists of two parts: the income (loss) from operations and the gain (loss) on disposal of the component. To illustrate, assume that during 2020 Acro Energy Ltd. has income before income taxes ‘of NT$800,000, During 2020, Acro discontinued and sold its unprofitable chemical division. ‘The loss in 2020 from chemical operations (net of NTS60,000 taxes) was NT$140,000. The loss on disposal of the chemical division (net of NT$30,000 taxes) was NT$70,000, Assum- ing a 30% tax rate on income, Illustration 15.28 shows Acro’s statement of comprehensive income presentation (see Helpful Hint), ‘Note thatthe statement uses the caption “Income from continuing operations” and adds & new section “Discontinued operations.” The new section reports both the operating loss and Sustainable Income 15-21 ‘Statement of comprehensive HELPFUL HINT Observe the dual disclosures: (2) the results of operations of the discontinued division must be eliminated from the re sls of continuing operations, and @) the company must ‘also report the disposal ofthe ‘operation,15-22 CHAPTER 15, Stent reenaon Samet Financial Analysis: The Big Picture eran Ree eee ny ean ce For the Year Ended December 31, 2020 Income before income txet 1NTS800,000 Income tax expense 240,000 Income from continuing operations 560,000 Discontinued operations ‘Loss from operations of chemical division, et of NTS60,000 income tax savings NTS140,000 Loss from disposal of chemical division, net of NT$30,000 income tax savings 70,000 Net income 1NT8350,000 the loss on disposal net of applicable income taxes. This presentation cleatly indicates the separate effects of continuing operations and discontinued operations on net income. Investor Insight _ Procter & Gamble Co. = What Does “Non-Recurring” But so Really Mean? ‘Many companies ineur restructuring charges as they attempt to reduce costs, companies report “one-time” restructuring charges over and over again. For example, toothpaste and other consumer-goods giant Procter & Gamble Co. (USA) reported a restructuring charge in 12 consecutive quarters. Motorola (USA) had “special” charges in 14 consecutive quarters. On the other ‘They often label these items in the in- come statement as “non-recurring” charges to suggest that they are isolated events which are unlikely to occur in future periods. The Kents © Ziel! ‘Stakpbote question for analysts is, are these costs really one-time, “non- recurring” events or do they reflect problems thatthe company will be facing for many periods in the future? If they are one- time events, they ean be largely ignored when trying to predict hhand, other companies have a restructuring charge anly once in a five- or ten-year period. There appears to be no substitute for ‘careful analysis of the numbers thal comprise net income. Ifa company takes a large restructuring charge, what is the ‘effect on the company's current income statement versus future ones? (Go to the book’s companion website for this ature earnings. ‘answer and additional questions.) ETHICS NOTE Changes in accounting prin- ‘ple should result in finan- cal statements that are more informative for statement us- ers. They should not be used to artificially improve the re ported performance or finan. ‘al position ofthe company. Changes in Accounting Principle For ease of comparison, users of financial statements expect companies to prepare such state- ‘ments on a basis consistent with the preceding period. A change in accounting principle oc- ccurs when the principle used in the current year is different from the one used in the preceding year. Accounting rules permit a change when management can show that the new principle is preferable tothe old principle (see Ethics Note), An example is a change in inventory costing methods (such as FIFO to average-cost) ‘Companies report most changes in accounting principle retroactively. That is, they 1e- port both the current period and previous periods using the new principle. As a result, the same principle applies in all periods. This treatment improves the ability to compare results across years. Comprehensive Income Most revenues, expenses, gains, and losses are included in net income, However, certain gains and losses bypass net income, Instead, these items are reported as part of a more inclusive ccarnings measure called comprehensive income. The IASB requires companies to report not only net income but also comprehensive income. Comprehensive income is the sum of net income and other comprehensive income items.Illustration of Comprehensive Income ‘Accounting standards require that companies adjust most investments in shares and bonds up ‘or down to their market price at the end of each accounting period. For example, assume that during 2020 Stassi AG purchased shares for €10,000 as an investment. At the end of 2020, ‘Stassi was sill holding the investment, but the shares’ market price was now €8,000. In this case, Stassi is required to reduce the recorded value of its investment by €2,000. The €2,000 difference is an unrealized loss Should Stassi include this €2,000 unrealized loss in net income? It depends on whether ‘Stass classifies the shaxes as wading security or non-trading. A trading security is bought and hheld primarily forsale in the neat term to generate income on short-term price differences. Com- ppanies report untealized losses on trading securities in the “Other expenses and losses” section of the income statement. The rationale: It is likely that the company will realize the unrealized Joss (or an unrealized gain), so the company should repost the loss (gain) as part of net income. If Stassi did not purchase the investment for wading purposes, itis classified as non-trading Non-trading securities are held with the intent of selling them sometime in the future. Compa- nies do not include unrealized gains or losses on non-trading securities in net income. Instead, they teport them as past of “Other comprehensive income.” Other comprehensive income is not included in net income. It bypasses net income and is recorded as a direct adjustment to equity. Format, ‘One format for reporting other comprehensive income is to report a statement of compre- hensive income, For example, assuming that Stassi AG has a net income of €300,000, the unrealized loss would be reported below net income as shown in Illustration 15.29, Teal ‘Statement of Comprehensive Income (partial) For the Year Ended 2020 Netincome Other comprehensive income ‘Unrealized loss on non-trading securities (net of tax) Comprehensive income Companies also report the unrealized loss asa separate component of equity. To illustrate, assume Stassi AG has ordinary shares of €3,000,000, retained earnings of €1,500,000, and accumulated other comprehensive loss of €2,000, Illustration 15.30 shows the statement of financial position presentation of the unrealized loss eS eect) Equity ‘Share capitalordinary Retained earnings Accumulated other comprehensive loss ‘Total equity [Note that the presentation of the accumulated other comprehensive loss is similar to the presentation of the cost of treasury shares in the equity section. (An unrealized gain would bbe added in this section of the statement of financial position.) Reporting the unrealized gain ‘or loss in the equity section serves two important purposes: (1) it reduces the volatility of net income due to fluctuations in fair value, and (2) it informs the financial statement user of the {gain of loss that would occur if the company sold the securities at fair value. Complete Statement of Comprehensive Income ‘The statement of comprehensive income for Pace AG in Illustration 15.31 presents the types ‘of items found on this statement, such as net sales, cost of goods sold, operating expenses. and Sustainable Income 15-23, Lower portion of statement of ‘comprehensive income ‘Unrealized loss in equity section15-24 CHAPTER 15. Financial Analysis: The Big Picture ‘Complete statement of ‘comprehensive income ACTION PLAN + Disclose the income tax cffect ofeach component of income, beginning with {income from con ‘operations. income taxes. In addition, it shows how companies report discontinued operations and other comprehensive income (highlighted in red) Pace AG Cae ay PcuehGne recused Net sales +€440,000, Cast of goods sold Gross profit, 180,000 (Operating expenses 110,000 Income from operations 770,000 Other revenues and gains 5,600 Other expenses and losses 9.600 Income before income taxes "6,000 Income tax expense (€66,000 x 30%) 39,800 Income from continuing operations 46,200 Discontinued operations Loss from operation of plastics division, met ‘of income tax savings €18,000 (€60,000 x 30%) _-€42,000 Gain on disposal of plastics division, net of +€15,000 income taxes (€50,000 x 30%) 35,000 7,000 Net income 39,200 Other comprehensive incon ‘Unrealized gain on non-trading securities, net ‘of income taxes (€15,000 x 30%) 10,800 ‘Comprehensive income DOIT!3 | Unusual Items nits proposed 2020 statement of comprehensive income, AIR ple reports income before income taxes £400,000, loss on operation of discontinued flower division £50,000, and loss on disposal ‘of discontinued flower division £90,000, The income tax rates 30%, Prepare a correct statement ‘of comprehensive income, beginning with “Tncome before income taxes.” Solution AIR ple ‘Statement of Comprehensive Income (partial) For the Year Ended December $1, 2020 Income before income taxes £400,000 Income tax expense (£400,000 x 30%) 120,000 Income ftom continuing operations 280,000, Discontinued operations [Loss from operstion of lower division, nt of £15,000 tax savings £35,000 Loss on disposal of flower division, nt of £27,000 tax savings 63,000 98,000 Netincore +2182,000 Related exercise maters: BELS.14, BEIS1S, DOI 15.3, F1S.12, and F15.13.