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Prepared by

Coby Harmon
University of California, Santa Barbara
Westmont College

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18

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 firms 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 18

Accounting Principles
Eleventh 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

Intercompany

LO 1 Discuss the need for comparative analysis.


LO 2 Identify the tools of financial statement analysis.

Horizontal Analysis
Horizontal analysis, also called trend analysis, is a
technique for evaluating a series of financial statement data
over a period of time.

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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
Illustration 18-5
Horizontal analysis of
balance sheets

Changes suggest
that the company
expanded its asset
base during 2011
and financed this
expansion primarily
by retaining income
rather than assuming
additional long-term
debt.

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LO 3 Explain and apply horizontal analysis.

Horizontal Analysis
Illustration 18-6
Horizontal analysis of
Income statements

Overall, gross profit and


net income were up
substantially. Gross
profit increased
17.1%, and net income,
26.5%. Qualitys profit
trend appears
favorable.

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LO 3 Explain and apply horizontal analysis.

Horizontal Analysis

Illustration 18-7
Horizontal analysis of
retained earnings
statements

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In the horizontal analysis of the balance sheet the ending


retained earnings increased 38.6%. As indicated earlier, the
company retained a significant portion of net income to
finance additional plant facilities.
LO 3 Explain and apply horizontal analysis.

Vertical Analysis
Vertical analysis, also called common-size analysis, is a
technique that expresses each financial statement item as
a percent of a base amount.

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On an income statement, we might say that selling


expenses are 16% of net sales.

Vertical analysis is commonly applied to the balance


sheet and the income statement.

LO 4 Describe and apply vertical analysis.

Vertical Analysis
Illustration 18-8
Vertical analysis of
balance sheets

These results reinforce


the earlier observations
that Quality is
choosing to finance
its growth through
retention of earnings
rather than through
issuing additional
debt.

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LO 4 Describe and apply vertical analysis.

Vertical Analysis
Illustration 18-9
Vertical analysis of
Income statements

Quality appears
to be a profitable
enterprise that is
becoming even more
successful.

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LO 4 Describe and apply vertical analysis.

Vertical Analysis
Enables a comparison of companies of different sizes.

Illustration 18-10
Intercompany income
statement comparison
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LO 4 Describe and apply vertical analysis.

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


firms liquidity, profitability, and solvency.

Ratio Analysis
A single ratio by itself is not very meaningful.
The discussion of 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 Macys, Inc. as Quality
Department Stores principal competitor.

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LO 5 Identify and compute ratios used in analyzing a


firms liquidity, profitability, and solvency.

ANATOMY OF A FRAUD
This final Anatomy of a Fraud box demonstrates that sometimes relationships between
numbers can be used by companies to detect fraud. The numeric relationships that can reveal
fraud can be such things as financial ratios that appear abnormal, or statistical abnormalities in
the numbers themselves. For example, the fact that WorldComs line costs, as a percentage of
either total expenses or revenues, differed very significantly from its competitors should have
alerted people to the possibility of fraud. Or, consider the case of a bank manager, who
cooperated with a group of his friends to defraud the banks credit card department. The
managers friends would apply for credit cards and then run up balances of slightly less than
$5,000. The bank had a policy of allowing bank personnel to write-off balances of less than
$5,000 without seeking supervisor approval. The fraud was detected by applying statistical
analysis based on Benfords Law. Benfords Law states that in a random collection of
numbers, the frequency of lower digits (e.g., 1, 2, or 3) should be much higher than higher
digits (e.g., 7, 8, or 9). In this case, bank auditors analyzed the first two digits of amounts
written off. There was a spike at 48 and 49, which was not consistent with what would be
expected if the numbers were random.

Total take: Thousands of dollars


THE MISSING CONTROLS
Independent internal verification. While it might be efficient to allow employees to write off
accounts below a certain level, it is important that these write-offs be reviewed and verified
periodically. Such a review would likely call attention to an employee with large amounts of
write-offs, or in this case, write-offs that were frequently very close to the approval threshold.
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Advance slide in presentation mode to reveal answer.

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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,


accounts receivable turnover, and inventory turnover.

LO 5 Identify and compute ratios used in analyzing a


firms liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

Illustration 18-12

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Advance slide in presentation mode to reveal solution.

LO 5

Ratio Analysis
Current Ratio

Liquidity Ratios

Illustration 18-12

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 Identify and compute ratios used in analyzing a


firms liquidity, profitability, and solvency.

Ratio Analysis

Liquidity Ratios

Acid-Test Ratio
Illustration 18-13

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LO 5 Identify and compute ratios used in analyzing a


firms liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets


For the Years Ended December 31

Balance Sheet (partial)


For the Years Ended December 31

Illustration 18-12

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LO 5

Ratio Analysis

Liquidity Ratios

Acid-Test Ratio
Illustration 18-14

Acid-test ratio measures immediate liquidity.

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LO 5 Identify and compute ratios used in analyzing a


firms liquidity, profitability, and solvency.

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QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Balance Sheet (partial)


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

LO 5

Ratio Analysis
Accounts Receivable Turnover

Liquidity Ratios

Illustration 18-15

Measures the number of times, on average, the company collects


receivables during the period.
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LO 5

Ratio Analysis

Liquidity Ratios

$2,097,000

Accounts Receivable Turnover

= 10.2 times

($180,000 + $230,000) / 2
A variant of the accounts receivable turnover ratio is to convert it
to an average collection period in terms of days.

365 days / 10.2 times = every 35.78 days


Accounts receivable are collected on average every 36 days.

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LO 5 Identify and compute ratios used in analyzing a


firms liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Balance Sheet (partial)


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

Illustration 18-12

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LO 5

Ratio Analysis
Inventory Turnover

Liquidity Ratios

Illustration 18-16

Measures the number of times, on average, the inventory is sold


during the period.
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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


firms 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 companys 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
firms liquidity, profitability, and solvency.

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QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

LO 5

Ratio Analysis

Profitability Ratios

Profit Margin
Illustration 18-17

Measures the percentage of each dollar of sales that results in net


income.
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LO 5 Identify and compute ratios used in analyzing a


firms liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

Illustration 18-12

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LO 5

Ratio Analysis

Profitability Ratios

Asset Turnover
Illustration 18-18

Measures how efficiently a company uses its assets to generate


sales.
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LO 5 Identify and compute ratios used in analyzing a


firms liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

Illustration 18-12

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LO 5

Ratio Analysis

Profitability Ratios

Return on Asset
Illustration 18-19

An overall measure of profitability.


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LO 5 Identify and compute ratios used in analyzing a


firms liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

Illustration 18-12

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LO 5

Ratio Analysis

Profitability Ratios

Return on Common Stockholders Equity


Illustration 18-20

Shows how many dollars of net income the company earned for each
dollar invested by the owners.
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LO 5

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

Illustration 18-12

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LO 5

Ratio Analysis

Profitability Ratios

Earnings Per Share (EPS)


Illustration 18-22

A measure of the net income earned on each share of common stock.

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LO 5

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

Illustration 18-12

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LO 5

Ratio Analysis

Profitability Ratios

Price-Earnings Ratio
Illustration 18-23

Measures the net income earned on each share of common stock.

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LO 5

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

Illustration 18-12

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LO 5

Ratio Analysis

Profitability Ratios

Payout Ratio
Illustration 18-24

Measures the percentage of earnings distributed in the form of cash


dividends.
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LO 5

Ratio Analysis
Solvency Ratios
Solvency ratios measure the ability of a company to survive
over a long period of time.

Debt to Assets and

Times Interest Earned

are two ratios that provide information about debtpaying ability.

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LO 5 Identify and compute ratios used in analyzing a


firms liquidity, profitability, and solvency.

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

Illustration 18-12

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LO 5

Ratio Analysis

Solvency Ratios

Debt to Total Assets Ratio


Illustration 18-25

Measures the percentage of the total assets that creditors provide.

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LO 5

QUALITY DEPARTMENT STORE INC.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets


For the Years Ended December 31

Condensed Income Statements


For the Years Ended December 31

Illustration 18-12

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LO 5

Ratio Analysis

Solvency Ratios

Times Interest Earned


Illustration 18-25

Provides an indication of the companys ability to meet interest


payments as they come due.
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LO 5

Ratio Analysis
Summary of Ratios
Illustration 18-27

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LO 5

Summary of Ratios
Illustration 18-27

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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.

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) 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 BD Inc. has income before income
taxes of $79,000,000. During 2014, BD discontinued and sold
its unprofitable chemical division. The loss in 2014 from
chemical operations (net of $135,000 taxes) was $315,000. The
loss on disposal of the chemical division (net of $81,000 taxes)
was $189,000. Assuming a 30% tax rate on income.

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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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LO 6

Earning Power and Irregular Items


Extraordinary Items
Nonrecurring material items that differ significantly from a
companys typical business activities.

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Must be both of an

Unusual Nature and

Occur Infrequently.

Must consider the environment in which it operates.

Amounts reported net of tax.

LO 6 Understand the concept of earning power,


and how irregular items are presented.

Earning Power and Irregular Items


Are these considered Extraordinary Items?
(a) A large portion of a tobacco manufacturers 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 Understand the concept of earning power,


and how irregular items are presented.

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 Understand the concept of earning power,


and how irregular items are presented.

Earning Power and Irregular Items


Illustration: In 2014 a foreign government expropriated property
held as an investment by DB Inc. If the loss is $770,000 before
applicable income taxes of $231,000, the income statement will
report a deduction of $539,000.

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LO 6 Understand the concept of earning power,


and how irregular items are presented.

Earning Power and Irregular Items


Extraordinary Items are
reported after Income
from continuing
operations.

Previously labeled as
Net Income.
Moved to

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LO 6 Understand the concept of earning power,


and how irregular items are presented.

Earning Power and Irregular Items


Reporting when both
Discontinued
Operations and
Extraordinary Items
are present.

Discontinued
Operations
Extraordinary Item

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LO 6 Understand the concept of earning power,


and how irregular items are presented.

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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.

Earning Power and Irregular Items


Comprehensive Income

All changes in stockholders


equity except those resulting
from investments by
stockholders and distributions
to stockholders.
Reported in Stockholders
Equity

Unrealized gains and


losses on available-forsale securities.
Plus other items

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LO 6 Understand the concept of earning power,


and how irregular items are presented.

Earning Power and Irregular Items


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.
The issue of quality of earnings has taken on increasing
importance because recent accounting scandals suggest that
some companies are spending too much time managing their
income and not enough time managing their business.

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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.

A Look at IFRS
Key Points

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The tools of financial statement analysis covered in this chapter are


universal and therefore no significant differences exist in the analysis
methods used.

The basic objectives of the income statement are the same under both
GAAP and IFRS. Thus, both the IASB and the FASB are interested in
distinguishing normal levels of income from irregular items in order to
better predict a companys future profitability.

The basic accounting for discontinued operations is the same under


IFRS and GAAP.

LO 8 Compare financial statement analysis and income


statement presentation under GAAP and IFRS..

A Look at IFRS
Key Points

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Under IFRS, there is no classification for extraordinary items. In other


words, extraordinary item treatment is prohibited under IFRS. All revenue
and expense items are considered ordinary in nature.

The accounting for changes in accounting principles and changes in


accounting estimates are the same for both GAAP and IFRS.

Both GAAP and IFRS follow the same approach in reporting


comprehensive income. The statement of comprehensive income can be
prepared under the one-statement approach or the two-statement
approach.

LO 8 Compare financial statement analysis and income


statement presentation under GAAP and IFRS..

A Look at IFRS
Key Points

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The issues related to quality of earnings are the same under both GAAP
and IFRS. It is hoped that by adopting a more principles-based
approach, as found in IFRS, many of the earnings quality issues will
disappear.

LO 8 Compare financial statement analysis and income


statement presentation under GAAP and IFRS..

A Look at IFRS
Looking to the Future
The FASB and the IASB are working on a project that would rework the
structure of financial statements. Recently, the IASB decided to require a
statement of comprehensive income, similar to what was required under
GAAP. In addition, another part of this project addresses the issue of how to
classify various items in the income statement. A main goal of this new
approach is to provide information that better represents how businesses
are run. In addition, the approach draws attention away from one number
net income.

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LO 8 Compare financial statement analysis and income


statement presentation under GAAP and IFRS..

A Look at IFRS
IFRS Self-Test Questions
The basic tools of financial analysis are the same under both GAAP and
IFRS except that:

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a)

horizontal analysis cannot be done because the format of the


statements is sometimes different.

b)

analysis is different because vertical analysis cannot be done


under IFRS.

c)

the current ratio cannot be computed because current liabilities


are often reported before current assets in IFRS statements of
position.

d)

None of the above.


LO 8 Compare financial statement analysis and income
statement presentation under GAAP and IFRS..

A Look at IFRS
IFRS Self-Test Questions
Under IFRS:

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a)

the reporting of discontinued items is different than GAAP.

b)

the reporting of extraordinary items is prohibited.

c)

the reporting of changes in accounting principles is different than


under GAAP.

d)

None of the above.

LO 8 Compare financial statement analysis and income


statement presentation under GAAP and IFRS..

A Look at IFRS
IFRS Self-Test Questions
Presentation of comprehensive income must be reported under IFRS in:

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a)

the statement of stockholders equity.

b)

the income statement ending with net income.

c)

the notes to the financial statements.

d)

a statement of comprehensive income.

LO 8 Compare financial statement analysis and income


statement presentation under GAAP and IFRS..

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