Financial Accounting, 4e

Weygandt, Kieso, & Kimmel

Prepared by
Gregory K. Lowry
Mercer University
Marianne Bradford
The University of Tennessee

John Wiley & Sons, Inc.

 CHAPTER 15
FINANCIAL STATEMENT ANALYSIS

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.
 CHAPTER 15
FINANCIAL STATEMENT ANALYSIS

After studying this chapter, you should be able to:

5 Identify and compute ratios and describe their
purpose and use in analyzing a firm’s liquidity,
profitability, and solvency.
6 Understand the concept of earning power and
indicate how material items not typical of
regular operations are presented.
7 Recognize the limitations of financial statement
analysis.
 PREVIEW OF CHAPTER 15
FINANCIAL STATEMENT ANALYSIS

Horizontal and Earning Power

Basics of Financial Limitations of
Vertical Ratio Analysis and Irregular
Statement Analysis Financial Analysis
Analysis Items

Need for  Balance sheet  Liquidity  Discontinued  Estimates
comparative operations 
 Income  Profitability Cost
analysis
statement  Extraordinary
 Solvency  Accounting
 Tools of analysis items
 Retained  methods
Summary
earnings  Change in 
Atypical data
statement accounting
principle 
Diversification
Comprehensive
income
 BASICS OF
FINANCIAL STATEMENT ANALYSIS
• Analyzing financial statements involves Three
characteristics of a company: 1 its liquidity, 2 its
profitability, and 3 its solvency.
• Every item reported in a financial statement has
significance.
• In order to obtain information as to whether the amount
1 represents an increase over prior years or 2 is
adequate in relation to the company’s need for cash,
the amount of cash must be compared with other financial
statement data.
• Comparisons can be made on several difference bases
– three are illustrated in this chapter: 1 intracompany
basis, 2 industry averages, and 3 intercompany basis.
 TOOLS OF
FINANCIAL STATEMENT ANALYSIS

Three commonly used tools are utilized to evaluate

the significance of financial statement data.
1 Horizontal analysis (trend analysis) is a technique
for evaluating a series of financial statement data
over a period of time.
2 Vertical analysis is a technique for evaluating
financial statement data that expresses each item
in a financial statement in terms of a percent of
a base amount.
3 Ratio analysis expresses the relationship among
selected items of financial statement data.
 ILLUSTRATION 15-1, 15-2
SEARS ROEBUCK’S NET SALES
SEARS, ROEBUCK AND CO.
(Net Sales Stated in Millions)

2000 1999 1998 1997 1996

$ 40,937 $ 39,484 $ 39,953 $ 39,837 $ 36,662

The purpose of horizontal analysis is to determine

the increase or decrease that has taken place,
expressed as either an amount or a percentage.
The recent net sales figures of Sears, Roebuck and
Co. are shown above. Given that 1996 is the base
year, we can measure all percentage increases or
decreases from this base period amount as shown
below.

Change since base

period =
 ILLUSTRATION 15-4
HORIZONTAL ANALYSIS OF SEARS,
ROEBUCK’S NET SALES

We can determine that net sales for Sears,

Roebuck increased approximately 8.7% [($39,837
- $36,662) ÷ $36,662] from 1996 to 1997. We can
also determine that net sales increased over 11.7%
[($40,937 - $36,662) ÷ $36,662] from 1996 to 2000.
The percentage of the base period for each of the 5
years, assuming 1996 as the base period, is shown
below.

Sears, Roebuck and Co.

Net Sales (in Millions)
Base Period 1996

2000 1999 1998 1997 1996

$40,937 $ 39,484 $ 39,953 $ 39,837 $36,662
111.7% 107.7% 109% 108.7% 100%
 ILLUSTRATION 15-5
HORIZONTAL ANALYSIS OF A
BALANCE SHEET
The 2-year condensed
balance sheet of Quality
Department Store Inc. for QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheet
2000 and 1999 showing December 31
dollar and percentage
Increase or (Decrease)
changes is displayed on the during 2000
right. In the asset section, 2000 1999 Amount Percentage
plant assets (net) increased Assets
Current assets $ 1,020,000 $ 945,000 $ 75,000 7.9%
$167,500 or 26.5%. In the Plant assets (net) 800,000 632,500 167,500 26.5%
liabilities section, current Intangible assets 15,000 17,500 ( 2,500) ( 14.3%)
liabilities increased $41,500 Total assets $ 1,835,000 $ 1,595,000 $ 240,000 15.0%
Liabilities
or 13.7%. In the
Current liabilities $ 344,500 $ 303,000 $ 41,500 13.7%
stockholders’ equity section, Long-term liabilities 487,500 497,000 ( 9,500) ( 1.9%)
retained earnings increased Total liabilities 832,000 800,000 32,000 4.0%
$202,600 or 38.6%. It Stockholders’ Equity
Common stock, $1 par 275,400 270,000 5,400 2.0%
appears the company Retained earnings 727,600 525,000 202,600 38.6%
expanded its asset base Total stockholders’ equity 1,003,000 795,000 208,000 26.2%
during 2000 and financed the Total liabilities and stockholders’ equity $ 1,835,000 $ 1,595,000 $ 240,000 15.0%

expansion by retaining
income in the firm.
 ILLUSTRATION 15-6
HORIZONTAL ANALYSIS OF AN
INCOME STATEMENT
The 2-year comparative
income statement of Quality
Department Store Inc. for QUALITY DEPARTMENT STORE INC.
2000 and 1999 is shown in Condensed Income Statement
condensed form on the right. For the Years Ended December 31
Horizontal analysis of the Increase or (Decrease)
comparative income during 2000
statement shows the 2000 1999 Amount Percentage
following changes: Sales $ 2,195,000 $ 1,960,000 $ 235,000 12.0%
Sales returns and allowances 98,000 123,000 ( 25,000) ( 20.3%)
1 Net sales increased Net sales 2,097,000 1,837,000 260,000 14.2%
$260,000, or 14.2% Cost of goods sold 1,281,000 1,140,000 141,000 12.4%
($260,000 ÷ $1,837,000). Gross profit 816,000 697,000 119,000 17.1%
Selling expenses 253,000 211,500 41,500 19.6%
2 Cost of goods sold Administrative expenses 104,000 108,500 ( 4,500) ( 4.1%)
increased $141,000, or Total operating expenses 357,000 320,000 37,000 11.6%
12.4% ($141,000 ÷ Income from operations 459,000 377,000 82,000 21.8%
$1,140,000). Other revenues and gains
Interest and dividends 9,000 11,000 ( 2,000) ( 18.2%)
3 Total operating expenses Other expenses and losses
increased $37,000, or Interest expense 36,000 40,500 ( 4,500) ( 11.1%)
11.6% ($37,000 ÷ Income before income taxes 432,000 347,500 84,500 24.3%
Income tax expense 168,200 139,000 29,200 21.0%
$320,000). Net income $ 263,800 $ 208,500 $ 55,300 26.5%
 ILLUSTRATION 15-7
HORIZONTAL ANALYSIS OF A
RETAINED EARNINGS STATEMENT

The 2-year comparative

retained earnings
statement of Quality
Department Store Inc.
for 2000 and 1999 is QUALITY DEPARTMENT STORE INC.
presented on the right. Retained Earnings Statement
For the Years Ended December 31
Analyzed horizontally:
Increase or (Decrease)
1 Net income increased during 2000
$55,300, or 26.5%. 2000 1999 Amount Percentage
Retained earnings, January 1 $ 525,000 $ 376,500 $ 148,500 39.4%
2 Common dividends Add: Net income 263,800 208,500 55,300 26.5%
increased only $1,200, 788,800 585,000 203,800
Deduct: Dividends 61,200 60,000 1,200 2.0%
or 2%. Retained earnings, December 31 $ 727,600 $ 525,000 $ 202,600 38.6%
3 Ending retained
earnings increased
38.6%.
 ILLUSTRATION 15-8
VERTICAL
ANALYSIS OF A
Presented on the right is the
BALANCE SHEET
2-year comparative balance
sheet of Quality Department QUALITY DEPARTMENT STORE INC.
Store Inc. for 2000 and 1999. Condensed Balance Sheet
December 31
1 Current assets increased
$75,000 from 1999 to 2000, 2000 1999
they decreased from Amount Percent Amount Percent
59.2% to 55.6% of total Assets
Current assets $ 1,020,000 55.6% $ 945,000 59.2%
assets. Plant assets (net) 800,000 43.6% 632,500 39.7%
2 Plant assets (net) increased Intangible assets 15,000 0.8% 17,500 1.1%
Total assets $ 1,835,000 100.0% $ 1,595,000 100.0%
from 39.7% to 43.6% of
Liabilities
total assets, and Current liabilities $ 344,500 18.8% $ 303,000 19.0%
3 Retained earnings increased Long-term liabilities 487,500 26.5% 497,000 31.2%
from 32.9% to 39.7% of Total liabilities 832,000 45.3% 800,000 50.2%
Stockholders’ Equity
total liabilities and Common stock, $1 par 275,400 15.0% 270,000 16.9%
stockholders’ equity. Retained earnings 727,600 39.7% 525,000 32.9%
These results reinforce earlier Total stockholders’ equity 1,003,000 54.7% 795,000 49.8%
Total liabilities and stockholders’ equity $ 1,835,000 100.0% $1,595,000 100.0%
observations that Quality is
financing its growth through
retention of earnings.
 ILLUSTRATION 15-9
VERTICAL
ANALYSIS OF AN
Vertical analysis of the INCOME STATEMENT
2-year comparative income
2-year comparative income
statement of Quality QUALITY DEPARTMENT STORE INC.
Department Store Inc. for Condensed Income Statement
2000 and 1999 is shown on For the Years Ended December 31
the right.
2000 1999
1 Cost of goods sold as a Amount Percent Amount Percent
percentage of net sales Sales $ 2,195,000 104.7% $ 1,960,000 106.7%
declined 1% (62.1% Sales returns and allowances 98,000 4.7% 123,000 6.7%
Net sales 2,097,000 100.0% 1,837,000 100.0%
versus 61.1%). Cost of goods sold 1,281,000 61.1% 1,140,000 62.1%
2 Total operating expenses Gross profit 816,000 38.9% 697,000 37.9%
declined 0.4% (17.4% Selling expenses 253,000 12.0% 211,500 11.5%
Administrative expenses 104,000 5.0% 108,500 5.9%
versus 17.0%). Total operating expenses 357,000 17.0% 320,000 17.4%
3 Net income as a percent of Income from operations 459,000 21.9% 377,000 20.5%
net sales therefore Other revenues and gains
Interest and dividends 9,000 0.4% 11,000 0.6%
increased from 11.4% to Other expenses and losses
12.6%. Interest expense 36,000 1.7% 40,500 2.2%
Quality appears to be a Income before income taxes 432,000 20.6% 347,500 18.9%
Income tax expense 168,200 8.0% 139,000 7.5%
profitable enterprise that is Net income $ 263,800 12.6% $ 208,500 11.4%
becoming more successful.
 ILLUSTRATION 15-10
INTERCOMPANY
INCOME STATEMENT
Vertical analysis enables you COMPARISON
to compare companies of different sizes. Quantity’s
major competitor is a Sears store in a town nearby town. Using vertical analysis,
the small Quality Department Store Inc. can be meaningfully compared to the
much larger Sears, as shown below. 1 Gross profit rates were somewhat
comparable at 38.9% and 34.3%. 2 Income from operations percentages were
significantly different at 21.9% and 5.3% . 3 Quality’s selling and administrative
expenses percentage was much lower than Sears’ – 17% to 28.9%. 4 Sears’ net
income as a percentage of sales was much lower than Quality’s: 3.3% to 12.6%.
CONDENSED INCOME STATEMENTS

Quality
Department Sears, Roebuck
Store Inc. And Co.
(in thousands) Dollars Percent Dollars Percent
Net sales $ 2,097 100.0% $ 46,937,000 100.0%
Cost of goods sold 1,281 61.1% 26,899,000 65.7%
Gross profit 816 38.9% 14,038,000 34.3%
Selling and administrative expenses 357 17.0% 11,851,000 28.9%
Income from operations 459 21.9% 2,187,000 5.3%
Other expenses and revenues (including income taxes 195 9.3% 884,000 2.1%
Net income $ 264 12.6% $ 1,343,000 3.3%
 RATIO ANALYSIS
• Ratio analysis expresses the relationship among selected items of
financial statement data.
• A ratio expresses the mathematical relationship between one
quantity and another.
• A single ratio by itself is not very meaningful, in the upcoming
illustrations we will use:
1 Intracompany comparisons covering two years for the
Quality Department Store.
2 Industry average comparisons based on median ratios for
department stores
3 Intercompany comparisons based on Sears, Roebuck and Co. as
Quality Department Store’s principal competitor.
 ILLUSTRATION 15-11
FINANCIAL RATIO CLASSIFICATIONS

Liquidity Ratios
Measures of short-term ability
of the enterprise to pay its
maturing obligations and to
meet unexpected needs for cash

Profitability Ratios
Revenues Expenses

-
Measures of the income or

= Net
Income
operating success of an
enterprise for a given period of
time

Solvency Ratios
Measures of the ability of the
XYZ Co. enterprise to survive over a
long period of time
 ILLUSTRATION 15-12
CURRENT RATIO
The current ratio (working capital ratio) is a widely used measure for evaluating a company’s
liquidity and short-term debt-paying ability. It is calculated by dividing current assets by current
liabilities and is a more dependable indicator of liquidity than working capital. The current ratios for
Quality Department Store and comparative data are shown below.

CURRENT ASSETS
CURRENT RATIO =
———————————

Quality Department Store

2000 1999
CURRENT LIABILITIES
$1,020,000 $945,000
—————= 2.96:1 ————= 3.1:1
$344,500 $303,000
Industry average Sears, Roebuck and Co.
———————— ———————————
1.34:1 2.38:1
 ILLUSTRATION 15-13
CURRENT ASSETS OF
QUALITY DEPARTMENT STORE

2000 1999
Current assets
Cash $ 100,000 $ 155,000
Temporary invest. 20,000 70,000
Receivables (net) 230,000 180,000
Inventory 620,000 500,000
Prepaid expenses 50,000 40,000
Total current assets $ 1,020,000 $ 945,000
 ILLUSTRATION 15-14
ACID-TEST RATIO
The acid-test ratio (quick ratio) is a measure of a company’s short-term liquidity and is calculated
by dividing the sum of cash, marketable securities, and net receivables by current liabilities. The
acid-test ratios for Quality Department Store and comparative data are shown below.

CASH + MARKETABLE SECURITIES + RECEIVABLES (NET)

ACID-TEST RATIO = ————————————————————————————

CURRENT LIABILITIES
Quality Department Store
2000 1999

$100,000 + $20,000 + $230,000 $155,000 + $70,000 + $180,000

—————————————— = 1.0:1 —————————————— = 1.3:1
$344,500 $303,000

Industry average Sears, Roebuck and Co.

———————— ———————————
1.3:1 1.3:1
 ILLUSTRATION 15-15
CURRENT CASH DEBT COVERAGE RATIO
The current cash debt coverage ratio usually provides a superior representation of liquidity since it
uses not cash provided by operating activities rather than a balance at a point in time. Quality
Department Store’s current cash debt coverage ratios for 2000 and 1999 are calculated below.

CURRENT CASH DEBT NET CASH PROVIDED BY OPERATING ACTIVITIES

COVERAGE RATIO =
————————————————————————
Quality Department Store
2000 LIABILITIES
AVERAGE CURRENT 1999

$404,000 $340,000
—————————— - 1.25:1 —————————— - 1.15:1

[ ] [ ]
$303,000 + $344,500 $290,000 + $303,000
—————————— ——————————
2 2

Industry average Sears, Roebuck & Co.

———————— ———————————
1.1:1 0.137:1
 ILLUSTRATION 15-16
RECEIVABLES TURNOVER
The receivables turnover ratio is used to assess the liquidity of the receivables. It measures the
number of times, on average, receivables are collected during the period. The ratio is calculated by
dividing net credit sales by average net receivables during the year. The receivables turnover ratio
and comparative data for Quality Department Store for 2000 and 1999 are calculated below.

NET CREDIT SALES

RECEIVABLES TURNOVER =
———————————————

Quality Department Store

AVERAGE NET RECEIVABLES
2000 1999

$2,097,000 $1,837,000
——————————= 10.2 times ——————————= 9.7 times

[ ] [ ]
$180,000 + $230,000 $200,000 + $180,000
—————————— ——————————
2 2

Industry average Sears, Roebuck & Co.

———————— ———————————
15.7 times 2.19 times
 ILLUSTRATION 15-17
INVENTORY TURNOVER
The inventory turnover ratio measures the number of times, on average, the inventory is sold during
the period – which measures the liquidity of the inventory. It is calculated by dividing cost of goods
sold by average inventory during the year. The inventory turnover ratio and comparative data for
Quality Department Store for 2000 and 1999 are calculated below.

COST OF GOODS SOLD

INVENTORY TURNOVER =
————————————

Quality Department Store

2000
AVERAGE INVENTORY 1999

$1,281,000 $1,140,000
—————————— = 2.3 times —————————— = 2.4 times

[ ] [ ]
$500,000 + $620,000 $450,000 + $500,000
—————————— ——————————
2 2

Industry average Sears, Roebuck and Co.

———————— ———————————
6.22 times 4.61 times
 ILLUSTRATION 15-18
PROFIT MARGIN RATIO
The profit margin ratio is a measure of the percentage of each dollar of sales
that results in net income. It is calculated by dividing net income by net sales
for the period. The profit margin ratios and comparative data for Quality
Department Store for 2000 and 1999 are calculated below.

NET INCOME
PROFIT MARGIN ON
SALES = ——————

Quality Department Store

2000 1999
NET SALES

$263,800 $208,500
————— = 12.6% ————— = 11.4%
$2,097,000 $1,837,000
Industry average Sears, Roebuck and Co.
———————— ———————————
3.16% 1.8%
 ILLUSTRATION 15-19
CASH RETURN ON SALES RATIO
The cash basis counterpart of the profit margin ratio is the cash return on sales
ratio which uses net cash provided by operating activities as the numerator and
net sales as the denominator. Using net cash provided by operating activities of
$404,000 in 2000 and $340,000 in 1999, Quality Department Store’s cash return on
sales ratios are calculated and evaluated below.

NET CASH PROVIDED BY OPERATING ACTIVITIES

CASH RETURN ON SALES RATIO =
—————————————————————————

NET
SALES
Quality Department Store
2000 1999

$404,000 $340,000
————— = 19.3% ————— = 18.5%
$2,097,000 $1,837,000
Industry average Sears, Roebuck and Co.
———————— ———————————
6.2% 7.4%
 ILLUSTRATION 15-20
ASSET TURNOVER
The asset turnover ratio measures how efficiently a company uses its asset to generate
sales. It is determined by dividing net sales by average assets for the period. Quality
Department Store’s cash return on sales ratios are calculated and evaluated below.

NET SALES
ASSET TURNOVER =
—————————

Quality Department Store

2000 1999
AVERAGE ASSETS
$2,097,000 $1,837,000
—————————— = 1.2 times——————————— = 1.21 times

[ $1,595,000 + $1,835,000
———————————
2 ] [
$1,446,000 + $1,595,000
———————————
2 ]
Industry average Sears, Roebuck & Co.
———————— ———————————
2.32 times 1.1 times
 ILLUSTRATION 15-21

RETURN ON ASSETS
An overall measure of profitability is the return on assets ratio. It is calculated by
dividing net income by average assets for the period. Quality Department Store’s
return on assets ratios for 2000 and 1999 are calculated and evaluated below.

NET INCOME
RETURN ON ASSETS =
—————————

Quality Department Store

2000 AVERAGE ASSETS 1999

$263,800 $208,500
——————————— = 15.4% ——————————— = 13.7%

[ ] [ ]
$1,595,000 + $1,835,000 $1,446,000 + $1,595,000
——————————— ———————————
2 2

Industry average Sears, Roebuck & Co.

———————— ———————————
7.42% 1.99%
 ILLUSTRATION 15-22
RETURN ON COMMON
STOCKHOLDERS’ EQUITY
A ratio that measures profitability from the viewpoint of the common stockholder is
return on common stockholders’ equity. It is calculated by dividing net income by
average common stockholders’ equity for the period. Quality Department Store’s return
on common stockholders’ equity for 2000 and 1999 are calculated and evaluated below.

RETURN ON COMMON NET INCOME

STOCKHOLDERS’ EQUITY =
———————————————————————

Quality Department Store AVERAGE

COMMON STOCKHOLDERS’ EQUITY
2000 1999

$263,800 $208,500
——————————— = 29.3% ——————————— = 28.5%

[ ] [ ]
$795,000 + $1,003,000 $667,000 + $795,000
——————————— ———————————
2 2

Industry average Sears, Roebuck and Co.

———————— ———————————
18.6% 10.9%
 ILLUSTRATION 15-23
RETURN ON COMMON STOCKHOLDERS’
EQUITY WITH PREFERRED STOCK

When preferred stock is present, preferred

dividend requirements are deducted from net
income to determine income available to common
stockholders. The par value of preferred stock (or
call price – if applicable) must be deducted from
total stockholders’ equity to arrive at the amount
of common stockholders’ equity used in this ratio.
The ratio then appears as shown below.

RATE OF RETURN ON COMMON NET INCOME – PREFERRED DIVIDENDS

STOCKHOLDERS’ EQUITY =
———————————————————————

AVERAGE COMMON
 ILLUSTRATION 15-24
EARNINGS PER SHARE
Earnings per share (EPS) of common stock is a measure of net income earned on
each share of common stock. It is calculated by dividing net income by the
number of weighted average common shares outstanding during the year. Quality
Department Store’s EPS for 2000 and 1999 are calculated and evaluated below.

EARNINGS NET INCOME

PER SHARE = ————————————————————————————

WEIGHTED AVERAGE COMMON SHARES OUTSTANDING

Quality Department Store
2000 1999

$263,000 $208,500
————————— - $.97 ————— - $.77

[ ]
270,000 + 275,400 270,000
—————————
2
 ILLUSTRATION 15-25
PRICE-EARNINGS RATIO
The price-earnings (PE) ratio measures the ratio of the market price of each share
of common stock to the earnings per share. It is calculated by dividing the market
price per share of common stock by earnings per share. Quality Department
Store’s PE ratios for 2000 and 1999 are calculated and evaluated below.

MARKET PRICE PER SHARE OF COMMON STOCK

PRICE-EARNINGS RATIO =
—————————————————————————

EARNINGS PER
SHARE
Quality Department Store
2000 1999

$12.00 $ 8.00
——— = 12.4 times ——— = 10.4 times
$ .97 $ .77
Industry average Sears, Roebuck and Co.
———————— ———————————
33 times 22 times
 ILLUSTRATION 15-26

PAYOUT RATIO
The payout ratio measures the percentage of earnings distributed in the
form of cash dividends. It is calculated by dividing cash dividends by net
income. Quality Department Store’s payout ratios for 2000and 1999 are
calculated and evaluated below.

CASH DIVIDENDS

PAYOUT RATIO =
—————————
Quality Department Store
2000 1999

$61,200 NET INCOME $60,000

————— = 23.2% ————— = 28.8%
$263,800 $208,500
Industry average Sears, Roebuck and Co.
———————— ———————————
17.5% 44.5%
 ILLUSTRATION 15-27
DEBT TO TOTAL ASSETS
The debt to total assets ratio measures the percentage of total assets
provided by creditors, indicating the degree of leveraging. It is calculated
by dividing total debt by total assets. Quality Department Store’s total debt
to total assets ratios for 2000 and 1999 are calculated and evaluated below.

TOTAL DEBT

DEBT TO TOTAL ASSETS = ————————

Quality Department Store

2000 1999
TOTAL ASSETS
$832,000 $800,000
————— = 45.3% ————— = 50.2%
$1,835,000 $1,595,000
Industry average Sears, Roebuck and Co.
———————— ———————————
42.0% 81.7%
 ILLUSTRATION 15-28
TIMES INTEREST EARNED
The times interest earned ratio provides an indication of the company’s ability to
meet interest payments as they come due. It is calculated by dividing income before
income taxes and interest expense by interest expense. Quality Department Store’s
times interest earned ratios for 2000 and 1999 are calculated and evaluated below.

TIMES INTEREST INCOME BEFORE INCOME TAXES AND INTEREST EXPENSE

EARNED =
—————————————————————————————
Quality Department Store
2000
INTEREST EXPENSE 1999

$468,000 $388,000
————= 13 times ————= 9.6 times
$36,000 $40,500

Industry average Sears, Roebuck and Co.

———————— ———————————
7.39 times 1.86 times
 ILLUSTRATION 15-29
CASH DEBT COVERAGE RATIO
The ratio of net cash provided by operating activities to average total liabilities is the
cash debt coverage ratio and is a measure of solvency. Quality Department Store’s
cash debt coverage ratios for 2000 and 1999 are calculated and evaluated below.

NET CASH PROVIDED BY OPERATING ACTIVITIES

CASH DEBT COVERAGE RATIO =
—————————————————————————

Quality Department Store AVERAGE

TOTAL LIABILITIES
2000 1999

$404,000 $340,000
—————————— = .495 times —————————— = .442 times

[ ] [ ]
$800,000 + $832,000 $740,000 + $800,000
——————————— ———————————
2 2

Industry average Sears, Roebuck and Co.

———————— ———————————
.38 times .09 times
 ILLUSTRATION 15-30
SUMMARY OF LIQUIDITY,
PROFITABILITY, AND SOLVENCY RATIOS
 ILLUSTRATION 15-30
SUMMARY OF LIQUIDITY,
PROFITABILITY, AND SOLVENCY RATIOS
 ILLUSTRATION 15-30
SUMMARY OF LIQUIDITY,
PROFITABILITY, AND SOLVENCY RATIOS
 ILLUSTRATION 15-30
SUMMARY OF LIQUIDITY,
PROFITABILITY, AND SOLVENCY RATIOS
 EARNING POWER AND
IRREGULAR ITEMS
• For users of financial statements to
determine earning power or regular
income, the irregular items are
separately identified on the income
statement.
• Three types of irregular items are reported:
1 Discontinued operations,
2 Extraordinary items, and
3 Changes in accounting principle.
 DISCONTINUED
OPERATIONS
• Discontinued operations constitutes
the disposal of a significant segment of a
business.
• The income (loss) from discontinued
operations consists of
1 the income (loss) from operations and
2 the gain (loss) on disposal of the
segment.
 ILLUSTRATION 15-31
STATEMENT PRESENTATION OF
DISCONTINUED OPERATIONS
Acro Energy Inc. has revenues of $2.5 million and expenses of $1.7 million
from continuing operations in 2002. The company therefore has income before
income taxes of $800,000. The company discontinued and sold its unprofitable
chemical division during 2002. The 2002 loss from chemical operations was
$140,000 (net of $60,000 in income taxes), and the loss on disposal of the
chemical division (net of $30,000 in income taxes), was $70,000. Given a 30%
income tax rate, the partial income statement presentation is shown below.
 EXTRAORDINARY
ITEMS
• Extraordinary items are events and
transactions that meet two conditions:
they are
1 unusual in nature and
2 infrequent in occurrence.
• Extraordinary items are reported net
of taxes in a separate section of the
income statement immediately below
discontinued operations.
 ILLUSTRATION 15-32
EXAMPLES OF
EXTRAORDINARY AND
ORDINARY ITEMS

SALE

ED
ND EMN
CO

4. Destruction of property by
fire or explosion
 ILLUSTRATION 15-33
STATEMENT PRESENTATION OF
EXTRAORDINARY ITEMS
In 2002 a revolutionary foreign government expropriated property
held as an investment by Acro Energy Inc. If the loss is $70,000,
before applicable income taxes of $21,000, the partial income
statement presentation will show a deduction of $49,000 – as shown
below.
ACRO ENERGY INC.
Partial Income Statement
For the Year Ended December 31, 2002

Income before income taxes $800,000

Income tax expense 240,000
Income 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 70,000 210,000
Income before extraordinary item 350,000
Extraordinary item
Expropriation of investment, net of $21,000 income tax saving 49,000
Net income $ 301,000
 CHANGE IN
ACCOUNTING PRINCIPLE
• To make them comparable, financial statements
are expected to be prepared on a basis consistent
with that used in the preceding period.
• A change in accounting principle occurs when the
principle used in the current year is different from
the one used in the preceding year.
• A change is permitted when
1 management can show that the new principle is
preferable to the old principle and
2 the effects of the change are clearly disclosed in
the income statement.
 CHANGE IN
ACCOUNTING PRINCIPLE
When a change in accounting principle has
occurred,
1 the new principle should be used in
reporting the results of operations of the
current year and
2 the cumulative effect of the change on all
prior year income statements should be
disclosed net of applicable income taxes in
a special section immediately preceding net
income.
 ILLUSTRATION 15-34
STATEMENT PRESENTATION OF CUMULATIVE
EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE
At the beginning of 2002, Acro Energy Inc. changes from the straight-line method of
depreciation to the declining-balance method for equipment purchased on January 1,
1999. Assuming a 30% income tax rate the net of income tax effect of the change is
$16,800 ($24,000 X 70%). The partial income statement presentation is shown below.
 LIMITATIONS OF
FINANCIAL ANALYSIS
You should be aware of some of the limitations of the
three analytical tools illustrated in the chapter and of the
financial statements on which they are based.
1 Estimates: Financial statements contain numerous
estimates; to the extent that these estimates are
inaccurate, the financial ratios and percentages
are inaccurate.
2 Cost: Traditional financial statements are based on
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.
 LIMITATIONS OF
FINANCIAL ANALYSIS
3 Alternative Accounting Methods: Variations among companies in
the application of GAAP may hamper comparability. Although
differences in accounting methods might be detectable from reading
the notes to the financial statements, adjusting the financial data to
compensate for the different methods is difficult, if not impossible, in
some cases.
4 Atypical Data: Fiscal year-end data may not be typical of the
financial condition during the year. Firms often establish a fiscal
year-end that coincides with the low point in operating activity or
in inventory levels. Thus, certain account balances may not be
representative of the account balances during the year.
5 Diversification of Firms: Diversification in American industry also
restricts the usefulness of financial analysis. Many firms today are
too diversified to be classified by industry, while others appear to be
comparable when they are not.
 COPYRIGHT

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 CHAPTER 15
FINANCIAL STATEMENT ANALYSIS