Accounting Principles: Financial Analysis: The Big Picture

Accounting Principles
Thirteenth Edition
Weygandt Kimmel Kieso
Chapter 18
Financial Analysis:
The Big Picture
Prepared by
Coby Harmon
University of California, Santa Barbara
Westmont College
Chapter 18
Financial Analysis:
The Big Picture
Chapter Outline
Learning Objectives
LO 1 Apply horizontal and vertical analysis to financial
statements.
LO 2 Analyze a company’s performance using ratio analysis.
LO 3 Apply the concept of sustainable income.
Copyright ©2019 John Wiley & Son, Inc. 3

Basics of Financial Statement Analysis
Apply horizontal and vertical analysis to financial statements.
Comparison Tools of
Characteristics
Bases Analysis
 Liquidity  Intracompany  Horizontal

 Profitability  Industry  Vertical
 Solvency averages  Ratio
 Intercompany
LO 1 Copyright ©2019 John Wiley & Son, Inc. 4

Horizontal Analysis
Horizontal analysis, also called trend analysis, is a
technique for evaluating a series of financial statement data
over a period of time.
 Purpose is to determine the increase or decrease.
 Commonly applied to the
► statement of financial position,
► income statement, and
► statement of retained earnings.

Horizontal Analysis
Illustration 18.5
Horizontal analysis of
statements of financial
position
Changes suggest that the

company expanded its asset
base during 2020 and
financed this expansion
primarily by retaining
income rather than
assuming additional long-
term debt.

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%.
Quality’s profit trend
appears favorable.

Horizontal Analysis
Illustration 18.7
Horizontal analysis of The ending retained earnings increased 38.6%. As indicated
retained earnings
statements
earlier, the company retained a significant portion of net
income to finance additional plant facilities.

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 (see Decision Tools).
 On an income statement, we might say that selling
expenses are 16% of net sales.
 Vertical analysis is commonly applied to the
► statement of financial position and
► income statement.

Vertical Analysis
Illustration 18.8
Vertical analysis of
statements of financial
position
Quality is choosing to
finance its growth
through retention of
earnings rather than
through issuing
additional debt.
HELPFUL HINT
The formula for calculating
these statement of financial
position percentages is:
Each item
=%
Total assets

Vertical Analysis
Illustration 18.9
Vertical analysis of
income statements
Quality appears
to be a profitable
enterprise that is
becoming even more
successful.

Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 18.10
Intercompany income statement comparison

DO IT! 1 Horizontal Analysis

Ratio Analysis
Ratio analysis expresses the relationship among selected
items of financial statement data.
Financial Ratio Classifications
Liquidity Profitability Solvency
Measures short-term Measures the Measures the ability

ability of the company income or operating of the company to
to pay its maturing success of a survive over a long
obligations and to company for a given period of time.
meet unexpected period of time.
needs for cash.

Ratio Analysis
A single ratio by itself is not very meaningful.
The discussion of ratios includes 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 principal competitor.

Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for cash.
 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.

QUALITY DEPARTMENT STORE
Condensed Income Statements
Statement of Financial Position
For the Years Ended December 31

Ratio Analysis
Liquidity Ratios
1. CURRENT RATIO Illustration 18.12
Ratio of 2.96:1 means that for every euro of current liabilities, Quality
has €2.96 of current assets.
Ratio Analysis
Liquidity Ratios
2. ACID-TEST RATIO
Illustration 18.13

QUALITY DEPARTMENT STORE QUALITY DEPARTMENT STORE
Statement of Financial Position Statement of Financial Position
Illustration 14-12

Ratio Analysis
Liquidity Ratios
2. ACID-TEST RATIO
Illustration 18.14
Acid-test ratio measures immediate liquidity.


Liquidity Ratios
Ratio Analysis
3. ACCOUNTS RECEIVABLE TURNOVER
Illustration 18.15
Measures the number of times, on average, the company collects

receivables during the period.
Ratio Analysis Liquidity Ratios
3. ACCOUNTS RECEIVABLE TURNOVER
€2,097,000
= 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.

Illustration 14-12

Liquidity Ratios
Ratio Analysis
4. INVENTORY TURNOVER Illustration 18.16
Measures the number of times, on average, the inventory is sold

during the period.
Ratio Analysis Liquidity Ratios
4. INVENTORY TURNOVER
€1,281,000
= 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.

Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for a

given period of time.
 Income affects the company’s ability to obtain debt and
equity financing, their liquidity position, and their ability to
grow.
 Ratios include the profit margin, asset turnover, return
on assets, return on ordinary shareholders’ equity,
earnings per share, price-earnings ratio, and payout
ratio.
Condensed Statements of Financial Position

Ratio Analysis Profitability Ratios
5. PROFIT MARGIN
Illustration 18.17
Measures the percentage of each euro of sales that results in net

income.
Illustration 14-12

Ratio Analysis
6. ASSET TURNOVER Illustration 18.18
Measures how efficiently a company uses its assets to generate

sales.
Illustration 14-12

7. RETURN ON ASSETS
Illustration 18.19
An overall measure of profitability.

Illustration 14-12

Ratio Analysis
8. RETURN ON ORDINARY SHAREHOLDERS’ EQUITY
Illustration 18.20
Shows how many euros of net income the company earned for each
euro invested by the owners.
8. RETURN ON ORDINARY SHAREHOLDERS’ EQUITY

With Preference Shares
 Deduct preferred dividend from net income.
Illustration 18.20
Return on ordinary shareholders’ equity

Illustration 14-12

9. EARNINGS PER SHARE (EPS)

Illustration 18.21
A measure of the net income earned on each ordinary share.

Illustration 14-12

10. PRICE-EARNINGS RATIO

Illustration 18.22
Reflects investors’ assessments of a company’s future earnings.

Illustration 14-12

11. PAYOUT RATIO
Illustration 18.23
Measures the percentage of earnings distributed in the form of cash

dividends.

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 debt-paying

ability.

Illustration 14-12

Solvency Ratios
Ratio Analysis
12. DEBT TO TOTAL ASSETS RATIO
Illustration 18.24
Measures the percentage of the total assets that creditors provide.

Illustration 14-12

Ratio Analysis Solvency Ratios
13. TIMES INTEREST EARNED Illustration 18.25
Provides an indication of the company’s

ability to meet interest payments as they
come due.
Ratio Analysis
Summary of Ratios
Illustration 18.26

Summary of Ratios Illustration 18.26

Sustainable Income
Sustainable income is the most likely level of income to be
obtained by a company in the future. It differs from actual net
income by the amount of unusual revenues, expenses,
gains, and losses included in the current year’s income.
Information on unusual items such as gains or losses on

discontinued items and components of other comprehensive
income are disclosed.
These unusual items are reported net of income taxes.

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).

Illustration: 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 NT$60,000
taxes) was NT$140,000. The loss on disposal of the chemical
division (net of $30,000 taxes) was NT$70,000. Assuming a
30% tax rate on income:

Discontinued Operations are reported after “Income from continuing
operations.”
Income before income taxes NT$800,000

Income tax expense 240,000
Previously
Previously labeled
labeled as
as Income from continuing operations 560,000
Discontinued operations
“Net
“Net Income”.
Income”. Loss from operations of chemical division,
net of NT$60,000 income tax savings NT$140,000
Loss from disposal of chemical division,
net of NT$30,000 income tax savings 70,000 210,000
Moved to
Net income NT$350,000

Comprehensive Income
Illustration: During 2020 Stassi AG purchased shares for €10,000 as
an investment. At the end of 2020, Stassi was still holding the
investment, but the shares’s 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 Stassi classifies the shares as trading security or
non-trading.
Trading securities: Unrealized gains and losses are reported in the

“Other expenses and losses” section of the income statement.
Non-trading securities: Unrealized gains and losses are reported as

a direct adjustment to equity.
Assume Stassi AG has a net income of €300,000, the unrealized loss
would be reported below net income as shown:

Assume Stassi Corporation has ordinary shares of €3,000,000,
retained earnings of €1,500,000, and accumulated other
comprehensive loss of €2,000. Illustration 18.30 shows the statement
of financial position presentation of the unrealized loss.
Illustration 18.30
Unrealized loss in equity section

DO IT! 3 Unusual Items
In its proposed 2020 statement of comprehensive income, AIR
plc 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
rate is 30%.
Prepare a correct statement of comprehensive income,
beginning with “Income before income taxes.”

DO IT! 3 Unusual Items
AIR PLC
2020

A Look at U.S. GAAP
Key Points
Similarities
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. As indicated in the textbook, a very important
objective is to ensure that users of the income statement can
evaluate the earning power of the company. Thus, both the IASB and
the FASB are interested in distinguishing normal levels of income
from unusual items in order to better predict a company’s future
profitability.
A Look at U.S. GAAP
Key Points
Similarities
The basic accounting for discontinued operations is the same under
IFRS and GAAP.
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.
Differences
None

A Look at U.S. GAAP
Looking to the Future
The FASB and the IASB are working on a project that would rework the
structure of financial statements. One 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.

Copyright
Copyright © 2019 John Wiley & Sons, Inc.
All rights reserved. Reproduction or translation of this work beyond that permitted in
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Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies
for his/her own use only and not for distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages, caused by the use of these programs or
from the use of the information contained herein.
Copyright ©2019 John Wiley & Son, Inc. 63

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Accounting Principles

Copyright ©2019 John Wiley & Son, Inc. 3

 Liquidity  Intracompany  Horizontal

LO 1 Copyright ©2019 John Wiley & Son, Inc. 4

► income statement, and

► statement of retained earnings.

LO 1 Copyright ©2019 John Wiley & Son, Inc. 5

Changes suggest that the

LO 1 Copyright ©2019 John Wiley & Son, Inc. 6

Overall, gross profit

LO 1 Copyright ©2019 John Wiley & Son, Inc. 7

LO 1 Copyright ©2019 John Wiley & Son, Inc. 8

LO 1 Copyright ©2019 John Wiley & Son, Inc. 9

LO 1 Copyright ©2019 John Wiley & Son, Inc. 10

LO 1 Copyright ©2019 John Wiley & Son, Inc. 11

LO 1 Copyright ©2019 John Wiley & Son, Inc. 12

LO 1 Copyright ©2019 John Wiley & Son, Inc. 13

Liquidity Profitability Solvency

Measures short-term Measures the Measures the ability

LO 2 Copyright ©2019 John Wiley & Son, Inc. 14

The discussion of ratios includes the following types of

2. Industry average comparisons based on median ratios

3. Intercompany comparisons based on Park Street as

LO 2 Copyright ©2019 John Wiley & Son, Inc. 15

Measure the short-term ability of the company to pay its

LO 2 Copyright ©2019 John Wiley & Son, Inc. 16

LO 2 Copyright ©2019 John Wiley & Son, Inc. 17

1. CURRENT RATIO Illustration 18.12

LO 2 Copyright ©2019 John Wiley & Son, Inc. 19

LO 2 Copyright ©2019 John Wiley & Son, Inc. 20

Acid-test ratio measures immediate liquidity.

LO 2 Copyright ©2019 John Wiley & Son, Inc. 22

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

3. ACCOUNTS RECEIVABLE TURNOVER

A variant of the accounts receivable turnover ratio is to convert it

365 days / 10.2 times = every 35.78 days

Accounts receivable are collected on average every 36 days.

LO 2 Copyright ©2019 John Wiley & Son, Inc. 24

LO 2 Copyright ©2019 John Wiley & Son, Inc. 25

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

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.

LO 2 Copyright ©2019 John Wiley & Son, Inc. 27

Measure the income or operating success of a company for a

LO 2 Copyright ©2019 John Wiley & Son, Inc. 29

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

LO 2 Copyright ©2019 John Wiley & Son, Inc. 31

Measures how efficiently a company uses its assets to generate

LO 2 Copyright ©2019 John Wiley & Son, Inc. 33

An overall measure of profitability.

LO 2 Copyright ©2019 John Wiley & Son, Inc. 35

8. RETURN ON ORDINARY SHAREHOLDERS’ EQUITY

 Deduct preferred dividend from net income.

LO 2 Copyright ©2019 John Wiley & Son, Inc. 37

LO 2 Copyright ©2019 John Wiley & Son, Inc. 38

9. EARNINGS PER SHARE (EPS)

A measure of the net income earned on each ordinary share.

LO 2 Copyright ©2019 John Wiley & Son, Inc. 39

LO 2 Copyright ©2019 John Wiley & Son, Inc. 40

10. PRICE-EARNINGS RATIO

Reflects investors’ assessments of a company’s future earnings.

LO 2 Copyright ©2019 John Wiley & Son, Inc. 41