Managing and Accounting

for Financial Resources

CHAPTER 5
Financial Statement Analysis

14-1
 Financial Statement
Learning Objectives
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.
5. Identify and compute ratios used in analyzing a firm’s 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.
Preview of Chapter 5
 Basics of Financial Statement Analysis

Analyzing financial statements involves:

Comparison Tools of
Characteristics
Bases Analysis

 Liquidity  Intracompany  Horizontal

 Profitability  Industry  Vertical
averages
 Solvency  Ratio
 Intercompany

LO 1 Discuss the need for comparative analysis.

LO 2 Identify the tools of financial statement
 Horizontal Analysis

Horizontal analysis, also called trend analysis:

 Technique for evaluating a series of financial statement
data over a period of time.

 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

Balance Sheet
These changes
suggest that the
company expanded its
asset base during
2009 and financed
this expansion
primarily by retaining
income rather than
assuming additional
long-term debt.

Illustration 5-5
Horizontal analysis of
balance sheets

LO 3
 Horizontal Analysis

Income
Statement
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.

Illustration 5-6
Horizontal analysis of
Income statements

LO 3 Explain and apply horizontal analysis.

 Horizontal Analysis
Illustration 5-7
Retained Earnings Statement Horizontal analysis of
retained earnings statements

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
 Financial information for Rosepatch Company is as follows.

Compute the amount and percentage changes in 2014 using

horizontal analysis, assuming 2013 is the base year.

14-9
LO 3
 Vertical Analysis

Vertical analysis, also called common-size analysis:

 Technique that expresses each financial statement item as

a percent of a base amount.

 On an income statement, we might say that selling

expenses are 16% of net sales.

 Commonly applied to the balance sheet and the income

statement.

LO 4 Describe and apply vertical analysis.

 Vertical Analysis

Balance
Sheet
These results
reinforce the earlier
observations that
Quality is
choosing to
finance its growth
through retention
of earnings rather
than through
issuing additional
debt.
Illustration 5-8

LO 4
 Vertical Analysis

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

Illustration 5-9

LO 4
 Vertical Analysis

Enables a comparison of companies of different sizes.

Illustration 14-10

LO 4
 Ratio Analysis

Ratio analysis expresses the relationship among selected

items of financial statement data.

Financial Ratio Classifications

Liquidity Profitability Solvency

Measures short- Measures the Measures the ability

term ability of the income or operating of the company to
company to pay its success of a survive over a long
maturing obligations company for a given period of time.
and to meet period of time.
unexpected needs
for cash.
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 Ratio Analysis

A single ratio by itself is not very meaningful.

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 J.C. Penney Company

as Quality Department Store’s principal competitor.

LO 5 Identify and compute ratios used in analyzing a

firm’s liquidity, profitability, and solvency.
 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,

receivables turnover, and inventory turnover.

LO 5 Identify and compute ratios used in analyzing a

firm’s liquidity, profitability, and solvency.
 Ratio Analysis Liquidity Ratios

1. Current Ratio
Illustration 5-12

The ratio of 2.96:1 means that for every dollar of current liabilities,
Quality has $2.96 of current assets.
LO 5
 Ratio Analysis Liquidity Ratios

2. Acid-Test Ratio
Illustration 5-13

LO 5
 Ratio Analysis Liquidity Ratios

2. Acid-Test Ratio
Illustration 5-14

Measures immediate short-term liquidity.

LO 5 Identify and compute ratios used in analyzing a

firm’s liquidity, profitability, and solvency.
 Ratio Analysis Liquidity Ratios

3. Receivables Turnover
Illustration 5-15

Number of times, on average, the company collects receivables.

LO 5
 Ratio Analysis Liquidity Ratios

Receivables Turnover
$2,097,000
= 10.2 times
($180,000 + $230,000) ÷ 2

A variant of the receivables turnover ratio is to convert it to an

average collection period in terms of days.

365 days ÷ 10.2 times = every 35.78 days

This means that receivables are collected on average every 36

days.

LO 5 Identify and compute ratios used in analyzing a

firm’s liquidity, profitability, and solvency.
 Ratio Analysis Liquidity Ratios

4. Inventory Turnover
Illustration 5-16

Number of times, on average, the inventory is sold.

LO 5
 Ratio Analysis Liquidity Ratios

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.

LO 5 Identify and compute ratios used in analyzing a

firm’s liquidity, profitability, and solvency.
 Ratio Analysis

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 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

firm’s liquidity, profitability, and solvency.
 Ratio Analysis Profitability Ratios

5. Profit Margin Illustration 5-17

Measures net income generated by each dollar of sales.

LO 5
 Ratio Analysis Profitability Ratios

6. Asset Turnover Illustration 5-18

Measures how efficiently assets are used to generate sales.

LO 5
 Ratio Analysis Profitability Ratios

7. Return on Assets Illustration 5-19

An overall measure of profitability.

LO 5
 Ratio Analysis Profitability Ratios

8. Return on Common Stockholders’ Equity

Illustration 5-20

Dollars of net income earned for each dollar invested by the owners.
LO 5
 Ratio Analysis Profitability Ratios

9. Earnings per Share (EPS) Illustration 5-21

Measures net income earned on each share of common stock.

LO 5
 Ratio Analysis Profitability Ratios

10. Price-Earnings Ratio Illustration 5-22

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

LO 5
 Ratio Analysis Profitability Ratios

11. Payout Ratio Illustration 5-23

Measures the percentage of earnings distributed in the form of cash

dividends.
* From analysis of retained earnings. LO 5
 Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a company to survive

over a long period of time.

 Debt to total assets and times interest earned are two

ratios that provide information about debt-paying ability.

LO 5 Identify and compute ratios used in analyzing a

firm’s liquidity, profitability, and solvency.
 Ratio Analysis Solvency Ratios

12. Debt to Total Assets Ratio Illustration 5-24

Measures the percentage of the total assets provided by creditors.

LO 5
 Ratio Analysis Solvency Ratios

13. Times Interest Earned Illustration 5-25

Provides an indication of the company’s ability to meet interest

payments as they come due. LO 5
Summary of Ratios
Illustration 5-26

LO 5
Summary of Ratios
Illustration 5-26

LO 5
Summary of Ratios
Illustration 5-26

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.

These “irregular” items are reported net of income taxes.

LO 6 Understand the concept of earning power,

and how irregular items are presented.
 Earning Power and Irregular Items

Discontinued Operations
(a) Refers to the 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).

LO 6 Understand the concept of earning power,

and how irregular items are presented.
 Earning Power and Irregular Items
Illustration: During 2014 Acro Energy Inc. has income before
income taxes of $800,000. During 2014, Acro discontinued and sold its
unprofitable chemical division. The loss in 2014 from chemical operations
(net of $60,000 taxes) was $140,000. The loss on disposal of the chemical
division (net of $30,000 taxes) was $70,000. Assuming a 30% tax rate on
income. Illustration 5-27

LO 6
 Earning Power and Irregular Items
Income Statement (in thousands)
Discontinued
Sales $ 285,000
Operations are reported Cost of goods sold 149,000
after “Income from Gross profit 136,000

continuing operations.”
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Previously labeled as
Income from continuing operations 55,000
“Net Income”.
Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Moved to
Net income $ 54,496

LO 6
 Earning Power and Irregular Items

Extraordinary items are nonrecurring material items that differ

significantly from a company’s typical business activities.

Extraordinary Item must be both of an

 Unusual Nature and

 Occur Infrequently

Company must consider the environment in which it operates.

Amount reported “net of tax.”

LO 6
 Earning Power and Irregular Items

Are these considered Extraordinary Items?

(a) A large portion of a tobacco manufacturer’s

crops are destroyed by a hail storm. Severe YES
damage from hail storms in the locality where
the manufacturer grows tobacco is rare.

(b) A citrus grower's Florida crop is damaged by NO

frost.

(c) Loss from sale of temporary investments. NO

(d) Loss attributable to a labor strike. NO

LO 6
 Earning Power and Irregular Items

Are these considered Extraordinary Items?

(e) Loss from flood damage. (The nearby Black NO

River floods every 2 to 3 years.)

(f) An earthquake destroys one of the oil

refineries owned by a large multi-national oil YES
company. Earthquakes are rare in this
geographical location.

(g) Write-down of obsolete inventory. NO

(h) Expropriation of a factory by a foreign YES

government.
LO 6
 Earning Power and Irregular Items

Illustration: In 2014 a 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 income statement will report a deduction of
$49,000. Illustration 5-29

LO 6
 Earning Power and Irregular Items

Income Statement (in thousands)

Extraordinary Items
Sales $ 285,000
are reported after Cost of goods sold 149,000
“Income from continuing Gross profit 136,000

operations.”
Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Previously labeled as
Income from continuing operations 55,000
“Net Income”.
Extraordinary loss, net of tax 539
Net income $ 54,461
Moved to

LO 6
 Earning Power and Irregular Items

Income Statement (in thousands)

Reporting when both
Sales $ 285,000
Discontinued Cost of goods sold 149,000
Operations and Gross profit 136,000

Extraordinary Items
Income before taxes 79,000
are present. Income tax expense 24,000
Income from continuing operations 55,000
Discontinued operations:
Discontinued Loss from operations, net of tax 315
Operations Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Income before extraordinary item 54,496
Extraordinary Items Extraordinary loss, net of tax 539
Net income $ 54,496

LO 6
 Earning Power and Irregular Items

Change in Accounting Principle

 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.
 In its proposed 2014 income statement, AIR Corporation
reports income before income taxes $400,000, extraordinary
loss due to earthquake $100,000, income taxes $120,000 (not
including irregular items), 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 income statement, beginning with “Income

before income taxes.”

14-51 LO 6 Understand the concept of earning power,

and how irregular items are presented.
 Prepare a correct income statement

14-52
LO 6
 Comprehensive Income

Income Statement (in thousands)

Other Comprehensive
Sales
Cost of goods sold
$ 285,000
149,000 + Income
Gross profit 136,000  Unrealized gains and
Operating expenses:
losses on available-for-
Selling expenses 10,000
Administrative expenses 43,000 sale securities.
Total operating expense 53,000  Translation gains and
Income from operations 83,000
losses on foreign
Other revenue (expense):
Interest revenue 17,000
currency.
Interest expense (21,000)  Plus others
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Reported in Stockholders’
Net income $ 55,000 Equity

LO 6
 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.

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.

Companies have incentives to manage income to meet or beat

Wall Street expectations, so that

 the market price of stock increases and

 the value of stock options increase.

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

 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:
 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.

 Match each of the following terms with the phrase that it best
matches.

a. Comprehensive income d. Vertical analysis

b. Quality of earnings e. Pro forma income
c. Solvency ratio f. Extraordinary item

c Measures the ability of the company to survive over a long

1. ___
period of time.
e Usually excludes items that a company thinks are unusual
2. ___
or non-recurring.

14-58 LO 7 Understand the concept of quality of earnings.

 Match each of the following terms with the phrase that it best
matches.

a. Comprehensive income d. Vertical analysis

b. Quality of earnings e. Pro forma income
c. Solvency ratio f. Extraordinary item

a Includes all changes in stockholders’ equity during a period

3. ___
except those resulting from investments by stockholders and
distributions to stockholders.
b Indicates the level of full and transparent information
4. ___
provided to users of the financial statements.

14-59 LO 7 Understand the concept of quality of earnings.

 Match each of the following terms with the phrase that it best
matches.

a. Comprehensive income d. Vertical analysis

b. Quality of earnings e. Pro forma income
c. Solvency ratio f. Extraordinary item

f Describes events and transactions that are unusual in

5. ___
nature and infrequent in occurrence.
d Expresses each item within a financial statement as a
6. ___
percent of a base amount.

14-60 LO 7 Understand the concept of quality of earnings.