ch18 ANALYZING FINANCIAL STATEMENTS

Accounting Principles
Thirteenth Edition
Weygandt ● Kimmel ● Kieso
Chapter 18
Financial Analysis: The Big Picture

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Chapter Outline
Learning Objectives
LO 1 Apply the concepts of sustainable income and
quality of earnings.
LO 2 Apply horizontal analysis and vertical analysis.
LO 3 Analyze a company’s performance using ratio
analysis.
Copyright ©2018 John Wiley & Sons, Inc. 2

Sustainable Income and Quality of
Earnings (1 of 2)
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.

Sustainable Income and Quality of Earnings
(2 of 2)

Sustainable Income
A statement of comprehensive income includes
• net income and
• comprehensive income.
The two major unusual items in this statement are
o discontinued operations and
o other comprehensive income.
Discontinued operations and other comprehensive income,
are reported net of tax.

Discontinued Operations (1 of 3)
A. Disposal of a significant component of a business.
B. Report 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 Inc. has income
before income taxes of $800,000. During 2020, Acro
discontinued and sold its unprofitable chemical division.
The loss in 2020 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.
Assume a 30% tax rate on income.


Comprehensive Income (1 of 5)
Comprehensive income is the sum of
• net income and
• other comprehensive income items.
o Example: Unrealized gains or losses on available-for-sale debt
securities

Illustration: During 2020 Stassi Corporation purchased IBM bonds
for $10,500 as an investment, which it intends to sell sometime in
the future. At the end of 2020, Stassi was still holding the
investment, but the bonds’ market price was now $8,000. Stassi is
required to reduce the recorded value of its IBM investment by the
unrealized loss of $2,500. Should Stassi include this $2,500
unrealized loss in net income? Assume a tax rate of 20%.
Trading securities: Unrealized gains and losses are reported in the
“Other expenses and losses” section of the income statement.
Available-for-sale securities: Unrealized gains and losses are
reported as “Other comprehensive income” in stockholders’ equity.

Stassi did not purchase the investment for trading purposes, it is
classified as available-for-sale.

Assume Stassi has common stock of $3,000,000, retained earnings
of $300,000, and accumulated other comprehensive loss of $2,000.
This illustration shows the balance sheet presentation of the
accumulated other comprehensive loss.
Balance Sheet (partial)

Stockholders’ equity
Common stock $3,000,000
Retained earnings 300,000
Total paid-in capital and retained earnings 3,300,000
Accumulated other comprehensive loss (2,000)
Total stockholders’ equity $3,298,000
$3,298,000 double ruled


Changes in Accounting Principle
Occurs when the principle used in the current year is different from
the one used in the preceding year.
• Example: Change in inventory costing methods (such as FIFO to
average-cost)
Accounting rules permit a change when management can show
that the new principle is preferable.
Companies report most changes in accounting principle
retroactively.

Quality of Earnings (1 of 3)
A high quality of earnings provides full and transparent
information that will not confuse or mislead users.
Alternative Accounting Methods
Variations among companies in the application of generally
accepted accounting principles may hamper comparability
and reduce quality of earnings
• FIFO versus FIFO inventory cost flow
• Straight-line versus declining balance depreciation

Pro Forma Income
Companies whose stock is publicly traded are required to present
their income statement following GAAP.
Many companies have been also reporting pro forma income that
usually excludes items that the company thinks are unusual or non-
recurring (pro forma income).
Many analysts and investors are critical of using pro forma income
because these numbers often make companies look better than
they really are.

Improper Recognition
Most common abuse is improper recognition of revenue.
• Channel stuffing (Bristol-Myers Squibb)
Another practice is improper capitalization of operating
expenses.
• Capitalization of operating expenses (WorldCom)
• Failure to report liabilities (Enron)

Do It! 1: Unusual Items (1 of 2)
In its proposed 2020 income statement, AIR Corporation reports
income before income taxes $400,000, unrealized gain on available-
for-sale securities $100,000, income taxes $120,000 (not including
unusual items), loss from 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! 1: Unusual Items (2 of 2)

Horizontal Analysis and Vertical Analysis (1 of 2)
Investors are interested in:

• Core or sustainable earnings of a company
• Making comparisons from period to period
o Three types of comparisons:
• Intracompany basis
• Intercompany basis
• Industry averages

Horizontal Analysis and Vertical Analysis (2 of 2)
Three basic tools in financial statement analysis:

1. Horizontal analysis
2. Vertical analysis
3. Ratio analysis

Horizontal Analysis (1 of 5)
Also called trend analysis, is a technique for evaluating a
series of financial statement data over a period of time.
Purpose is to determine
• Increase or decrease
• Expressed as either an amount or a percentage


The comparative balance sheets show a number of changes.
In the assets section:
• current assets increased $290,000, or 11.9% ($290 ÷ $2,427)
• property assets (net) increased $174,000, or 6.2%
• other assets increased $219,000, or 4.0%
In the liabilities section:
• current liabilities increased $24,000, or 0.6%
• long-term liabilities increased $202,000, or 4.4%
In the stockholders’ equity section:
• retained earnings increased $806,000, or 31.2%

Analysis of the income statements shows the following changes.
• Net sales increased $869,000, or 8.0% ($869 ÷ $10,907)
• Cost of goods sold increased $515,000, or 8.5%
• Selling and administrative expenses increased $252,000, or 8.2%
• Gross profit increased 7.3%
• Net income increased 9.9%
The increase in net income can be attributed to the increase in net
sales and a decrease in income tax expense.

Vertical Analysis (1 of 7)
Also called common-size analysis, is a technique that expresses
each financial statement item as a percentage of a base amount.
• On a balance sheet we might express current assets as 22% of
total assets (total assets being the base amount)
• On an income statement we might say that selling expenses are
16% of net sales (net sales being the base amount)


Analysis of the balance sheet shows the following changes.
• Current assets increased $290,000 from 2019 to 2020, and they
increased from 22.6% to 23.8% of total assets
• Property assets (net) decreased from 26.3% to 26.2% of total
assets
• Other assets decreased from 51.1% to 50.0% of total assets
• Retained earnings increased by $806,000 from 2019 to 2020
• Total stockholders’ equity increased from 19.3% to 22.1% of total
liabilities and stockholders’ equity


Analysis of the income statements shows the following changes.
• Cost of goods sold as a percentage of net sales increased from
55.8% to 56.0%
• Selling and administrative expenses increased from 28.0% to
28.1%
• Net income as a percentage of net sales increased from 9.2% to
9.4%
Increase in net income as a percentage of sales is due primarily to
the decrease in income tax expense as a percentage of sales.


Vertical analysis also enables you to compare companies of
different sizes.
• Chicago Cereal net sales are much less than those of Giant,
vertical analysis eliminates the impact of this size difference
• Chicago Cereal has a higher gross profit percentage 44.0%,
compared to 35.6% for Giant
• But, Chicago Cereal’s selling and administrative expenses are
28.1% of net sales, while those of Giant Mills are 19.4%
• Chicago Cereal’s net income as a percentage of net sales is 9.4%,
compared to 10.2% for Giant

Do It! 2: Horizontal Analysis
Summary financial information for Rosepatch Company.
December 31, 2020 December 31, 2019
Current assets $234,000 $180,000
Plant assets (net) 756,000 420,000
Total assets $990,000 $600,000
Compute the amount and percentage changes in 2020 using horizontal
analysis, assuming 2019 is the base year.
Increase in 2020
Amount Percent
Current assets $ 54,000 30% [($234,000 − $180,000) ÷ $180,000]
Plant assets (net) 336,000 80% [($756,000 − $420,000) ÷ $420,000]
Total assets $390,000 65% [($990,000 − $600,000) ÷ $600,000]
Ratio Analysis (1 of 2)
Ratio analysis expresses the relationship among selected items of
financial statement data.
Financial Ratio Classifications

Liquidity Profitability Solvency
Measure short-term Measure the income or Measure the ability of
ability of the company operating success of a the company to survive
to pay its maturing company for a given over a long period of
obligations and to meet period of time time
unexpected needs for
cash

Ratio Analysis (2 of 2)
A single ratio by itself is not very meaningful.
We will use the following types of comparisons.
1. Intracompany comparisons for two years for Chicago Cereal.
2. Industry average comparisons based on median ratios for the
industry.
3. Intercompany comparisons based on Giant Mills as Chicago
Cereal’s principal competitor.

Comprehensive Ratio Analysis (1 of 3)



Liquidity Ratios (1 of 6)
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.

Current Assets
1. Current Ratio 
Current Liabilities
Chicago Cereal
2020 2019
. .
$2,717 = 0.67 0.60

$4 ,044
Industry Average Giant Mills 2020
1.06 .67
Chicago has $0.67 of current assets for every dollar of current liabilities.

Net credit sales
2. Accounts Receivable Turnover 
Average net accounts receivable
Chicago Cereal
2020 2019
. .
$11,776 = 11.9 12.0

$1,026 + $945 ÷ 2
11.2 12.2
Measures the number of times, on average, the company collects
receivables during the period.
365 days
3. Average Collection Period 
Average accounts turnover
Chicago Cereal
2020 2019
. .
365 = 30.7 30.4

11.9
32.6 29.9
Analysts frequently use average collection period to assess the

effectiveness of a company’s credit and collection policies.
Cost of goods sold
4. Inventory Turnover 
Average inventory
Chicago Cereal
2020 2019
. .
$6,597 = 7.5 7.9

$924  $824   2
6.7 7.4
The faster the inventory turnover, the less cash is tied up in inventory and
less chance of inventory becoming obsolete.
365 days
5. Days in Inventory 
Inventory turnover
Chicago Cereal
2020 2019
. .
365 = 48.7 46.2

7.5
54.5 49.3
Measures the average number of days inventory is held.

Solvency Ratios (1 of 4)
Measure the ability of a company to survive over a long
period of time.
• Debt to assets ratio and times interest earned provide
information about debt-paying ability
• Free cash flow provides information about solvency and
ability to pay additional dividends or invest in new projects

Total liabilities
6. Debt to assets ratio 
Total assets
Chicago Cereal
2020 2019
. .
$8,871 = 78% 81%

$11,397
55% 55%
Provides some indication of company’s ability to withstand losses without

impairing the interests of its creditors.
Net Interest Incometax
+ +
Income expense expense
7. Times interest earned 
Interest expense
Chicago Cereal
2020 2019
. .
$1,103  $321  $444 = 5.8 6.0

$321
5.5 9.9
Provides an indication of company’s ability to meet interest payments as
they come due.
Net cash
provided Capital Cash
8. Free Cash Flow 
by operating

expenditures

dividends
activities
Chicago Cereal
2020 2019
$556 $507
$1,503 − $472 − $475 =
(in thousands) (in thousands)

na $895 (in millions)
One indication of solvency is the amount of excess cash generated after

investing in capital expenditures and paying dividends.
Profitability Ratios (1 of 11)
Measure the income or operating success of a company for a
given period of time.
• Income affects ability to obtain debt and equity financing,
liquidity, and ability to grow
• Creditors and investors are interested in evaluating
profitability
• Analysts use profitability as ultimate test of management’s
operating effectiveness


9. Return on Common Net Income  Preferred dividends

Stockholders’ Equity Average common stockholders’ equity
Chicago Cereal
blank
2020 2019
$1,103 minus $0 divided by ($2,526 + $2,069), divided by
2
$1, 103  $0 = 48% 46%
$2, 526 + $2, 069  ÷ 2
19% 25%
Shows how many dollars of net income the company earned for each
dollar invested by the owners.
Neti ncome
10. Return on Assets 
Average total assets
Chicago Cereal
blank
2020 2019
$1,103 divided by ($11,397 + $10,714), divided by 2
$1,103 = 10.0% 9.4%

$11,397 + $10, 714  ÷ 2
5.3% 6.2%
Measures the overall profitability of assets in terms of the income earned

on each dollar invested in assets.
Neti ncome
11. Profit Margin 
Net sales
Chicago Cereal
blank
2020 2019
$1,103 divided by $11,776
$1,103 = 9.4% 9.2%

$11,776
6.1% 8.2%
Measures of the percentage of each dollar of sales that results in net

income.
Net sales
12. Asset Turnover 
Average total assets
Chicago Cereal
blank
2020 2019
$11,776 divided by ($11,397 + $10,714), divided by 2
$11,776 = 1.07 1.02

$11,397 + $10,714  ÷ 2
.87 .76
Measures how efficiently a company uses its assets to generate sales.

Ratios Profit Asset Return
× ×
Margin Turnover on Assets
Net income divided by Net Sales
Net Sales divided by Average Total Net income by Average Total
Net income × Net SalesAssets
× Net income
Assets
Net Sales Average Total Assets Average Total Assets

Chicago Cereal
2020 9.4% × 1.07 times = 10.1%*
2019 9.2% × 1.02 times = 9.4%
*Difference from value in Illustration 18.32 due to rounding.

Gross profit
13. Gross Profit Rate 
Net sales
Chicago Cereal
blank
2020 2019
$5,179 divided by $11,776
$5,179 = 44% 44%

$11,776
30% 34%
Indicates a company’s ability to maintain an adequate selling price above

its cost of goods sold.
Netincome – Preferred dividends
14. Earnings Per Share 
Weighted  average common shares outstanding
Chicago Cereal
blank
2020 2019
$1,103 minus $0 divided by 418.7
$1,103  $0 = $2.63 $2.40

418.7
na $2.90
A measure of the net income earned on each share of common stock.

Market price per share
15. Price Earnings Ratio 
Earnings per share
Chicago Cereal
blank
2020 2019
$52.92 divided by $2.63
$52.92 = 20.1 20.9

$2.63
35.8 24.3
Reflects investors’ assessments of a company’s future earnings.

Cash dividends declared on common stock
16. Payout ratio 
Net income
Chicago Cereal
blank
2020 2019
$475 divided by $1,103
$475 = 43% 45%

$1,103
37% 54%
Measures the percentage of earnings distributed in the form of cash

dividends.
Do It! 3: Ratio Analysis (1 of 2)
The condensed financial statements of John Cully Company, for the years ended June 30,
2020 and 2019, are presented as follows.

Do It! 3: Ratio Analysis (2 of 2)

A Look at IFRS (1 of 4)
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 G AAP
and IFRS. As indicated in the textbook, a very important objective is to
ensure that users of the income statement can evaluate the sustainable
income 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.

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.
• The basic accounting for discontinued operations is the same under
IFRS and GAAP.

Similarities
• 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

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.

Copyright
Copyright © 2018 John Wiley & Sons, Inc.
All rights reserved. Reproduction or translation of this work beyond that permitted in
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from the use of the information contained herein.

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Accounting Principles

Financial Analysis: The Big Picture

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Balance Sheet (partial)

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Investors are interested in:

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Three basic tools in financial statement analysis:

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Financial Ratio Classifications

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$2,717 = 0.67 0.60

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$11,776 = 11.9 12.0

365 = 30.7 30.4

Analysts frequently use average collection period to assess the

$6,597 = 7.5 7.9

365 = 48.7 46.2

Measures the average number of days inventory is held.

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$8,871 = 78% 81%

Provides some indication of company’s ability to withstand losses without

$1,103  $321  $444 = 5.8 6.0

Industry Average Giant Mills 2020

One indication of solvency is the amount of excess cash generated after

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$1,103 = 10.0% 9.4%

Measures the overall profitability of assets in terms of the income earned

$1,103 = 9.4% 9.2%

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