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ELS Financial Accounting: Tools for Business Decision Making, 3rd Ed. Kimmel, Weygandt, Kieso Chapter 13 ` Chapter 13 Performance Measurement After studying Chapter 13, you should be able to: Understand the concept of sustainable income. Indicate how irregular items are presented.

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ELS

Financial Accounting:Tools for Business Decision Making, 3rd Ed.

Kimmel, Weygandt, Kieso


Chapter 13

`


Chapter 13Performance Measurement

After studying Chapter 13, you should be able to:

  • Understand the concept of sustainable income.

  • Indicate how irregular items are presented.

  • Explain the concept of comprehensive income.

  • Describe and apply horizontal analysis.

  • Describe and apply vertical analysis.


Chapter 13Performance Measurement

After studying Chapter 13, you should be able to:

  • Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

  • Understand the concept of quality of earnings.


Sustainable Income...

  • Is the most likely level of income to be obtained in the future.

  • Does not include irregular revenues, expenses, gains, or losses.


Comprehensive Income...

Includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders.


Comprehensive Income

  • Most revenues, expenses, gains, and losses recognized during the period are included in net income.

  • Specific exceptions to this practice have developed - these items bypass income and are reported directly in stockholders’ equity.


Irregular Items

Three types of irregular items are reported -- (all net of taxes)

  • discontinued operations

  • extraordinary items

  • changes in accounting principle


Discontinued Operations...

Refers to the disposal of a significant segment of a business...

  • the elimination of a major class of customers or

  • an entire activity.


Discontinued Operations

  • Assume Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million or net income of $800,000 from continuing operations in 2004.

  • During 2004 the company discontinued and sold its unprofitable chemical division. The loss in 2004 from chemical operations (net of $90,000 taxes) was $210,000. The tax rate is 30%.


Rozek Inc.

Income Statement (Partial)

For the Year Ended December 31, 2004

Income before income taxes$800,000

Income tax expense (30% Tax Rate) 240,000

Income before irregular items 560,000 Discontinued operations

Loss from operations of chemical division, net of $90,000 income tax saving(210,000)


Extraordinary Items...

Are events and transactions that meet two conditions:

  • Unusual in nature

  • Infrequent in occurrence


Extraordinary Items


Ordinary Items


Extraordinary Items

  • In 2004 a revolutionary foreign government expropriated property held as an investment by Rozek Inc.

  • The loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000.


Rozek Inc.

Partial Income Statement

For the Year Ended December 31, 2004

Income before income taxes $800,000

Income tax expense 240,000

Income from continuing operations 560,000 Discontinued operations

Loss from disposal of chemical division, net of $90,000 income tax saving (210,000)

Net 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

  • Occur when the principle used in the current year is different from the one used in the preceding year.

  • Is permitted, when

    • management can show that the new principle is preferable to the old and

    • the effects of the change are clearly disclosed in the income statement.

  • Examples:

    • a change in depreciation methods (such as declining-balance to straight-line)

    • a change in inventory costing methods (such as FIFO to average cost).


Change in Accounting Principle

  • The new principle should be used in reporting the results of operations of the current year.

  • The cumulative effect of the change on all prior-year income statements should be disclosed net of applicable taxes in a special section immediately preceding net income.


Changes in Accounting Principle

  • Rozek Inc. changes from the straight-line method to the declining-balance method for equipment purchased on January 1, 2001.

  • The cumulative effect on prior-year income statements (statements for 2001-2003) is to increase depreciation expense and decrease income before income taxes by $24,000.

  • If there is a 30% tax rate, the net-of-tax effect of the change is ($16,800) ($24,000 x 70%).


Rozek Inc.

Partial Income Statement

For the Year Ended December 31, 2004

Income before income taxes $800,000

Income tax expense 240,000

Income from continuing operations 560,000 Discontinued operations

Loss from disposal of chemical division, net of $90,000 income tax saving (210,000)

Net income before extraordinary item 350,000

Extraordinary item

Expropriation of investment, net of $21,000 income tax saving (49,000)

Cumulative effect of change in accounting principle

Effect on prior years of change in depreciation method, net of $ 7,200 tax (16,800)

Net Income 284,200


Estimating Sustainable Income

SUMMARY

When evaluating a company,

it generally makes sense to eliminate all irregular items.


Comprehensive Income...

Includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders.


Comprehensive Income

  • Most revenues, expenses, gains, and losses recognized during the period are included in net income.

  • Specific exceptions to this practice have developed - these items bypass income and are reported directly in stockholders’ equity.


Comprehensive Income

Unrealized gains and losses on available-for-sale securities are excluded from net income because disclosing them separately -

  • reduces the volatility of net income due to fluctuations in fair value, yet

  • informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value.


Comprehensive Income

  • The FASB now requires that, in addition to reporting net income, a company must also report comprehensive income.


Comparative Analysis

  • Any item reported in a financial statement has significance if:

    • Its inclusion indicates that the item exists at a given time and in a certain quantity.

  • For example, when Kellogg Company reports $136.4 million on its balance sheet as cash, we know that Kellogg did have cash and that the quantity was $136.4 million.


Comparative Analysis

  • Whether the amount represents an increase over prior years, or whether it is adequate in relation to the company's needs, cannot be determined from the amount alone.

  • The amount must be compared with other financial data to provide more information.


Comparative Analysis

There are three types of comparisons to provide decision usefulness of financial information:

  • Intracompany basis

  • Intercompany basis

  • Industry averages


Intracompany Basis

  • Comparisons within a company are often useful to detect changes in financial relationships and significant trends.

  • A comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease.

  • A comparison of Kellogg's year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash.


Intercompany Basis

  • Comparisons with other companies provide insight into a company's competitive position.

  • Kellogg's total sales for the year can be compared with the total sales of its competitors such as Quaker Oats and General Mills.


Industry Averages

  • Comparisons with industry averages provide information about a company's relative position within the industry.

  • Kellogg's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's.


Financial Statement Analysis

Three basic tools are used in financial statement analysis :

1.Horizontal analysis

2.Vertical analysis

3.Ratio analysis


Horizontal Analysis

  • Is a technique for evaluating a series of financial statement data over a period of time.

  • Purpose is to determine whether an increase or decrease has taken place.

  • The increase or decrease can be expressed as either an amount or a percentage.


Horizontal Analysis

CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT

BASE-YEAR AMOUNT


Percentage Change in Sales

The percentage change in sales for each of the 5 years, assuming 1997 as the base period is:

Kellogg Company

Net Sales (in millions) Base Period 2000

20012000199919981997

$8,853.3 $6,954.7 $6,984.2 $6762.1 $6,830.1

129.62% 101.82 % 102.26% 99% 100.0%


Horizontal Analysis of a Balance Sheet

KELLOGG COMPANY, INC.

Condensed Balance Sheets

December 31

(In millions)

Increase (Decrease)

during 2001 20012000AmountPercent

Assets

Current Assets $1,902.0 $1,617.1 $ 284.9 17.6

Plant assets 2,952.8 2,526.9 425.9 16.9

Other assets5,513.8 742.04,771.8643.1

Total assets $10,368.6 $4,886.0 $5,482.6 112.2


Horizontal Analysis of a Balance Sheet

Increase (Decrease)

during 2001

20012000AmountPercent

Liabilities and

Stockholders' Equity

Current liabilities$2,207.6$2,482.3 (274.7) (11.1)

Long-term liabilities 7,289.5 1,506.25,783.3384.0

Total liabilities 9,497.1 3,988.55,508.6 138.1

Stockholders' equity

Common stock 195.3 205.8 (10.5) (5.1)

Retained earnings

and other 1,013.3 1,065.7 (52.4) (4.9)

Treasury stock (337.1) (374.0) 36.99.9

Total stockholders'

equity 871.5897.5(26.0)(2.9)

Total liabilities and

stockholders' equity $10,368.6$4,886.0 $5,482.6 112.2


KELLOGG COMPANY, INC.

Condensed Income Statement

For the Years Ended December 31

(In millions)

Increase (Decrease)

during 2001 20012000AmountPercent

Net sales$8,853.3 $6,954.7 $1,898.6 27.3

Cost of goods sold 4,128.53,327.0801.524.1

Gross profit 4,724.8 3,627.7 1,097.1 30.2

Selling & Admin. 3,523.6 2,551.4 972.2 38.1

Nonrecurring charges 33.3 86.5(53.2)(61.5)

Income from operations 1,167.9 989.8 178.1 18.0

Interest expense 1351.5 137.5 214.0 155.6

Other income

(expense), net (12.3) 15.4 (27.7)(179.9)

Income before taxes 804.1 867.7 (63.6) (7.3)

Income tax expense 322.1 280.0 42.115.0

Net income $482.0 $587.7 ($105.7) (18.0)


Vertical Analysis

  • Is a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount.

  • Total assets is always the base amount in vertical analysis of a balance sheet.

  • Net sales is always the base amount in vertical analysis of an income statement.


KELLOGG COMPANY, INC.

Condensed Balance Sheets

December 31

(In millions)

2001 2000 z

AssetsAmountPercentAmountPercent

Current Assets $1,902.0 18.3 $1,617.1 33.1

Property Assets 2,952.8 28.5 2,526.9 51.7

Other assets 5,513.853.2 742.015.2

Total assets $10,368.6 100.0% $4,886.0 100.0%


KELLOGG COMPANY, INC.

Condensed Balance Sheets

December 31

(In millions)

2001 2000

Liabilities andAmountPercent AmountPercent

Stockholders' Equity

Current liabilities $2,207.6 21.3 $2,482.3 50.8

Long-term liabilities 7,289.570.3 1,506.230.8

Total liabilities 9,497.191.63,988.581.6

Stockholders' equity

Common stock 195.3 1.9 205.8 4.2

Retained earnings

and other 1,013.3 9.8 1,065.7 21.8

Treasury stock (337.1)(3.3) (374.0)(7.6)

Total stockholders'

equity 871.5 8.4 897.5 18.4

Total liabilities and

stockholders' equity $10,368.6 100.0 $4,886.0 100.0


KELLOGG COMPANY, INC.

Condensed Income Statement

For the Years Ended December 31

(In millions)

2001 2000 AmountPercentAmountPercent

Net sales $8,853.3 100.0 $6,954.7 100.0

Cost of goods sold 4,128.5 46.6 3,327.0 47.8

Gross profit 4,724.8 53.4 3,627.7 52.2

Selling & Admin. 3,523.6 39.8 2,551.4 36.7

Nonrecurring Chgs 33.30.4 86.5 1.2

Income operations 1,167.9 13.2 989.8 14.3

Interest expense 351.5 4.0 137.5 2.0 Other income

(expense),net (12.3) (0.1) 15.4 0.2

Income before

income taxes 804.1 9.1 867.7 12.5

Income tax expense 322.1 3.6 280.04.0

Net income $482.0 5.5 $587.7 8.5


Condensed Income StatementsFor the Year Ended December 31, 2001(in millions)

Kellogg Company, Inc.General Mills,Inc

AmountPercent AmountPercent

Net sales $8,853.3 100.0 $7,949.0 100.0

Cost of goods sold 4,128.546.6 4,767.0 60.0

Gross profit 4,724.8 53.4 3,182.0 40.0

Selling and administrative

expenses 3,523.6 39.8 1,909.0 24.0

Nonrecurring charges 33.3 0.4 190.0 2.4

Income from operations 1,167.9 13.2 1,083.0 13.6

Other expenses and

revenues (including

income taxes) 685.9 7.7 622.0 7.8

Net income $482.0 5.5 $461.0 5.8


Ratio Analysis


Ratios

  • Three types:

    • Liquidity ratios

    • Solvency ratios

    • Profitability ratios

  • Can provide clues to underlying conditions that may not be apparent from an inspection of the individual components.

  • Single ratio by itself is not very meaningful.


Liquidity Ratios

Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash.

WHO CARES?

Short-term creditors such as bankers and suppliers


Liquidity Ratios

  • Working capital

  • Current ratio

  • Current cash debt coverage ratio

  • Inventory turnover ratio

  • Days in inventory

  • Receivables turnover ratio

  • Average collection period


Working Capital

Indicates immediate short-term debt-paying ability

Current Capital - Current liabilities


Current Ratio

Indicates short-term debt-paying ability

Current Assets

Current Liabilities


Current Cash Debt Coverage Ratio

Indicates short-term debt-paying ability (cash basis)

Cash provided by operations Average current liabilities


Indicates liquidity of inventory

Cost of Goods Sold

Average Inventory

Inventory Turnover Ratio


Days in Inventory

Indicates liquidity of inventory and inventory management

365 days

Inventory Turnover Ratio


Receivables Turnover Ratio

Indicates liquidity of receivables

Net Credit Sales

Average Gross Receivables


Average Collection Period

Indicates liquidity of receivables and collection success

365 days

Receivables Turnover Ratio


Solvency Ratios

Measure the ability of the enterprise to survive over a long period of time

WHO CARES?

Long-term creditors and stockholders


Illustration 13-18

Solvency Ratios

  • Debt to total assets ratio

  • Cash debt coverage ratio

  • Times interest earned ratio

  • Free cash flow


Debt to Total Assets Ratio

Indicates % of total assets provided by creditors

Total Liabilities

Total Assets


Cash Debt Coverage Ratio

Indicates long-term debt-paying ability (cash basis)

Cash provided by operations

Average total liabilities


Times Interest Earned Ratio

Indicates company’s ability to meet interest payments as they come due

Net Income Before Interest

Expense & Income Tax

Interest Expense


Free Cash Flow

Indicates cash available for paying dividends or expanding operations

Cash Provided By Operations

- Capital Expenditures

- Dividends Paid

Free Cash Flow


Profitability Ratios

Measure the income or operating success of an enterprise for a given period of time

WHO CARES? Everybody

WHY? A company’s income affects:

  • its ability to obtain debt and equity financing

  • its liquidity position

  • its ability to grow


Profitability Ratios

  • Earnings per share (EPS)

  • Price-earnings ratio

  • Gross profit rate

  • Profit margin ratio

  • Return on assets ratio

  • Assets turnover ratio

  • Payout ratio

  • Return on common stockholders’ equity ratio


Net Income - Preferred Stock

Average common shares outstanding

Earnings Per Share (EPS)

Indicates net income earned on each share of common stock sales


Stock Price Per Share

Earnings Per Share

Price Earnings Ratio

Indicates relationship between market price per share and earnings per share


Gross Profit Rate

Indicates margin between selling price and cost of good sold

Gross profit

Net sales


Net income

Net sales

Higher value suggests favorable return on each dollar of sales.

Profit Margin Ratio

Indicates net income generated by each dollar of sales


Higher value suggests favorable efficiency.

Return On Assets Ratio

Reveals the amount of net income generated by each dollar invested

Net income

Average total assets


Asset Turnover Ratio

Indicates how efficiently assets are used to generate sales

Net sales

Average total assets


Cash Dividends Declared on Common Stock

Net Income

Payout Ratio

Indicates % of earnings distributed in the form of cash dividends


Return on Common Stockholders’ Equity Ratio

Indicates profitability of common stockholders’ investment

Net income - preferred stock dividends

Average common stockholders’ equity


Limitations Of Financial Analysis

  • Horizontal, vertical, and ratio analysis are frequently used in making significant business decisions.

  • One should be aware of the limitations of these tools and the financial statements.


Estimates

  • Financial statements are based on estimates.

    • allowance for uncollectible accounts

    • depreciation

    • costs of warranties

    • contingent losses

      To the extent that these estimates are inaccurate, the financial ratios and percentages are also inaccurate.


Alternative Accounting Methods

  • One company may use the FIFO method, while another company in the same industry may use LIFO.

  • If the inventory is significant for both companies, it is unlikely that their current ratios are comparable.

  • In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization.


Quality of Earnings

Indicates the level of full and transparent information that is provided to users of the financial statement.


Pro Forma Income

A measure of the net income generated that usually excludes items that the company thinks are unusual or nonrecurring.


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