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Financial A ccounting, 5e. Weygandt, Kieso, & Kimmel. Prepared by Kurt M. Hull, MBA CPA California State University, Los Angeles. John Wiley & Sons, Inc. CHAPTER 15 FINANCIAL STATEMENT ANALYSIS. STUDY OBJECTIVES After studying this chapter, you should understand:. STUDY OBJECTIVE 1

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Financial Accounting, 5e

Weygandt, Kieso, & Kimmel

Prepared by

Kurt M. Hull, MBA CPA

California State University, Los Angeles

John Wiley & Sons, Inc.

CHAPTER 15

FINANCIAL STATEMENT ANALYSIS

STUDY OBJECTIVES

After studying this chapter, you should understand:

STUDY OBJECTIVE 1

COMPARATIVE ANALYSIS

STUDY OBJECTIVE 2

ANALYSIS TOOLS

HORIZONTAL (TREND) ANALYSIS

evaluates a series of financial statement

data over a period of time.

VERTICAL ANALYSIS

expresses each item

in a financial statement

as a percent of a base amount

RATIO ANALYSIS

expresses the relationship among

selected items of financial statement data.

Change since base period

STUDY OBJECTIVE 3

HORIZONTAL ANALYSIS

Changes are measured

against a base year with

the following formula.

HORIZONTAL ANALYSIS

OF BALANCE SHEET

HORIZONTAL ANALYSIS

OF INCOME STATEMENT

QUALITY DEPARTMENT STORE INC.

Retained Earnings Statement

ILLUSTRATION15-7

For the Years Ended December 31

Increase or (Decrease)

during 1999

200

3

200

2

Amount

Percentage

Retained earnings, January 1

\$ 525,000

\$ 376,500

\$ 148,500

3

9.4%

263,800

208,500

55,300

26.5%

788,800

585,000

203,800

Deduct: Dividends

61,200

60,000

1,200

2.0%

Retained earnings, December 31

\$ 727,600

\$ 525,000

\$ 202,600

38.6%

HORIZONTAL ANALYSIS

OF RETAINED EARNINGS STATEMENT

The change in January 1 retained earnings is calculated as follows

39.4%

525,000-376,500

376,500

=

STUDY OBJECTIVE 4

VERTICAL ANALYSIS

Financial statement elements are

measured as a percent of the total.

Balance Sheet

Income Statement

Elements are a

percent of total assets

Elements are a

percent of total sales

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheets

December 31

2003

200

2

Amount

Percent

Amount

Percent

Assets

Current assets

\$ 1,020,000

55.6%

\$ 945,000

59.2%

Plant assets (net)

800,000

43.6%

632,500

39.7%

Inta

ngible assets

15,000

0.8%

17,500

1.1%

Total assets

\$ 1,835,000

100.0%

\$ 1,595,000

100.0%

Liabilities

Current liabilities

\$ 344,500

18.8%

\$

303,000

19.0%

Long

-

term liabilities

487,500

26.5%

497,000

31.2%

Total liabilities

832,000

45.3%

800,000

50.2%

Stockholders’ Equity

VERTICAL ANALYSIS

OF BALANCE SHEET

Common st

ock, \$1 par

275,400

15.0%

270,000

16.9%

Retained earnings

727,600

39.7%

525,000

32.9%

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%

QUALITY DEPARTMENT STORE INC.

Condensed Income Statements

For the Years Ended December 31

2003

2002

Amount

Percent

Amount

Percent

Sales

\$ 2,195,000

104.7%

\$ 1,960,000

106.7%

Sales returns and allowances

98,000

4.7%

123,000

6.7%

Net sales

2,097,000

100.0%

1,837,000

100.0%

Cost of goods sold

1,281,000

61.1%

1,140,000

62.1%

Gross profit

816,000

38.9%

697,000

37.9%

Selling expenses

253,000

12.0%

211,500

11.5%

104,000

5.0%

108,500

5.9%

Total

operating expenses

357,000

17.0%

320,000

17.4%

Income from operations

459,000

21.9%

377,000

20.5%

Other revenues and gains

VERTICAL ANALYSIS

OF BALANCE SHEET

Interest and dividends

9,000

0.4%

11,000

0.6%

Other expenses and losses

Interest expense

36,000

1.7%

40,500

2.2%

Income before income taxes

432,000

20.6%

347,500

18.9%

Income tax expense

168,200

8.0%

139,000

7.5%

Net income

\$ 263,800

12.6%

\$ 208,500

11.4%

INTERCOMPANY COMPARISION

OF INCOME STATEMENT

REVIEW QUESTION

Sammy Corporation reported net sales of

\$300,000 and \$330,000 for 2004 and 2005.

Calculate the percentage increase.

330,000 - 300,000

10%

=

300,000

Another way to express this change:

2005 sales are 110% of 2004 sales

STUDY OBJECTIVE 5

RATIO ANALYSIS

2003

2002

\$1,020,000

\$945,000

—————

= 2.96:1

————

= 3.12:1

\$344,500

\$303,000

CURRENT RATIO

A LIQUIDITY RATIO

Evaluates liquidity

and short-term

debt-paying ability.

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

Quality Department Store

Industry average

Sears, Roebuck and Co.

————————

————————————

1.2

8

:1

1.32:1

ACID-TEST/QUICK RATIO

A LIQUIDITY RATIO

Measures short-term liquidity.

CASH + MARKETABLE SECURITIES + RECEIVABLES (NET) ACID-TEST RATIO = ———————————————————————————— CURRENT LIABILITIES

ACID-TEST/QUICK RATIO

Quality Department Store

2003

2002

\$100,000 + \$20,000 + \$230,000

\$155,000 + \$70,000 + \$180,000

= 1.02

——————————————

:1

——————————————

= 1.3:1

\$344,500

\$303,000

Industry average

Sears, Roebuck and Co.

————————

————————————

0.33:1

0.85:1

NET CREDIT SALES RECEIVABLES TURNOVER = ——————————————— AVERAGE NET RECEIVABLES

RECEIVABLES TURNOVER

A LIQUIDITY RATIO

• Measures the liquidity of receivables.

• Measures the number of times, on average, receivables are collected during the period.

RECEIVABLES TURNOVER

Quality Department Store

2003

2002

\$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 and Co.

————————

————————————

10.8

times

2.4

times

INVENTORY TURNOVER

A LIQUIDITY RATIO

• Measures the number of times, on average, the inventory is sold during the period .

• Measures the liquidity of the inventory.

COST OF GOODS SOLD INVENTORY TURNOVER = ———————————— AVERAGE INVENTORY

INVENTORY TURNOVER

Quality Department Store

2003

2002

\$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.

7

times

5.0

times

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

PROFIT MARGIN

A PROFITABILITY RATIO

• Measures the percentage of each dollar of sales that results in net income.

• Measures how profitable the company is

PROFIT MARGIN

Quality Department Store

2003

2002

\$263,800

\$208,500

—————

= 12.6%

—————

= 11.4%

\$2,097,000

\$1,837,000

Industry average

Sears, Roebuck and Co.

————————

————————————

3

.5

7%

8.

26

%

ASSET TURNOVER

A PROFITABILITY RATIO

Measures how efficiently

a company uses its assets

to generate sales.

NET SALES ASSET TURNOVER = ————————— AVERAGE ASSETS

ASSET TURNOVER

Quality Department Store

2003

2002

\$2,097,000

\$1,837,000

= 1.21

times

———————————

= 1.22

times

———————————

[

]

[

]

\$1,595,000 + \$1,835,000

\$1,446,000 + \$1,595,000

———————————

———————————

2

2

Industry average

Sears, Roebuck and Co.

2.37 times

1.05

times

RETURN ON ASSETS

A PROFITABILITY RATIO

An overall measure

of profitability.

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

RETURN ON ASSETS

Quality Department Store

2003

200

2

\$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 and Co.

————————

————————————

8.29%

8.7%

RETURN ON COMMON NET INCOME STOCKHOLDERS’ EQUITY = ——————————————————————— AVERAGE COMMON STOCKHOLDERS’ EQUITY

RETURN ON COMMON EQUITY

A PROFITABILITY RATIO

Measures profitability

from the viewpoint of the

common stockholder.

RETURN ON COMMON EQUITY

Quality Department Store

2003

2002

\$263,800

\$208,500

———————————

= 29.3%

———————————

= 28.5%

]

]

[

[

\$795,000 + \$1,003,000

\$667,000 + \$795,000

———————————

———————————

2

2

EARNINGS PER SHARE

A PROFITABILITY RATIO

EPS measures

net income earned

on each share

of common stock.

EARNINGS NET INCOME PER SHARE = ———————————————————————————— WEIGHTED AVERAGE COMMON SHARES OUTSTANDING

EARNINGS PER SHARE

Quality Department Store

2003

2002

\$263,000

\$208,500

————————— = \$.97

————— = \$.77

[

]

270,000 + 275,400

270,000

—————————

2

PRICE TO EARNINGS

A PROFITABILITY RATIO

Measures the ratio of the market price

of each share of common stock

to the earnings per share.

MARKET PRICE PER SHARE OF COMMON STOCK PRICE-EARNINGS RATIO = ————————————————————————— EARNINGS PER SHARE

PRICE TO EARNINGS

Quality Department Store

2003

2002

\$12.00

\$ 8.00

——— =12.4 times

——— = 10.4 times

\$ .97

\$ .77

Industry average

Sears, Roebuck and Co.

————————

———————————

26 times

3.8 times

PAYOUT RATIO

A PROFITABILITY RATIO

Measures the percentage of earnings

distributed in the form of

cash dividends.

CASH DIVIDENDS PAYOUT RATIO = ————————————————————————— NET INCOME

PAYOUT RATIO

A PROFITABILITY RATIO

Quality Department Store

2003

2002

= 23.2%

\$61,200

\$60,000

= 28.8%

—————

—————

\$263,800

\$208,500

Industry average

Sears, Roebuck and Co.

————————

———————————

16.0%

9.6%

TIMES INTEREST EARNED

A SOLVENCY RATIO

Measures ability

to meet interest

payments as they

come due.

Income before Income Taxes and Interest Expense

Interest Expense

Quality Department Store

2003

2002

\$468,000

\$388,000

———— = 13 times

———— = 9.6 times

\$36,000

\$40,500

DEBT TO TOTAL ASSETS

A SOLVENCY RATIO

Total Debt

Total Assets

Measures % of

total assets

provided by creditors

Quality Department Store

2003

2002

\$832,000 =

45.30%

\$800,000 =

50.20%

\$1,835,000

\$1,595,000

Industry average

Sears, Roebuck and Co.

————————

————————————

40.1%

76.9%

REVIEW QUESTION

Ace Ventura Pet Detective, Inc. reported the following:

Cash \$125,000

Marketable Securities \$342,500

Accounts Receivable \$780,000

Inventory \$56,000

Prepaid Insurance \$3,600

Prepaid Rent \$4,900

Total Assets \$1,729,000

Current Liabilities \$562,000

Calculate the Quick Ratio.

2.22 = (125000+342500+780000) / 562000

STUDY OBJECTIVE 6

EARNINGS POWER & IRREGULAR ITEMS

Three types of “Irregular” items:

1) Discontinued operations

2) Extraordinary items

3) Changes in accounting principle

Earnings power is the

NORMAL LEVEL OF INCOME

to be obtained in the future.

Earnings power is affected by irregular items.

DISCONTINUED OPERATIONS

• The disposal of a significant segment of a business.

• The income or (loss) form discontinued operations consists of two parts:

• The income or (loss) form operations and

• The gain/loss on the disposal of the segment

• The results are shown “net of tax”

DISCONTINUED OPERATIONS

STATEMENT PRESENTATION

For the year ended December 31, 2006

EXTRAORDINARY ITEMS

• Extraordinary items are events and transactions that meet two conditions.

• unusual in nature and

• infrequent in occurrence

• the results are shown “net of tax”

EXTRAORDINARY ITEMS

STATEMENT PRESENTATION

For the year ended December 31, 2006

ORDINARY VS. EXTRAORDINARY

CHANGE IN

ACCOUNTING PRINCIPLE

• Occurs when the principle used in the current year is different form the one used last year. When this happens:

• The new principle is used to report the results of operations for current year

• The cumulative effect of the change on all prior year income statements should be disclosed “net of tax”

CHANGE IN PRINCIPLE

STATEMENT PRESENTATION

For the year ended December 31, 2006

STUDY OBJECTIVE 7

LIMITATIONS OF F/S ANALYSIS