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Financial Statement Analysis. Chapter 14. Objectives. Discuss the need for comparative analysis and identify the tools of financial statement analysis. Explain and apply horizontal and vertical analysis.

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Chapter 14

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Financial statement analysis

Financial Statement Analysis

Chapter 14


Objectives

Objectives

Discuss the need for comparative analysis and identify the tools of financial statement analysis.

Explain and apply horizontal and vertical analysis.

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

Understand the concept of earning power, and how irregular items are presented.

Understand the concept of quality of earnings.


Objectives of fs analysis

Objectives of FS Analysis

  • Forensic. . . Assessment of Past Performance and Current position

  • Future. . . Assessment of Future potential and related Risk


Sources

Sources

  • Inside the company

  • Outside the company

  • Really outside the company


Sources1

Sources

  • Inside the company – 10K, website, press releases

  • Outside the company – external analysts, Standard and Poors, Valueline, Hoovers, Dun & Bradstreet, Moody’s, etc.


Financial statement analysis1

Financial Statement Analysis

Three basic tools are used in financial statement analysis :

1.Horizontal (also called trend)analysis

2.Vertical analysis

3.Ratio analysis


Horizontal analysis

Horizontal Analysis

  • Looking at the Trends over time….

  • In $$$$$$$$$$ or %%%%%%%%%%

  • From the base year

  • Shows growth or decline

  • Used with Balance Sheet and Income Statement


Horizontal analysis of a income statement items

Horizontal Analysis of a INCOME STATEMENT ITEMS

Analysis:

Look at the Trends, all of them

What can you say about them?


Horizontal analysis of a income statement items1

Horizontal Analysis of a INCOME STATEMENT ITEMS

Analysis:

Sales grew in 2009 compared to 2008, however dipped in 2010. Net income grew each year; reviewing costs, Kellogg’s Operating Expenses grew at a much slower pace, which contributed to the Net Income growth. Also Kellogg’s gross profit improved in 2010, even though its sales did not. This suggests that Kellogg’s is controlling costs.

Note: with more space, you would quote actual numbers and % for evidence.


Chapter 14

Horizontal Analysis – Income Statement

CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT

BASE-YEAR AMOUNT

12,822.0 – 11,776= 108.88%

11,776.0

Net sales for Kellogg company increased 8.88% in 2011 compared to 2011.


Horizontal analysis of a balance sheet items

Horizontal Analysis of a balance sheet ITEMS

Analysis:

Look at the Trends, all of them

What can you say about them?


Horizontal analysis of a balance sheet items1

Horizontal Analysis of a balance sheet ITEMS

Analysis: Total Assets are decreasing; Current Assets are decreasing at a faster rate, suggesting more funds are being dedicated to Long Term Assets. However, Long Term Liabilities are stable, suggesting that the company is maintaining the same debt levels. Retained Earnings has grown by almost 30% over the base year, indicating that the company has been profitable.


What does it tell you

What does it tell you?

  • BALANCE SHEET:

    • What changed and in what direction?

    • How was it financed?

  • INCOME STATEMENT:

    • Are sales increasing?

    • Are costs following sales? (growth, decline)


What does it tell you1

What does it tell you?

  • Tracks changes over time

  • Tracks changes in one area (sales) compared to other areas (net income)


Vertical analysis

Vertical Analysis

  • Common size analysis

  • What is your basis?

    • Balance Sheet: Total Assets

    • Income Statement: Net Sales (net revenues)


Vertical analysis income statement

Vertical Analysis – Income statement

Note that Net Sales is always the 100% base figure for Vertical Analysis and all other items are a percentage of this

Analysis:

Look at the Trends, all of them

What can you say about them?


Vertical analysis income statement1

Vertical Analysis – Income statement

Note that Net Sales is always the 100% base figure for Vertical Analysis and all other items are a percentage of this

Analysis: You can’t analyze Sales much, as it is the 100% number; so talk about the other numbers: Net Income as a percent of sales increased in 2009 compared to 2008. It dipped slightly in 2010 compared to 2009, but is still above 2008’s percentage level.

Analysis:

The improvements in Net Income were caused by reduction in Operating Expenses which reduced almost 1.5%, as a percentage of net sales) and Gross Profit (declined in 2008, but improved) in 2010


Vertical analysis balance sheet

Vertical Analysis – Balance Sheet

Note that Total Assets are the 100% base figure and all other items are a percentage of this


Let s go back and look at kellogg s history

The years were 1998 and 1997

Let’s go back and look at Kellogg’s history


Chapter 14

KELLOGG COMPANY, INC.

Condensed Income Statement – Vertical Analysis

For the Years Ended December 31

(In millions)

1998 1997 AmountPercentAmountPercent

Net sales $6,762.1 100.0 $6,830.1 100.0

Cost of goods sold 3,282.6 48.6 3,270.1 47.9

Gross profit 3,479.5 51.4 3,560.0 52.1

Selling & Admin. 2,513.9 37.2 2,366.8 34.6

Nonrecurring Chgs 70.51.0 184.1 2.7

Income operations 895.1 13.2 1,009.1 14.8

Interest expense 119.5 1.8 108.3 1.6 Other income

(expense),net 6.9 0.1 3.7 0.1

Income before

income taxes 782.5 11.5 904.5 13.3

Income tax expense 279.9 4.1 340.55.0

Net income $502.6 7.4 $564.0 8.3


What is wrong with this picture

  • Look at the changes in each year?

  • What is the trend in Sales?

  • Does Cost of Goods Sold follow the same trend?

  • What about other costs?

    You may not know the reason, but what are your questions as to WHY things do not look right?

What is wrong with this picture

See end of slides for solution


What does it tell you2

What does it tell you?

  • Relative size of things on the statement. . . .Over time

  • Allows comparisons between companies


End of part 1

End of Part 1


Limitations of financial analysis

Limitations Of Financial Analysis

  • Estimates

  • Cost

  • Alternative Accounting

    Methods

  • Atypical Data

  • Diversification


Estimates

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.


Chapter 14

Cost

  • Traditional financial statements are based on historical cost and are not adjusted for price level changes.

  • Comparisons of unadjusted financial data from different periods may be rendered invalid by significant inflation or deflation.


Alternative accounting methods

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.


Atypical data

Atypical Data

Fiscal year-end data may not be typical of a company's financial condition during the year.


Diversification

Diversification

  • Diversification in American industry also limits the usefulness of financial analysis.

  • Many firms are so diverse they cannot be classified by industry.


Ratio analysis

Ratio Analysis


Ratios

Ratios

  • Types:

    • Liquidity ratios

    • Profitability ratios

    • Solvency 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


Chapter 14

RATIO Analysis – Galore!


Liquidity ratios

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 banks, suppliers, employees


Chapter 14

Liquidity Ratios

  • Current ratio

  • Acid-test ratio

  • Receivables turnover ratio

  • Inventory turnover


Current ratio

Current Ratio

Indicates short-term debt-paying ability

Current Assets

Current Liabilities


Acid test ratio

Acid-Test Ratio

Indicates immediate short-term debt-paying ability

Cash + Short-term Investments

+ Net Receivables

Current Liabilities


Receivables turnover ratio

Receivables Turnover Ratio

Indicates liquidity of receivables

Net Credit Sales

Average Net Receivables


Average collection period

Average Collection Period

Indicates liquidity of receivables and collection success

365 days

Receivables Ratio Turnover


Inventory turnover ratio

Inventory Turnover Ratio

Indicates liquidity of inventory

Cost of Goods Sold

Average Inventory


Average days in inventory

Average Days in Inventory

Indicates liquidity of inventory and inventory management

365 days

Inventory Turnover Ratio


Profitability ratios

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


Chapter 14

Profitability Ratios

  • Return on common stockholders’ equity ratio

  • Return on assets ratio

  • Profit margin ratio

  • Assets turnover ratio

  • Gross profit rate

  • Operating expenses to sales ratio

  • Cash return on sales ratio

  • Earnings per share (EPS)

  • Price-earnings ratio

  • Payout ratio


Return on common stockholders equity ratio

Return on Common Stockholders’ Equity Ratio

Indicates profitability of common stockholders’ investment

Net income -preferred stock dividends

Average common stockholders’ equity


Return on assets ratio

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


Profit margin ratio

Higher value suggests favorable return on each dollar of sales.

Profit Margin Ratio

Indicates net income generated by each dollar of sales

Net income

Net sales


Asset turnover ratio

Asset Turnover Ratio

Indicates how efficiently assets are used to generate sales

Net sales

Average total assets


Gross profit rate

Gross Profit Rate

Indicates margin between selling price and cost of good sold

Gross profit

Net sales


Operating expenses to sales ratio

Operating Expensesto Sales Ratio

Indicates the cost incurred to support each dollar of sales

Operating expenses

Net sales


Cash return on sales ratio

Cash Return on Sales Ratio

Indicates net cash flow generated by each dollar of sales

Cash provided by operations

Net sales


Earnings per share eps

Earnings Per Share (EPS)

Indicates net income earned on each share of common stock sales

Income available to common stockholders

Average number of outstanding common shares


Price earnings ratio

Price Earnings Ratio

Indicates relationship between market price per share and earnings per share

Stock Price

Earnings Per Share


Payout ratio

Payout Ratio

Indicates % of earnings distributed in the form of cash dividends

Cash Dividends

Net Income


Solvency ratios

Solvency Ratios

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

WHO CARES?

Long-term creditors and stockholders


Chapter 14

Solvency Ratios

  • Debt to total assets ratio

  • Times interest earned ratio


Debt to total assets ratio

Debt to Total Assets Ratio

Indicates % of total assets provided by creditors

Total Liabilities

Total Assets


Times interest earned ratio

Times Interest Earned Ratio

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

Income before* Interest Expense & Income Tax

Interest Expense

* Also called Operating Income


Chapter 14

  • Review and STOP HERE!


End of part 2

End of Part 2


Earning power

Earning POWER

The value of a company is a function of its future cash flows at normal income levels.


Affected by

Affected by. . . .

  • Accounting methods & estimates

    • Industry dependent

    • Requires FULL DISCLOSURE & CONSISTENCY

  • Non operating items on the Income Statement

    • Look at the D-E-A


Irregular items

Irregular Items

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


Discontinued operations

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.


Examples

Examples:

  • Pepsi spun off: Taco Bell, Pizza Hut, and KFC

  • Quaker Oats spun off: Gatorade

  • Western Wireless spun off: Voicestream

  • PACCAR spun off: Paccar Automotive and Trico (oil well digging manufacturer)


Chapter 14

Discontinued Operations

  • Assume a company, Agroworld Inc. During 2001 the company discontinued and sold its chemical division.

    • The income in 2001 from chemical operations was $200,000, and

    • The loss on disposal of the chemical division $130,000.

    • Apply a 30% tax rate


Chapter 14

Discontinued Operations

Or, I could word this:

  • During 2001 the company discontinued and sold its chemical division.

    • The income in 2001 from chemical operations (net of $60,000 taxes) was $140,000, and

    • The loss on disposal of the chemical division (net of $39,000 taxes) was $91,000.


Chapter 14

Agroworld Inc.

Income Statement (Partial)

For the Year Ended December 31, 2001

Income before income taxes$800,000

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

Income from continuing operations 560,000

Discontinued operations:

1) Income from operations of chemical division,

net of taxes, $60,000 $140,000

2) Loss from disposal of chemical division, net of $39,000 income

tax saving(91,000) 49,000

Net income before extraordinary item 609,000


Extraordinary items

Extraordinary Items...

Are events and transactions that meet two conditions:

  • Unusual in nature

  • Infrequent in occurrence


Extraordinary items1

Illustration 14-2

Extraordinary Items


Ordinary items

Illustration 14-2

Ordinary Items


Chapter 14

Extraordinary Items

  • In 2001 a revolutionary foreign government expropriated property held as an investment by Agroworld Inc.

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


Chapter 14

Agroworld Inc.

Income Statement(Partial)

For the Year Ended December 31, 2001

Income before income taxes$800,000

Income tax expense 240,000

Income from continuing operations 560,000

Discontinued operations:

Income from operations of chemical

division, net of taxes, $60,000 $140,000

Loss from disposal of chemical

division, net of $39,000 income

tax saving(91,000)49,000

Net income before extraordinary item 609,000

Extraordinary item

Expropriation of investment, net of

$21,000 income tax saving49,000

Net income $560,000


Change in accounting principle

Change in Accounting Principle

  • Is permitted, when

    • New principle is PREFERABLE to the old and

    • Effects are clearly DISCLOSED in the income statement.


Change in accounting principle1

Change in Accounting Principle

  • 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).


Chapter 14

Change in Accounting Principle

  • Use new principle in results of operations of the current year.

  • The cumulative effect of the change on all prior-yearincome statements should be disclosed net of applicable taxes in a special section below Net Income.


Chapter 14

Comprehensive Income

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

  • Plus:

    • Discontinued Operations

    • Extraordinary Items

    • Accounting Changes.

  • Plus changes in unrealized investment gains and losses


Quality of earnings

Quality of Earnings

  • The substance of earnings

  • And their sustainability into the future.


Chapter 14

Quality of Earnings

A company that has a high quality of earningsprovides 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.


Chapter 14

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.


Chapter 14

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).


Chapter 14

End of Chapter 14

Good Bye and Good Luck. – solutions follow


Kellogg s discussion of 1998 and 1997 trend analysis

Kellogg’s – DISCUSSION OF 1998 AND 1997 Trend analysis


Kellogg s 1998 and 1997 results

  • COGSincreased, but Sales went down – this is reverse trend as Costs should directly proportional to Sales (when sales go up, COGS should go up, when sales go down, COGS should go down)…what happened?

  • Selling & Admin dramatically went up 2.6%, why?

  • Most alarming, Net Income went down a full point (0.9%)

  • Why????????

Kellogg’s 1998 and 1997 results


Kellogg s in 1998 and 1997

  • Big, generic bags of cereal hit the supermarkets in 1997 and 1998.

  • Kellogg’s made the management decision not to participate in the big bags of cereal line

    • Argument: Our corn flake cereal is premium, fresh, in a box. Customer will pay more for a better product.

  • It didn’t work. Customers switched to the cheaper cereal.

  • Kellogg’s spent more on advertising (reflected in growth in Selling & Admin costs).

  • Kellogg’s finally reduced its prices (reflected in lower sales but no corresponding reduction in Cost of Goods Sold

  • The end result  Lower Net Income

Kellogg’s in 1998 and 1997


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