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Prepared by Gregory K. Lowry Mercer University Marianne Bradford The University of Tennessee John Wiley & Sons, Inc. Financial Accounting, 4e Weygandt, Kieso, & Kimmel CHAPTER 15 FINANCIAL STATEMENT ANALYSIS After studying this chapter, you should be able to:

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Prepared by

Gregory K. Lowry

Mercer University

Marianne Bradford

The University of Tennessee

John Wiley & Sons, Inc.

Financial Accounting, 4e Weygandt, Kieso, & Kimmel


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CHAPTER 15FINANCIAL STATEMENT ANALYSIS

After studying this chapter, you should be able to:

1 Discuss the need for comparative analysis.

2Identifythe tools of financial statement analysis.

3 Explain and apply horizontal analysis.

4Describe and apply vertical analysis.


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CHAPTER 15FINANCIAL STATEMENT ANALYSIS

After studying this chapter, you should be able to:

5 Identify and compute ratios and describe their purpose and use in analyzing a firm’s liquidity, profitability, and solvency.

6Understand the concept of earning power and indicate how material items not typical of regular operations are presented.

7 Recognize the limitations of financial statement analysis.


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FINANCIAL STATEMENT ANALYSIS

Horizontal and Vertical Analysis

Earning Power and Irregular Items

Basics of Financial Statement Analysis

Limitations of Financial Analysis

Ratio Analysis

Need for comparative analysis

Tools of analysis

Balance sheet

Income statement

Retained earnings statement

Liquidity

Profitability

Solvency

Summary

Estimates

Cost

Accounting methods

Atypical data

Diversification

PREVIEW OF CHAPTER 15

Discontinued operations

Extraordinary items

Change in accounting principle

Comprehensive income


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BASICS OF FINANCIAL STATEMENT ANALYSIS

  • Analyzing financial statements involves Three characteristics of a company: 1its liquidity, 2 its profitability, and 3its solvency.

  • Every item reported in a financial statement has significance.

  • In order to obtain information as to whether the amount 1represents an increase over prior years or 2is adequate in relation to the company’s need for cash, the amount of cash must be compared with other financial statement data.

  • Comparisons can be made on several difference bases – threeare illustrated in this chapter: 1intracompany basis, 2industry averages, and 3intercompany basis.


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TOOLS OF FINANCIAL STATEMENT ANALYSIS

Three commonly used tools are utilized to evaluate the significance of financial statement data.

1Horizontal analysis (trend analysis) is a technique for evaluating a series of financial statement data over a period of time.

2Vertical analysis is a technique for evaluating financial statement data that expresses each item in a financial statement in terms of a percent of a base amount.

3Ratio analysis expresses the relationship among selected items of financial statement data.


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ILLUSTRATION 15-1, 15-2 SEARS ROEBUCK’S NET SALES

SEARS, ROEBUCK AND CO.

The purpose of horizontal analysis is to determine the increase or decrease that has taken place, expressed as either an amount or a percentage. The recent net sales figures of Sears, Roebuck and Co. are shown above. Given that 1996 is the base year, we can measure all percentage increases or decreases from this base period amount as shown below.

(Net Sales Stated in Millions)

2000

1999

1998

1997

1996

$ 40,937

$ 39,484

$ 39,953

$ 39,837

$ 36,662

Change since base period

=


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ILLUSTRATION 15-4 HORIZONTAL ANALYSIS OF SEARS, ROEBUCK’S NET SALES

We can determine that net sales for Sears, Roebuck increased approximately 8.7% [($39,837 - $36,662) ÷ $36,662] from 1996 to 1997. We can also determine that net sales increased over 11.7% [($40,937 - $36,662) ÷ $36,662] from 1996 to 2000. The percentage of the base period for each of the 5 years, assuming 1996 as the base period, is shown below.

Sears, Roebuck and Co.

Net Sales (in Millions)

Base Period 1996

2000

1999

1998

1997

1996

$40,937

$ 39,484

$ 39,953

$ 39,837

$36,662

111.7%

107.7%

109%

108.7%

100%


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Increase or (Decrease)

during 2000

Current assets

$ 1,020,000

$ 75,000

7.9%

Intangible assets

17,500

( 2,500)

( 14.3%)

$ 1,835,000

Current liabilities

13.7%

487,500

Total liabilities

800,000

32,000

Stockholders’ Equity

5,400

2.0%

Retained earnings

1,003,000

208,000

Total liabilities and stockholders’ equity

ILLUSTRATION 15-5 HORIZONTAL ANALYSIS OF A BALANCE SHEET

The 2-year condensed balance sheet of Quality Department Store Inc. for 2000 and 1999 showing dollar and percentage changes is displayed on the right. In the asset section, plant assets (net) increased $167,500 or 26.5%. In the liabilities section, current liabilities increased $41,500 or 13.7%. In the stockholders’ equity section, retained earnings increased $202,600 or 38.6%. It appears the company expanded its asset base during 2000 and financed the expansion by retaining income in the firm.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheet

December 31

2000

1999

Amount

Percentage

Assets

$ 945,000

Plant assets (net)

800,000

632,500

167,500

26.5%

15,000

Total assets

$ 1,595,000

$ 240,000

15.0%

Liabilities

$ 344,500

$ 303,000

$ 41,500

Long-term liabilities

497,000

( 9,500)

( 1.9%)

832,000

4.0%

Common stock, $1 par

275,400

270,000

727,600

525,000

202,600

38.6%

Total stockholders’ equity

795,000

26.2%

$ 1,835,000

$ 1,595,000

$ 240,000

15.0%


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ILLUSTRATION 15-6 HORIZONTAL ANALYSIS OF AN INCOME STATEMENT

The 2-year comparative income statement of Quality Department Store Inc. for 2000 and 1999 is shown in condensed form on the right. Horizontal analysis of the comparative income statement shows the following changes:

1Net sales increased $260,000, or 14.2% ($260,000 ÷ $1,837,000).

2Cost of goods sold increased $141,000, or 12.4% ($141,000 ÷ $1,140,000).

3Total operating expenses increased $37,000, or 11.6% ($37,000 ÷ $320,000).

QUALITY DEPARTMENT STORE INC.

Condensed Income Statement

For the Years Ended December 31

Increase or (Decrease)

during 2000

2000

1999

Amount

Percentage

Sales

$ 2,195,000

$ 1,960,000

$ 235,000

12.0%

Sales returns and allowances

98,000

123,000

( 25,000)

( 20.3%)

Net sales

2,097,000

1,837,000

260,000

14.2%

Cost of goods sold

1,281,000

1,140,000

141,000

12.4%

Gross profit

816,000

697,000

119,000

17.1%

Selling expenses

253,000

211,500

41,500

19.6%

Administrative expenses

104,000

108,500

( 4,500)

( 4.1%)

Total operating expenses

357,000

320,000

37,000

11.6%

Income from operations

459,000

377,000

82,000

21.8%

Other revenues and gains

Interest and dividends

9,000

11,000

( 2,000)

( 18.2%)

Other expenses and losses

Interest expense

36,000

40,500

( 4,500)

( 11.1%)

Income before income taxes

432,000

347,500

84,500

24.3%

Income tax expense

168,200

139,000

29,200

21.0%

Net income

$ 263,800

$ 208,500

$ 55,300

26.5%


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ILLUSTRATION 15-7 HORIZONTAL ANALYSIS OF A RETAINED EARNINGS STATEMENT

The 2-year comparative retained earnings statement of Quality Department Store Inc. for 2000 and 1999 is presented on the right. Analyzed horizontally:

1Net income increased $55,300, or 26.5%.

2Common dividends increased only $1,200, or 2%.

3Ending retained earnings increased 38.6%.

QUALITY DEPARTMENT STORE INC.

Retained Earnings Statement

For the Years Ended December 31

Increase or (Decrease)

during 2000

2000

1999

Amount

Percentage

Retained earnings, January 1

$ 525,000

$ 376,500

$ 148,500

39.4%

Add: Net income

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%


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ILLUSTRATION 15-8 VERTICAL ANALYSIS OF A BALANCE SHEET

Presented on the right is the 2-year comparative balance sheet of Quality Department Store Inc. for 2000 and 1999.

1Current assets increased $75,000 from 1999 to 2000, they decreased from 59.2% to 55.6% of total assets.

2Plant assets (net) increased from 39.7% to 43.6% of total assets, and

3Retained earnings increased from 32.9% to 39.7% of total liabilities and stockholders’ equity.

These results reinforce earlier observations that Quality is financing its growth through retention of earnings.

QUALITY DEPARTMENT STORE INC.

Condensed Balance Sheet

December 31

2000

1999

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%

Intangible 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

Common stock, $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%


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ILLUSTRATION 15-9 VERTICAL ANALYSIS OF AN INCOME STATEMENT

Vertical analysis of the 2-year comparative income statement of Quality Department Store Inc. for 2000 and 1999 is shown on the right.

1Cost of goods sold as a percentage of net sales declined 1% (62.1% versus 61.1%).

2Total operating expenses declined 0.4% (17.4% versus 17.0%).

3Net income as a percent of net sales therefore increased from 11.4% to 12.6%.

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

QUALITY DEPARTMENT STORE INC.

Condensed Income Statement

For the Years Ended December 31

2000

1999

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%

Administrative expenses

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

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%


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ILLUSTRATION 15-10 INTERCOMPANY INCOME STATEMENT COMPARISON

Vertical analysis enables you to compare companies of different sizes. Quantity’s major competitor is a Sears store in a town nearby town. Using vertical analysis, the small Quality Department Store Inc. can be meaningfully compared to the much larger Sears, as shown below. 1Gross profit rates were somewhat comparable at 38.9% and 34.3%. 2Income from operations percentages were significantly different at 21.9% and 5.3% . 3 Quality’s selling and administrative expenses percentage was much lower than Sears’ – 17% to 28.9%. 4 Sears’ net income as a percentage of sales was much lower than Quality’s: 3.3% to 12.6%.

CONDENSED INCOME STATEMENTS

Quality

Department

Sears, Roebuck

Store Inc.

And Co.

(in thousands)

Dollars

Percent

Dollars

Percent

Net sales

$ 2,097

100.0%

$ 46,937,000

100.0%

Cost of goods sold

1,281

61.1%

26,899,000

65.7%

Gross profit

816

38.9%

14,038,000

34.3%

Selling and administrative expenses

357

17.0%

11,851,000

28.9%

Income from operations

459

21.9%

2,187,000

5.3%

Other expenses and revenues (including income taxes

195

9.3%

884,000

2.1%

Net income

$ 264

12.6%

$ 1,343,000

3.3%


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RATIO ANALYSIS

  • Ratio analysis expresses the relationship among selected items of financial statement data.

  • A ratio expresses the mathematical relationship between one quantity and another.

  • A single ratio by itself is not very meaningful, in the upcoming illustrations we will use:

    1 Intracompany comparisons covering two years for the Quality Department Store.

    2 Industry average comparisons based on median ratios for department stores

    3 Intercompany comparisons based on Sears, Roebuck and Co. as Quality Department Store’s principal competitor.


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Liquidity Ratios

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

Profitability Ratios

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

-

Revenues

Expenses

=

Net Income

Solvency Ratios

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

XYZ Co.

ILLUSTRATION 15-11 FINANCIAL RATIO CLASSIFICATIONS


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

ILLUSTRATION 15-12 CURRENT RATIO

The current ratio (working capital ratio) is a widely used measure for evaluating a company’s liquidity and short-term debt-paying ability. It is calculated by dividing current assets by current liabilities and is a more dependable indicator of liquidity than working capital. The current ratios for Quality Department Store and comparative data are shown below.

Quality Department Store

2000

1999

$1,020,000

$945,000

=

=

—————

2.96:1

————

3.1:1

$344,500

$303,000

Industry average

Sears, Roebuck and Co.

————————

———————————

1.34:1

2.38:1


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ILLUSTRATION CURRENT RATIO = ——————————— CURRENT LIABILITIES 15-13 CURRENT ASSETS OF QUALITY DEPARTMENT STORE

2000

1999

Current assets

Cash

$ 100,000

$ 155,000

20,000

Temporary invest.

70,000

Receivables (net)

180,000

230,000

Inventory

500,000

620,000

Prepaid expenses

50,000

40,000

Total current assets

$ 1,020,000

$ 945,000


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

ILLUSTRATION 15-14 ACID-TEST RATIO

The acid-test ratio (quick ratio) is a measure of a company’s short-term liquidity and is calculated by dividing the sum of cash,marketable securities, andnet receivables by current liabilities. The acid-test ratios for Quality Department Store and comparative data are shown below.

Quality Department Store

2000

1999

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

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

—————————————— = 1.0:1

—————————————— = 1.3:1

$344,500

$303,000

Industry average

Sears, Roebuck and Co.

————————

———————————

1.3:1

1.3:1


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CURRENT CASH DEBT NET CASH PROVIDED BY OPERATING ACTIVITIES COVERAGE RATIO = ———————————————————————— AVERAGE CURRENT LIABILITIES

ILLUSTRATION 15-15 CURRENT CASH DEBT COVERAGE RATIO

The current cash debt coverage ratio usually provides a superior representation of liquidity since it uses not cash provided by operating activities rather than a balance at a point in time. Quality Department Store’s current cash debt coverage ratios for 2000 and 1999 are calculated below.

Quality Department Store

2000

1999

$404,000

$340,000

-

-

——————————

1.25:1

——————————

1.15:1

[

]

[

]

$303,000 + $344,500

$290,000 + $303,000

——————————

——————————

2

2

Industry average

Sears, Roebuck & Co.

————————

———————————

1.1:1

0.137:1


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

ILLUSTRATION 15-16 RECEIVABLES TURNOVER

The receivables turnover ratio is used to assess the liquidity of the receivables. It measures the number of times, on average, receivables are collected during the period. The ratio is calculated by dividing net credit sales by average net receivables during the year. The receivables turnover ratio and comparative data for Quality Department Store for 2000 and 1999 are calculated below.

Quality Department Store

2000

1999

$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 & Co.

————————

———————————

15.7 times

2.19 times


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

ILLUSTRATION 15-17 INVENTORY TURNOVER

The inventory turnover ratio measures the number of times, on average, the inventory is sold during the period – which measures the liquidity of the inventory. It is calculated by dividing cost of goods sold by average inventory during the year. The inventory turnover ratio and comparative data for Quality Department Store for 2000 and 1999 are calculated below.

Quality Department Store

2000

1999

$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.

————————

———————————

6.22 times

4.61 times


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

ILLUSTRATION 15-18 PROFIT MARGIN RATIO

The profit margin ratio is a measure of the percentage of each dollar of sales that results in net income. It is calculated by dividing net income by net sales for the period. The profit margin ratios and comparative data for Quality Department Store for 2000 and 1999 are calculated below.

Quality Department Store

2000

1999

$263,800

$208,500

————— = 12.6%

————— = 11.4%

$2,097,000

$1,837,000

Industry average

Sears, Roebuck and Co.

————————

———————————

3.16%

1.8%


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NET CASH PROVIDED BY OPERATING ACTIVITIES CASH RETURN ON SALES RATIO = ————————————————————————— NET SALES

ILLUSTRATION 15-19 CASH RETURN ON SALES RATIO

The cash basis counterpart of the profit margin ratio is the cash return on sales ratio which uses net cash provided by operating activities as the numerator and net sales as the denominator. Using net cash provided by operating activities of $404,000 in 2000 and $340,000 in 1999, Quality Department Store’s cash return on sales ratios are calculated and evaluated below.

Quality Department Store

2000

1999

$404,000

$340,000

————— = 19.3%

————— = 18.5%

$2,097,000

$1,837,000

Industry average

Sears, Roebuck and Co.

————————

———————————

6.2%

7.4%


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

ILLUSTRATION 15-20 ASSET TURNOVER

The asset turnover ratio measures how efficiently a company uses its asset to generate sales. It is determined by dividing net sales by average assets for the period. Quality Department Store’s cash return on sales ratios are calculated and evaluated below.

Quality Department Store

2000

1999

$2,097,000

$1,837,000

—————————— = 1.2 times

——————————— = 1.21 times

[

]

[

]

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

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

———————————

———————————

2

2

Industry average

Sears, Roebuck & Co.

————————

———————————

2.32 times

1.1 times


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

ILLUSTRATION 15-21 RETURN ON ASSETS

An overall measure of profitability is the return on assets ratio. It is calculated by dividing net income by average assets for the period. Quality Department Store’s return on assets ratios for 2000 and 1999 are calculated and evaluated below.

Quality Department Store

2000

1999

$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 & Co.

————————

———————————

1.99%

7.42%


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

ILLUSTRATION 15-22 RETURN ON COMMON STOCKHOLDERS’ EQUITY

A ratio that measures profitability from the viewpoint of the common stockholder is return on common stockholders’ equity. It is calculated by dividing net income by average common stockholders’ equity for the period. Quality Department Store’s return on common stockholders’ equity for 2000 and 1999 are calculated and evaluated below.

Quality Department Store

2000

1999

$263,800

$208,500

[

]

[

]

——————————— = 29.3%

——————————— = 28.5%

$795,000 + $1,003,000

$667,000 + $795,000

———————————

———————————

2

2

Industry average

Sears, Roebuck and Co.

————————

———————————

18.6%

10.9%


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RATE OF RETURN ON COMMON NET INCOME – PREFERRED DIVIDENDS STOCKHOLDERS’ EQUITY = ——————————————————————— AVERAGE COMMON STOCKHOLDERS’ EQUITY

ILLUSTRATION 15-23 RETURN ON COMMON STOCKHOLDERS’ EQUITY WITH PREFERRED STOCK

When preferred stock is present, preferred dividend requirements are deducted from net income to determine income available to common stockholders. The par value of preferred stock (or call price – if applicable) must be deducted from total stockholders’ equity to arrive at the amount of common stockholders’ equity used in this ratio. The ratio then appears as shown below.


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

ILLUSTRATION 15-24 EARNINGS PER SHARE

Earnings per share (EPS) ofcommon stock is a measure of net income earned on each share of common stock. It is calculated by dividing net income by the number of weighted average common shares outstanding during the year. Quality Department Store’s EPS for 2000 and 1999 are calculated and evaluated below.

Quality Department Store

2000

1999

$263,000

$208,500

-

-

[

]

—————————

$.97

—————

$.77

270,000 + 275,400

270,000

—————————

2


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

ILLUSTRATION 15-25 PRICE-EARNINGS RATIO

The price-earnings (PE) ratio measures the ratio of the market price of each share of common stock to the earnings per share. It is calculated by dividing the market price per share of common stock by earnings per share. Quality Department Store’s PE ratios for 2000 and 1999 are calculated and evaluated below.

Quality Department Store

2000

1999

$12.00

$ 8.00

——— = 12.4 times

——— = 10.4 times

$ .97

$ .77

Industry average

Sears, Roebuck and Co.

————————

———————————

33 times

22 times


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

ILLUSTRATION 15-26 PAYOUT RATIO

The payout ratio measures the percentage of earnings distributed in the form of cash dividends. It is calculated by dividing cash dividends by net income. Quality Department Store’s payout ratios for 2000and 1999 are calculated and evaluated below.

Quality Department Store

2000

1999

$61,200

$60,000

————— = 23.2%

————— = 28.8%

$263,800

$208,500

Industry average

Sears, Roebuck and Co.

————————

———————————

17.5%

44.5%


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TOTAL DEBT DEBT TO TOTAL ASSETS = ———————— TOTAL ASSETS

ILLUSTRATION 15-27 DEBT TO TOTAL ASSETS

The debt to total assets ratio measures the percentage of total assets provided by creditors, indicating the degree of leveraging. It is calculated by dividing total debt by total assets. Quality Department Store’s total debt to total assets ratios for 2000 and 1999 are calculated and evaluated below.

Quality Department Store

2000

1999

$832,000

$800,000

————— = 45.3%

————— = 50.2%

$1,835,000

$1,595,000

Industry average

Sears, Roebuck and Co.

————————

———————————

42.0%

81.7%


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TIMES INTEREST INCOME BEFORE INCOME TAXES AND INTEREST EXPENSE EARNED = ————————————————————————————— INTEREST EXPENSE

ILLUSTRATION 15-28 TIMES INTEREST EARNED

The times interest earned ratio provides an indication of the company’s ability to meet interest payments as they come due. It is calculated by dividing income before income taxes and interest expense by interest expense. Quality Department Store’s times interest earned ratios for 2000 and 1999 are calculated and evaluated below.

Quality Department Store

2000

1999

$468,000

$388,000

————

13 times

————

9.6 times

=

=

$36,000

$40,500

Industry average

Sears, Roebuck and Co.

————————

———————————

7.39 times

1.86 times


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NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES

ILLUSTRATION 15-29 CASH DEBT COVERAGE RATIO

The ratio of net cash provided by operating activities to average total liabilities is the cash debt coverage ratio and is a measure of solvency. Quality Department Store’s cash debt coverage ratios for 2000 and 1999 are calculated and evaluated below.

Quality Department Store

2000

1999

$404,000

$340,000

[

]

[

]

—————————— = .495 times

—————————— = .442 times

$800,000 + $832,000

$740,000 + $800,000

———————————

———————————

2

2

Industry average

Sears, Roebuck and Co.

————————

———————————

.38 times

.09 times


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ILLUSTRATION NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS


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ILLUSTRATION NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS


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ILLUSTRATION NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS


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ILLUSTRATION NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS


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EARNING POWER NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES AND IRREGULAR ITEMS

  • For users of financial statements to determine earning power or regular income, the irregular items are separately identified on the income statement.

  • Three types of irregular items are reported:

    1Discontinued operations,

    2Extraordinary items, and

    3Changes in accounting principle.


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DISCONTINUED OPERATIONS NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES

  • Discontinued operations constitutes the disposal of a significant segment of a business.

  • The income (loss) from discontinued operations consists of

    1 the income (loss) from operations and

    2the gain (loss) on disposal of the segment.


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ILLUSTRATION NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES 15-31 STATEMENT PRESENTATION OF DISCONTINUED OPERATIONS

Acro Energy Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in 2002. The company therefore has income before income taxes of $800,000. The company discontinued and sold its unprofitable chemical division during 2002. The 2002 loss from chemical operations was $140,000 (net of $60,000 in income taxes), and the loss on disposal of the chemical division (net of $30,000 in income taxes), was $70,000. Given a 30% income tax rate, the partial income statement presentation is shown below.


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EXTRAORDINARY ITEMS NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES

  • Extraordinary items are events and transactions that meet two conditions: they are

    1unusual in nature and

    2infrequent in occurrence.

  • Extraordinary items are reported net of taxes in a separate section of the income statement immediately below discontinued operations.


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CONDEMNED NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES

ILLUSTRATION 15-32 EXAMPLES OF EXTRAORDINARY AND ORDINARY ITEMS

SALE

4.Destruction of property by

fire or explosion


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ILLUSTRATION NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES 15-33 STATEMENT PRESENTATION OF EXTRAORDINARY ITEMS

In 2002 a revolutionary 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 partial income statement presentation will show a deduction of $49,000 – as shown below.

ACRO ENERGY INC.

Partial Income Statement

For the Year Ended December 31, 2002

Income before income taxes

$800,000

Income tax expense

240,000

Income from continuing operations

560,000

Discontinued operations

Loss from operations of chemical division, net of $60,000 income tax

saving

$ 140,000

Loss from disposal of chemical division, net of $30,000 income tax

saving

70,000

210,000

Income before extraordinary item

350,000

Extraordinary item

Expropriation of investment, net of $21,000 income tax saving

49,000

Net income

$ 301,000


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CHANGE IN NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES ACCOUNTING PRINCIPLE

  • To make them comparable, financial statements are expected to be prepared on a basis consistent with that used in the preceding period.

  • A change in accounting principle occurs when the principle used in the current year is different from the one used in the preceding year.

  • A change is permitted when

    1management can show that the new principle is preferable to the old principle and

    2the effects of the change are clearly disclosed in the income statement.


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CHANGE IN NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES ACCOUNTING PRINCIPLE

When a change in accounting principle has occurred,

1the new principle should be used in reporting the results of operations of the current year and

2the cumulative effect of the change on all prior year income statements should be disclosed net of applicable income taxes in a special section immediately preceding net income.


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ILLUSTRATION NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES 15-34 STATEMENT PRESENTATION OF CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE

At the beginning of 2002, Acro Energy Inc. changes from the straight-line method of depreciation to the declining-balance method for equipment purchased on January 1, 1999. Assuming a 30% income tax rate the net of income tax effect of the change is $16,800 ($24,000 X 70%). The partial income statement presentation is shown below.


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LIMITATIONS OF NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES FINANCIAL ANALYSIS

You should be aware of some of the limitations of the three analytical tools illustrated in the chapter and of the financial statements on which they are based.

1Estimates: Financial statements contain numerous estimates; to the extent that these estimates are inaccurate, the financial ratios and percentages are inaccurate.

2Cost: Traditional financial statements are based on 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.


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LIMITATIONS OF NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES FINANCIAL ANALYSIS

3Alternative Accounting Methods: Variations among companies in the application of GAAP may hamper comparability. Although differences in accounting methods might be detectable from reading the notes to the financial statements, adjusting the financial data to compensate for the different methods is difficult, if not impossible, in some cases.

4Atypical Data: Fiscal year-end data may not be typical of the financial condition during the year. Firms often establish a fiscal year-end that coincides with the low point in operating activity or in inventory levels. Thus, certain account balances may not be representative of the account balances during the year.

5Diversification of Firms: Diversification in American industry also restricts the usefulness of financial analysis. Many firms today are too diversified to be classified by industry, while others appear to be comparable when they are not.


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CHAPTER reserved. Reproduction or translation of this work beyond that named in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions15FINANCIAL STATEMENT ANALYSIS


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