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Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso ELS Prepared by: Ellen L. Sweatt Georgia Perimeter College Chapter 14 ` Financial Analysis: The Big Picture Chapter 14 Financial Analysis: The Big Picture After studying Chapter 14, you should be able to:

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slide1

Financial Accounting:Tools for Business Decision Making

Kimmel, Weygandt, Kieso

ELS

Prepared by:

Ellen L. Sweatt

Georgia Perimeter College

slide2

Chapter 14

`

Financial Analysis:

The Big Picture

chapter 14 financial analysis the big picture
Chapter 14Financial Analysis:The Big Picture

After studying Chapter 14, you should be able to:

  • Understand the concept of earning power and indicate how irregular items are presented.
  • Discuss the need for comparative analysis and identify the tools of financial statement analysis.
  • Explain and apply horizontal analysis.
  • Describe and apply vertical analysis.
  • Identify and compute ratios and describe their purpose and use in analyzing a firm's liquidity, solvency, and profitability.
  • Discuss the limitations of financial statement analysis.

3

earning power
Earning Power

The value of a company is a function of its future cash flows.

4

earning power5
Earning Power

The most likely level of income to be obtained in the future

- that is, to the extent this year’s net income is a good predictor of future years’ net income.

5

earning power6
Earning Power
  • Earning power differs from actual net income by the amount of irregular revenues, expenses, gains, and losses included in this year's net income.
  • Users are interested in earning power because it helps them derive an estimate of future earnings without the "noise" of irregular items.

6

irregular items
Irregular Items

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

  • discontinued operations
  • extraordinary items
  • changes in accounting principle

7

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

8

slide9

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 1998.
  • During 1998 the company discontinued and sold its unprofitable chemical division. The loss in 1998 from chemical operations (net of $60,000 taxes) was $140,000, and the loss on disposal of the chemical division (net $30,000 taxes) was $70,000.

9

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Page 649 in book

Discontinued Operations

Assuming a 30% tax rate on the income. Rozek Inc.

Partial Income Statement

For the Year Ended December 31, 1998

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 $30,000 income tax saving 70,000210,000

Net income $350,000

10

extraordinary items
Extraordinary Items

Events and transactions that meet two conditions:

  • Unusual in nature
  • Infrequent in occurrence
extraordinary items12
Extraordinary Items
  • To be considered unusual, the item should be abnormal and only incidentally related to customary activities of the entity.
  • To be regarded as infrequent, the event or transaction should not be reasonably expected to recur in the foreseeable future.
  • Both criteria must be evaluated in terms of the environment in which the entity operates.

12

slide15

Extraordinary Items

  • In 1998 a revolutionary foreign government expropriated property held as an investment by Rozek Inc.
  • If the loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000.

15

slide16

Page 651 in book

Rozek Inc.

Partial Income Statement

For the Year Ended December 31, 1998

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 $30,000 income tax

saving 70,000210,000

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

16

slide17

Changes in Accounting Principle

  • For ease of comparison, financial statements are expected to be prepared on a basis consistent with that used for the preceding period.
  • When a choice of principles is available, the principal initially chosen should be applied consistently from period to 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.

17

slide18

Changes in Accounting Principle

  • A change is permitted, when
    • management can show that the new principle is preferable to the old;
    • 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)

18

slide19

Changes in Accounting Principle

A change in accounting principle affects reporting in two ways:

  • 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.

19

slide20

Changes in Accounting Principle

  • Rozek Inc. changes from the straight-line method to the declining-balance method for equipment purchased on January 1, 1995.
  • The cumulative effect on prior-year income statements (statements for 1995-1997) 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%).

20

slide21

Page 653 in book

Rozek Inc.

Partial Income Statement

For the Year Ended December 31, 1998

Income before income taxes $800,000

Income tax expense 240,000

Income from continuing operations 560,000Discontinued operations

Loss from operations of chemical division,

net of $60,000 income tax saving $140,000

Loss from disposal of chemical

division, net $30,000 income tax saving 70,000210,000

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

slide22

Changes in Accounting Principle

  • Although most revenues, expenses, gains, and losses recognized during the period are included in net income, specific exceptions to this practice have developed.
  • Certain items such as unrealized gains and losses on available-for-sale securities, now bypass income and are reported directly in stockholders' equity.

22

slide23

Changes in Accounting Principle

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.

23

slide24

Changes in Accounting Principle

  • Analysts have expressed concern that the number of items bypassing the income statement has increased significantly.
  • The FASB now requires that, in addition to reporting net income, a company must also report comprehensive income.

24

comprehensive income
Comprehensive Income

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

25

comparative analysis
Comparative Analysis
  • Any item reported in a financial statement has significance:
    • Its inclusion indicates that the item exists at a given time and in a certain quantity.
  • For example, when Kellogg Company reports $243.8 million on its balance sheet as cash, we know that Kellogg did have cash and that the quantity was $243.8 million.

26

comparative analysis27
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.

27

slide28

Comparative Analysis

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

  • Intracompany basis
  • Intercompany basis
  • Industry averages

28

intracompany basis
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.
  • Likewise, 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.

29

intercompany basis
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.

30

slide31

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.

31

financial statement analysis
Financial Statement Analysis

Three basic tools are used in financial statement analysis :

1. Horizontal analysis

2. Vertical analysis

3. Ratio analysis

horizontal analysis
Horizontal Analysis
  • Horizontal analysis is a technique for evaluating a series of financial statement data over a period of time.
  • The purpose of horizontal analysis 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.

33

slide34

Page 656 in book

Horizontal Analysis

KELLOGG COMPANY

Net Sales (in millions)

Base Period 1992

19961995199419931992 6,676.6 7,003.7 6,562.0 6,295.4 6,190.6

34

slide35

Page 656 in book

Horizontal Analysis

  • If we assume that 1992 is the base year, we can measure all percentage increases or decreases from this base-period amount with the following formula:

CURRENT-YEAR AMOUNT – BASE-YEAR AMOUNT

BASE-YEAR AMOUNT

  • We can determine that net sales for Kellogg company increased approximately 1.7% [($6,295.4 – $6,190.6)/$6,190.6] from 1992 to 1993.

35

percentage change in sales

Page 656 in book

Percentage Change in Sales

The percentage change in sales for each of the 5 years, assuming 1992 as the base period is:

19961995199419931992

6,676.6 7,003.7 6,562.0 6,295.4 6,190.6 107.8% 113.1% 106.0% 100.2% 100%

36

horizontal analysis of a balance sheet

Page 657 in book

Horizontal Analysis of a Balance Sheet

The financial statements of Kellogg Company are used to illustrate horizontal analysis:

KELLOGG COMPANY, INC.

Condensed Balance Sheets

December 31

(In millions)

Increase (Decrease)

during 1996

19961995AmountPercent

Assets

Current Assets $1,528.6 $1,428.8 $ 99.8 7.0%Plant assets 2,932.9 2,784.8 148.1 5.3

Other assets 588 .5 201.0387.5 192.8

Total assets 5,050.0 4,414.6 635.4 14.4%

horizontal analysis of a balance sheet38

Page 657 in book

Horizontal Analysis of a Balance Sheet

Increase (Decrease)

during 1996 19961995AmountPercent

Liabilities and

Stockholders' Equity

Current liabilities $2,199.0 $1,265.4 $933.6 73.8%

Long-term liabilities 1,568.6 1,558.3 10.3 .7

Total liabilities 3,767.6 2,823.7 943.9 33.4%

Stockholders' equity

Common stock 201.8 183.0 18.8 10.3

Retained earnings

and other 3,984.0 3,769.1 214.9 5.7

Treasury stock (2,903.4)(2,361.2) 542.2 23.0

Total stockholders'

equity 1,282.4 1,590.9(308.5) (19.4)

Total liabilities and

stockholders' equity $5,050.0 $4,414.6 $635.4 14.4%

slide39

Horizontal Analysis of an Income Statement

Page 657 in book

The following is a 2-year comparative income statement of Kellogg Company for 1996 and 1995 (in condensed format):

KELLOGG COMPANY, INC.

Condensed Income Statement

For the Years Ended December 31

(In millions)

Increase (Decrease)

during 1996 19961995AmountPercent

Net sales $6,676.6 $7.003.7 ($327.1) (4.7%)

Cost of goods sold 3,122.9 3,177.7 (54.8) (1.7)

Gross profit 3,553.7 3,826.0 (272.3) (7.1)

slide40

Page 657 in book

Horizontal Analysis of an Income Statement

Increase (Decrease)

during 1996

19961995AmountPercent

Gross profit 3,553.7 3,826.0 (272.3) (7.1)

Selling and administrative

expenses 2,458.7 2,566.7 (108.0) (4.2)

Nonrecurring charges 136.1 421.8 285.7 (67.7)

Income from operations 958.9 837.5 121.4 14.5

Interest expense 65.6 62.6 3.0 4.8

Other income

(expense), net (33.4) 21.1 54.5 n/a

Income before

income taxes 859.9 796.0 63.9 8.0%

Income tax expense 328.9 305.7 32.2 7.6

Net income $531.0 $490.3 $40.7 8.3%

slide41

Horizontal Analysis of an Income Statement

Horizontal analysis of the income statements on Page 657shows these changes:

  • Net sales decreased $327.1, or 4.7% ($327.1 ÷ $7,003.7).
  • Cost of goods sold increased $54.8, or 1.7% ($54.8 ÷ $3,177.7).
  • Selling and administrative expenses decreased $108.0, or 4.2% ($108.0 ÷ $2,566.7).

41

slide42

Horizontal Analysis of an Income Statement

  • Although gross profit decreased by 7.2%, net income increased by 8.3%.
  • The increase in net income can be attributed almost entirely to the decrease in nonrecurring charges due to the restructuring of the company.

42

vertical analysis
Vertical Analysis
  • 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.

43

vertical analysis of a balance sheet

Page 659 in book

Vertical Analysis of a Balance Sheet

Presented below is the comparative balance sheet of Kellogg for 1996 and 1995, analyzed vertically.

KELLOGG COMPANY, INC.

Condensed Balance Sheets

December 31

(In millions)

19961995

AssetsAmountPercentAmountPercent

Current Assets $1,528.6 30.3% $1,428.8 32.4%

Plant assets (net) 2,932.9 58.1 2,784.8 63.1

Other assets 588.511.7 201.0 4.6

Total assets $5,050.0 100.0% $4,414.6 100.0%

44

vertical analysis of a balance sheet45

Page 659 in book

Vertical Analysis of a Balance Sheet

19961995 AmountPercentAmountPercent

Liabilities and

Stockholders' Equity

Current liabilities $2,199.0 43.5% $1,265.4 28.7%

Long-term

liabilities 1,568.6 31.1 1,558.3 35.3

Total liabilities 3,767.6 74.6 2,823.7 64.0

45

vertical analysis of a balance sheet46

Page 659 in book

Vertical Analysis of a Balance Sheet

19961995 AmountPercentAmountPercent

Total liabilities 3,767.6 74.6 2,823.7 64.0

Stockholders' equity

Common stock 201.8 4.0 183.0 4.1

Retained earnings

and other 3,984.0 78.9 3,769.1 85.4

Treasury stock (2,903.4) 57.5(2,361.2) 53.5

Total stockholders'

equity 1,282.4 25.4 1,590.9 36.0

Total liabilities and

stockholders'

equity $5,050.0 100.0% $4,414.6 100.0%

46

slide47

Vertical Analysis of a Balance Sheet

  • In addition to showing the relative size of each category on the balance sheet, vertical analysis may show the percentage change in the individual asset, liability, and stockholders' equity items.
  • Although, Kellogg's current assets increased $99.8 million from 1995 to 1996, they decreased from 32.4% to 30.3% of total assets.

47

slide48

Vertical Analysis of a Balance Sheet

  • Plant assets decreased from 63.1% to 58.1% of total assets.
  • Current liabilities increased by $933.6 million, going from 28.7% to 43.5% of total liabilities and stockholders' equity.
slide49

Page 660 in book

Vertical Analysis of an Income Statement

KELLOGG COMPANY, INC.

Condensed Income Statement

For the Years Ended December 31

(In millions)

1996 1995 AmountPercentAmountPercent

Net sales $6,676.6 100.0% $7,003.7 100.0%

Cost of goods sold 3,122.9 46.8 3,177.7 45.4

Gross profit 3,553.7 53.2 3,826.0 54.6

Selling and administrative

expenses 2,458.7 36.8 2,566.7 36.6

Nonrecurring

charges 136.1 2.0 421.8 6.0

Income from

operations 958.9 14.4 837.5 12.0

slide50

Page 660 in book

Vertical Analysis of an Income Statement

1996 1995 AmountPercentAmountPercent

Income from

operations 958.9 14.4 837.5 12.0

Interest expense 65.6 1.0 62.6 .9

Other income

(expense),net (33.4) .5 21.1 .3

Income before

income taxes 859.9 12.9 796.0 11.4

Income tax expense 328.9 4.9 305.7 43.6

Net income $531.0 8.0% $490.3 7.0%

slide51

Vertical Analysis of an Income Statement

  • Vertical analysis of the comparative income statements of Kellogg reveals that cost of goods sold as a percentage of net sales increased 1.4% (from 45.5% to 46.8%) and selling and administrative expenses increased 0.2% (from 36.6% to 36.8%).
  • Net income as a percent of net sales increased from 7.0% to 8.0% attributed almost entirely to the decline in nonrecurring charges which decreased from 6% to 2% of sales.

51

intercompany comparison by vertical analysis

Page 660 in book

Intercompany Comparison by Vertical Analysis
  • Vertical analysis enables you to compare companies of different sizes.
  • Shown below is a comparison of the income statements of Kellogg and Quaker Oats:

CONDENSED INCOME STATEMENTS

For the Year Ended December 31, 1996

(In millions)

The Quaker

Kellogg Company, Inc.Oats Company

AmountPercentAmountPercent

Net sales $6,676.6 100.0% $5,199.0 100.0%

Cost of goods sold 3,122.9 46.8 2,807.5 54.0

Gross profit 3,553.7 53.2 2,391.5 46.0

intercompany comparison by vertical analysis53
Intercompany Comparison by Vertical Analysis

The Quaker

Kellogg Company, Inc.Oats Company

AmountPercentAmountPercent

Gross profit 3,553.7 53.2 2,391.5 46.0

Selling and administrative

expenses 2,458.7 36.8 1,981.0 38.1

Nonrecurring charges 136.1 2.0 113.4 2.2

Income from operations 958.9 14.4 415.6 8.0

Other expenses and

revenues (including

income taxes) 427.9 6.4 167.7 3.2

Net income $531.0 8.0% $247.9 4.8%

53

slide54

Intercompany Comparison by Vertical Analysis

  • Although Kellogg's net sales are 28% greater than the net sales of Quaker Oats, vertical analysis facilitates a comparison.
  • Kellogg's income from operations as a percentage of sales is 14.4% compared to 8.0% for Quaker Oats.
  • Kellogg's higher percentage income from operations is attributed to its superior gross profit margin rate of 53.2%.

54

ratio analysis56
Ratio Analysis

Ratios can be classified into three types:

  • Liquidity ratios - measures of the short-term ability of the enterprise to pay its maturing obligations an to meet unexpected needs for cash
  • Solvency ratios - measures of the ability of the enterprise to survive over a long period of time
  • Profitability ratios - measures of the income or operating success of an enterprise for a given period of time

56

ratio analysis57
Ratio Analysis
  • As a tool of analysis, ratios can provide clues to underlying conditions that may not be apparent from an inspection of the individual components of a particular ratio.
  • A single ratio by itself is not very meaningful.

57

liquidity ratios
Liquidity Ratios
  • Liquidity ratios measure the short-term ability of the enterprise 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.

58

slide59

Liquidity Ratios

  • Current ratio
  • Acid-test ratio
  • Current cash debt coverage ratio
  • Receivables turnover ratio
  • Average collection period
  • Inventory turnover
  • Average days in inventory

59

current ratio
Current Ratio
  • The current ratio is widely used for evaluating a company's liquidity and short-term debt-paying ability.
  • The current ratio does not take into account the composition of the current assets.
  • A satisfactory current ratio does not disclose that portion of the current assets that may be tied up in slow-moving inventory.

60

current ratio61

Current Assets

Current Liabilities

Current Ratio =

Current Ratio

Indicates short-term debt-paying ability

61

acid test ratio
Acid-Test Ratio
  • The acid-test ratio or quick ratio is a measure of a company's immediate short-term liquidity.
  • The acid-test ratio is computed by dividing the sum of cash, marketable securities, and net receivables by current liabilities.
  • The ratio does not include inventory or prepaid expenses.
  • Cash, marketable securities, and receivables are highly liquid compared with inventory and prepaid expenses.

62

acid test ratio63

Cash,Marketable

Securities, Net Receivables

Current Liabilities

Acid-Test Ratio

Indicates immediate short-term debt-paying ability.

Acid-Test Ratio =

63

current cash debt coverage ratio
Current Cash Debt Coverage Ratio

Indicates short-term debt-paying ability on the cash basis.

Cash provided by operations

Average current liabilities

64

receivables turnover ratio
Receivables Turnover Ratio
  • Indicates liquidity of receivables by determining how quickly receivables can be converted to cash.
  • The receivables turnover ratio measures the number of times, on average, receivables are collected during the period.

65

receivables turnover ratio66
Receivables Turnover Ratio =

a measure of the liquidity

of receivables

Net Credit Sales

Average Net Receivables

66

average collection period
Average Collection Period
  • The average collection period is a popular variant of the receivables turnover ratio.
  • The average collection period converts the receivables turnover into an average collection period expressed in days.
  • The general rule is that the collection period should not greatly exceed the credit term period.

67

average collection period68
Average Collection Period =

the average amount of time that a receivable is outstanding.

365 days

Receivables Ratio Turnover

68

inventory turnover ratio
Inventory Turnover Ratio
  • The inventory turnover ratio measures the number of times on average the inventory is sold during the period.
  • Indicates the liquidity of the inventory

69

inventory turnover ratio70
Inventory Turnover Ratio =

Cost of Goods Sold

Average Inventory

70

average days in inventory
Average Days in Inventory
  • Is a variant of the inventory turnover ratio.
  • Measures the average number of days it takes to sell the inventory.

71

average days in inventory72
Average Days in Inventory =

365 days

Inventory Turnover Ratio

72

solvency ratios
Solvency Ratios
  • Measure the ability of the enterprise to survive over a long period of time
  • Long-term creditors and stockholders are interested in a company's long-run solvency, particularly its ability to pay interest as it comes due and to repay the face value of the debt at maturity.

73

slide74

Solvency Ratios

  • Debt to total assets ratio
  • Times interest earned ratio
  • Cash debt coverage ratio
  • Free cash flow

74

debt to total assets ratio
Debt to Total Assets Ratio

Indicates % of total assets provided by creditors.

Total Debt

Total Assets

times interest earned ratio
Times Interest Earned Ratio

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

Interest Before Interest Expense & Income Tax

Interest Expense

76

cash debt coverage ratio
Cash Debt Coverage Ratio

Indicates: Long-term debt-paying ability on the cash basis.

Cash provided by operations

Average total liabilities

77

slide78

Free Cash Flow

Indicates cash available for paying dividends or expanding operations.

Cash Provided By Operations

- Capital Expenditures

- Dividends Paid

Free Cash Flow

78

profitability ratios
Profitability Ratios
  • Measures the income or operating success of an enterprise for a given period of time
  • These are important because a company's income, or lack of it, affects its ability to obtain debt and equity financing, its liquidity position, and its ability to grow.

79

slide80

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

80

return on common stockholders equity ratio
Return on Common Stockholders’ Equity Ratio

Measures the profitability from the stockholders’ point of view

Net income - Preferred stock dividends

Average common stockholders’ equity

82

return on assets ratio

Net income

Average assets

Return on Assets Ratio =

Higher value suggests favorable efficiency.

Return on Assets Ratio

Reveals the amount of net income generated by each dollar invested

83

profit margin ratio

Net income

Net sales

Profit Margin Ratio =

Higher value suggests favorable return on each dollar of sales.

Profit Margin Ratio

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

84

asset turnover ratio
Asset Turnover Ratio

Indicates how efficiently assets are used to generate sales.

Net sales

Average total assets

85

gross profit rate
Gross Profit Rate

Indicates margin between selling price and cost of good sold.

Gross profit

Net sales

86

operating expenses to sales ratio
Operating Expenses toSales Ratio

Indicates the cost incurred to support each dollar of sales.

Operating expenses

Net sales

87

cash return on sales ratio
Cash Return on Sales Ratio
  • The cash return on sales ratio indicates the company's ability to turn sales into dollars for the firm.
  • A low cash return on sales ratio should be investigated because it might indicate the firm is recognizing sales that are not really sales - that is, sales it will never collect.

88

limitations of financial analysis
Limitations Of Financial Analysis
  • Horizontal, vertical, and ratio analysis are frequently used in making significant business decisions.
  • One should be aware ofthe limitations of thesetools and the financialstatements.

89

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.

90

costs
Costs
  • 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.
  • Some assets such as property, plant, and equipment may be many years old. The cost at which they are shown on the balance sheet might be significantly lower than current market value.

91

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.

92

atypical data
Atypical Data

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

93

diversification
Diversification
  • Diversification in American industry also limits the usefulness of financial analysis.
  • Many firms are so diverse they cannot be classified by industry.

94