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Chapter 18

Financial Statement Analysis. Chapter 18. Accounting Principles, Ninth Edition. Financial Statement Analysis. Basics of Financial Statement Analysis. Horizontal and Vertical Analysis. Ratio Analysis. Earning Power and Irregular Items. Quality of Earnings. Need for comparative analysis

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Chapter 18

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  1. Financial Statement Analysis Chapter18 Accounting Principles, Ninth Edition

  2. Financial Statement Analysis Basics of Financial Statement Analysis Horizontal and Vertical Analysis Ratio Analysis Earning Power and Irregular Items Quality of Earnings Need for comparative analysis Tools of analysis Balance sheet Income statement Retained earnings statement Liquidity Profitability Solvency Summary Discontinued operations Extraordinary items Changes in accounting principle Comprehensive income Alternative accounting methods Pro forma income Improper recognition

  3. Basics of Financial Statement Analysis Analyzing financial statements involves: Characteristics Comparison Bases Tools of Analysis Liquidity Profitability Solvency Intracompany Industry averages Intercompany Horizontal Vertical Ratio SO 1 Discuss the need for comparative analysis. SO 2 Identify the tools of financial statement analysis.

  4. Horizontal Analysis Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place. Horizontal analysis is commonly applied to the balance sheet, income statement, and statement of retained earnings. SO 3 Explain and apply horizontal analysis.

  5. Horizontal Analysis Illustration 18-5 Horizontal analysis of balance sheets These changes suggest that the company expanded its asset base during 2007 and financed this expansion primarily by retaining income rather than assuming additional long-term debt. SO 3 Explain and apply horizontal analysis.

  6. Horizontal Analysis Illustration 18-6 Horizontal analysis of Income statements Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality’s profit trend appears favorable. SO 3 Explain and apply horizontal analysis.

  7. Horizontal Analysis Illustration 18-7 Horizontal analysis of retained earnings statements We saw in the horizontal analysis of the balance sheet that ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities. SO 3 Explain and apply horizontal analysis.

  8. Vertical Analysis Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount. On an income statement, we might say that selling expenses are 16% of net sales. Vertical analysis is commonly applied to the balance sheet and the income statement. SO 4 Describe and apply vertical analysis.

  9. Vertical Analysis Illustration 18-8 Vertical analysis of balance sheets These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt. SO 4 Describe and apply vertical analysis.

  10. Vertical Analysis Illustration 18-9 Vertical analysis of Income statements Quality appears to be a profitable enterprise that is becoming even more successful. SO 4 Describe and apply vertical analysis.

  11. Vertical Analysis Enables a comparison of companies of different sizes. Illustration 18-10 Intercompany income statement comparison J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C. Penney’s net income as a percent of each sales dollar (5.6%) is only 4% of Quality’s (12.6%). SO 4 Describe and apply vertical analysis.

  12. Ratio Analysis Ratio analysisexpresses the relationship among selected items of financial statement data. Financial Ratio Classifications Liquidity Profitability Solvency Measures short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Measures the income or operating success of a company for a given period of time. Measures the ability of the company to survive over a long period of time. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  13. Ratio Analysis A single ratio by itself is not very meaningful. The discussion of ratios will include the following types of comparisons. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  14. Ratio Analysis Liquidity Ratios • Measure the short-term ability of the company 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. • Ratios include the current ratio, the acid-test ratio, receivables turnover, and inventory turnover. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  15. Liquidity Ratios Ratio Analysis Compute the Current Ratio for 2007. Current Assets = Current Ratio Current Liabilities $1,020,000 = 2.96 : 1 $344,500 The ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  16. Liquidity Ratios Ratio Analysis Compute the Acid-Test Ratiofor 2007. Illustration 18-13 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  17. Liquidity Ratios Ratio Analysis Compute the Acid-Test Ratio for 2007. Cash + Short-Term Investments + Receivables (Net) Acid-Test Ratio = Current Liabilities $100,000 + $20,000 + $230,000 = 1.02 : 1 $344.500 The acid-test ratio measures immediate liquidity. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  18. Liquidity Ratios Ratio Analysis Compute the Receivables Turnoverratio for 2007. Net Credit Sales Receivables Turnover = Average Net Receivables $2,097,000 = 10.2 times ($180,000 + $230,000) / 2 It measures the number of times, on average, the company collects receivables during the period. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  19. Liquidity Ratios Ratio Analysis Receivables Turnover $2,097,000 = 10.2 times ($180,000 + $230,000) / 2 A variant of the receivables turnover ratio is to convert it to an average collection periodin terms of days. 365 days / 10.2 times = every 35.78 days This means that receivables are collected on average every 36 days. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  20. Liquidity Ratios Ratio Analysis Compute the Inventory Turnoverratio for 2007. Cost of Good Sold Inventory Turnover = Average Inventory $1,281,000 = 2.31 times ($500,000 + $620,000) / 2 Inventory turnover measures the number of times, on average, the inventory is sold during the period. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  21. Liquidity Ratios Ratio Analysis Inventory Turnover $1,281,000 = 2.3 times ($500,000 + $620,000) / 2 A variant of inventory turnover is the days in inventory. 365 days / 2.3 times = every 159 days Inventory turnover ratios vary considerably among industries. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  22. Ratio Analysis Profitability Ratios • Measure the income or operating success of a company for a given period of time. • Income, or the lack of it, affects the company’s ability to obtain debt and equity financing, liquidity position, and the ability to grow. • Ratios include the profit margin, asset turnover, return on assets, return on common stockholders’ equity, earnings per share, price-earnings, and payout ratio. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  23. Profitability Ratios Ratio Analysis Compute the Profit Marginratio for 2007. Net Income Profit Margin = Net Sales $263,800 = 12.6% $2,097,000 Measures the percentage of each dollar of sales that results in net income. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  24. Profitability Ratios Ratio Analysis Compute the Asset Turnoverratio for 2007. Net Sales Asset Turnover = Average Assets $2,097,000 = 1.22 times ($1,95,000 + $1,835,000) / 2 Measures how efficiently a company uses its assets to generate sales. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  25. Profitability Ratios Ratio Analysis Compute the Return on Assetsratio for 2007. Net Income Return on Assets = Average Assets $263,800 = 15.4% ($1,595,000 + $1,835,000) / 2 An overall measure of profitability. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  26. Profitability Ratios Ratio Analysis Compute the Return on Common Stockholders’ Equity ratio for 2007. Return on Common Stockholders’ Equity Net Income – Preferred Dividends = Average Common Stockholders’ Equity $263,000 - $0 = 29.3% ($795,000 + $1,003,000) / 2 Shows how many dollars of net income the company earned for each dollar invested by the owners. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  27. Profitability Ratios Ratio Analysis Compute the Earnings Per Share for 2007. Net Income Earnings Per Share = Weighted Average Common Shares Outstanding $263,800 = $0.97 per share 270,000 + 275,400 / 2 A measure of the net income earned on each share of common stock. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  28. Profitability Ratios Ratio Analysis Compute the Price Earnings Ratio for 2007. Price Earnings Ratio Market Price per Share of Stock = Earnings Per Share $12.00 = 12.4 times $0.97 The price-earnings (PE) ratio reflects investors’ assessments of a company’s future earnings. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  29. Profitability Ratios Ratio Analysis Compute the Payout Ratio for 2007. Cash Dividends Payout Ratio = Net Income * $61,200 = 23.2% $263,800 Measures the percentage of earnings distributed in the form of cash dividends. * From analysis of retained earnings. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

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