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Chapter 9. The Analysis of the Balance Sheet and the Income Statement. The Analysis of the Balance Sheet and the Income Statement. Link to Previous Chapter. Chapter 8 reformulated the. statement of owners’ equity. This Chapter. How are taxes. What ratios. What items in. What assets.

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chapter 9

Chapter 9

The Analysis of the Balance Sheet and the Income Statement

the analysis of the balance sheet and the income statement
The Analysis of the Balance Sheet and the Income Statement

Link to Previous Chapter

Chapter 8 reformulated the

statement of owners’ equity.

This Chapter

How are taxes

What ratios

What items in

What assets

This chapter continues the

allocated to the

are calculated

the income

and liabilities

reformulation and analysis

with the balance sheet and

income statement.

operating and


statement are

are classified



classified as

as operating ?

components of

statements ?

operating ? As

As financing ?

the income

What do they

financing ?

The reformulation follows the

statement ?

mean ?

design in Chapter 7.

Link to Next Chapter

Chapters 10 reformulates the

cash flow statement.

More applications and discussion are on the web page.

Link to Web Page

what you will learn from this chapter
What you will learn from this chapter
  • Why reformulated income statements and balance sheets are desirable
  • How knowledge of the business is incorporated in reformulated statements
  • How operating and financing components of the two statements are identified
  • Which assets and liabilities typically fall into operating and financing categories
  • Why income taxes are allocated to different parts of the income statement
  • What balance sheet and income statement ratios reveal
analysis of balance sheet and income statement the steps
Analysis of Balance Sheet and Income Statement: the Steps
  • Reformulate to distinguish between operating and financing activities
  • Carry out common size and trend analysis
  • Calculate balance sheet and income statement ratios
reformulating the balance sheet the governing accounting relations
Reformulating the Balance Sheet: The Governing Accounting Relations

Net Operating Assets (NOA)

= Operating Assets (OA) – Operating

Liabilities (OL)

Net Financial Obligations (NFO)

= Financial Obligations (FO) – Financial

Assets (FA)

Common Shareholders’ Equity (CSE)


issues in reformulating balance sheets
Issues in Reformulating Balance Sheets
  • Cash: working cash and excess cash
  • Short term notes receivable: trade receivables or investment of cash?
  • Finance receivables: an operating asset
  • Debt investments: financial assets
  • Short-term equity investments: excess cash or trading securities?
  • Short-term notes payable: trade notes or borrowing?
  • Lease assets: operating assets
  • Lease liabilities: financial obligation
  • Deferred tax assets and liabilities: operating
  • Deferred revenues and accrued expenses: operating
  • Minority interest: not a financial obligation
  • For financial firms, many “financial items” are operating assets and liabilities
reebok gaap balance sheet 1
Reebok: GAAP Balance Sheet (1)

December 31


2004 2003

---------------- ----------------

Amounts in thousands,

except per share data


Current assets:

Cash and cash equivalents $ 565,233 $ 693,599

Accounts receivable, net of allowance for 660,599 532,320

doubtful accounts (2004, $81,280; 2003,


Inventory 458,435 352,692

Deferred income taxes 111,516 100,070

Prepaid expenses and other current assets 61,730 48,169

----------- ------------

Total current assets 1,857,513 1,726,850

----------- ------------

Property and equipment, net 183,799 149,765

Other non-current assets:

Goodwill, net 124,125 24,690

Intangibles, net of amortization 196,138 42,296

Deferred income taxes 44,892 22,478

Other 34,161 23,663

-------------- --------------

Total Assets $ 2,440,628 $ 1,989,742

-------------- --------------

reebok gaap balance sheet cont
Reebok: GAAP Balance Sheet (cont.)

December 31

------------------------------------ 2004 2003 ---------------- -------------- Amounts in thousands,

except per share data

Liabilities and Stockholders' Equity

Current liabilities:

Notes payable to banks $ 63,179 $ 8,055

Current portion of long-term debt 100,627 163

Accounts payable 183,853 155,904

Accrued expenses 386,725 374,849

Income taxes payable 71,930 27,017

----------- -----------

Total current liabilities 806,314 565,988

----------- -----------

Long-term debt, net of current portion 360,126 353,225

Minority interest 8,514 11,657

Other long-term liabilities 45,718 25,162

Commitments and contingencies

Stockholders' equity:

Common stock, par value $.01; authorized 250,000 shares; 1.018 1.011

issued shares: 101,827 in 2004; 101,081 in 2003

Retained earnings 1,985,324 1,796,321

Less shares in treasury at cost: 42,619 in 2004; 41,473 in 2003 (780,510) (740,189)

Unearned compensation (5,804) (1,225)

Accumulated other comprehensive income (expense) 19,928 (22,208)

------------- -------------

Total Stockholders' Equity 1,219,956 1,033,710

------------- -------------

Total Liabilities and Stockholders' Equity $ 2,440,628 $ 1,989,742

-------------- --------------

the reformulated income statement 1
The Reformulated Income Statement (1)
  • Operating items are separated from financing items.
  • Operating income from sales is separated from other operating income.
  • Tax is allocated to components of the statement, with no allocation to items reported on an after-tax basis

Reformulated Comprehensive Income Statement

Net sales

– Expenses to generate sales

Operating income from sales (before tax)

– Tax on operating income from sales

+ Tax as reported

+ Tax benefit from net financial expenses

– Tax allocated to other operating income

Operating income from sales (after tax)

±Other operating income (expense) requiring tax allocation

Restructuring charges and asset impairments

Merger expenses

Gains and losses on asset sales

Gains and losses on security transactions

− Tax on other operating income

± After-tax operating items

Equity share in subsidiary income

Operating items in extraordinary income

Dirty-surplus operating items in Table 8.1

Hidden-dirty surplus operating items

Operating income (after tax)

the allocation of taxes
The Allocation of Taxes
  • In the income statement only one tax number is reported: It must be allocated to the operating and financial components to put both on an after-tax basis
  • First, calculate the tax benefit (tax shield) provided by deducting interest expense

where t is the marginal (not effective) tax rate.

(The statutory rate is usually the marginal rate)

  • From the operating income deduct both the total tax and the tax benefit, to capture what the operating income would have been, after tax, had there been no financing activities
  • To the net financial expense add the tax benefit, because its net effect is attributable to the financing activities
top down and bottom up methods for tax allocation tax rate 35
Top-down and Bottom-up Methods for Tax Allocation: Tax Rate = 35%

GAAP Top-down Bottom-up

Income Statement Tax Allocation Tax Allocation

Revenue $4,000

Operating expenses (3,400)

Interest expense (100)

Income before tax 500

Income tax expense (150)

Net income $ 350

Revenue $4000

Operating expenses (3,400)

Operating income before tax 600

Tax expense:

Tax reported $150

Tax benefit for interest 35(185)

($100 x 0.35)

Operating income after tax $ 415

Net income $350

Interest expense $100

Tax benefit 3565

Operating income after tax $415

additional tax allocation within operations
Additional Tax Allocation within Operations
  • Allocate taxes between operating income from sales and other operating income (not from sales) so that both are after tax.
  • Remember: some other operating income items are after tax (if they appear below the tax line on the GAAP statement)
  • Remember: losses draw negative tax
Starting Point for Income Statement Reformulation: Identify Comprehensive Income from Equity Statement

Nike Reebok

Balance May 31, 2003 $4,028 $1,035

Transactions with shareholders:

Shares issued, at market $388 $83

Shares repurchased (416) (88)

Common dividends (179) (207) (18) (23)

Comprehensive income

Net income reported $946 $192

Currency translation gain 28 38

Gains on hedging instruments 126 4

Loss on option exercise $127 $32

Tax benefit (47)(80) 1,019 12(20) 214

Balance May 31, 2004 $4,840 $1,226

common size analysis
Common Size Analysis

Comparison to other firms is called cross-sectional analysis

Common size analysis gives a ready comparison:

  • The Income Statement
    • Each item/Total revenues
  • The Balance Sheet
    • Operating items/Totals
    • Financing items/Totals
income statement ratios
Income Statement Ratios
  • Revenue composition ratios
    • Operating Revenue Composition Ratio:
    • Financial Income Composition Ratio:
  • Profit margin ratios
    • Operating Profit Margin:
    • Sales Profit Margin:
    • Other Items Profit Margin:
income statement ratios cont
Income Statement Ratios (cont.)
  • Profit Margin Ratios (cont.)
    • Financial Income Contribution Ratio:
    • Net Income Profit Margin
  • Expense Ratios
    • Expense Ratio
    • 1 - Sales PM = Sum of Expense Ratios
balance sheet ratios
Balance Sheet Ratios
  • Composition Ratios
    • Operating Asset Composition Ratio
    • Operating Liability Composition Ratio
    • Financial Asset Composition Ratio
    • Financial Liability Composition Ratio
balance sheet leverage ratios
Balance Sheet Leverage Ratios
  • Financial Leverage Ratios
    • Capitalization Ratio:
    • Financial Leverage Ratio (FLEV)

It is always the case that

Capitalization Ratio - Leverage Ratio = 1.0

  • Operating Liability Leverage Ratio

Operating Liability Leverage (OLLEV)

summary profitability measures
Summary Profitability Measures

Operating Profitability:

Financing Profitability:

All measures are after tax.

financial statement analysis procedures
Financial Statement Analysis Procedures

1. Reformulate the statement of stockholders’ equity on clean surplus basis (Chapter 8)

2. Calculate comprehensive rate of return on common equity, ROCE, from reformulated statement of common stockholders’ equity (Chapter 8)

3. Reformulate the balance sheet to distinguish operating and financial assets and obligations

4. Reformulate the income statement on clean surplus basis and distinguish operating and financing income

5. Compare reformulated balance sheets and income statements with reformulated statements of comparison firms and over time through a common size analysis and a trend analysis

6. Calculate balance sheet and income statement ratios

7. Carry out the analysis of ROCE: Chapter 11

8. Carry out the analysis of growth: Chapter 12