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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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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.

slide10
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

slide20
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
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.

slide26
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.
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
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

slide34
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
slide42
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

slide54
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

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)
slide64
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
slide65
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.
slide66
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
slide70
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.
slide71
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).
slide74
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.
slide75
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.
slide77
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.
slide78
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.
slide79
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).
slide80
End of Chapter 14

Good Bye and Good Luck. – solutions follow

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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