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Financial Accounting:Tools for Business Decision Making, 4th Edition

Kimmel, Weygandt, Kieso

CHAPTER 13

Prepared by

Ellen L. Sweatt

Georgia Perimeter College

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Chapter 13

FINANCIAL FINANCIAL ANALYSIS: ANALYSIS:

The Big PictureThe Big Picture

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Chapter 13

After studying Chapter 13, you should be able to:

Understand the concept of sustainable income.

Indicate how irregular items are presented. Explain the concept of comprehensive

income. Describe and apply horizontal analysis. Describe and apply vertical analysis.

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After studying Chapter 13, you should be able to:

Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

Understand the concept of quality of earnings.

Chapter 13

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Sustainable Income...

Is the most likely level of income to be obtained in the future.

Does not include irregular revenues, expenses, gains, or losses.

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Components of the Income Statement

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Irregular Items

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

discontinued operations extraordinary items

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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.

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Rozek net income of $800,000 from continuing operations in 2007.During 2007 the company discontinued and sold its unprofitable chemical division. The loss in 2007 from chemical operations (net of $90,000 taxes) was $210,000. The tax rate is 30%.

Discontinued Operations

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Extraordinary Items...

Are events and transactions that meet two conditions: Unusual in nature

Infrequent in occurrence

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In 20047 a revolutionary foreign government expropriated property held as an investment by Rozek Inc.

The loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000.

Extraordinary Items

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Presentation of Extraordinary Items...

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Extraordinary Items

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Estimating Sustainable Income

When evaluating a company, it generally makes sense to eliminate all irregular items in estimating future sustainable income.

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Change in Accounting Principle

Occur when the principle used in the current year is different from the one used in the preceding year.

Is permitted, when management can show that the new principle is

preferable to the old and Most changes are reported retroactively – improves

comparability

Example: a change in inventory costing methods (such as FIFO to average cost).

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Most revenues, expenses, gains, and losses recognized during the period are included in net income.

Specific exceptions to this practice have developed - these items bypass income and are reported directly in stockholders’ equity.

Comprehensive Income

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The FASB now requires that, in addition to reporting net income, a company must also report comprehensive income.

Comprehensive Income

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Comprehensive Income

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

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Complete Income Statement

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

Intracompany basis Intercompany basis Industry averages

Comparative Analysis

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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.

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.

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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.

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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.

Industry Averages

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Financial Statement Analysis

Three basic tools are used in financial statement analysis :1. Horizontal analysis2. Vertical analysis3. Ratio analysis

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Horizontal Analysis

Is a technique for evaluating a series of financial statement data over a period of time.

Purpose 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.

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Horizontal Analysis

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Horizontal Analysis- Balance Sheet

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Horizontal Analysis – Income Statement

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ReviewReview

In horizontal analysis, each item is In horizontal analysis, each item is expressed as a percentage of the:expressed as a percentage of the:

a.a. net income amount.net income amount.

d.d. base-year amount.base-year amount.c. c. total assets amount.total assets amount.

b.b. stockholders’ equity amount.stockholders’ equity amount.

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ReviewReview

In horizontal analysis, each item is In horizontal analysis, each item is expressed as a percentage of the:expressed as a percentage of the:

a.a. net income amount.net income amount.

d.d. base-year amount.base-year amount.c. c. total assets amount.total assets amount.

b.b. stockholders’ equity amount.stockholders’ equity amount.

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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 the base amount in vertical analysis of a balance sheet.

Net sales is the base amount in vertical analysis of an income statement.

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Vertical Analysis - Balance Sheet

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Intercompany Comparison by Vertical Analysis

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ReviewReview

In vertical analysis, the base amount for In vertical analysis, the base amount for depreciation expense is generally:depreciation expense is generally:

a.a. net sales.net sales.

d.d. fixed assets.fixed assets.c. c. gross profit.gross profit.

b.b. depreciation expense in a previous year.depreciation expense in a previous year.

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ReviewReview

In vertical analysis, the base amount for In vertical analysis, the base amount for depreciation expense is generally:depreciation expense is generally:

a.a. net sales.net sales.

d.d. fixed assets.fixed assets.c. c. gross profit.gross profit.

b.b. depreciation expense in a previous year.depreciation expense in a previous year.

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Ratio Analysis

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Ratios Three types:

Liquidity ratios Solvency ratios Profitability 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.

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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 bankers and suppliers

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Liquidity Ratios

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Solvency Ratios

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

WHO CARES?Long-term creditors and stockholders

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Solvency Ratios

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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

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Profitability Ratios

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Limitations Of Financial Analysis

Horizontal, vertical, and ratio analysis are frequently used in making significant business decisions.

One should be aware of the limitations of these tools and the financial statements.

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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.

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Quality of Earnings

A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements.

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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.

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Pro Forma Income

A measure of the net income generated that usually excludes items that the company thinks are unusual or nonrecurring.

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Improper Recognition

Offering big discounts (channel stuffing) to companies to get them to buy early- Often leads to disaster in subsequent periods.

Improper capitalization of operating expenses

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Price Earnings Ratio

The P/E ratio reflects the investors’ assessment of a company’s future earnings.

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Earnings Per Share and Price Earnings Ratio

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