Chapter 18-1 Chapter 18 Financial Statement Analysis Chapter 18-2 Accounting Principles, Ninth Edition Study Study Objectives Objectives Discuss the need for comparative analysis Identify the tools of financial statement analysis Explain and apply horizontal analysis Describe and apply 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 Chapter 18-3 Financial Financial Statement Statement Analysis Analysis Basics of Financial Statement Analysis Need for comparative analysis Tools of analysis Horizontal and Vertical Analysis Balance sheet Income statement Retained earnings statement Ratio Analysis Liquidity Profitability Solvency Summary Earning Power and Irregular Items Quality of Earnings Discontinued operations Extraordinary items Changes in accounting principle Alternative accounting methods Pro forma income Improper recognition Comprehensive income Chapter 18-4 Basics Basics of of Financial Financial Statement Statement Analysis Analysis Analyzing financial statements involves: Comparison Bases Characteristics Liquidity Intracompany Horizontal Profitability Industry averages Vertical Solvency Chapter 18-5 Tools of Analysis Intercompany SO SO Ratio Discuss the need for comparative analysis Identify the tools of financial statement analysis Horizontal Horizontal Analysis 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 Chapter 18-6 SO Explain and apply horizontal analysis Horizontal Horizontal Analysis 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 Chapter 18-7 SO Explain and apply horizontal analysis Horizontal Horizontal Analysis 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 Chapter 18-8 SO Explain and apply horizontal analysis Horizontal Horizontal Analysis 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 Chapter 18-9 SO Explain and apply horizontal analysis Vertical Vertical Analysis 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 Chapter 18-10 SO Describe and apply vertical analysis Earning Earning Power Power and and Irregular Irregular Items Items Illustration: During 2010 Acro Energy Inc has income from continuing operations of $560,000 During 2010 Acro discontinued and sold its unprofitable chemical division The loss in 2010 from chemical operations (net of $60,000 taxes) was $140,000 The loss on disposal of the chemical division (net of $30,000 taxes) was $70,000 Assuming a 30% tax rate Chapter 18-37 Income from continuing operations Discontinued operations: Loss from operations, net of $60,000 tax Loss on disposal, net of $30,000 tax Total loss on discontinued operations $560,000 Net income $350,000 140,000 70,000 210,000 SO Understand the concept of earning power, and how irregular items are presented Earning Earning Power Power and and Irregular Irregular Items Items Discontinued Operations are reported after “Income from continuing operations.” Previously labeled as “Net Income” Moved to Chapter 18-38 Income Statement (in thousands) Sales Cost of goods sold $ 285,000 149,000 Other revenue (expense): Interest revenue Interest expense Total other Income before taxes Income tax expense Income from continuing operations 17,000 (21,000) (4,000) 79,000 24,000 55,000 Discontinued operations: Loss from operations, net of tax 315 Loss on disposal, net of tax 189 Total loss on discontinued operations Net income 504 $ 54,496 SO Understand the concept of earning power, and how irregular items are presented Earning Earning Power Power and and Irregular Irregular Items Items Extraordinary items are nonrecurring material items that differ significantly from a company’s typical business activities An extraordinary item must be both of an Unusual Nature and Occur Infrequently Company must consider the environment in which it operates Amounts reported “net of tax.” Chapter 18-39 SO Understand the concept of earning power, and how irregular items are presented Earning Earning Power Power and and Irregular Irregular Items Items Are these considered Extraordinary Items? (a) A large portion of a tobacco manufacturer’s crops are destroyed by a hail storm Severe damage from hail storms in the locality where the manufacturer grows tobacco is rare YES (b) A citrus grower's Florida crop is damaged by frost NO (c) Loss from sale of temporary investments NO (d) Loss attributable to a labor strike NO Chapter 18-40 SO Understand the concept of earning power, and how irregular items are presented Earning Earning Power Power and and Irregular Irregular Items Items Are these considered Extraordinary Items? (d) Loss from flood damage (The nearby Black River floods every to years.) NO (e) An earthquake destroys one of the oil refineries owned by a large multi-national oil company Earthquakes are rare in this geographical location YES (f) Write-down of obsolete inventory NO (g) Expropriation of a factory by a foreign government YES Chapter 18-41 SO Understand the concept of earning power, and how irregular items are presented Earning Earning Power Power and and Irregular Irregular Items Items Illustration: In 2010 a foreign government expropriated property held as an investment by Acro Energy Inc If the loss is $70,000 before applicable income taxes of $21,000, the income statement will report a deduction of $49,000 Illustration 18-30 Chapter 18-42 Earning Earning Power Power and and Irregular Irregular Items Items Extraordinary Items are reported after “Income from continuing operations.” Previously labeled as “Net Income” Moved to Chapter 18-43 Income Statement (in thousands) Sales Cost of goods sold $ 285,000 149,000 Other revenue (expense): Interest revenue Interest expense Total other Income before taxes Income tax expense Income from continuing operations 17,000 (21,000) (4,000) 79,000 24,000 55,000 539 Extraordinary loss, net of tax Net income $ 54,461 SO Understand the concept of earning power, and how irregular items are presented Earning Earning Power Power and and Irregular Irregular Items Items Reporting when both Discontinued Operations and Extraordinary Items are present Discontinued Operations Extraordinary Item Chapter 18-44 Income Statement (in thousands) Sales Cost of goods sold $ 285,000 149,000 Interest expense Total other Income before taxes Income tax expense Income from continuing operations (21,000) (4,000) 79,000 24,000 55,000 Discontinued operations: Loss from operations, net of tax 315 Loss on disposal, net of tax 189 Total loss on discontinued operations 504 Income before extraordinary item 54,496 539 Extraordinary loss, net of tax Net income $ 53,957 SO Understand the concept of earning power, and how irregular items are presented Earning Earning Power Power and and Irregular Irregular Items Items Change in Accounting Principle Occurs when the principle used in the current year is different from the one used in the preceding year Accounting rules permit a change if justified Changes are reported retroactively Example would include a change in inventory costing method such as FIFO to average cost Chapter 18-45 SO Understand the concept of earning power, and how irregular items are presented Earning Earning Power Power and and Irregular Irregular Items Items Comprehensive Income All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders Income Statement (in thousands) Sales $ 285,000 Cost of goods sold Gross profit Operating expenses: Advertising expense Depreciation expense Total operating expense Income from operations 149,000 136,000 10,000 43,000 53,000 83,000 Reported in Stockholders’ Equity Other revenue: Interest revenue Total other Income before taxes Income tax expense Net income Chapter 18-46 17,000 17,000 100,000 24,000 $ 76,000 + Unrealized gains and losses on availablefor-sale securities Plus other items SO Understand the concept of earning power, and how irregular items are presented Earning Earning Power Power and and Irregular Irregular Items Items Comprehensive Income Why are gains and losses on available-for-sale securities 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 Chapter 18-47 SO Understand the concept of earning power, and how irregular items are presented Quality Quality of of Earnings 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 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 Chapter 18-48 SO Understand the concept of quality of earnings Quality Quality of of Earnings 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 Chapter 18-49 SO Understand the concept of quality of earnings Quality Quality of of Earnings 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) Chapter 18-50 SO Understand the concept of quality of earnings Copyright Copyright “Copyright © 2009 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.” Chapter 18-51 .. .Chapter 18 Financial Statement Analysis Chapter 18- 2 Accounting Principles, Ninth Edition Study Study Objectives Objectives Discuss... operations Extraordinary items Changes in accounting principle Alternative accounting methods Pro forma income Improper recognition Comprehensive income Chapter 18- 4 Basics Basics of of Financial Financial... Ratio Analysis Analysis Liquidity Ratios Compute the Acid-Test Ratio for 2007 Illustration 18- 13 Chapter 18- 18 SO Identify and compute ratios used in analyzing a firm’s liquidity, profitability,