Corporate finance accounting 14e by warren reeve duchac chapter 14

Chapter 14 Financial Statement Analysis Corporate Financial Accounting 14e Warren Reeve Duchac đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part The Value of Financial Statement Information • General-purpose financial statements are distributed to a wide range of potential users, providing each group with valuable information about a company’s economic performance and financial condition • Users typically evaluate this information along three dimensions: o Liquidity o Solvency o Profitability đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Liquidity • Short-term creditors such as banks and financial institutions are primarily concerned with whether a company will be able to repay short-term borrowings such as loans and notes • As such, they are most interested in evaluating a company’s ability to convert assets into cash, which is called liquidity đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Solvency • • Long-term creditors, such as bondholders, loan money for long periods of time Thus, they are interested in evaluating a company’s ability to make its periodic interest payments and repay the face amount of debt at maturity, which is called solvency đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Profitability • Investors, such as stockholders, are interested in evaluating the potential for the price of the company’s stock to increase • As such, investors focus on evaluating a company’s ability to generate earnings, which is called profitability đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Techniques for Analyzing Financial Statements (slide of 2) • Financial statement users rely on the following techniques to analyze and interpret a company’s financial performance and condition: o Analytical methods examine changes in the amount and percentage of financial statement items within and across periods o Ratios express a financial statement item or set of financial statement items as a percentage of another financial statement item, in order to measure an important economic relationship as a single number ® © 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Techniques for Analyzing Financial Statements (slide of 2) • Both analytical methods and ratios can be used to compare a company’s financial performance over time or to another company o Comparisons Over Time: The comparison of a financial statement item or ratio with the same item or ratio from a prior period often helps the user identify trends in a company’s economic performance, financial condition, liquidity, solvency, and profitability o Comparisons Between Companies: The comparison of a financial statement item or ratio to another company in the same industry can provide insight into a company’s economic performance and financial condition relative to its competitors đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Analytical Methods • Users analyze a company’s financial statements using a variety of analytical methods Three such methods are: o Horizontal analysis o Vertical analysis o Common-sized statements đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Horizontal Analysis (slide of 2) • The analysis of increases and decreases in the amount and percentage of comparative financial statement items is called horizontal analysis o Each item on the most recent statement is compared with the same item on one or more earlier statements in terms of the following:  Amount of increase or decrease  Percent of increase or decrease đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Horizontal Analysis (slide of 2) • When comparing statements, the earlier statement is normally used as the base year for computing increases and decreases đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Summary of Analytical Measures (slide of 3) ® © 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Corporate Annual Reports • In addition to the financial statements and the accompanying notes, corporate annual reports normally include the following sections: o Management discussion and analysis o Report on internal control o Report on fairness of the financial statements đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Management Discussion and Analysis • Management’s Discussion and Analysis (MD&A) is required in annual reports filed with the Securities and Exchange Commission • • It includes management’s analysis of current operations and its plans for the future Typical items included in the MD&A are as follows: o Management’s analysis and explanations of any significant changes between the current and prior years’ financial statements o Important accounting principles or policies that could affect interpretation of the financial statements, including the effect of changes in accounting principles or the adoption of new accounting principles o Management’s assessment of the company’s liquidity and the availability of capital to the company o Significant risk exposures that might affect the company o Any “off-balance-sheet” arrangements such as leases not included in the financial statements đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Report on Internal Control (slide of 2) • The Sarbanes-Oxley Act of 2002 requires a report on internal control by management o The report states management’s responsibility for establishing and maintaining internal control o In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report ® © 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Report on Internal Control (slide of 2) • Sarbanes-Oxley also requires a public accounting firm to verify management’s conclusions on internal control o Thus, two reports on internal control, one by management and one by a public accounting firm, are included in the annual report đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Report on Fairness of the Financial Statements • All publicly held corporations are required to have an independent audit (examination) of their financial statements • The Certified Public Accounting (CPA) firm that conducts the audit renders an opinion, called the Report of Independent Registered Public Accounting Firm, on the fairness of the statements o An opinion stating that the financial statements present fairly the financial position, results of operations, and cash flows of the company is said to be an unqualified opinion, sometimes called a clean opinion o Any report other than an unqualified opinion raises a “red flag” for financial statement users and requires further investigation as to its cause ® © 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Unusual Items on the Income Statement • Generally accepted accounting principles require that unusual items be reported separately on the income statement o This is because such items not occur frequently and are typically unrelated to current operations • Unusual items on the income statement are classified as one of the following: o Affecting the current period income statement o Affecting a prior period income statement đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Unusual Items Affecting the Current Period’s Income Statement • • Discontinued operations are an unusual item that affect the current period’s: o Income statement presentation o Earnings per share presentation Discontinued operations are reported separately on the income statement for any period in which they occur đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Unusual Items Affecting the Current Period’s Income Statement—Income Statement Presentation • A company may discontinue a component of its operations by selling or abandoning the component’s operations o If the discontinued component is (1) the result of a strategic shift and (2) has a major effect on the entity’s operations and financial results, any gain or loss on discontinued operations is reported on the income statement as a Gain (or loss) from discontinued operations o A note to the financial statements should describe the operations sold, including the date operations were discontinued, and details about the assets, liabilities, income, and expenses of the discontinued component đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Unusual Items Affecting the Current Period’s Income Statement—Earnings per Share • Earnings per common share should be reported separately in the notes to the financial statements for discontinued operations đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Unusual Items Affecting the Prior Period’s Income Statement • An unusual item may occur that affects a prior period’s income statement o Two such items are as follows:  Errors in applying generally accepted accounting principles  Changes from one generally accepted accounting principle to another đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 2: Fair Value • Fair value is the price that would be received for selling an asset if it were sold today o This differs from historical cost, in that the amount reported on the balance sheet changes each period to reflect the asset’s fair (current) value at the balance sheet date  The change in an asset’s fair value from one period to the next is recorded in the financial statements as either: – a gain or loss on the income statement, or – an increase or decrease in stockholders’ equity reported as other comprehensive income đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 2: Comprehensive Income (slide of 2) • When a change in an asset’s fair value is not recorded as a gain or loss on the income statement, it is recorded as an element of other comprehensive income o • These include changes in the fair value of certain investment securities, foreign currency exposures, and pension assets The elements of other comprehensive income are included in the computation of comprehensive income, which is defined as all changes in stockholders’ equity during a period, except those resulting from dividends and stockholders’ investments • Comprehensive income is determined as follows: đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 2: Comprehensive Income (slide of 2) • Companies must report comprehensive income in the financial statements either: o on the income statement, directly below net income, or o in a separate statement of comprehensive income đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 2: Accumulated Other Comprehensive Income • The cumulative effect of the elements of other comprehensive income is reported on the balance sheet as accumulated other comprehensive income đ â 2017 Cengage Learning May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part ... current liabilities A company’s working capital is often monitored monthly, quarterly, or yearly by creditors and other debtors • However, it is difficult to use working capital to compare companies... part Inventory Analysis (slide of 2) • Excess inventory does the following: o Decreases liquidity by tying up funds (cash) in inventory o Increases insurance expense, property taxes, storage costs,