Prepared by Coby Harmon University of California, Santa Barbara 13-1 Westmont College 13 Financial Analysis: The Big Picture Learning Objectives 13-2 Apply the concepts of sustainable income and quality of earnings Apply horizontal analysis and vertical analysis Analyze a company’s performance using ration analysis LEARNING OBJECTIVE Apply the concepts of sustainable income and quality of earnings Sustainable Income The most likely level of income to be obtained by a company in the future Unusual Items Separately disclosed Discontinued operations Other comprehensive income These unusual items are reported net of income tax 13-3 LO Sustainable Income Illustration 13-1 Statement of comprehensive income 13-4 LO Sustainable Income DISCONTINUED OPERATIONS 13-5 (a) Disposal of a significant component of a business (b) The income (loss) from discontinued operations consists of two parts: the income (loss) from operations and the gain (loss) on disposal of the component LO DISCONTINUED OPERATIONS Illustration: Assume that during 2019 Acro Energy Inc has income before income taxes of $800,000 During 2019, Acro discontinued and sold its unprofitable chemical division The loss in 2019 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 on income Prepare Acro’s statement of comprehensive income for the year ended December 31, 2019 13-6 LO DISCONTINUED OPERATIONS Illustration 13-2 Statement presentation of discontinued operations 13-7 LO INVESTOR INSIGHT What Does “Non-Recurring” Really Mean Many companies incur restructuring charges as they attempt to reduce costs They often label these items in the income statement as “non-recurring” charges, to suggest that they are isolated events, unlikely to occur in future periods The question for analysts is, are these costs really one-time, “nonrecurring events” or they reflect problems that the company will be facing for many periods in the future? If they are one-time events, then they can be largely ignored when trying to predict future earnings But, some companies report “one-time” restructuring charges over and over again For example, Procter & Gamble reported a restructuring charge in 12 consecutive quarters, and Motorola had “special” charges in 14 consecutive quarters On the other hand, other companies have a restructuring charge only once in a 5- or 10-year period There appears to be no substitute for careful analysis of the numbers that comprise net income 13-8 LO Sustainable Income COMPREHENSIVE INCOME All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders Certain gains and losses bypass net income and instead are reported as direct adjustments to stockholders’ equity 13-9 Example – Unrealized gain or loss on Available-for-sale securities LO COMPREHENSIVE INCOME ILLUSTRATION OF COMPREHENSIVE INCOME Accounting standards require companies to adjust most investments in stocks and bonds up or down to their market value at the end of each accounting period Illustration: During 2019 Stassi Company purchased IBM bonds for $10,000 as an investment At the end of 2019 Stassi was still holding the investment, but the bonds’ market value was now $8,000 How should Stassi account for the $2,000 unrealized loss? 13-10 LO Return on Assets Measures the overall profitability of assets in terms of the income earned on each dollar invested in assets Illustration 13A-15 Return on assets Note that Chicago’s rate of return on common stockholders’ equity (48%) is substantially higher than its rate of return on assets (10%) Chicago has made effective use of leverage 13-58 LO Profit Margin Or rate of return on sales, is a measure of the percentage of each dollar of sales that results in net income Illustration 13A-16 Profit margin High-volume (high inventory turnover) businesses such as grocery stores and pharmacy chains generally have low profit margins 13-59 LO Asset Turnover Measures how efficiently a company uses its assets to generate sales Illustration 13A-17 Asset turnover The average asset turnover for utility companies is 45, for example, while the grocery store industry has an average asset turnover of 3.49 13-60 LO Return on Assets You can analyze the combined effects of profit margin and asset turnover on return on assets for Chicago as shown Illustration 13A-18 Composition of return on assets 13-61 LO Gross Profit Rate Indicates a company’s ability to maintain an adequate selling price above its cost of goods sold Illustration 13A-19 Gross profit rate As an industry becomes more competitive, this ratio declines 13-62 LO Earnings Per Share (EPS) A measure of the net income earned on each share of common stock Illustration 13A-20 Earnings per share 13-63 LO Price-Earnings (P-E) Ratio Reflects investors’ assessments of a company’s future earnings Illustration 13A-21 Price-earnings ratio A lower P-E ratio suggests that the market is less optimistic about Chicago cereal than about General Mills It might also signal that its stock is underpriced 13-64 LO Payout Ratio Measures the percentage of earnings distributed in the form of cash dividends Illustration 13A-22 Payout ratio This ratio should be calculated over a longer period of time to evaluate any trends 13-65 LO LEARNING OBJECTIVE Compare financial statement analysis and income statement presentation under GAAP and IFRS Key Points The tools of financial statement analysis covered in this chapter are universal and therefore no significant differences exist in the analysis methods used The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS 13-66 Both GAAP and IFRS follow the same approach in reporting comprehensive income LO Key Points The basic objectives of the income statement are the same under both GAAP and IFRS A very important objective is to ensure that users of the income statement can evaluate the sustainable income of the company Thus, both the IASB and the FASB are interested in distinguishing normal levels of income from unusual items in order to better predict a company’s future profitability 13-67 The basic accounting for discontinued operations is the same under IFRS and GAAP LO Looking to the Future The FASB and the IASB are working on a project that would rework the structure of financial statements Recently, the IASB decided to require a statement of comprehensive income, similar to what was required under GAAP In addition, another part of this project addresses the issue of how to classify various items in the income statement A main goal of this new approach is to provide information that better represents how businesses are run In addition, the approach draws attention away from one number—net income 13-68 LO IFRS Self-Test Questions The basic tools of financial analysis are the same under both GAAP and IFRS except that: a) horizontal analysis cannot be done because the format of the statements is sometimes different b) analysis is different because vertical analysis cannot be done under IFRS c) the current ratio cannot be computed because current liabilities are often reported before current assets in IFRS statements of position d) 13-69 None of the above LO IFRS Self-Test Questions Presentation of comprehensive income must be reported under IFRS in: 13-70 a) the statement of stockholders’ equity b) the income statement ending with net income c) the notes to the financial statements d) a statement of comprehensive income LO IFRS Self-Test Questions In preparing its income statement for 2019, Parmalane assembles the following information Sales revenue $500,000 Cost of goods sold 300,000 Operating expenses 40,000 Loss on discontinued operations 20,000 Ignoring income taxes, what is Parmalane’s income from continuing operations for 2019 under IFRS? 13-71 a) $260,000 c) $240,000 b) $250,000 d) $160,000 LO COPYRIGHT “Copyright © 2017 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.” 13-72 ... stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders Certain gains and losses bypass net income and instead are reported as direct adjustments... ILLUSTRATION OF COMPREHENSIVE INCOME Accounting standards require companies to adjust most investments in stocks and bonds up or down to their market value at the end of each accounting period Illustration:... result in better transparency by eliminating the noise of past plan performance.” When UPS switched, it resulted in a charge of $827 million from the change in accounting principle Source: Bob