Accounting Principles Thirteenth Edition Weygandt Kimmel Kieso Chapter 18 Financial Analysis: The Big Picture Prepared by Coby Harmon University of California, Santa Barbara Westmont College Chapter Outline Learning Objectives LO Apply the concepts of sustainable income and quality of earnings LO Apply horizontal analysis and vertical analysis LO Analyze a company’s performance using ratio analysis Copyright ©2018 John Wiley & Son, Inc Sustainable Income and Quality of Earnings Sustainable income is the most likely level of income to be obtained by a company in the future It differs from actual net income by the amount of unusual revenues, expenses, gains, and losses included in the current year’s income Information on unusual items such as gains or losses on discontinued items and components of other comprehensive income are disclosed These unusual items are reported net of income taxes LO Copyright ©2018 John Wiley & Son, Inc Cruz Company Statement of Comprehensive Income For the Year Ended 2020 Sales revenue Cost of goods sold Gross profit Operating expenses Income from operations Other revenues (expenses) and gains (losses) Income before income taxes Income tax expense Income from continuing operations Discontinued operations (net of tax) Net income Other comprehensive income items (net of tax) Comprehensive income LO Copyright ©2018 John Wiley & Son, Inc ILLUSTRATION 18.1 $900,000 650,000 250,000 100,000 150,000 20,000 170,000 24,000 146,000 30,000 176,000 10,000 $186,000 Sustainable Income A statement of comprehensive income includes net income and comprehensive income The two major unusual items in this statement are discontinued operations and other comprehensive income Discontinued operations and other comprehensive income, are reported net of tax LO Copyright ©2018 John Wiley & Son, Inc Discontinued Operations A Disposal of a significant component of a business B Report income (loss) from discontinued operations in two parts: income (loss) from operations (net of tax) and gain (loss) on disposal (net of tax) LO Copyright ©2018 John Wiley & Son, Inc Discontinued Operations Illustration: During 2020 Acro Energy Inc has income before income taxes of $800,000 During 2020, Acro discontinued and sold its unprofitable chemical division The loss in 2020 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 Assume a 30% tax rate on income LO Copyright ©2018 John Wiley & Son, Inc Discontinued Operations Acro Energy Inc Statement of Comprehensive Income (partial) For the Year Ended December 31, 2020 Income before income taxes Income tax expense Income from continuing operations Discontinued operations Loss from operation of chemical division, net of $60,000 income tax savings $140,000 Loss from disposal of chemical division, net of $30,000 income tax savings 70,000 Net income LO Copyright ©2018 John Wiley & Son, Inc ILLUSTRATION 18.2 $800,000 240,000 560,000 210,000 $350,000 Comprehensive 0Income Comprehensive income is the sum of net income and other comprehensive income items LO Example: Unrealized gains or losses on availablefor-sale debt securities Copyright ©2018 John Wiley & Son, Inc Comprehensive Income Illustration: During 2020 Stassi Corporation purchased IBM bonds for $10,500 as an investment, which it intends to sell sometime in the future At the end of 2020, Stassi was still holding the investment, but the bonds’ market price was now $8,000 Stassi is required to reduce the recorded value of its IBM investment by the unrealized loss of $2,500 Should Stassi include this $2,500 unrealized loss in net income? Assume a tax rate of 20% Trading securities: Unrealized gains and losses are reported in the “Other expenses and losses” section of the income statement Available-for-sale securities: Unrealized gains and losses are reported as “Other comprehensive income” in stockholders’ equity LO Copyright ©2018 John Wiley & Son, Inc 10 Profitability Ratios Measure the income or operating success of a company for a given period of time Income affects ability to obtain debt and equity financing, liquidity, and ability to grow Creditors and investors are interested in evaluating profitability Analysts use profitability as ultimate test of management’s operating effectiveness LO Copyright ©2018 John Wiley & Son, Inc 50 Profitability Ratios Profit margin Return on common stockholders’ equity LO Return on assets Asset turnover Leverage (debt to assets ratio) Copyright ©2018 John Wiley & Son, Inc ILLUSTRATION 18.30 Relationships among profitability measures 51 Return on Common Stockholders’ Net Income - Preferred dividends Equity = Average common stockholders’ equity Chicago Cereal $1,103 - $0 ($2,526 + $2,069) ÷ Shows how many dollars of net income the company earned for each dollar invested by the owners LO = 2020 2019 48% 46% Industry Average 19% Giant Mills 2020 25% Copyright ©2018 John Wiley & Son, Inc 52 10 Return on Assets = Net income Average total assets Chicago Cereal $1,103 = ($11,397 + $10,714) ÷ 2020 2019 10.0% 9.4% Industry Average 5.3% Giant Mills 2020 6.2% Measures the overall profitability of assets in terms of the income earned on each dollar invested in assets LO Copyright ©2018 John Wiley & Son, Inc 53 11 Profit Margin Net income Net sales = Chicago Cereal $1,103 $11,776 = 2020 2019 9.4% 9.2% Industry Average 6.1% Giant Mills 2020 8.2% Measures of the percentage of each dollar of sales that results in net income LO Copyright ©2018 John Wiley & Son, Inc 54 12 Asset Turnover = Net sales Average total assets Chicago Cereal $11,776 = ($11,397 + $10,714) ÷ 2020 2019 1.07 1.02 Industry Average 87 Giant Mills 2020 76 Measures how efficiently a company uses its assets to generate sales LO Copyright ©2018 John Wiley & Son, Inc 55 Profitability Ratios Ratios Profit Margin x Net income x Net Sales ILLUSTRATION 18.35 Composition of return on assets Asset Turnover x Return on Assets Net Sales Average Total Assets x Net income Average Total Assets Chicago Cereal 2020 9.4% x 1.07 times = 10.1%* 2019 9.2% x 1.02 times = 9.4% *Difference from value due to rounding LO Copyright ©2018 John Wiley & Son, Inc 56 13 Gross Profit Rate Gross profit Net sales = Chicago Cereal $5,179 $11,776 = 2020 2019 44% 44% Industry Average 30% Giant Mills 2020 34% Indicates a company’s ability to maintain an adequate selling price above its cost of goods sold LO Copyright ©2018 John Wiley & Son, Inc 57 14 Earnings Per Share = Net income – Preferred dividends Weighted-average common shares outstanding Chicago Cereal $1,103 - $0 418.7 = 2020 2019 $2.63 $2.40 Industry Average na Giant Mills 2020 $2.90 A measure of the net income earned on each share of common stock LO Copyright ©2018 John Wiley & Son, Inc 58 15 Price Earnings Ratio Market price per share Earnings per share = Chicago Cereal $52.92 $2.63 = 2020 2019 20.1 20.9 Industry Average 35.8 Giant Mills 2020 24.3 Reflects investors’ assessments of a company’s future earnings LO Copyright ©2018 John Wiley & Son, Inc 59 16 Payout ratio Cash dividends declared on common stock = Net income Chicago Cereal $475 $1,103 = 2020 2019 43% 45% Industry Average 37% Giant Mills 2020 54% Measures the percentage of earnings distributed in the form of cash dividends LO Copyright ©2018 John Wiley & Son, Inc 60 A Look at IFRS Key Points Similarities The tools of financial statement analysis covered in this chapter are universal and therefore no significant differences exist in the analysis methods used The basic objectives of the income statement are the same under both GAAP and IFRS As indicated in the textbook, 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 LO Copyright ©2018 John Wiley & Son, Inc 61 A Look at IFRS Key Points Similarities The basic accounting for discontinued operations is the same under IFRS and GAAP The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS Both GAAP and IFRS follow the same approach in reporting comprehensive income Differences None LO Copyright ©2018 John Wiley & Son, Inc 62 A Look at IFRS 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 LO Copyright ©2018 John Wiley & Son, Inc 63 Copyright Copyright © 2018 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States 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 Copyright ©2018 John Wiley & Son, Inc 64 ... (such as FIFO to average-cost) Accounting rules permit a change when management can show that the new principle is preferable Companies report most changes in accounting principle retroactively... information that will not confuse or mislead users Alternative Accounting Methods Variations among companies in the application of generally accepted accounting principles may hamper comparability and reduce... 70,000 5,600 9,600 66,000 19,800 46,200 $42,000 35,000 7,000 39,200 10,500 $ 49,700 13 Changes in Accounting Principle Occurs when the principle used in the current year is different from the one