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The contents of this chapter include all of the following: Understand the concept of earning power and indicate how irregular items are presented, discuss the need for comparative analysis and identify the tools of financial statement analysis, explain and apply horizontal analysis, explain and apply vertical analysis,...
PART III: Decision Tools Lecture 27 Financial Statement Analysis Learning Learning 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 Financial Financial Statement Statement Analysis Analysis Basics of Financial Statement Analysis Need for comparative analysis Tools of analysis Horizontal and Vertical Analysis Ratio Analysis Balance sheet Liquidity Income statement Solvency Retained earnings statement Profitability Summary Earning Power and Irregular Items Discontinued operations Extraordinary items Changes in accounting principle Comprehensiv e income Quality of Earnings Alternative accounting methods Pro forma income Improper recognition Basics Basics of of Financial Financial Statement Statement Analysis Analysis Analyzing financial statements involves: Comparison Bases Characteristics Tools of Analysis Liquidity Intracompany Horizontal Profitability Industry averages Vertical Solvency Ratio Intercompany LO LO 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 LO Explain and apply horizontal analysis Horizontal Horizontal Analysis Analysis 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 LO Explain and apply horizontal analysis Horizontal Horizontal Analysis Analysis 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 LO Explain and apply horizontal analysis Horizontal Horizontal Analysis Analysis 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 LO 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 LO Describe and apply vertical analysis Vertical Vertical Analysis Analysis These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt 10 LO Describe and apply vertical analysis Earning Earning Power Power and and Irregular Irregular Items Items Discontinued Operations (a) Refers to the disposal of a significant component of a business (b) Report the income (loss) from discontinued operations in two parts: income (loss) from operations (net of tax) and gain (loss) on disposal (net of tax) 40 LO Understand the concept of earning power, and how irregular items are presented 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 41 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 LO Understand the concept of earning power, and how irregular items are presented Earning Earning Power Power and and Irregular Irregular Items Items I nc o m e S t a t e m e nt (in t h o us a nd s ) Discontinued Operations are reported after “Income from continuing operations.” Previously labeled as “Net Income” Moved to 42 S a le s Co s t o f g o o d s s o ld $ 2 ,0 0 14 ,0 0 O t h e r r e ve nue (e x pe ns e ) : I nt e r e s t r e ve nue I nt e r e s t e x pe ns e T o t al o t h e r I nc o m e b e f o r e t ax e s I nc o m e t a x e x pe ns e I nc o m e f r o m c o nt inuing o pe r a t io ns 17 ,0 0 (2 1,0 0 ) (4 ,0 0 ) 7 ,0 0 2 ,0 0 5 ,0 0 Dis c o nt inue d o pe r a t io ns : Lo s s f r o m o pe r a t io ns , ne t o f t a x 3 Lo s s o n d is po s a l, ne t o f t a x 1 T o t a l lo s s o n d is c o nt inue d o pe r a t io ns 5 N e t inc o m e $ 5 ,4 LO 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.” 43 LO 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 44 LO 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 45 LO 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 46 Earning Earning Power Power and and Irregular Irregular Items Items I nc o m e S t a t e m e nt (in t h o us a nd s ) Extraordinary Items are reported after “Income from continuing operations.” Previously labeled as “Net Income” S a le s Co s t o f g o o d s s o ld $ 2 ,0 0 14 ,0 0 O t h e r r e ve nue (e x pe ns e ) : I nt e r e s t r e ve nue I nt e r e s t e x pe ns e T o t a l o t h e r I nc o m e b e f o r e t ax e s I nc o m e t a x e x pe ns e I nc o m e f r o m c o nt inuing o pe r a t io ns Ex t r a o r d ina r y lo s s , ne t o f t a x 17 ,0 0 (2 1,0 0 ) (4 ,0 0 ) 7 ,0 0 2 ,0 0 5 ,0 0 5 N e t inc o m e $ 5 ,4 Moved to 47 LO 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 I nc o m e S t a t e m e nt (in t h o us a nd s ) S a le s Co s t o f g o o d s s o ld $ 2 ,0 0 14 ,0 0 I nt e r e s t e x pe ns e T o t a l o t h e r I nc o m e b e f o r e t a x e s I nc o m e t a x e x pe ns e I nc o m e f r o m c o nt inuing o pe r a t io ns (2 1,0 0 ) (4 ,0 0 ) 7 ,0 0 2 ,0 0 5 ,0 0 Dis c o nt inue d o pe r a t io ns : Discontinued Operations Extraordinary Item 48 Lo s s f r o m o pe r a t io ns , ne t o f t a x 3 Lo s s o n d is po s a l, ne t o f t a x 1 T o t a l lo s s o n d is c o nt inue d o pe r a t io ns 5 I nc o m e b e f o r e e x t r a o r d ina r y it e m Ex t r a o r d ina r y lo s s , ne t o f t a x 5 ,4 5 N e t inc o m e $ 5 ,9 LO 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 49 LO 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 I nc o m e S t a t e m e nt (in t h o us and s ) S a le s Co s t o f g o o d s s o ld Gr o s s pr o f it O pe r a t ing e x pe ns e s : A d ve r t is ing e x pe ns e De pr e c iat io n e x pe ns e T o t al o pe r at ing e x pe ns e I nc o m e f r o m o pe r a t io ns $ 2 ,0 0 14 ,0 0 13 ,0 0 10 ,0 0 4 ,0 0 5 ,0 0 8 ,0 0 Reported in Stockholders’ Equity O t h e r r e ve nue : I nt e r e s t r e ve nue T o t al o t h e r I nc o m e b e f o r e t ax e s I nc o m e t ax e x pe ns e N e t inc o m e 50 17 ,0 0 17 ,0 0 10 ,0 0 2 ,0 0 $ 7 ,0 0 + Unrealized gains and losses on available-forsale securities Plus other items LO 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 51 LO 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 52 LO 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 53 LO 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) 54 LO Understand the concept of quality of earnings ... earnings Financial Financial Statement Statement Analysis Analysis Basics of Financial Statement Analysis Need for comparative analysis Tools of analysis Horizontal and Vertical Analysis Ratio Analysis. .. Comprehensiv e income Quality of Earnings Alternative accounting methods Pro forma income Improper recognition Basics Basics of of Financial Financial Statement Statement Analysis Analysis Analyzing financial. .. Liquidity Income statement Solvency Retained earnings statement Profitability Summary Earning Power and Irregular Items Discontinued operations Extraordinary items Changes in accounting principle