Financial Accounting:
Tools for Business Decision Making
Chapter 14
Financial Analysis:
The Big Picture
After studying Chapter 14, you should be able to:
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. Describe and apply vertical analysis.
Identify and compute ratios and describe their purpose
Earning Power
The value of a company is a
Earning Power
The most likely level of income to be
obtained in the future
Earning power differs from actual net
income by the amount of irregular revenues, expenses, gains, and losses included in this year's net income.
Users are interested in earning power
because it helps them derive an estimate of future earnings without the "noise" of
irregular items.
Irregular Items
Three types of irregular items are
reported - (all net of taxes):
discontinued operations
extraordinary items
Discontinued Operations
Refers to the disposal of a significant
segment of a business
the elimination of a major class of
Assume Rozek Inc. has revenues of $2.5 million
and expenses of $1.7 million or net income of $800,000 from continuing operations in 1998.
During 1998 the company discontinued and sold
its unprofitable chemical division. The loss in 1998 from chemical operations (net of $60,000 taxes) was $140,000, and the loss on disposal of the chemical division (net $30,000 taxes) was $70,000.
Assuming a 30% tax rate on the income.
Rozek Inc.
Partial Income Statement
For the Year Ended December 31, 1998
Income before income taxes $800,000
Income tax expense 240,000 Income from continuing operations 560,000
Discontinued operations
Loss from operations of chemical division, net of $60,000 income tax saving $140,000 Loss from disposal of chemical division,
net $30,000 income tax saving 70,000 210,000
Net income $350,000
Discontinued Operations
Extraordinary Items
Events and
transactions that
meet two
conditions:
Unusual in nature
Infrequent in
To be considered unusual, the item should be
abnormal and only incidentally related to customary activities of the entity.
To be regarded as infrequent, the event or
transaction should not be reasonably expected to recur in the foreseeable future.
Both criteria must be evaluated in terms of the
environment in which the entity operates.
Extraordinary Items
In 1998 a revolutionary foreign
government expropriated
property held as an investment by Rozek Inc.
If the loss is $70,000 before
applicable income taxes of
$21,000, the income statement presentation will show a
deduction of $49,000.
Rozek Inc.
Partial Income Statement
For the Year Ended December 31, 1998
Income before income taxes $800,000 Income tax expense - 240,000
Income from continuing operations 560,000 Discontinued operations
Loss from operations of chemical division,
net of $60,000 income tax saving $140,000
Loss from disposal of chemical division, net $30,000 income tax
saving 70,000 210,000 Net income before extraordinary item 350,000
Extraordinary item
Expropriation of investment, net of
$21,000 income tax saving 49,000
Net income $301,000
For ease of comparison, financial statements are
expected to be prepared on a basis consistent with that used for the preceding period.
When a choice of principles is available, the
principal initially chosen should be applied consistently from period to period.
A change in accounting principle occurs when
the principle used in the current year is different from the one used in the preceding year.
Changes in
A change is permitted, when
management can show that the new
principle is preferable to the old;
the effects of the change are clearly
disclosed in the income statement.
Examples:
a change in depreciation methods (such as
declining-balance to straight-line)
a change in inventory costing methods (such
Changes in
A change in accounting principle
affects reporting in two ways:
The new principle should be used in
reporting the results of operations of the current year.
The cumulative effect of the change on all
prior-year income statements should be
disclosed net of applicable taxes in a special section immediately preceding Net Income.
Changes in
Rozek Inc. changes from the straight-line method
to the declining-balance method for equipment purchased on January 1, 1995.
The cumulative effect on prior-year income
statements (statements for 1995-1997) is to increase depreciation expense and decrease income before income taxes by $24,000.
If there is a 30% tax rate, the net-of-tax effect of
the change is $16,800 ($24,000 x 70%).
Changes in
Rozek Inc.
Partial Income Statement
For the Year Ended December 31, 1998
Income before income taxes $800,000
Income tax expense 240,000
Income from continuing operations 560,000 Discontinued operations
Loss from operations of chemical division,
net of $60,000 income tax saving $140,000 Loss from disposal of chemical
division, net $30,000 income tax saving 70,000 210,000 Net income before extraordinary item 350,000
Extraordinary item
Expropriation of investment, net of
$21,000 income tax saving 49,000
Cumulative effect of change in accounting principle
Effect on prior years of change in
depreciation method, net of $ 7,200 tax 16,800
Net Income 284,200
Although most revenues, expenses, gains, and
losses recognized during the period are
included in net income, specific exceptions to this practice have developed.
Certain items such as unrealized gains and
losses on available-for-sale securities, now bypass income and are reported directly in stockholders' equity.
Changes in
Unrealized gains and losses on available-for-sale securities are 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.
Changes in
Analysts have expressed concern that the
number of items bypassing the income statement has increased significantly.
The FASB now requires that, in addition
to reporting net income, a company must also report comprehensive income.
Changes in
Comprehensive Income
Includes all changes in stockholders'
equity during a period except those
resulting from investments by
Comparative Analysis
Any item reported in a financial statement
has significance:
Its inclusion indicates that the item exists at a
given time and in a certain quantity.
For example, when Kellogg Company
reports $243.8 million on its balance sheet
as cash, we know that Kellogg did have
Whether the amount represents an
increase over prior years, or whether it
is adequate in relation to the company's
needs, cannot be determined from the
amount alone.
The amount must be compared with
other financial data to provide more
information.
There are three types of comparisons to provide decision usefulness of financial information:
Intracompany basis
Intercompany basis
Industry averages
Intracompany Basis
Comparisons within a company are often
useful to detect changes in financial relationships and significant trends.
A comparison of Kellogg's current year's cash
amount with the prior year's cash amount shows either an increase or a decrease.
Likewise, a comparison of Kellogg's year-end
Intercompany Basis
Comparisons with other companies provide
insight into a company's competitive position.
Kellogg's total sales for the year can be
compared with the total sales of its
Comparisons with industry averages
provide information about a company's relative position within the industry.
Kellogg's financial data can be compared
with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's.
Financial Statement Analysis
Three basic tools are used in
financial statement analysis :
1.
Horizontal analysis
2.
Vertical analysis
Horizontal Analysis
Horizontal analysis is a technique for
evaluating a series of financial statement data over a period of time.
The purpose of horizontal analysis is to
determine whether an increase or decrease has taken place.
The increase or decrease can be expressed as
KELLOGG COMPANY
Net Sales (in millions)
Base Period 1992
1996 1995 1994 1993
1992 6,676.6 7,003.7 6,562.0 6,295.4 6,190.6
Page 656 in book
If we assume that 1992 is the base year, we can
measure all percentage increases or decreases from this base-period amount with the following formula:
CURRENT-YEAR AMOUNT – BASE-YEAR AMOUNT
BASE-YEAR AMOUNT
We can determine that net sales for Kellogg
company increased approximately 1.7% [($6,295.4 – $6,190.6)/$6,190.6] from 1992 to 1993.
Horizontal Analysis
Percentage Change in Sales
The percentage change in sales for each of the 5 years, assuming 1992 as the base period is:
1996 1995 1994 1993 1992 6,676.6 7,003.7 6,562.0 6,295.4
6,190.6 107.8% 113.1% 106.0% 100.2% 100%
Horizontal Analysis
of a Balance Sheet
The financial statements of Kellogg Company are used to illustrate horizontal analysis:
KELLOGG COMPANY, INC. Condensed Balance Sheets
December 31 (In millions) Increase (Decrease)
during 1996
1996 1995 Amount Percent
Assets
Current Assets $1,528.6 $1,428.8 $ 99.8
7.0% Plant assets 2,932.9 2,784.8 148.1 5.3
Increase (Decrease) during 1996
1996 1995 Amount Percent
Liabilities and
Stockholders' Equity
Current liabilities $2,199.0 $1,265.4 $933.6 73.8% Long-term liabilities 1,568.6 1,558.3 10.3
.7
Total liabilities 3,767.6 2,823.7 943.9 33.4% Stockholders' equity
Common stock 201.8 183.0 18.8 10.3 Retained earnings
and other 3,984.0 3,769.1 214.9 5.7 Treasury stock (2,903.4) (2,361.2) 542.2 23.0 Total stockholders'
equity 1,282.4 1,590.9 (308.5) (19.4) Total liabilities and
Page 657 in book
The following is a 2-year comparative income statement of Kellogg Company for 1996 and 1995 (in condensed format):
KELLOGG COMPANY, INC.
Condensed Income Statement For the Years Ended December 31
(In millions)
Increase (Decrease) during 1996
1996 1995 Amount Percent
Net sales $6,676.6 $7.003.7 ($327.1) (4.7%)
Cost of goods sold 3,122.9 3,177.7 (54.8)
Horizontal Analysis
of an Income Statement
Increase (Decrease) during 1996
1996 1995 Amount Percent
Gross profit 3,553.7 3,826.0 (272.3) (7.1) Selling and administrative
expenses 2,458.7 2,566.7 (108.0) (4.2)
Nonrecurring charges 136.1 421.8 285.7 (67.7)
Income from operations 958.9 837.5 121.4 14.5 Interest expense 65.6 62.6 3.0 4.8 Other income
(expense), net (33.4) 21.1 54.5 n/a Income before
income taxes 859.9 796.0 63.9 8.0% Income tax expense 328.9 305.7 32.2
7.6
Horizontal Analysis
of an Income Statement
Horizontal analysis of the income statements on Page 657shows these changes:
Net sales decreased $327.1, or 4.7% ($327.1
÷ $7,003.7).
Cost of goods sold increased $54.8, or 1.7%
($54.8 ÷ $3,177.7).
Selling and administrative expenses
decreased $108.0, or 4.2% ($108.0 ÷ $2,566.7).
Horizontal Analysis
Although gross profit decreased by
7.2%, net income increased by 8.3%.
The increase in net income can be
attributed almost entirely to the
decrease in nonrecurring charges due
to the restructuring of the company.
Horizontal Analysis
Vertical Analysis
Vertical analysis is a technique for
evaluating financial statement data that
expresses each item in a financial
statement as a percent of a base amount.
Total assets is always the base amount in
vertical analysis of a balance sheet.
Net sales is always the base amount in
Vertical Analysis of a Balance
Sheet
Presented below is the comparative balance sheet of Kellogg for 1996 and 1995, analyzed vertically.
KELLOGG COMPANY, INC.
Condensed Balance Sheets December 31
(In millions)
1996 1995
Assets Amount Percent Amount Percent Current Assets $1,528.6 30.3% $1,428.8 32.4% Plant assets (net) 2,932.9 58.1 2,784.8 63.1 Other assets 588.5 11.7 201.0 4.6 Total assets $5,050.0 100.0% $4,414.6 100.0%
1996 1995 Amount Percent Amount Percent
Liabilities and
Stockholders' Equity
Current liabilities $2,199.0 43.5% $1,265.4 28.7%
Long-term
liabilities 1,568.6 31.1 1,558.3 35.3
Total liabilities 3,767.6 74.6 2,823.7 64.0
Vertical Analysis of a Balance
Sheet
1996 1995
Amount Percent Amount Percent
Total liabilities 3,767.6 74.6 2,823.7 64.0 Stockholders' equity
Common stock 201.8 4.0 183.0 4.1 Retained earnings
and other 3,984.0 78.9 3,769.1 85.4
Treasury stock (2,903.4) 57.5 (2,361.2) 53.5
Total stockholders'
equity 1,282.4 25.4 1,590.9 36.0
Total liabilities and stockholders'
Vertical Analysis of a Balance
Sheet
In addition to showing the relative size of each
category on the balance sheet, vertical analysis may show the percentage change in the
individual asset, liability, and stockholders' equity items.
Although, Kellogg's current assets increased
$99.8 million from 1995 to 1996, they
decreased from 32.4% to 30.3% of total assets.
Plant assets decreased from
63.1% to 58.1% of total assets.
Current liabilities increased by
$933.6 million, going from 28.7% to 43.5% of total
liabilities and stockholders' equity.
KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31
(In millions)
1996 1995 Amount Percent Amount
Percent
Net sales $6,676.6 100.0% $7,003.7 100.0%
Cost of goods sold 3,122.9 46.8 3,177.7 45.4
Gross profit 3,553.7 53.2 3,826.0 54.6
Selling and administrative
expenses 2,458.7 36.8 2,566.7 36.6
Nonrecurring
charges 136.1 2.0 421.8 6.0
Income from
Vertical Analysis of
an Income Statement
1996 1995 Amount Percent
Amount Percent
Income from
operations 958.9 14.4 837.5 12.0 Interest expense 65.6 1.0 62.6 .9 Other income
(expense),net (33.4) .5 21.1 .3
Income before
income taxes 859.9 12.9 796.0 11.4
Income tax expense 328.9 4.9 305.7 43.6
Net income $531.0 8.0% $490.3
Vertical Analysis of
an Income Statement
Vertical analysis of the comparative income
statements of Kellogg reveals that cost of goods sold as a percentage of net sales increased 1.4% (from 45.5% to 46.8%) and selling and
administrative expenses increased 0.2% (from 36.6% to 36.8%).
Net income as a percent of net sales increased
from 7.0% to 8.0% attributed almost entirely to the decline in nonrecurring charges which
Intercompany Comparison by
Vertical Analysis
Vertical analysis enables you to compare companies
of different sizes.
Shown below is a comparison of the income
statements of Kellogg and Quaker Oats:
CONDENSED INCOME STATEMENTS
For the Year Ended December 31, 1996 (In millions)
The Quaker
Kellogg Company, Inc. Oats Company
Amount Percent Amount Percent
Net sales $6,676.6 100.0% $5,199.0 100.0%
Intercompany Comparison by
Vertical Analysis
The Quaker
Kellogg Company, Inc. Oats Company
Amount Percent Amount Percent
Gross profit 3,553.7 53.2 2,391.5 46.0 Selling and administrative
expenses 2,458.7 36.8 1,981.0 38.1 Nonrecurring charges 136.1 2.0 113.4
2.2
Income from operations 958.9 14.4 415.6 8.0 Other expenses and
revenues (including
Although Kellogg's net sales are 28% greater
than the net sales of Quaker Oats, vertical analysis facilitates a comparison.
Kellogg's income from operations as a
percentage of sales is 14.4% compared to 8.0% for Quaker Oats.
Kellogg's higher percentage income from
operations is attributed to its superior gross profit margin rate of 53.2%.
Ratio Analysis
Ratios can be classified into three types:
Liquidity ratios - measures of the short-term
ability of the enterprise to pay its maturing
obligations an to meet unexpected needs for cash
Solvency ratios - measures of the ability of the
enterprise to survive over a long period of time
Profitability ratios - measures of the income or
operating success of an enterprise for a given period of time
As a tool of analysis, ratios can provide
clues to underlying conditions that
may not be apparent from an
inspection of the individual
components of a particular ratio.
A single ratio by itself is not very
meaningful.
Liquidity Ratios
Liquidity ratios measure the
short-term ability of the
enterprise to pay its maturing obligations and to meet
unexpected needs for cash.
Short-term creditors such as
Current ratio
Acid-test ratio
Current cash debt coverage ratio
Receivables turnover ratio
Average collection period
Inventory turnover
Average days in inventory
Current Ratio
The current ratio is widely used for
evaluating a company's liquidity and short-term debt-paying ability.
The current ratio does not take into account
the composition of the current assets.
A satisfactory current ratio does not disclose
Current Ratio
Indicates short-term debt-paying
ability
Current Ratio =
Current Assets
Acid-Test Ratio
The acid-test ratio or quick ratio is a measure of
a company's immediate short-term liquidity.
The acid-test ratio is computed by dividing the
sum of cash, marketable securities, and net receivables by current liabilities.
The ratio does not include inventory or prepaid
expenses.
Cash, marketable securities, and receivables are
Indicates immediate short-term
debt-paying ability.
Acid-Test
Ratio
=
Securities, Net Receivables
Current Liabilities
Current Cash Debt
Coverage Ratio
Indicates short-term debt-paying
ability on the cash basis.
Cash provided by operations
Receivables Turnover Ratio
Indicates liquidity of receivables by
determining how quickly receivables can
be converted to cash.
The receivables turnover ratio measures
the number of times, on average,
Receivables Turnover Ratio =
a measure of the liquidity
of receivables
Net Credit Sales
Average Collection Period
The average collection period is a popular
variant of the receivables turnover ratio.
The average collection period converts the
receivables turnover into an average collection period expressed in days.
The general rule is that the collection period
the average amount of time that a
receivable is outstanding.
365 days
Receivables Ratio Turnover
Inventory Turnover Ratio
The inventory turnover ratio measures
the number of times on average the
inventory is sold during the period.
Inventory Turnover Ratio =
Average Days in Inventory
Is a variant of the inventory turnover
ratio.
Measures the average number of days
365 days
Inventory Turnover Ratio
Solvency Ratios
Measure the ability of the enterprise to
survive over a long period of time
Long-term creditors and stockholders are
interested in a company's long-run
Debt to total assets ratio
Times interest earned ratio
Cash debt coverage ratio
Free cash flow
Debt to Total Assets Ratio
Indicates % of total assets provided
by creditors.
Times Interest Earned Ratio
Indicates a company’s ability to meet
interest payments as they come due.
Interest Before Interest Expense & Income Tax
Cash Debt Coverage Ratio
Indicates: Long-term debt-paying ability on
the cash basis.
Indicates cash available for paying
dividends or expanding operations.
Cash Provided By Operations
- Capital Expenditures
- Dividends Paid Free Cash Flow
Profitability Ratios
Measures the income or operating
success of an enterprise for a given
period of time
These are important because a
company's income, or lack of it, affects
its ability to obtain debt and equity
Return on common stockholders’ equity ratio
Return on assets ratio
Profit margin ratio
Assets turnover ratio
Gross profit rate
Operating expenses to sales ratio
Cash return on sales ratio
Earnings per share (EPS)
Price-earnings ratio
Relationships Among
Profitability Measures
Return on Common
Stockholders’ Equity Ratio
Measures the profitability from the
stockholders’ point of view
Net income - Preferred stock dividends
Return on Assets Ratio
Reveals the amount of net income
generated by each dollar invested
Net income Average assets Return on Assets Ratio =
Profit Margin Ratio
Indicates the percentage of each dollar of
sales that results in net income.
Profit Margin Ratio Net income=Net sales
Asset Turnover Ratio
Indicates how efficiently assets are
used to generate sales.
Net sales
Gross Profit Rate
Indicates margin between selling price
and cost of good sold.
Operating Expenses to
Sales Ratio
Indicates the cost incurred to
support each dollar of sales.
Cash Return on Sales Ratio
The cash return on sales ratio indicates
the company's ability to turn sales into
dollars for the firm.
A low cash return on sales ratio should
be investigated because it might
indicate the firm is recognizing sales
Limitations Of
Financial Analysis
Horizontal, vertical, and ratio analysis
are frequently used in making significant
business decisions.
One should be aware of
Estimates
Financial statements are based on
estimates.
allowance for uncollectible accounts
depreciation
costs of warranties
contingent losses
To the extent that these estimates are
inaccurate, the financial ratios and
Costs
Traditional financial statements are based on
historical cost and are not adjusted for price level changes.
Comparisons of unadjusted financial data from
different periods may be rendered invalid by significant inflation or deflation.
Some assets such as property, plant, and
Alternative Accounting Methods
One company may use the FIFO method,
while another company in the same industry may use LIFO.
If the inventory is significant for both
companies, it is unlikely that their current ratios are comparable.
In addition to differences in inventory costing
Atypical Data
Diversification
Diversification in American industry
also limits the usefulness of financial
analysis.
Many firms are so diverse they cannot
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