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Financial Analysis: The Big Picture

Kimmel ● Weygandt ● KiesoFinancial Accounting, Eighth Edition

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CHAPTER OUTLINE

Apply the concepts of sustainable income and quality of earnings.

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Apply horizontal analysis and verticalanalysis.

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LEARNING OBJECTIVES

Analyze a company’s performance using ratio analysis.

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The most likely level of income to be obtained by a company

in the future.

Unusual Items

Separately identified on the income statement.

Discontinued operations.

Other comprehensive income.

These “irregular” items are reported net of income tax.

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LEARNING OBJECTIVE

Apply the concepts of sustainable income and quality of earnings.1

SUSTAINABLE INCOME

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SUSTAINABLE INCOME ILLUSTRATION 13-1Statement of comprehensiveincome

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Discontinued Operations

(a) Disposal of a significant component of a business.

(b) Income statement should report a gain (or loss) from

discontinued operations, net of tax.

SUSTAINABLE INCOME

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Illustration: Assume that during 2017 Acro Energy Inc. has

income before income taxes of $800,000. During 2017, Acro

discontinued and sold its unprofitable chemical division. The

loss in 2017 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, 2017.

Discontinued Operations

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Discontinued Operations

ILLUSTRATION 13-2Statement presentation of discontinued operations

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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 do 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.

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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.

Example – Unrealized gain or loss on Available-for-

sale securities.

Comprehensive Income

SUSTAINABLE INCOME

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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 2017 Stassi Company purchased IBM stock

for $10,000 as an investment. At the end of 2017 Stassi was still

holding the investment, but the stock’s market value was now

$8,000.

How should Stassi account for the $2,000 unrealized loss?

Comprehensive Income

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How should Stassi account for the $2,000 unrealized loss?

Answer: Depends on whether Stassi classifies the IBM stock

as a

Trading security or an

Available for-sale security.

Unrealized gains and losses

(Income Statement)

Unrealized gains and losses

(Comprehensive Income - Stockholders’ Equity)

ILLUSTRATION OF COMPREHENSIVE INCOME

Comprehensive Income

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Format One

Combined statement of income and comprehensive income.

Illustration 13-5

Comprehensive Income

ILLUSTRATION 13-3Lower portion of combined statement of income and comprehensive income

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Format Two

Comprehensive Income

Separate component of Stockholders’ Equity.

ILLUSTRATION 13-4Unrealized loss in stockholders’ equity section

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ILLUSTRATION 13-5Complete statement ofcomprehensive income

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Principle used in the current year is different from one

used in the preceding year.

Example - change from FIFO to average cost.

Permissible when management can show new principle is

preferable.

Most changes are reported retroactively.

Changes in Accounting Principle

SUSTAINABLE INCOME

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INVESTOR INSIGHT

More Frequent Ups and Downs

In the past, U.S. companies used a method to account for their pension plans that smoothed out the gains and losses on their pension portfolios by spreading gains and losses over multiple years. Many felt that this approach was beneficial because it reduced the volatility of reported net income. However, recently some companies have opted to adopt a method that comes closer to recognizing gains and losses in the period in which they occur. Some of the companies that have adopted this approach are United Parcel Service (UPS), Honeywell International, IBM, AT&T, and Verizon Communications. The CFO at UPS said he favored the new approach because “events that occurred in prior years will no longer distort current-year results. It will 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 Sechler and Doug Cameron, “UPS Alters Pension-Plan Accounting,” Wall Street Journal (January 30, 2012).

United Parcel Service (UPS)

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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.

Recent accounting scandals suggest that some

companies are spending too much time managing their

income and not enough time managing their

business.

QUALITY OF EARNINGS

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Variations among companies in the application of GAAP

may hamper comparability and reduce quality of

earnings (FIFO vs. LIFO).

Usually excludes items that are unusual or nonrecurring.

Some companies have abused the flexibility that pro

forma numbers allow to put their companies in a more

favorable light.

Alternative Accounting Methods

Pro Forma Income

QUALITY OF EARNINGS

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Some managers have felt pressure to continually increase

earnings.

Abuses include:

Improper recognition of revenue (channel stuffing).

Improper capitalization of operating expenses

(WorldCom).

Failure to report all liabilities (Enron).

Improper Recognition

QUALITY OF EARNINGS

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In its proposed 2017 income statement, AIR Corporation

reports income before income taxes $400,000, unrealized gain

on available-for-sale securities $100,000, income taxes

$120,000 (not including unusual items), loss from operation of

discontinued flower division $50,000, and loss on disposal of

discontinued flower division $90,000. The income tax rate is

30%.

Prepare a correct statement of comprehensive income,

beginning with “Income before income taxes.”

Unusual ItemsDO IT! 1

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Unusual ItemsDO IT! 1

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Analyzing financial statements involves:

Comparison Bases

Basic Tools

Intracompany

Intercompany

Industry averages

Horizontal analysis

Vertical analysis

Ratio Analysis

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LEARNING OBJECTIVE

Apply horizontal analysis and vertical analysis. 2

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Also called trend analysis, is a technique for evaluating a

series of financial statement data over a period of time.

Purpose is to determine increase or decrease that has

taken place.

Commonly applied to the balance sheet and income

statement.

HORIZONTAL ANALYSIS

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ILLUSTRATION 13-9Horizontal analysis of balance sheets

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ILLUSTRATION 13-10Horizontal analysis of income statements

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Also called common-size analysis, is a technique that

expresses each financial statement item as a percent of a

base amount.

Vertical analysis is commonly applied to the balance sheet

and the income statement.

VERTICAL ANALYSIS

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ILLUSTRATION 13-11Vertical analysis of balance sheets

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ILLUSTRATION 13-12Vertical analysis of income statements

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ILLUSTRATION 13-13Intercompany comparison by vertical analysis

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Total take: Thousands of dollars

ANATOMY OF A FRAUD

This final Anatomy of a Fraud box demonstrates that sometimes relationships between numbers can be used to detect fraud. Financial ratios that appear abnormal or statistical abnormalities in the numbers themselves can reveal fraud. For example, the fact that WorldCom’s line costs, as a percentage of either total expenses or revenues, differed very significantly from its competitors should have alerted people to the possibility of fraud. Or, consider the case of a bank manager, who cooperated with a group of his friends to defraud the bank’s credit card department. The manager’s friends would apply for credit cards and then run up balances of slightly less than $5,000. The bank had a policy of allowing bank personnel to write-off balances of less than $5,000 without seeking supervisor approval. The fraud was detected by applying statistical analysis based on Benford’s Law. Benford’s Law states that in a random collection of numbers, the frequency of lower digits (e.g., 1, 2, or 3) should be much higher than higher digits (e.g., 7, 8, or 9). In this case, bank auditors analyzed the first two digits of amounts written off. There was a spike at 48 and 49, which was not consistent with what would be expected if the numbers were random.

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The Missing Control

Independent internal verification. While it might be efficient to allow employees to write off accounts below a certain level, it is important that these write-offs be reviewed and verified periodically. Such a review would likely call attention to an employee with large amounts of write-offs, or in this case, write-offs that were frequently very close to the approval threshold.

Source: Mark J. Nigrini, “I’ve Got Your Number,” Journal of Accountancy Online (May 1999).

Total take: Thousands of dollars

ANATOMY OF A FRAUD

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Summary financial information for Rosepatch Company is as

follows.

Compute the amount and percentage changes in 2017 using

horizontal analysis, assuming 2016 is the base year.

Horizontal AnalysisDO IT! 2

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Reflects investors’ assessment of a company’s future

earnings.

Will be higher if investors think that earnings will

increase substantially in the future.

Will be lower when there is the belief that a company

has poor-quality earnings.

PRICE-EARNINGS RATIO

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LEARNING OBJECTIVE

Analyze a company’s performance using ratio analysis.3

ILLUSTRATION 13-14Formula for price-earnings (P-E) ratio

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ILLUSTRATION 13-14Formula for price-earnings (P-E) ratio

ILLUSTRATION 13-15Earnings per share and P-E ratios of various companies

PRICE-EARNINGS RATIO

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LIQUIDITY RATIOS

ILLUSTRATION 13-16Summary of liquidity ratios

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INVESTOR INSIGHT

How to Manage the Current Ratio

The apparent simplicity of the current ratio can have real-world limitations because adding equal amounts to both the numerator and the denominator causes the ratio to decrease.

Assume, for example, that a company has $2,000,000 of current assets and $1,000,000 of current liabilities. Its current ratio is 2:1. If it purchases $1,000,000 of inventory on account, it will have $3,000,000 of current assets and $2,000,000 of current liabilities. Its current ratio decreases to 1.5:1. If, instead, the company pays off $500,000 of its current liabilities, it will have $1,500,000 of current assets and $500,000 of current liabilities. Its current ratio increases to 3:1. Thus, any trend analysis should be done with care because the ratio is susceptible to quick changes and is easily influenced by management.

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SOLVENCY RATIOS

ILLUSTRATION 13-17Summary of solvency ratios

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PROFITABILITY RATIOSILLUSTRATION 13-18Summary of profitability ratios

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INVESTOR INSIGHT

High Ratings Can Bring Low Returns

Moody’s, Standard & Poor’s, and Fitch are three big firms that perform financial analysis on publicly traded companies and then publish ratings of the companies’ creditworthiness. Investors and lenders rely heavily on these ratings in making investment and lending decisions. Some people feel that the collapse of the financial markets was worsened by inadequate research reports and ratings provided by the financial rating agencies. Critics contend that the rating agencies were reluctant to give large companies low ratings because they feared that by offending them they would lose out on business opportunities. For example, the rating agencies gave many so-called mortgage-backed securities ratings that suggested that they were low risk. Later, many of these very securities became completely worthless. Steps have been taken to reduce the conflicts of interest that lead to these faulty ratings.

Source: Aaron Lucchetti and Judith Burns, “Moody’s CEO Warned Profit Push Posed a Risk to Quality of Ratings,” Wall Street Journal Online (October 23, 2008).

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Analyzing financial statements involves:

CharacteristicsComparison

Bases

Liquidity

Profitability

Solvency

Intracompany

Industry averages

Intercompany

The financial information in Illustrations 13A-1 through 13A-4 will be used to calculate Chicago’s 2014 ratios.

LEARNING OBJECTIVE

APPENDIX 13A: Evaluate a company comprehensively using ratio analysis.4

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ILLUSTRATION 13A-2Chicago Cereal Company’s income statements

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ILLUSTRATION 13A-3Chicago Cereal Company’sstatements of cash flows

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Profitability

Measures the income or

operating success of a company for a given period of

time.

Solvency

Measures the ability of the company to

survive over a long period of

time.

Ratio analysis expresses the relationship among selected

items of financial statement data.

Liquidity

Measures short-term ability of the company to pay

its maturing obligations and to meet unexpected needs for cash.

Financial Ratio Classifications

RATIO ANALYSIS

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Measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for

cash.

Short-term creditors such as bankers and suppliers are

particularly interested in assessing liquidity.

Ratios include the current ratio, the current cash debt

coverage, the accounts receivables turnover, the

average collection period, the inventory turnover,

and days in inventory.

LIQUIDITY RATIOS

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Expresses the relationship of current assets to current

liabilities.

What do the measures tell us?

A current ratio of .67 means that for every dollar of current

liabilities, the company has $0.67 of current assets.

Current Ratio

ILLUSTRATION 13A-5Current ratio

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Measures the number of times, on average, a company

collects receivables during the period.

How does Chicago’s turnover compare to General Mills’s?

The turnover of 11.9 times is higher than the industry

average of 11.2 times, and slightly lower than General Mills’

turnover of 12.2 times.

Accounts Receivable Turnover

ILLUSTRATION 13A-6Accounts receivable turnover

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Converts the receivable turnover ratio into days.

How effective is Chicago’s credit and collection policies?

General rule - collection period should not greatly exceed

the credit term period (i.e., the time allowed for payment).

Average Collection Period

ILLUSTRATION 13A-7Average collection period

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Measures the number of times average inventory was sold

during the period.

The ratio of 7.5 times is higher than the industry average of 6.7 times and similar to that of General Mills.

How does Chicago’s turnover compare to General Mills’s?

ILLUSTRATION 13A-8Inventory turnover

Inventory Turnover

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Measures the average number of days inventory is held.

An average selling time of 49 days is faster than the industry average and faster than that of General Mills.

How does Chicago’s days compare to General Mills’s?

Days in Inventory

ILLUSTRATION 13A-9Days in inventory

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Measure the ability of a company to survive over a long

period of time.

Debt-Paying Ability

► Debt to total assets ratio

► Times interest earned

► Free cash flow

SOLVENCY RATIOS

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Indicates the degree of financial leveraging. Provides

some indication of the company’s ability to withstand

losses.

Yes. The ratio of 78% says that Chicago would have to

liquidate 78% of its assets at their book value in order to pay

off all of its debts.

Has Chicago’s solvency improved during the year?

Debt to Assets Ratio

ILLUSTRATION 13A-10Debt to assets ratio

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Also called interest coverage, indicates the company’s

ability to meet interest payments as they come due.

Yes, the ratio indicates that income before interest and taxes

was 5.8 times the amount needed for interest expense.

Is Chicago able to service its’ debt?

Times Interest Earned

ILLUSTRATION 13A-11Times interest earned

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Ability to pay dividends or expand operations.

Cash provided by operations was more than enough to

allow Chicago to acquire additional productive assets and

maintain dividend payments.

Free Cash Flow

ILLUSTRATION 13A-12Free cash flow

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Measure the income or operating success of a company for a given period of time.

ILLUSTRATION 13A-13Relationships amongprofitability measures

PROFITABILITY RATIOS

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Shows how many dollars of net income the company

earned for each dollar invested by the owners.

Chicago’s 2014 rate of return on common

stockholders’ equity is unusually high at

48%, considering an industry average of

19% and General Mills’s return of 25%.

Return on Common Stockholders’ Equity

ILLUSTRATION 13A-14Return on commonstockholders’ equity

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Measures the overall profitability of assets in terms of the

income earned on each dollar invested in 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.

Return on Assets

ILLUSTRATION 13A-15Return on assets

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Or rate of return on sales, is a measure of the percentage

of each dollar of sales that results in net income.

High-volume (high inventory turnover) businesses such as

grocery stores and pharmacy chains generally have low

profit margins.

Profit Margin

ILLUSTRATION 13A-16Profit margin

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Measures how efficiently a company uses its assets to

generate sales.

The average asset turnover for utility companies is .45, for

example, while the grocery store industry has an average

asset turnover of 3.49.

Asset Turnover

ILLUSTRATION 13A-17Asset turnover

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You can analyze the combined effects of profit margin and

asset turnover on return on assets for Chicago as shown.

Return on Assets

ILLUSTRATION 13A-18Composition of return on assets

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Indicates a company’s ability to maintain an adequate

selling price above its cost of goods sold.

As an industry becomes more competitive, this ratio

declines.

Gross Profit Rate

ILLUSTRATION 13A-19Gross profit rate

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A measure of the net income earned on each share of

common stock.

Earnings Per Share (EPS)

ILLUSTRATION 13A-20Earnings per share

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Reflects investors’ assessments of a company’s future

earnings.

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.

Price-Earnings (P-E) Ratio

ILLUSTRATION 13A-21Price-earnings ratio

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Measures the percentage of earnings distributed in the

form of cash dividends.

This ratio should be calculated over a longer period of time

to evaluate any trends.

Payout Ratio

ILLUSTRATION 13A-22Payout ratio

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RELEVANT FACTS

A Look at IFRS

LEARNING OBJECTIVE

Compare financial statement analysis and income statement presentation under GAAP and IFRS.

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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.

Both GAAP and IFRS follow the same approach in reporting comprehensive income.

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RELEVANT FACTS

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.

The basic accounting for discontinued operations is the same under IFRS and GAAP.

A Look at IFRS

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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.

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IFRS Practice

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) None of the above.

A Look at IFRS

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IFRS Practice

Presentation of comprehensive income must be reported under

IFRS in:

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.

A Look at IFRS

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IFRS Practice

In preparing its income statement for 2017, Parmalane assembles

the following information.

Sales revenue $500,000Cost of goods sold 300,000Operating expenses 40,000Loss on discontinued operations 20,000

Ignoring income taxes, what is Parmalane’s income from

continuing operations for 2017 under IFRS?

a) $260,000. c) $240,000.

b) $250,000. d) $160,000.

A Look at IFRS

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