CHAPTER 11
                FINANCIAL STATEMENT ANALYSIS
CHAPTER OUTLINE
Closer look at the income statement
I.    Earnings...
b. Unrealized gains and losses on certain debt and equity investments
       c. Minimum pension liability adjustments
    ...
i. Sales as the base for income statement items
              ii. Total assets as the base for balance sheet items

Ratio ...
iii. Gives an indication of future earnings
              iv. An extremely high PE ratio might indicate an overpriced stoc...
CHAPTER 11
                                  TEN-MINUTE QUIZ
Name______________________________ Date____________ Section__...
7.    Liquidity ratios include all of the following, except
      a.     Return on assets
      b.     Current ratio
     ...
ANSWER KEY TO CHAPTER 11 QUIZ
            1.    D
            2.    A
            3.    D
            4.    B
            ...
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Chapter outline

  1. 1. CHAPTER 11 FINANCIAL STATEMENT ANALYSIS CHAPTER OUTLINE Closer look at the income statement I. Earnings (net income) is the focus of financial reporting a. Not uncommon for firms to be accused of manipulating their earnings b. GAAP defines three items that need to be separated from regular earnings of a business II. Discontinued operations a. Part of a company that is eliminated (division that is sold or disposed of) b. Financial implications related to that segment are separated from the regular operations of the firm i. Net income is used to evaluate the performance of a company and to predict future performance ii. To make evaluations meaningful, one-time occurrences are separated out c. Financial implications of discontinuing a business segment are reported separately i. Gain or loss on disposal ii. Earnings or loss of the segment for the accounting period III. Extraordinary items a. Unusual in nature (abnormal) b. Infrequent in occurrence (not reasonably expected to occur again in the foreseeable future) c. Examples i. Eruption of a volcano ii. Takeover of foreign operations by the foreign government iii. Effects of new laws or regulations that result in a one-time cost for compliance d. Each situation is unique and must be considered in the environment in which the company operates IV. Changes in accounting principle a. Generally accepted accounting principles (GAAP) are constantly evolving b. When the accounting profession changes one of its principles or a company chooses a different principle from the available choices (e.g., change in depreciation method), the effect of the change on net income must be segregated c. The amount is called the cumulative effect of a change in accounting principle d. Amount is singled out and identified Comprehensive income I. In general, revenues and expenses are included on the income statement II. However, there are some transactions that affect equity without going through the income statement a. Unrealized gains and losses from foreign currency translations 11-1
  2. 2. b. Unrealized gains and losses on certain debt and equity investments c. Minimum pension liability adjustments d. Unrealized gains and losses on certain derivatives III. Instead of showing these items on the income statement, they are reported as a direct adjustment to equity IV. FASB was concerned that these items may not be getting the attention that they deserve a. FASB decided to require the reporting of net income plus these items b. Total of net income plus these items is called comprehensive income c. Comprehensive income includes all changes in stockholders’ equity during a period, except those changes resulting from contributions by and distributions to stockholders. Investments in securities I. Held-to-maturity securities a. Debt securities that the company intends to hold on to until they mature b. Financial condition indicates that the company has the ability to hold the security until maturity c. Reported on the balance sheet at cost (plus or minus any discount or premium amortization d. Current market value is not reported II. Trading securities a. Debt or equity securities purchased solely to be traded and make a short-term profit b. Reported on the balance sheet at their market value i. Called marking to market ii. If market value is lower than cost, an unrealized loss is recognized iii. If market value is higher than cost, an unrealized gain is recognized iv. Unrealized (holding) gain or loss is reported on the income statement III. Available-for-sale securities a. Debt or equity securities purchased, but not for short term, quick profit and not intended to be held until maturity (debt securities) b. Reported on the balance sheet at their market value i. Called marking to market ii. If market value is lower than cost, an unrealized loss is recognized iii. If market value is higher than cost, an unrealized gain is recognized iv. Unrealized (holding) gain or loss is reported as a component of other comprehensive income (not net income) Financial statement analysis I. Horizontal analysis a. Technique for evaluating a series of financial data over a period of time b. Purpose is to express the change in an item in percentages, based on a specific past year chosen as the base year II. Vertical analysis a. Similar to horizontal analysis, but involves items on a financial statement for a single year b. Each item in the financial statement is expressed as a percentage of a selected item on the statement 11-2
  3. 3. i. Sales as the base for income statement items ii. Total assets as the base for balance sheet items Ratio analysis III. Liquidity ratios a. Current ratio i. Current assets divided by current liabilities ii. Chapter 2 b. Acid-test ratio (quick ratio) i. Cash + short-term investments + net current receivables divided by current liabilities ii. Chapter 7 c. Working capital i. Current assets minus current liabilities ii. Chapter 3 d. Inventory turnover ratio i. Cost of goods sold divided by average inventory ii. Chapter 6 e. Accounts receivable turnover ratio i. Net sales divided by average net accounts receivable ii. Chapter 7 IV. Solvency ratios a. Debt-to-equity i. Total liabilities divided by total equity ii. Chapter 8 b. Times interest earned i. Net income + interest expense divided by interest expense ii. Chapter 8 V. Profitability ratios a. Return on assets i. Net income + interest expense divided by average total assets ii. Chapter 5 b. Return on equity i. Net income minus preferred dividends divided by average common stockholders’ equity ii. Chapter 9 c. Gross margin ratio i. Gross margin divided by sales ii. Chapter 6 d. Earnings per share (EPS) i. Net income minus preferred dividends divided by average number of shares of common stock outstanding ii. Chapter 9 VI. Market indicator ratios a. Price-earnings ratio (PE) i. Market price of a share of stock divided by the current EPS ii. Indicates the return an investor might earn by purchasing the stock 11-3
  4. 4. iii. Gives an indication of future earnings iv. An extremely high PE ratio might indicate an overpriced stock v. A very low PE ratio might indicate an underpriced stock b. Dividend-yield ratio i. Dividend per share divided by the market price per share ii. Investors are willing to accept a low dividend yield when they anticipate an increase in the price of the stock iii. Stocks with low growth potential may offer a higher dividend yield VII. Understanding ratios a. A ratio by itself does not give much information b. To be useful, a ratio must be compared with i. Ratios from prior years ii. Ratios of other companies in the same industry iii. Industry average ratios iv. No standard formulas for computing ratios (except for EPS) v. Be consistent in calculating ratios so comparisons will be meaningful c. Look for trends, components in the values that are part of the ratios, and other information about the company that may not even be contained in the financial statements d. Financial statements are only one source of information e. Ratio analysis is only one tool for analyzing financial statements VIII. Using ratio analysis Conclusion I. Some analysts believe there is more real information about the health of a company in the notes to the financial statements than in the statements themselves II. Pro-forma financial statements are forecasted financial statements III. Because accounting is such an integral part of business, accounting principles will continue to change as business changes a. Each year the FASB and other standard-setting bodies add and changes rules for including, excluding, and valuing items in the financial statements b. The accounting profession will be increasingly concerned with electronic transactions, e-business, and real-time access to financial data SUGGESTED READINGS AND RESOURCES • IBM Investors’ Guide to Financials, http://www.ibm.com/investor/financialguide/. • MoneyCentral Key Ratios, http://moneycentral.msn.com/investor/invsub/results/compare.asp. • Corporate Information, http://www.corporateinformation.com/. • EdgarScan, http://edgarscan.pwcglobal.com/recruit/other.html. • MarketGuide, http://www.marketguide.com/home.asp. • “FASB's Emerging Issues Task Force Decides Against Extraordinary Treatment for Terrorist Attack Costs,” FASB News Release, October 10, 2001, Financial Accounting Standards Board. 11-4
  5. 5. CHAPTER 11 TEN-MINUTE QUIZ Name______________________________ Date____________ Section____________ Circle the letter of the best response. 1. Items separated from the regular earnings of a company include a. Discontinued operations b. Extraordinary items c. Changes in accounting principle d. All of the above 2. To be reported as an extraordinary item, the event must be a. Unusual and infrequent b. Unusual and frequent c. Normal and infrequent d. Part of continuing operations 3. Comprehensive income includes a. Unrealized gains and losses from foreign currency translations b. Unrealized gains and losses on certain investments c. Net income d. All of the above 4. A debt investment that the company intends (and has the ability to) hold on to until maturity should be classified as a a. Trading security b. Held-to-maturity security c. Available-for-sale security d. Comprehensive income item 5. An investment that a company does not intend to sell quickly, but may not hold on to until maturity should be classified as a a. Trading security b. Held-to-maturity security c. Available-for-sale security d. Comprehensive income item 6. Which of the following investments is not marked to market? a. Trading security b. Held-to-maturity security c. Available-for-sale security d. All of the above are marked to market 11-5
  6. 6. 7. Liquidity ratios include all of the following, except a. Return on assets b. Current ratio c. Working capital d. Acid test 8. Which of the following types of ratios measure the ability of a company to survive over a long period of time? a. Liquidity ratios b. Solvency ratios c. Profitability ratios d. Market indicators 9. An extremely high price-earnings ratio may indicate a. That the stock is underpriced b. That the stock is overpriced c. That the investment is low risk d. That the company pays high dividends 10. Dividend-yield ratio is calculated by a. Dividing dividend per share by market price per share b. Dividing market price per share by dividend per share c. Subtracting the dividend per share from the earnings per share d. Dividing the dividend per share by the earnings per share 11-6
  7. 7. ANSWER KEY TO CHAPTER 11 QUIZ 1. D 2. A 3. D 4. B 5. C 6. B 7. A 8. B 9. B 10. A 11-7

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