The document provides information on analyzing a company's financial performance using various analytical tools and ratios. It discusses concepts like sustainable income, quality of earnings, horizontal analysis, vertical analysis, and key financial ratios to measure liquidity, profitability, and solvency. Specific examples and illustrations are provided to demonstrate calculating and interpreting various ratios. The overall document aims to help readers understand and apply different financial statement analysis techniques.

1. 13-1
Financial Analysis: The Big
Picture
Kimmel ● Weygandt ● Kieso
Accounting, Sixth Edition
13

2. 13-2
CHAPTER OUTLINE
Apply the concepts of sustainable income and
quality of earnings.
1
Apply horizontal analysis and vertical
analysis.
2
LEARNING OBJECTIVES
Analyze a company’s performance using ratio
analysis.
3

3. 13-3
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.
LO 1
LEARNING
OBJECTIVE
Apply the concepts of sustainable income
and quality of earnings.1
SUSTAINABLE INCOME

4. 13-4
SUSTAINABLE INCOME ILLUSTRATION 13-1
Statement of comprehensive
income
LO 1

5. 13-5
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
LO 1

6. 13-6
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
LO 1

7. 13-7
Discontinued Operations
ILLUSTRATION 13-2
Statement presentation of discontinued operations
LO 1

8. 13-8
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.
LO 1

9. 13-9
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
LO 1

10. 13-10
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
LO 1

11. 13-11
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
LO 1

12. 13-12
Format One
Combined statement of income and comprehensive income.
Illustration 13-5
Comprehensive Income
ILLUSTRATION 13-3
Lower portion of combined statement of
income and comprehensive income
LO 1

13. 13-13
Format Two
Comprehensive Income
Separate component of Stockholders’ Equity.
ILLUSTRATION 13-4
Unrealized loss in stockholders’ equity section
LO 1

14. 13-14
ILLUSTRATION 13-5
Complete statement of
comprehensive income

15. 13-15
 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
LO 1

16. 13-16
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)
LO 1

17. 13-17
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
LO 1

18. 13-18
 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
LO 1

19. 13-19
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
LO 1

20. 13-20
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
LO 1

21. 13-21
Unusual ItemsDO IT! 1
LO 1

22. 13-22
Analyzing financial statements involves:
Comparison
Bases
Basic Tools
 Intracompany
 Intercompany
 Industry averages
 Horizontal analysis
 Vertical analysis
 Ratio Analysis
LO 2
LEARNING
OBJECTIVE
Apply horizontal analysis and vertical
analysis.2

23. 13-23
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
LO 2

24. 13-24
ILLUSTRATION 13-9
Horizontal analysis of
balance sheets

25. 13-25
ILLUSTRATION 13-10
Horizontal analysis of income statements
LO 2

26. 13-26
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
LO 2

27. 13-27
ILLUSTRATION 13-11
Vertical analysis of
balance sheets

28. 13-28
ILLUSTRATION 13-12
Vertical analysis of income statements
LO 2

29. 13-29
ILLUSTRATION 13-13
Intercompany comparison by vertical analysis
LO 2

30. 13-30
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.
LO 2(continued)

31. 13-31
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
LO 2

32. 13-32
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
LO 2

33. 13-33
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
LO 3
LEARNING
OBJECTIVE
Analyze a company’s performance using
ratio analysis.3
ILLUSTRATION 13-14
Formula for price-earnings (P-E) ratio

34. 13-34
ILLUSTRATION 13-14
Formula for price-earnings (P-E) ratio
ILLUSTRATION 13-15
Earnings per share and P-E ratios of various companies
PRICE-EARNINGS RATIO
LO 3

35. 13-35
LIQUIDITY RATIOS
ILLUSTRATION 13-16
Summary of liquidity ratios
LO 3

36. 13-36
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.
LO 3

37. 13-37
SOLVENCY RATIOS
ILLUSTRATION 13-17
Summary of solvency ratios
LO 3

38. 13-38
PROFITABILITY RATIOS
ILLUSTRATION 13-18
Summary of profitability ratios
LO 3

39. 13-39
LO 3
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).

40. 13-40
Analyzing financial statements involves:
Characteristics
Comparison
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
LO 4

41. 13-41
ILLUSTRATION 13A-1
Chicago Cereal Company’s balance sheets LO 4

42. 13-42
ILLUSTRATION 13A-2
Chicago Cereal Company’s income statements
LO 4

43. 13-43 LO 4
ILLUSTRATION 13A-3
Chicago Cereal Company’s
statements of cash flows

44. 13-44
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
LO 4

45. 13-45
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
LO 4

46. 13-46
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-5
Current ratio
LO 4

47. 13-47
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-6
Accounts receivable turnover
LO 4

48. 13-48
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-7
Average collection period
LO 4

49. 13-49
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-8
Inventory turnover
Inventory Turnover
LO 4

50. 13-50
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-9
Days in inventory
LO 4

51. 13-51
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
LO 4

52. 13-52
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-10
Debt to assets ratio
LO 4

53. 13-53
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-11
Times interest earned
LO 4

54. 13-54
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-12
Free cash flow
LO 4

55. 13-55
Measure the income or operating success of a company for
a given period of time.
ILLUSTRATION 13A-13
Relationships among
profitability measures
PROFITABILITY RATIOS
LO 4

56. 13-56
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-14
Return on common
stockholders’ equity
LO 4

57. 13-57
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-15
Return on assets
LO 4

58. 13-58
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-16
Profit margin
LO 4

59. 13-59
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-17
Asset turnover
LO 4

60. 13-60
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-18
Composition of return on assets
LO 4

61. 13-61
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-19
Gross profit rate
LO 4

62. 13-62
A measure of the net income earned on each share of
common stock.
Earnings Per Share (EPS)
ILLUSTRATION 13A-20
Earnings per share
LO 4

63. 13-63
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-21
Price-earnings ratio
LO 4

64. 13-64
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-22
Payout ratio
LO 4