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Financial Accounting, 4e
Weygandt, Kieso, & Kimmel
John Wiley & Sons, Inc.
Prepared by
Gregory K. Lowry
Mercer University
Marianne Bradford
The University of Tennessee
CHAPTER 15
FINANCIAL STATEMENT ANALYSIS
After studying this chapter, you should be able to:
1 Discuss the need for comparative analysis.
2 Identify the tools of financial statement
analysis.
3 Explain and apply horizontal analysis.
4 Describe and apply vertical analysis.
CHAPTER 15
FINANCIAL STATEMENT ANALYSIS
After studying this chapter, you should be able to:
5 Identify and compute ratios and describe their
purpose and use in analyzing a firm’s liquidity,
profitability, and solvency.
6 Understand the concept of earning power and
indicate how material items not typical of
regular operations are presented.
7 Recognize the limitations of financial statement
analysis.
PREVIEW OF CHAPTER 15
FINANCIAL STATEMENT ANALYSIS
Ratio Analysis
Liquidity
Profitability
Solvency
Summary




Earning Power
and Irregular
Items
Discontinued
operations
Extraordinary
items
Change in
accounting
principle
Comprehensive
income



Need for
comparative
analysis
Tools of analysis


Basics of Financial
Statement Analysis
Horizontal and
Vertical
Analysis



Balance sheet
Income
statement
Retained
earnings
statement
Limitations of
Financial Analysis
Estimates
Cost
Accounting
methods
Atypical data
Diversification






• Analyzing financial statements involves Three
characteristics of a company: 1 its liquidity, 2 its
profitability, and 3 its solvency.
• Every item reported in a financial statement has
significance.
• In order to obtain information as to whether the amount
1 represents an increase over prior years or 2 is
adequate in relation to the company’s need for cash, the
amount of cash must be compared with other financial
statement data.
• Comparisons can be made on several difference bases –
three are illustrated in this chapter: 1 intracompany
basis, 2 industry averages, and 3 intercompany basis.
BASICS OF
FINANCIAL STATEMENT ANALYSIS
Three commonly used tools are utilized to evaluate
the significance of financial statement data.
1 Horizontal analysis (trend analysis) is a technique
for evaluating a series of financial statement data
over a period of time.
2 Vertical analysis is a technique for evaluating
financial statement data that expresses each item
in a financial statement in terms of a percent of a
base amount.
3 Ratio analysis expresses the relationship among
selected items of financial statement data.
TOOLS OF
FINANCIAL STATEMENT ANALYSIS
ILLUSTRATION 15-1, 15-2
SEARS ROEBUCK’S NET SALES
SEARS, ROEBUCK AND CO.
(Net Sales Stated in Millions)
2000 1999 1998 1997 1996
$ 40,937 $ 39,484 $ 39,953 $ 39,837 $ 36,662
Current year amount — Base year amount
———————————————————————
Base year amount
The purpose of horizontal analysis is to determine
the increase or decrease that has taken place,
expressed as either an amount or a percentage.
The recent net sales figures of Sears, Roebuck and
Co. are shown above. Given that 1996 is the base
year, we can measure all percentage increases or
decreases from this base period amount as shown
below.
Change since base
period =
ILLUSTRATION 15-4
HORIZONTAL ANALYSIS OF SEARS,
ROEBUCK’S NET SALES
Sears, Roebuck and Co.
Net Sales (in Millions)
Base Period 1996
2000 1999 1998 1997 1996
$40,937 $ 39,484 $ 39,953 $ 39,837 $36,662
111.7% 107.7% 109% 108.7% 100%
We can determine that net sales for Sears,
Roebuck increased approximately 8.7% [($39,837 -
$36,662) ÷ $36,662] from 1996 to 1997. We can
also determine that net sales increased over 11.7%
[($40,937 - $36,662) ÷ $36,662] from 1996 to 2000.
The percentage of the base period for each of the 5
years, assuming 1996 as the base period, is shown
below.
ILLUSTRATION 15-5
HORIZONTAL ANALYSIS OF A
BALANCE SHEET
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheet
December 31
2000 1999 Amount Percentage
Assets
$ 945,000
Plant assets (net) 800,000 632,500 167,500 26.5%
15,000
Total assets $ 1,595,000 $ 240,000 15.0%
Liabilities
$ 344,500 $ 303,000 $ 41,500
Long-term liabilities 497,000 ( 9,500) ( 1.9%)
832,000 4.0%
Common stock, $1 par 275,400 270,000
727,600 525,000 202,600 38.6%
Total stockholders’ equity 795,000 26.2%
Increase or (Decrease)
during 2000
Current assets $ 1,020,000 $ 75,000 7.9%
Intangible assets 17,500 ( 2,500) ( 14.3%)
$ 1,835,000
Current liabilities 13.7%
487,500
Total liabilities 800,000 32,000
Stockholders’ Equity
5,400 2.0%
Retained earnings
1,003,000 208,000
Total liabilities and stockholders’ equity $ 1,835,000 $ 1,595,000 $ 240,000 15.0%
The 2-year condensed
balance sheet of Quality
Department Store Inc. for
2000 and 1999 showing
dollar and percentage
changes is displayed on the
right. In the asset section,
plant assets (net) increased
$167,500 or 26.5%. In the
liabilities section, current
liabilities increased $41,500
or 13.7%. In the
stockholders’ equity section,
retained earnings increased
$202,600 or 38.6%. It
appears the company
expanded its asset base
during 2000 and financed
the expansion by retaining
income in the firm.
ILLUSTRATION 15-6
HORIZONTAL ANALYSIS OF AN
INCOME STATEMENT
QUALITY DEPARTMENT STORE INC.
Condensed Income Statement
For the Years Ended December 31
Increase or (Decrease)
during 2000
2000 1999 Amount Percentage
Sales $ 2,195,000 $ 1,960,000 $ 235,000 12.0%
Sales returns and allowances 98,000 123,000 ( 25,000) ( 20.3%)
Net sales 2,097,000 1,837,000 260,000 14.2%
Cost of goods sold 1,281,000 1,140,000 141,000 12.4%
Gross profit 816,000 697,000 119,000 17.1%
Selling expenses 253,000 211,500 41,500 19.6%
Administrative expenses 104,000 108,500 ( 4,500) ( 4.1%)
Total operating expenses 357,000 320,000 37,000 11.6%
Income from operations 459,000 377,000 82,000 21.8%
Other revenues and gains
Interest and dividends 9,000 11,000 ( 2,000) ( 18.2%)
Other expenses and losses
Interest expense 36,000 40,500 ( 4,500) ( 11.1%)
Income before income taxes 432,000 347,500 84,500 24.3%
Income tax expense 168,200 139,000 29,200 21.0%
Net income $ 263,800 $ 208,500 $ 55,300 26.5%
The 2-year comparative
income statement of Quality
Department Store Inc. for
2000 and 1999 is shown in
condensed form on the right.
Horizontal analysis of the
comparative income
statement shows the
following changes:
1 Net sales increased
$260,000, or 14.2%
($260,000 ÷ $1,837,000).
2 Cost of goods sold
increased $141,000, or
12.4% ($141,000 ÷
$1,140,000).
3 Total operating expenses
increased $37,000, or
11.6% ($37,000 ÷
$320,000).
ILLUSTRATION 15-7
HORIZONTAL ANALYSIS OF A
RETAINED EARNINGS STATEMENT
QUALITY DEPARTMENT STORE INC.
Retained Earnings Statement
For the Years Ended December 31
Increase or (Decrease)
during 2000
2000 1999 Amount Percentage
Retained earnings, January 1 $ 525,000 $ 376,500 $ 148,500 39.4%
Add: Net income 263,800 208,500 55,300 26.5%
788,800 585,000 203,800
Deduct: Dividends 61,200 60,000 1,200 2.0%
Retained earnings, December 31 $ 727,600 $ 525,000 $ 202,600 38.6%
The 2-year comparative
retained earnings
statement of Quality
Department Store Inc.
for 2000 and 1999 is
presented on the right.
Analyzed horizontally:
1 Net income increased
$55,300, or 26.5%.
2 Common dividends
increased only $1,200,
or 2%.
3 Ending retained
earnings increased
38.6%.
ILLUSTRATION 15-8
VERTICAL ANALYSIS OF
A BALANCE SHEET
Presented on the right is the
2-year comparative balance
sheet of Quality Department
Store Inc. for 2000 and 1999.
1 Current assets increased
$75,000 from 1999 to 2000,
they decreased from
59.2% to 55.6% of total
assets.
2 Plant assets (net) increased
from 39.7% to 43.6% of
total assets, and
3 Retained earnings increased
from 32.9% to 39.7% of
total liabilities and
stockholders’ equity.
These results reinforce earlier
observations that Quality is
financing its growth through
retention of earnings.
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheet
December 31
2000 1999
Amount Percent Amount Percent
Assets
Current assets $ 1,020,000 55.6% $ 945,000 59.2%
Plant assets (net) 800,000 43.6% 632,500 39.7%
Intangible assets 15,000 0.8% 17,500 1.1%
Total assets $ 1,835,000 100.0% $ 1,595,000 100.0%
Liabilities
Current liabilities $ 344,500 18.8% $ 303,000 19.0%
Long-term liabilities 487,500 26.5% 497,000 31.2%
Total liabilities 832,000 45.3% 800,000 50.2%
Stockholders’ Equity
Common stock, $1 par 275,400 15.0% 270,000 16.9%
Retained earnings 727,600 39.7% 525,000 32.9%
Total stockholders’ equity 1,003,000 54.7% 795,000 49.8%
Total liabilities and stockholders’ equity $ 1,835,000 100.0% $1,595,000 100.0%
ILLUSTRATION 15-9
VERTICAL ANALYSIS OF
AN INCOME STATEMENT
Vertical analysis of the
2-year comparative income
statement of Quality
Department Store Inc. for
2000 and 1999 is shown on
the right.
1 Cost of goods sold as a
percentage of net sales
declined 1% (62.1% versus
61.1%).
2 Total operating expenses
declined 0.4% (17.4%
versus 17.0%).
3 Net income as a percent of
net sales therefore
increased from 11.4% to
12.6%.
Quality appears to be a
profitable enterprise that is
becoming more successful.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statement
For the Years Ended December 31
2000 1999
Amount Percent Amount Percent
Sales $ 2,195,000 104.7% $ 1,960,000 106.7%
Sales returns and allowances 98,000 4.7% 123,000 6.7%
Net sales 2,097,000 100.0% 1,837,000 100.0%
Cost of goods sold 1,281,000 61.1% 1,140,000 62.1%
Gross profit 816,000 38.9% 697,000 37.9%
Selling expenses 253,000 12.0% 211,500 11.5%
Administrative expenses 104,000 5.0% 108,500 5.9%
Total operating expenses 357,000 17.0% 320,000 17.4%
Income from operations 459,000 21.9% 377,000 20.5%
Other revenues and gains
Interest and dividends 9,000 0.4% 11,000 0.6%
Other expenses and losses
Interest expense 36,000 1.7% 40,500 2.2%
Income before income taxes 432,000 20.6% 347,500 18.9%
Income tax expense 168,200 8.0% 139,000 7.5%
Net income $ 263,800 12.6% $ 208,500 11.4%
ILLUSTRATION 15-10
INTERCOMPANY INCOME
STATEMENT COMPARISON
CONDENSED INCOME STATEMENTS
Quality
Department Sears, Roebuck
Store Inc. And Co.
(in thousands) Dollars Percent Dollars Percent
Net sales $ 2,097 100.0% $ 46,937,000 100.0%
Cost of goods sold 1,281 61.1% 26,899,000 65.7%
Gross profit 816 38.9% 14,038,000 34.3%
Selling and administrative expenses 357 17.0% 11,851,000 28.9%
Income from operations 459 21.9% 2,187,000 5.3%
Other expenses and revenues (including income taxes 195 9.3% 884,000 2.1%
Net income $ 264 12.6% $ 1,343,000 3.3%
Vertical analysis enables you to compare companies of different sizes. Quantity’s
major competitor is a Sears store in a town nearby town. Using vertical analysis,
the small Quality Department Store Inc. can be meaningfully compared to the much
larger Sears, as shown below. 1 Gross profit rates were somewhat comparable at
38.9% and 34.3%. 2 Income from operations percentages were significantly
different at 21.9% and 5.3% . 3 Quality’s selling and administrative expenses
percentage was much lower than Sears’ – 17% to 28.9%. 4 Sears’ net income as a
percentage of sales was much lower than Quality’s: 3.3% to 12.6%.
RATIO ANALYSIS
• Ratio analysis expresses the relationship among selected items of
financial statement data.
• A ratio expresses the mathematical relationship between one
quantity and another.
• A single ratio by itself is not very meaningful, in the upcoming
illustrations we will use:
1 Intracompany comparisons covering two years for the
Quality Department Store.
2 Industry average comparisons based on median ratios for
department stores
3 Intercompany comparisons based on Sears, Roebuck and Co. as
Quality Department Store’s principal competitor.
ILLUSTRATION 15-11
FINANCIAL RATIO CLASSIFICATIONS
Liquidity Ratios
Measures of short-term ability
of the enterprise to pay its
maturing obligations and to
meet unexpected needs for cash
Profitability Ratios
Measures of the income or
operating success of an
enterprise for a given period of
time
Solvency Ratios
Measures of the ability of the
enterprise to survive over a
long period of time
Revenues Expenses
- = Net
Income
XYZ Co.
Industry average Sears, Roebuck and Co.
———————— ———————————
1.34:1 2.38:1
CURRENT ASSETS
CURRENT RATIO = ———————————
CURRENT LIABILITIES
2000 1999
$1,020,000 $945,000
—————= 2.96:1 ————= 3.1:1
$344,500 $303,000
Quality Department Store
The current ratio (working capital ratio) is a widely used measure for evaluating a company’s
liquidity and short-term debt-paying ability. It is calculated by dividing current assets by
current liabilities and is a more dependable indicator of liquidity than working capital. The
current ratios for Quality Department Store and comparative data are shown below.
ILLUSTRATION 15-12
CURRENT RATIO
ILLUSTRATION 15-13
CURRENT ASSETS OF
QUALITY DEPARTMENT STORE
2000 1999
Current assets
Cash $ 100,000 $ 155,000
Temporary invest. 20,000 70,000
Receivables (net) 230,000 180,000
Inventory 620,000 500,000
Prepaid expenses 50,000 40,000
Total current assets $ 1,020,000 $ 945,000
ILLUSTRATION 15-14
ACID-TEST RATIO
CASH + MARKETABLE SECURITIES + RECEIVABLES (NET)
ACID-TEST RATIO = ————————————————————————————
CURRENT LIABILITIES
Quality Department Store
Industry average Sears, Roebuck and Co.
———————— ———————————
1.3:1 1.3:1
2000 1999
$100,000 + $20,000 + $230,000 $155,000 + $70,000 + $180,000
—————————————— = 1.0:1 —————————————— = 1.3:1
$344,500 $303,000
The acid-test ratio (quick ratio) is a measure of a company’s short-term liquidity and
is calculated by dividing the sum of cash, marketable securities, and net receivables by
current liabilities. The acid-test ratios for Quality Department Store and comparative
data are shown below.
ILLUSTRATION 15-15
CURRENT CASH DEBT COVERAGE RATIO
The current cash debt coverage ratio usually provides a superior representation of liquidity since it
uses not cash provided by operating activities rather than a balance at a point in time. Quality
Department Store’s current cash debt coverage ratios for 2000 and 1999 are calculated below.
CURRENT CASH DEBT NET CASH PROVIDED BY OPERATING ACTIVITIES
COVERAGE RATIO = ————————————————————————
AVERAGE CURRENT LIABILITIES
Quality Department Store
2000 1999
$404,000 $340,000
—————————— - 1.25:1 —————————— - 1.15:1
$303,000 + $344,500 $290,000 + $303,000
—————————— ——————————
2 2
[ ] [ ]
Industry average Sears, Roebuck & Co.
———————— ———————————
1.1:1 0.137:1
ILLUSTRATION 15-16
RECEIVABLES TURNOVER
2000 1999
$2,097,000 $1,837,000
——————————= 10.2 times ——————————=9.7 times
$180,000 + $230,000 $200,000 + $180,000
—————————— ——————————
2 2
[ ] [ ]
Quality Department Store
Industry average Sears, Roebuck & Co.
———————— ———————————
15.7 times 2.19 times
NET CREDIT SALES
RECEIVABLES TURNOVER = ———————————————
AVERAGE NET RECEIVABLES
The receivables turnover ratio is used to assess the liquidity of the receivables. It measures the
number of times, on average, receivables are collected during the period. The ratio is calculated by
dividing net credit sales by average net receivables during the year. The receivables turnover ratio
and comparative data for Quality Department Store for 2000 and 1999 are calculated below.
ILLUSTRATION 15-17
INVENTORY TURNOVER
Quality Department Store
Industry average Sears, Roebuck and Co.
———————— ———————————
6.22 times 4.61 times
COST OF GOODS SOLD
INVENTORY TURNOVER = ————————————
AVERAGE INVENTORY
2000 1999
$1,281,000 $1,140,000
—————————— = 2.3 times —————————— = 2.4 times
$500,000 + $620,000 $450,000 + $500,000
—————————— ——————————
2 2
[ ] [ ]
The inventory turnover ratio measures the number of times, on average, the inventory is sold
during the period – which measures the liquidity of the inventory. It is calculated by dividing
cost of goods sold by average inventory during the year. The inventory turnover ratio and
comparative data for Quality Department Store for 2000 and 1999 are calculated below.
ILLUSTRATION 15-18
PROFIT MARGIN RATIO
Quality Department Store
Industry average Sears, Roebuck and Co.
———————— ———————————
3.16% 1.8%
NET INCOME
PROFIT MARGIN ON SALES = ——————
NET SALES
2000 1999
$263,800 $208,500
————— = 12.6% ————— = 11.4%
$2,097,000 $1,837,000
The profit margin ratio is a measure of the percentage of each dollar of sales
that results in net income. It is calculated by dividing net income by net sales
for the period. The profit margin ratios and comparative data for Quality
Department Store for 2000 and 1999 are calculated below.
ILLUSTRATION 15-19
CASH RETURN ON SALES RATIO
Quality Department Store
Industry average Sears, Roebuck and Co.
———————— ———————————
6.2% 7.4%
NET CASH PROVIDED BY OPERATING ACTIVITIES
CASH RETURN ON SALES RATIO = —————————————————————————
NET SALES
2000 1999
$404,000 $340,000
————— = 19.3% ————— = 18.5%
$2,097,000 $1,837,000
The cash basis counterpart of the profit margin ratio is the cash return on sales
ratio which uses net cash provided by operating activities as the numerator and
net sales as the denominator. Using net cash provided by operating activities of
$404,000 in 2000 and $340,000 in 1999, Quality Department Store’s cash return on
sales ratios are calculated and evaluated below.
ILLUSTRATION 15-20
ASSET TURNOVER
2000 1999
$2,097,000 $1,837,000
—————————— = 1.2 times ——————————— = 1.21 times
$1,595,000 + $1,835,000 $1,446,000 + $1,595,000
——————————— ———————————
2 2
[ ] [ ]
Quality Department Store
Industry average Sears, Roebuck & Co.
———————— ———————————
2.32 times 1.1 times
NET SALES
ASSET TURNOVER = —————————
AVERAGE ASSETS
The asset turnover ratio measures how efficiently a company uses its asset to
generate sales. It is determined by dividing net sales by average assets for the
period. Quality Department Store’s cash return on sales ratios are calculated
and evaluated below.
ILLUSTRATION 15-21
RETURN ON ASSETS
2000 1999
$263,800 $208,500
——————————— = 15.4% ——————————— = 13.7%
$1,595,000 + $1,835,000 $1,446,000 + $1,595,000
——————————— ———————————
2 2
[ ] [ ]
Quality Department Store
Industry average Sears, Roebuck & Co.
———————— ———————————
7.42% 1.99%
NET INCOME
RETURN ON ASSETS = —————————
AVERAGE ASSETS
An overall measure of profitability is the return on assets ratio. It is calculated
by dividing net income by average assets for the period. Quality Department
Store’s return on assets ratios for 2000 and 1999 are calculated and evaluated
below.
ILLUSTRATION 15-22
RETURN ON COMMON
STOCKHOLDERS’ EQUITY
2000 1999
$263,800 $208,500
——————————— = 29.3% ——————————— = 28.5%
$795,000 + $1,003,000 $667,000 + $795,000
——————————— ———————————
2 2
[ ] [ ]
Quality Department Store
Industry average Sears, Roebuck and Co.
———————— ———————————
18.6% 10.9%
RETURN ON COMMON NET INCOME
STOCKHOLDERS’ EQUITY = ———————————————————————
AVERAGE COMMON STOCKHOLDERS’ EQUITY
A ratio that measures profitability from the viewpoint of the common stockholder is
return on common stockholders’ equity. It is calculated by dividing net income by
average common stockholders’ equity for the period. Quality Department Store’s return
on common stockholders’ equity for 2000 and 1999 are calculated and evaluated below.
ILLUSTRATION 15-23
RETURN ON COMMON STOCKHOLDERS’
EQUITY WITH PREFERRED STOCK
RATE OF RETURN ON COMMON NET INCOME – PREFERRED DIVIDENDS
STOCKHOLDERS’ EQUITY = ———————————————————————
AVERAGE COMMON STOCKHOLDERS’ EQUITY
When preferred stock is present, preferred
dividend requirements are deducted from net
income to determine income available to common
stockholders. The par value of preferred stock (or
call price – if applicable) must be deducted from
total stockholders’ equity to arrive at the amount
of common stockholders’ equity used in this ratio.
The ratio then appears as shown below.
ILLUSTRATION 15-24
EARNINGS PER SHARE
Quality Department Store
EARNINGS NET INCOME
PER SHARE = ————————————————————————————
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING
2000 1999
$263,000 $208,500
————————— - $.97 ————— - $.77
270,000 + 275,400 270,000
—————————
2
[ ]
Earnings per share (EPS) of common stock is a measure of net income earned on
each share of common stock. It is calculated by dividing net income by the number
of weighted average common shares outstanding during the year. Quality
Department Store’s EPS for 2000 and 1999 are calculated and evaluated below.
ILLUSTRATION 15-25
PRICE-EARNINGS RATIO
The price-earnings (PE) ratio measures the ratio of the market price of each share
of common stock to the earnings per share. It is calculated by dividing the market
price per share of common stock by earnings per share. Quality Department
Store’s PE ratios for 2000 and 1999 are calculated and evaluated below.
Quality Department Store
MARKET PRICE PER SHARE OF COMMON STOCK
PRICE-EARNINGS RATIO = —————————————————————————
EARNINGS PER SHARE
2000 1999
$12.00 $ 8.00
——— = 12.4 times ——— = 10.4 times
$ .97 $ .77
Industry average Sears, Roebuck and Co.
———————— ———————————
33 times 22 times
ILLUSTRATION 15-26
PAYOUT RATIO
Quality Department Store
Industry average Sears, Roebuck and Co.
———————— ———————————
17.5% 44.5%
2000 1999
$61,200 $60,000
————— = 23.2% ————— = 28.8%
$263,800 $208,500
CASH DIVIDENDS
PAYOUT RATIO = —————————
NET INCOME
The payout ratio measures the percentage of earnings distributed in the
form of cash dividends. It is calculated by dividing cash dividends by net
income. Quality Department Store’s payout ratios for 2000and 1999 are
calculated and evaluated below.
ILLUSTRATION 15-27
DEBT TO TOTAL ASSETS
Quality Department Store
Industry average Sears, Roebuck and Co.
———————— ———————————
42.0% 81.7%
2000 1999
$832,000 $800,000
————— = 45.3% ————— = 50.2%
$1,835,000 $1,595,000
TOTAL DEBT
DEBT TO TOTAL ASSETS = ————————
TOTAL ASSETS
The debt to total assets ratio measures the percentage of total assets
provided by creditors, indicating the degree of leveraging. It is calculated
by dividing total debt by total assets. Quality Department Store’s total debt
to total assets ratios for 2000 and 1999 are calculated and evaluated below.
ILLUSTRATION 15-28
TIMES INTEREST EARNED
Quality Department Store
TIMES INTEREST INCOME BEFORE INCOME TAXES AND INTEREST EXPENSE
EARNED = —————————————————————————————
INTEREST EXPENSE
Industry average Sears, Roebuck and Co.
———————— ———————————
7.39 times 1.86 times
2000 1999
$468,000 $388,000
———— = 13 times ———— = 9.6 times
$36,000 $40,500
The times interest earned ratio provides an indication of the company’s ability to
meet interest payments as they come due. It is calculated by dividing income before
income taxes and interest expense by interest expense. Quality Department Store’s
times interest earned ratios for 2000 and 1999 are calculated and evaluated below.
ILLUSTRATION 15-29
CASH DEBT COVERAGE RATIO
NET CASH PROVIDED BY OPERATING ACTIVITIES
CASH DEBT COVERAGE RATIO = —————————————————————————
AVERAGE TOTAL LIABILITIES
2000 1999
$404,000 $340,000
—————————— = .495 times —————————— = .442 times
$800,000 + $832,000 $740,000 + $800,000
——————————— ———————————
2 2
[ ] [ ]
Quality Department Store
Industry average Sears, Roebuck and Co.
———————— ———————————
.38 times .09 times
The ratio of net cash provided by operating activities to average total liabilities is the
cash debt coverage ratio and is a measure of solvency. Quality Department Store’s
cash debt coverage ratios for 2000 and 1999 are calculated and evaluated below.
ILLUSTRATION 15-30
SUMMARY OF LIQUIDITY, PROFITABILITY,
AND SOLVENCY RATIOS
Ratio Formula Purpose or Use
Liquidity Ratios
Current assets
1. Current ratio ———————— Measures short-term debt-paying ability.
Current liabilities
Cash + marketable
securities +
2. Acid-test or quick ratio receivables (net) Measures immediate short-term liquidity.
————————
Current liabilities
Net cash provided by
operating activities
3. Current cash debt ————————— Measures short-term debt-paying ability
coverage ratio Average current (cash basis).
liabilities
Net credit sales
4. Receivables turnover ——————— Measures liquidity of receivables.
Average net
receivables
Cost of goods sold
5. Inventory turnover ———————— Measures liquidity of inventory.
Average inventory
ILLUSTRATION 15-30
SUMMARY OF LIQUIDITY, PROFITABILITY,
AND SOLVENCY RATIOS
Ratio Formula Purpose or Use
Profitability Ratios
Net income
6. Profit margin ————— Measures net income generated by each
Net sales dollar of sales.
Net cash provided by
7. Cash return on sales operating activities Measures the net cash flow generated by
ratio ————————— each dollar of sales.
Net sales
Net sales
8. Asset turnover ——————— Measures how efficiently assets are used
Average assets to generate sales.
Net income
9. Return on assets ——————— Measures overall profitability of assets.
Average assets
ILLUSTRATION 15-30
SUMMARY OF LIQUIDITY, PROFITABILITY,
AND SOLVENCY RATIOS
Ratio Formula Purpose or Use
Profitability Ratios
Net income
10. Return on common ————————— Measures profitability of owners’
stockholders’ equity Average common investment.
stockholders’ equity
Net income
11. Earnings per share ————————— Measures net income earned on each
Weighted average share of common stock.
common shares
outstanding
Market price per share
12. Price-earnings ratio of common stock Measures the ratio of the market price
—————————— per share to earnings per share.
Earnings per share
Cash dividends
13. Payout ratio ——————— Measures percentage of earnings
Net income distributed in the form of dividends.
ILLUSTRATION 15-30
SUMMARY OF LIQUIDITY, PROFITABILITY,
AND SOLVENCY RATIOS
Ratio Formula Purpose or Use
Solvency Ratios
Total debt
14. Debt to total assets —————— Measures the percentage of total assets
Total assets provided by creditors.
Income before income
taxes and interest
15. Tmes interest earned expense Measures ability to meet interest
————————— payments as they come due.
Interest expense
Net cash provided by
16. Cash debt coverage operating activities
ratio —————————
—
Measures the long-term debt paying
Average total
liabilities
ability (cash basis).
• For users of financial statements to
determine earning power or regular
income, the irregular items are
separately identified on the income
statement.
• Three types of irregular items are reported:
1 Discontinued operations,
2 Extraordinary items, and
3 Changes in accounting principle.
EARNING POWER AND
IRREGULAR ITEMS
• Discontinued operations constitutes
the disposal of a significant segment of
a business.
• The income (loss) from discontinued
operations consists of
1 the income (loss) from operations and
2 the gain (loss) on disposal of the
segment.
DISCONTINUED
OPERATIONS
ILLUSTRATION 15-31
STATEMENT PRESENTATION OF
DISCONTINUED OPERATIONS
ACRO ENERGY INC.
Partial Income Statement
For the Year Ended December 31, 2002
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 of $30,000 income tax
saving 70,000 210,000
Net income $ 350,000
Acro Energy Inc. has revenues of $2.5 million and expenses of $1.7 million from
continuing operations in 2002. The company therefore has income before
income taxes of $800,000. The company discontinued and sold its unprofitable
chemical division during 2002. The 2002 loss from chemical operations was
$140,000 (net of $60,000 in income taxes), and the loss on disposal of the
chemical division (net of $30,000 in income taxes), was $70,000. Given a 30%
income tax rate, the partial income statement presentation is shown below.
• Extraordinary items are events and
transactions that meet two conditions:
they are
1 unusual in nature and
2 infrequent in occurrence.
• Extraordinary items are reported net
of taxes in a separate section of the
income statement immediately below
discontinued operations.
EXTRAORDINARY
ITEMS
ILLUSTRATION 15-32
EXAMPLES OF EXTRAORDINARY
AND ORDINARY ITEMS
Extraordinary Items Ordinary Items
1. Effects of major
casualties (acts of
God), if rare in the
area.
1. Effects of major
casualties (acts of
God), in the area.
2. Expropriation
(takeover) of
property by a
foreign government.
2. Write-down of
inventories or
write-off of
receivables.
3. Effects of a newly
enacted law or
regulation, such as a
condemnation
action.
3. Losses attributable
to labor strikes.
4. Gains or losses from
sales of property,
plant, or equipment.
4. Destruction of property by
fire or explosion
ILLUSTRATION 15-33
STATEMENT PRESENTATION OF
EXTRAORDINARY ITEMS
ACRO ENERGY INC.
Partial Income Statement
For the Year Ended December 31, 2002
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 of $30,000 income tax
saving 70,000 210,000
Income before extraordinary item 350,000
Extraordinary item
Expropriation of investment, net of $21,000 income tax saving 49,000
Net income $ 301,000
In 2002 a revolutionary 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 partial income
statement presentation will show a deduction of $49,000 – as shown
below.
• To make them comparable, financial statements
are expected to be prepared on a basis consistent
with that used in the preceding 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.
• A change is permitted when
1 management can show that the new principle is
preferable to the old principle and
2 the effects of the change are clearly disclosed in
the income statement.
CHANGE IN
ACCOUNTING PRINCIPLE
When a change in accounting principle has
occurred,
1 the new principle should be used in
reporting the results of operations of the
current year and
2 the cumulative effect of the change on all
prior year income statements should be
disclosed net of applicable income taxes in a
special section immediately preceding net
income.
CHANGE IN
ACCOUNTING PRINCIPLE
ILLUSTRATION 15-34
STATEMENT PRESENTATION OF CUMULATIVE
EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE
ACRO ENERGY INC.
Partial Income Statement
For the Year Ended December 31, 2002
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 of $30,000 income tax
saving 70,000 210,000
Income before extraordinary item and cumulative effect of change in
accounting principle 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
income tax saving 16,800
Net income $ 284,200
At the beginning of 2002, Acro Energy Inc. changes from the straight-line method of
depreciation to the declining-balance method for equipment purchased on January 1,
1999. Assuming a 30% income tax rate the net of income tax effect of the change is
$16,800 ($24,000 X 70%). The partial income statement presentation is shown below.
You should be aware of some of the limitations of the
three analytical tools illustrated in the chapter and of the
financial statements on which they are based.
1 Estimates: Financial statements contain numerous
estimates; to the extent that these estimates are
inaccurate, the financial ratios and percentages are
inaccurate.
2 Cost: Traditional financial statements are based on
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.
LIMITATIONS OF
FINANCIAL ANALYSIS
3 Alternative Accounting Methods: Variations among companies in
the application of GAAP may hamper comparability. Although
differences in accounting methods might be detectable from reading
the notes to the financial statements, adjusting the financial data to
compensate for the different methods is difficult, if not impossible, in
some cases.
4 Atypical Data: Fiscal year-end data may not be typical of the
financial condition during the year. Firms often establish a fiscal
year-end that coincides with the low point in operating activity or in
inventory levels. Thus, certain account balances may not be
representative of the account balances during the year.
5 Diversification of Firms: Diversification in American industry also
restricts the usefulness of financial analysis. Many firms today are
too diversified to be classified by industry, while others appear to be
comparable when they are not.
LIMITATIONS OF
FINANCIAL ANALYSIS
COPYRIGHT
Copyright © 2003 John Wiley & Sons, Inc. All rights reserved. Reproduction or
translation of this work beyond that named in Section 117 of the 1976 United
States Copyright Act without the express written consent of the copyright owner is
unlawful. Request for further information should be addressed to the Permissions
Department, John Wiley & Sons, Inc. The purchaser may make back-up copies
for his/her own use only and not for distribution or resale. The Publisher assumes
no responsibility for errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.
CHAPTER 15
FINANCIAL STATEMENT ANALYSIS

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CHAPTET 15 FINANCIAL STATEMENT ANALYSIS.ppt

  • 1. Financial Accounting, 4e Weygandt, Kieso, & Kimmel John Wiley & Sons, Inc. Prepared by Gregory K. Lowry Mercer University Marianne Bradford The University of Tennessee
  • 2. CHAPTER 15 FINANCIAL STATEMENT ANALYSIS After studying this chapter, you should be able to: 1 Discuss the need for comparative analysis. 2 Identify the tools of financial statement analysis. 3 Explain and apply horizontal analysis. 4 Describe and apply vertical analysis.
  • 3. CHAPTER 15 FINANCIAL STATEMENT ANALYSIS After studying this chapter, you should be able to: 5 Identify and compute ratios and describe their purpose and use in analyzing a firm’s liquidity, profitability, and solvency. 6 Understand the concept of earning power and indicate how material items not typical of regular operations are presented. 7 Recognize the limitations of financial statement analysis.
  • 4. PREVIEW OF CHAPTER 15 FINANCIAL STATEMENT ANALYSIS Ratio Analysis Liquidity Profitability Solvency Summary     Earning Power and Irregular Items Discontinued operations Extraordinary items Change in accounting principle Comprehensive income    Need for comparative analysis Tools of analysis   Basics of Financial Statement Analysis Horizontal and Vertical Analysis    Balance sheet Income statement Retained earnings statement Limitations of Financial Analysis Estimates Cost Accounting methods Atypical data Diversification      
  • 5. • Analyzing financial statements involves Three characteristics of a company: 1 its liquidity, 2 its profitability, and 3 its solvency. • Every item reported in a financial statement has significance. • In order to obtain information as to whether the amount 1 represents an increase over prior years or 2 is adequate in relation to the company’s need for cash, the amount of cash must be compared with other financial statement data. • Comparisons can be made on several difference bases – three are illustrated in this chapter: 1 intracompany basis, 2 industry averages, and 3 intercompany basis. BASICS OF FINANCIAL STATEMENT ANALYSIS
  • 6. Three commonly used tools are utilized to evaluate the significance of financial statement data. 1 Horizontal analysis (trend analysis) is a technique for evaluating a series of financial statement data over a period of time. 2 Vertical analysis is a technique for evaluating financial statement data that expresses each item in a financial statement in terms of a percent of a base amount. 3 Ratio analysis expresses the relationship among selected items of financial statement data. TOOLS OF FINANCIAL STATEMENT ANALYSIS
  • 7. ILLUSTRATION 15-1, 15-2 SEARS ROEBUCK’S NET SALES SEARS, ROEBUCK AND CO. (Net Sales Stated in Millions) 2000 1999 1998 1997 1996 $ 40,937 $ 39,484 $ 39,953 $ 39,837 $ 36,662 Current year amount — Base year amount ——————————————————————— Base year amount The purpose of horizontal analysis is to determine the increase or decrease that has taken place, expressed as either an amount or a percentage. The recent net sales figures of Sears, Roebuck and Co. are shown above. Given that 1996 is the base year, we can measure all percentage increases or decreases from this base period amount as shown below. Change since base period =
  • 8. ILLUSTRATION 15-4 HORIZONTAL ANALYSIS OF SEARS, ROEBUCK’S NET SALES Sears, Roebuck and Co. Net Sales (in Millions) Base Period 1996 2000 1999 1998 1997 1996 $40,937 $ 39,484 $ 39,953 $ 39,837 $36,662 111.7% 107.7% 109% 108.7% 100% We can determine that net sales for Sears, Roebuck increased approximately 8.7% [($39,837 - $36,662) ÷ $36,662] from 1996 to 1997. We can also determine that net sales increased over 11.7% [($40,937 - $36,662) ÷ $36,662] from 1996 to 2000. The percentage of the base period for each of the 5 years, assuming 1996 as the base period, is shown below.
  • 9. ILLUSTRATION 15-5 HORIZONTAL ANALYSIS OF A BALANCE SHEET QUALITY DEPARTMENT STORE INC. Condensed Balance Sheet December 31 2000 1999 Amount Percentage Assets $ 945,000 Plant assets (net) 800,000 632,500 167,500 26.5% 15,000 Total assets $ 1,595,000 $ 240,000 15.0% Liabilities $ 344,500 $ 303,000 $ 41,500 Long-term liabilities 497,000 ( 9,500) ( 1.9%) 832,000 4.0% Common stock, $1 par 275,400 270,000 727,600 525,000 202,600 38.6% Total stockholders’ equity 795,000 26.2% Increase or (Decrease) during 2000 Current assets $ 1,020,000 $ 75,000 7.9% Intangible assets 17,500 ( 2,500) ( 14.3%) $ 1,835,000 Current liabilities 13.7% 487,500 Total liabilities 800,000 32,000 Stockholders’ Equity 5,400 2.0% Retained earnings 1,003,000 208,000 Total liabilities and stockholders’ equity $ 1,835,000 $ 1,595,000 $ 240,000 15.0% The 2-year condensed balance sheet of Quality Department Store Inc. for 2000 and 1999 showing dollar and percentage changes is displayed on the right. In the asset section, plant assets (net) increased $167,500 or 26.5%. In the liabilities section, current liabilities increased $41,500 or 13.7%. In the stockholders’ equity section, retained earnings increased $202,600 or 38.6%. It appears the company expanded its asset base during 2000 and financed the expansion by retaining income in the firm.
  • 10. ILLUSTRATION 15-6 HORIZONTAL ANALYSIS OF AN INCOME STATEMENT QUALITY DEPARTMENT STORE INC. Condensed Income Statement For the Years Ended December 31 Increase or (Decrease) during 2000 2000 1999 Amount Percentage Sales $ 2,195,000 $ 1,960,000 $ 235,000 12.0% Sales returns and allowances 98,000 123,000 ( 25,000) ( 20.3%) Net sales 2,097,000 1,837,000 260,000 14.2% Cost of goods sold 1,281,000 1,140,000 141,000 12.4% Gross profit 816,000 697,000 119,000 17.1% Selling expenses 253,000 211,500 41,500 19.6% Administrative expenses 104,000 108,500 ( 4,500) ( 4.1%) Total operating expenses 357,000 320,000 37,000 11.6% Income from operations 459,000 377,000 82,000 21.8% Other revenues and gains Interest and dividends 9,000 11,000 ( 2,000) ( 18.2%) Other expenses and losses Interest expense 36,000 40,500 ( 4,500) ( 11.1%) Income before income taxes 432,000 347,500 84,500 24.3% Income tax expense 168,200 139,000 29,200 21.0% Net income $ 263,800 $ 208,500 $ 55,300 26.5% The 2-year comparative income statement of Quality Department Store Inc. for 2000 and 1999 is shown in condensed form on the right. Horizontal analysis of the comparative income statement shows the following changes: 1 Net sales increased $260,000, or 14.2% ($260,000 ÷ $1,837,000). 2 Cost of goods sold increased $141,000, or 12.4% ($141,000 ÷ $1,140,000). 3 Total operating expenses increased $37,000, or 11.6% ($37,000 ÷ $320,000).
  • 11. ILLUSTRATION 15-7 HORIZONTAL ANALYSIS OF A RETAINED EARNINGS STATEMENT QUALITY DEPARTMENT STORE INC. Retained Earnings Statement For the Years Ended December 31 Increase or (Decrease) during 2000 2000 1999 Amount Percentage Retained earnings, January 1 $ 525,000 $ 376,500 $ 148,500 39.4% Add: Net income 263,800 208,500 55,300 26.5% 788,800 585,000 203,800 Deduct: Dividends 61,200 60,000 1,200 2.0% Retained earnings, December 31 $ 727,600 $ 525,000 $ 202,600 38.6% The 2-year comparative retained earnings statement of Quality Department Store Inc. for 2000 and 1999 is presented on the right. Analyzed horizontally: 1 Net income increased $55,300, or 26.5%. 2 Common dividends increased only $1,200, or 2%. 3 Ending retained earnings increased 38.6%.
  • 12. ILLUSTRATION 15-8 VERTICAL ANALYSIS OF A BALANCE SHEET Presented on the right is the 2-year comparative balance sheet of Quality Department Store Inc. for 2000 and 1999. 1 Current assets increased $75,000 from 1999 to 2000, they decreased from 59.2% to 55.6% of total assets. 2 Plant assets (net) increased from 39.7% to 43.6% of total assets, and 3 Retained earnings increased from 32.9% to 39.7% of total liabilities and stockholders’ equity. These results reinforce earlier observations that Quality is financing its growth through retention of earnings. QUALITY DEPARTMENT STORE INC. Condensed Balance Sheet December 31 2000 1999 Amount Percent Amount Percent Assets Current assets $ 1,020,000 55.6% $ 945,000 59.2% Plant assets (net) 800,000 43.6% 632,500 39.7% Intangible assets 15,000 0.8% 17,500 1.1% Total assets $ 1,835,000 100.0% $ 1,595,000 100.0% Liabilities Current liabilities $ 344,500 18.8% $ 303,000 19.0% Long-term liabilities 487,500 26.5% 497,000 31.2% Total liabilities 832,000 45.3% 800,000 50.2% Stockholders’ Equity Common stock, $1 par 275,400 15.0% 270,000 16.9% Retained earnings 727,600 39.7% 525,000 32.9% Total stockholders’ equity 1,003,000 54.7% 795,000 49.8% Total liabilities and stockholders’ equity $ 1,835,000 100.0% $1,595,000 100.0%
  • 13. ILLUSTRATION 15-9 VERTICAL ANALYSIS OF AN INCOME STATEMENT Vertical analysis of the 2-year comparative income statement of Quality Department Store Inc. for 2000 and 1999 is shown on the right. 1 Cost of goods sold as a percentage of net sales declined 1% (62.1% versus 61.1%). 2 Total operating expenses declined 0.4% (17.4% versus 17.0%). 3 Net income as a percent of net sales therefore increased from 11.4% to 12.6%. Quality appears to be a profitable enterprise that is becoming more successful. QUALITY DEPARTMENT STORE INC. Condensed Income Statement For the Years Ended December 31 2000 1999 Amount Percent Amount Percent Sales $ 2,195,000 104.7% $ 1,960,000 106.7% Sales returns and allowances 98,000 4.7% 123,000 6.7% Net sales 2,097,000 100.0% 1,837,000 100.0% Cost of goods sold 1,281,000 61.1% 1,140,000 62.1% Gross profit 816,000 38.9% 697,000 37.9% Selling expenses 253,000 12.0% 211,500 11.5% Administrative expenses 104,000 5.0% 108,500 5.9% Total operating expenses 357,000 17.0% 320,000 17.4% Income from operations 459,000 21.9% 377,000 20.5% Other revenues and gains Interest and dividends 9,000 0.4% 11,000 0.6% Other expenses and losses Interest expense 36,000 1.7% 40,500 2.2% Income before income taxes 432,000 20.6% 347,500 18.9% Income tax expense 168,200 8.0% 139,000 7.5% Net income $ 263,800 12.6% $ 208,500 11.4%
  • 14. ILLUSTRATION 15-10 INTERCOMPANY INCOME STATEMENT COMPARISON CONDENSED INCOME STATEMENTS Quality Department Sears, Roebuck Store Inc. And Co. (in thousands) Dollars Percent Dollars Percent Net sales $ 2,097 100.0% $ 46,937,000 100.0% Cost of goods sold 1,281 61.1% 26,899,000 65.7% Gross profit 816 38.9% 14,038,000 34.3% Selling and administrative expenses 357 17.0% 11,851,000 28.9% Income from operations 459 21.9% 2,187,000 5.3% Other expenses and revenues (including income taxes 195 9.3% 884,000 2.1% Net income $ 264 12.6% $ 1,343,000 3.3% Vertical analysis enables you to compare companies of different sizes. Quantity’s major competitor is a Sears store in a town nearby town. Using vertical analysis, the small Quality Department Store Inc. can be meaningfully compared to the much larger Sears, as shown below. 1 Gross profit rates were somewhat comparable at 38.9% and 34.3%. 2 Income from operations percentages were significantly different at 21.9% and 5.3% . 3 Quality’s selling and administrative expenses percentage was much lower than Sears’ – 17% to 28.9%. 4 Sears’ net income as a percentage of sales was much lower than Quality’s: 3.3% to 12.6%.
  • 15. RATIO ANALYSIS • Ratio analysis expresses the relationship among selected items of financial statement data. • A ratio expresses the mathematical relationship between one quantity and another. • A single ratio by itself is not very meaningful, in the upcoming illustrations we will use: 1 Intracompany comparisons covering two years for the Quality Department Store. 2 Industry average comparisons based on median ratios for department stores 3 Intercompany comparisons based on Sears, Roebuck and Co. as Quality Department Store’s principal competitor.
  • 16. ILLUSTRATION 15-11 FINANCIAL RATIO CLASSIFICATIONS Liquidity Ratios Measures of short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash Profitability Ratios Measures of the income or operating success of an enterprise for a given period of time Solvency Ratios Measures of the ability of the enterprise to survive over a long period of time Revenues Expenses - = Net Income XYZ Co.
  • 17. Industry average Sears, Roebuck and Co. ———————— ——————————— 1.34:1 2.38:1 CURRENT ASSETS CURRENT RATIO = ——————————— CURRENT LIABILITIES 2000 1999 $1,020,000 $945,000 —————= 2.96:1 ————= 3.1:1 $344,500 $303,000 Quality Department Store The current ratio (working capital ratio) is a widely used measure for evaluating a company’s liquidity and short-term debt-paying ability. It is calculated by dividing current assets by current liabilities and is a more dependable indicator of liquidity than working capital. The current ratios for Quality Department Store and comparative data are shown below. ILLUSTRATION 15-12 CURRENT RATIO
  • 18. ILLUSTRATION 15-13 CURRENT ASSETS OF QUALITY DEPARTMENT STORE 2000 1999 Current assets Cash $ 100,000 $ 155,000 Temporary invest. 20,000 70,000 Receivables (net) 230,000 180,000 Inventory 620,000 500,000 Prepaid expenses 50,000 40,000 Total current assets $ 1,020,000 $ 945,000
  • 19. ILLUSTRATION 15-14 ACID-TEST RATIO CASH + MARKETABLE SECURITIES + RECEIVABLES (NET) ACID-TEST RATIO = ———————————————————————————— CURRENT LIABILITIES Quality Department Store Industry average Sears, Roebuck and Co. ———————— ——————————— 1.3:1 1.3:1 2000 1999 $100,000 + $20,000 + $230,000 $155,000 + $70,000 + $180,000 —————————————— = 1.0:1 —————————————— = 1.3:1 $344,500 $303,000 The acid-test ratio (quick ratio) is a measure of a company’s short-term liquidity and is calculated by dividing the sum of cash, marketable securities, and net receivables by current liabilities. The acid-test ratios for Quality Department Store and comparative data are shown below.
  • 20. ILLUSTRATION 15-15 CURRENT CASH DEBT COVERAGE RATIO The current cash debt coverage ratio usually provides a superior representation of liquidity since it uses not cash provided by operating activities rather than a balance at a point in time. Quality Department Store’s current cash debt coverage ratios for 2000 and 1999 are calculated below. CURRENT CASH DEBT NET CASH PROVIDED BY OPERATING ACTIVITIES COVERAGE RATIO = ———————————————————————— AVERAGE CURRENT LIABILITIES Quality Department Store 2000 1999 $404,000 $340,000 —————————— - 1.25:1 —————————— - 1.15:1 $303,000 + $344,500 $290,000 + $303,000 —————————— —————————— 2 2 [ ] [ ] Industry average Sears, Roebuck & Co. ———————— ——————————— 1.1:1 0.137:1
  • 21. ILLUSTRATION 15-16 RECEIVABLES TURNOVER 2000 1999 $2,097,000 $1,837,000 ——————————= 10.2 times ——————————=9.7 times $180,000 + $230,000 $200,000 + $180,000 —————————— —————————— 2 2 [ ] [ ] Quality Department Store Industry average Sears, Roebuck & Co. ———————— ——————————— 15.7 times 2.19 times NET CREDIT SALES RECEIVABLES TURNOVER = ——————————————— AVERAGE NET RECEIVABLES The receivables turnover ratio is used to assess the liquidity of the receivables. It measures the number of times, on average, receivables are collected during the period. The ratio is calculated by dividing net credit sales by average net receivables during the year. The receivables turnover ratio and comparative data for Quality Department Store for 2000 and 1999 are calculated below.
  • 22. ILLUSTRATION 15-17 INVENTORY TURNOVER Quality Department Store Industry average Sears, Roebuck and Co. ———————— ——————————— 6.22 times 4.61 times COST OF GOODS SOLD INVENTORY TURNOVER = ———————————— AVERAGE INVENTORY 2000 1999 $1,281,000 $1,140,000 —————————— = 2.3 times —————————— = 2.4 times $500,000 + $620,000 $450,000 + $500,000 —————————— —————————— 2 2 [ ] [ ] The inventory turnover ratio measures the number of times, on average, the inventory is sold during the period – which measures the liquidity of the inventory. It is calculated by dividing cost of goods sold by average inventory during the year. The inventory turnover ratio and comparative data for Quality Department Store for 2000 and 1999 are calculated below.
  • 23. ILLUSTRATION 15-18 PROFIT MARGIN RATIO Quality Department Store Industry average Sears, Roebuck and Co. ———————— ——————————— 3.16% 1.8% NET INCOME PROFIT MARGIN ON SALES = —————— NET SALES 2000 1999 $263,800 $208,500 ————— = 12.6% ————— = 11.4% $2,097,000 $1,837,000 The profit margin ratio is a measure of the percentage of each dollar of sales that results in net income. It is calculated by dividing net income by net sales for the period. The profit margin ratios and comparative data for Quality Department Store for 2000 and 1999 are calculated below.
  • 24. ILLUSTRATION 15-19 CASH RETURN ON SALES RATIO Quality Department Store Industry average Sears, Roebuck and Co. ———————— ——————————— 6.2% 7.4% NET CASH PROVIDED BY OPERATING ACTIVITIES CASH RETURN ON SALES RATIO = ————————————————————————— NET SALES 2000 1999 $404,000 $340,000 ————— = 19.3% ————— = 18.5% $2,097,000 $1,837,000 The cash basis counterpart of the profit margin ratio is the cash return on sales ratio which uses net cash provided by operating activities as the numerator and net sales as the denominator. Using net cash provided by operating activities of $404,000 in 2000 and $340,000 in 1999, Quality Department Store’s cash return on sales ratios are calculated and evaluated below.
  • 25. ILLUSTRATION 15-20 ASSET TURNOVER 2000 1999 $2,097,000 $1,837,000 —————————— = 1.2 times ——————————— = 1.21 times $1,595,000 + $1,835,000 $1,446,000 + $1,595,000 ——————————— ——————————— 2 2 [ ] [ ] Quality Department Store Industry average Sears, Roebuck & Co. ———————— ——————————— 2.32 times 1.1 times NET SALES ASSET TURNOVER = ————————— AVERAGE ASSETS The asset turnover ratio measures how efficiently a company uses its asset to generate sales. It is determined by dividing net sales by average assets for the period. Quality Department Store’s cash return on sales ratios are calculated and evaluated below.
  • 26. ILLUSTRATION 15-21 RETURN ON ASSETS 2000 1999 $263,800 $208,500 ——————————— = 15.4% ——————————— = 13.7% $1,595,000 + $1,835,000 $1,446,000 + $1,595,000 ——————————— ——————————— 2 2 [ ] [ ] Quality Department Store Industry average Sears, Roebuck & Co. ———————— ——————————— 7.42% 1.99% NET INCOME RETURN ON ASSETS = ————————— AVERAGE ASSETS An overall measure of profitability is the return on assets ratio. It is calculated by dividing net income by average assets for the period. Quality Department Store’s return on assets ratios for 2000 and 1999 are calculated and evaluated below.
  • 27. ILLUSTRATION 15-22 RETURN ON COMMON STOCKHOLDERS’ EQUITY 2000 1999 $263,800 $208,500 ——————————— = 29.3% ——————————— = 28.5% $795,000 + $1,003,000 $667,000 + $795,000 ——————————— ——————————— 2 2 [ ] [ ] Quality Department Store Industry average Sears, Roebuck and Co. ———————— ——————————— 18.6% 10.9% RETURN ON COMMON NET INCOME STOCKHOLDERS’ EQUITY = ——————————————————————— AVERAGE COMMON STOCKHOLDERS’ EQUITY A ratio that measures profitability from the viewpoint of the common stockholder is return on common stockholders’ equity. It is calculated by dividing net income by average common stockholders’ equity for the period. Quality Department Store’s return on common stockholders’ equity for 2000 and 1999 are calculated and evaluated below.
  • 28. ILLUSTRATION 15-23 RETURN ON COMMON STOCKHOLDERS’ EQUITY WITH PREFERRED STOCK RATE OF RETURN ON COMMON NET INCOME – PREFERRED DIVIDENDS STOCKHOLDERS’ EQUITY = ——————————————————————— AVERAGE COMMON STOCKHOLDERS’ EQUITY When preferred stock is present, preferred dividend requirements are deducted from net income to determine income available to common stockholders. The par value of preferred stock (or call price – if applicable) must be deducted from total stockholders’ equity to arrive at the amount of common stockholders’ equity used in this ratio. The ratio then appears as shown below.
  • 29. ILLUSTRATION 15-24 EARNINGS PER SHARE Quality Department Store EARNINGS NET INCOME PER SHARE = ———————————————————————————— WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 2000 1999 $263,000 $208,500 ————————— - $.97 ————— - $.77 270,000 + 275,400 270,000 ————————— 2 [ ] Earnings per share (EPS) of common stock is a measure of net income earned on each share of common stock. It is calculated by dividing net income by the number of weighted average common shares outstanding during the year. Quality Department Store’s EPS for 2000 and 1999 are calculated and evaluated below.
  • 30. ILLUSTRATION 15-25 PRICE-EARNINGS RATIO The price-earnings (PE) ratio measures the ratio of the market price of each share of common stock to the earnings per share. It is calculated by dividing the market price per share of common stock by earnings per share. Quality Department Store’s PE ratios for 2000 and 1999 are calculated and evaluated below. Quality Department Store MARKET PRICE PER SHARE OF COMMON STOCK PRICE-EARNINGS RATIO = ————————————————————————— EARNINGS PER SHARE 2000 1999 $12.00 $ 8.00 ——— = 12.4 times ——— = 10.4 times $ .97 $ .77 Industry average Sears, Roebuck and Co. ———————— ——————————— 33 times 22 times
  • 31. ILLUSTRATION 15-26 PAYOUT RATIO Quality Department Store Industry average Sears, Roebuck and Co. ———————— ——————————— 17.5% 44.5% 2000 1999 $61,200 $60,000 ————— = 23.2% ————— = 28.8% $263,800 $208,500 CASH DIVIDENDS PAYOUT RATIO = ————————— NET INCOME The payout ratio measures the percentage of earnings distributed in the form of cash dividends. It is calculated by dividing cash dividends by net income. Quality Department Store’s payout ratios for 2000and 1999 are calculated and evaluated below.
  • 32. ILLUSTRATION 15-27 DEBT TO TOTAL ASSETS Quality Department Store Industry average Sears, Roebuck and Co. ———————— ——————————— 42.0% 81.7% 2000 1999 $832,000 $800,000 ————— = 45.3% ————— = 50.2% $1,835,000 $1,595,000 TOTAL DEBT DEBT TO TOTAL ASSETS = ———————— TOTAL ASSETS The debt to total assets ratio measures the percentage of total assets provided by creditors, indicating the degree of leveraging. It is calculated by dividing total debt by total assets. Quality Department Store’s total debt to total assets ratios for 2000 and 1999 are calculated and evaluated below.
  • 33. ILLUSTRATION 15-28 TIMES INTEREST EARNED Quality Department Store TIMES INTEREST INCOME BEFORE INCOME TAXES AND INTEREST EXPENSE EARNED = ————————————————————————————— INTEREST EXPENSE Industry average Sears, Roebuck and Co. ———————— ——————————— 7.39 times 1.86 times 2000 1999 $468,000 $388,000 ———— = 13 times ———— = 9.6 times $36,000 $40,500 The times interest earned ratio provides an indication of the company’s ability to meet interest payments as they come due. It is calculated by dividing income before income taxes and interest expense by interest expense. Quality Department Store’s times interest earned ratios for 2000 and 1999 are calculated and evaluated below.
  • 34. ILLUSTRATION 15-29 CASH DEBT COVERAGE RATIO NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES 2000 1999 $404,000 $340,000 —————————— = .495 times —————————— = .442 times $800,000 + $832,000 $740,000 + $800,000 ——————————— ——————————— 2 2 [ ] [ ] Quality Department Store Industry average Sears, Roebuck and Co. ———————— ——————————— .38 times .09 times The ratio of net cash provided by operating activities to average total liabilities is the cash debt coverage ratio and is a measure of solvency. Quality Department Store’s cash debt coverage ratios for 2000 and 1999 are calculated and evaluated below.
  • 35. ILLUSTRATION 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS Ratio Formula Purpose or Use Liquidity Ratios Current assets 1. Current ratio ———————— Measures short-term debt-paying ability. Current liabilities Cash + marketable securities + 2. Acid-test or quick ratio receivables (net) Measures immediate short-term liquidity. ———————— Current liabilities Net cash provided by operating activities 3. Current cash debt ————————— Measures short-term debt-paying ability coverage ratio Average current (cash basis). liabilities Net credit sales 4. Receivables turnover ——————— Measures liquidity of receivables. Average net receivables Cost of goods sold 5. Inventory turnover ———————— Measures liquidity of inventory. Average inventory
  • 36. ILLUSTRATION 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS Ratio Formula Purpose or Use Profitability Ratios Net income 6. Profit margin ————— Measures net income generated by each Net sales dollar of sales. Net cash provided by 7. Cash return on sales operating activities Measures the net cash flow generated by ratio ————————— each dollar of sales. Net sales Net sales 8. Asset turnover ——————— Measures how efficiently assets are used Average assets to generate sales. Net income 9. Return on assets ——————— Measures overall profitability of assets. Average assets
  • 37. ILLUSTRATION 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS Ratio Formula Purpose or Use Profitability Ratios Net income 10. Return on common ————————— Measures profitability of owners’ stockholders’ equity Average common investment. stockholders’ equity Net income 11. Earnings per share ————————— Measures net income earned on each Weighted average share of common stock. common shares outstanding Market price per share 12. Price-earnings ratio of common stock Measures the ratio of the market price —————————— per share to earnings per share. Earnings per share Cash dividends 13. Payout ratio ——————— Measures percentage of earnings Net income distributed in the form of dividends.
  • 38. ILLUSTRATION 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS Ratio Formula Purpose or Use Solvency Ratios Total debt 14. Debt to total assets —————— Measures the percentage of total assets Total assets provided by creditors. Income before income taxes and interest 15. Tmes interest earned expense Measures ability to meet interest ————————— payments as they come due. Interest expense Net cash provided by 16. Cash debt coverage operating activities ratio ————————— — Measures the long-term debt paying Average total liabilities ability (cash basis).
  • 39. • For users of financial statements to determine earning power or regular income, the irregular items are separately identified on the income statement. • Three types of irregular items are reported: 1 Discontinued operations, 2 Extraordinary items, and 3 Changes in accounting principle. EARNING POWER AND IRREGULAR ITEMS
  • 40. • Discontinued operations constitutes the disposal of a significant segment of a business. • The income (loss) from discontinued operations consists of 1 the income (loss) from operations and 2 the gain (loss) on disposal of the segment. DISCONTINUED OPERATIONS
  • 41. ILLUSTRATION 15-31 STATEMENT PRESENTATION OF DISCONTINUED OPERATIONS ACRO ENERGY INC. Partial Income Statement For the Year Ended December 31, 2002 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 of $30,000 income tax saving 70,000 210,000 Net income $ 350,000 Acro Energy Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in 2002. The company therefore has income before income taxes of $800,000. The company discontinued and sold its unprofitable chemical division during 2002. The 2002 loss from chemical operations was $140,000 (net of $60,000 in income taxes), and the loss on disposal of the chemical division (net of $30,000 in income taxes), was $70,000. Given a 30% income tax rate, the partial income statement presentation is shown below.
  • 42. • Extraordinary items are events and transactions that meet two conditions: they are 1 unusual in nature and 2 infrequent in occurrence. • Extraordinary items are reported net of taxes in a separate section of the income statement immediately below discontinued operations. EXTRAORDINARY ITEMS
  • 43. ILLUSTRATION 15-32 EXAMPLES OF EXTRAORDINARY AND ORDINARY ITEMS Extraordinary Items Ordinary Items 1. Effects of major casualties (acts of God), if rare in the area. 1. Effects of major casualties (acts of God), in the area. 2. Expropriation (takeover) of property by a foreign government. 2. Write-down of inventories or write-off of receivables. 3. Effects of a newly enacted law or regulation, such as a condemnation action. 3. Losses attributable to labor strikes. 4. Gains or losses from sales of property, plant, or equipment. 4. Destruction of property by fire or explosion
  • 44. ILLUSTRATION 15-33 STATEMENT PRESENTATION OF EXTRAORDINARY ITEMS ACRO ENERGY INC. Partial Income Statement For the Year Ended December 31, 2002 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 of $30,000 income tax saving 70,000 210,000 Income before extraordinary item 350,000 Extraordinary item Expropriation of investment, net of $21,000 income tax saving 49,000 Net income $ 301,000 In 2002 a revolutionary 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 partial income statement presentation will show a deduction of $49,000 – as shown below.
  • 45. • To make them comparable, financial statements are expected to be prepared on a basis consistent with that used in the preceding 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. • A change is permitted when 1 management can show that the new principle is preferable to the old principle and 2 the effects of the change are clearly disclosed in the income statement. CHANGE IN ACCOUNTING PRINCIPLE
  • 46. When a change in accounting principle has occurred, 1 the new principle should be used in reporting the results of operations of the current year and 2 the cumulative effect of the change on all prior year income statements should be disclosed net of applicable income taxes in a special section immediately preceding net income. CHANGE IN ACCOUNTING PRINCIPLE
  • 47. ILLUSTRATION 15-34 STATEMENT PRESENTATION OF CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE ACRO ENERGY INC. Partial Income Statement For the Year Ended December 31, 2002 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 of $30,000 income tax saving 70,000 210,000 Income before extraordinary item and cumulative effect of change in accounting principle 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 income tax saving 16,800 Net income $ 284,200 At the beginning of 2002, Acro Energy Inc. changes from the straight-line method of depreciation to the declining-balance method for equipment purchased on January 1, 1999. Assuming a 30% income tax rate the net of income tax effect of the change is $16,800 ($24,000 X 70%). The partial income statement presentation is shown below.
  • 48. You should be aware of some of the limitations of the three analytical tools illustrated in the chapter and of the financial statements on which they are based. 1 Estimates: Financial statements contain numerous estimates; to the extent that these estimates are inaccurate, the financial ratios and percentages are inaccurate. 2 Cost: Traditional financial statements are based on 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. LIMITATIONS OF FINANCIAL ANALYSIS
  • 49. 3 Alternative Accounting Methods: Variations among companies in the application of GAAP may hamper comparability. Although differences in accounting methods might be detectable from reading the notes to the financial statements, adjusting the financial data to compensate for the different methods is difficult, if not impossible, in some cases. 4 Atypical Data: Fiscal year-end data may not be typical of the financial condition during the year. Firms often establish a fiscal year-end that coincides with the low point in operating activity or in inventory levels. Thus, certain account balances may not be representative of the account balances during the year. 5 Diversification of Firms: Diversification in American industry also restricts the usefulness of financial analysis. Many firms today are too diversified to be classified by industry, while others appear to be comparable when they are not. LIMITATIONS OF FINANCIAL ANALYSIS
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