3. 14-3
14 Financial Statement Analysis
Learning Objectives
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.
[5] Identify and compute ratios used in analyzing a firm’s liquidity,
profitability, and solvency.
[6] Understand the concept of earning power, and how irregular items are
presented.
[7] Understand the concept of quality of earnings.
4. 14-4
Analyzing financial statements involves:
Characteristics
Comparison
Bases
Tools of
Analysis
Liquidity
Profitability
Solvency
Intracompany
Industry
averages
Intercompany
Horizontal
Vertical
Ratio
Basics of Financial Statement Analysis
LO 1 & LO 2
5. 14-5
14 Financial Statement Analysis
Learning Objectives
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.
[5] Identify and compute ratios used in analyzing a firm’s liquidity,
profitability, and solvency.
[6] Understand the concept of earning power, and how irregular items are
presented.
[7] Understand the concept of quality of earnings.
6. 14-6
Horizontal Analysis
Horizontal analysis, also called trend analysis, is a
technique for evaluating a series of financial statement data
over a period of time.
Purpose is to determine the increase or decrease.
Commonly applied to the
► balance sheet,
► income statement, and
► statement of retained earnings.
LO 3
7. 14-7
Changes suggest that
the company
expanded its asset
base during 2011 and
financed this
expansion primarily
by retaining income
rather than assuming
additional long-term
debt.
Illustration 14-5
Horizontal analysis of
balance sheets
Horizontal Analysis
LO 3
8. 14-8
LO 3
Overall, gross profit
and net income were
up substantially.
Gross profit increased
17.1%, and net
income, 26.5%.
Quality’s profit trend
appears favorable.
Illustration 14-6
Horizontal analysis of
Income statements
Horizontal Analysis
9. 14-9
The ending retained earnings increased 38.6%. As
indicated earlier, the company retained a significant
portion of net income to finance additional plant facilities.
Illustration 14-7
Horizontal analysis of
retained earnings
statements
Horizontal Analysis
LO 3
10. 14-10
14 Financial Statement Analysis
Learning Objectives
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.
[5] Identify and compute ratios used in analyzing a firm’s liquidity,
profitability, and solvency.
[6] Understand the concept of earning power, and how irregular items are
presented.
[7] Understand the concept of quality of earnings.
11. 14-11
Vertical analysis, also called common-size analysis, is a
technique that expresses each financial statement item as a
percent of a base amount.
On an income statement, we might say that selling
expenses are 16% of net sales.
Vertical analysis is commonly applied to the
► balance sheet and
► income statement.
Vertical Analysis
LO 4
12. 14-12
Quality is choosing to
finance its growth
through retention of
earnings rather than
through issuing
additional debt.
Illustration 14-8
Vertical analysis of
balance sheets
Vertical Analysis
LO 4
13. 14-13
Illustration 14-9
Vertical analysis of
Income statements
Vertical Analysis
LO 4
Quality appears
to be a profitable
enterprise that is
becoming even more
successful.
14. 14-14
Enables a comparison of companies of different sizes.
Illustration 14-10
Intercompany income
statement comparison
Vertical Analysis
LO 4
15. 14-15
14 Financial Statement Analysis
Learning Objectives
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.
[5] Identify and compute ratios used in analyzing a firm’s liquidity,
profitability, and solvency.
[6] Understand the concept of earning power, and how irregular items are
presented.
[7] Understand the concept of quality of earnings.
16. 14-16
Ratio analysis expresses the relationship among selected
items of financial statement data.
Liquidity Profitability Solvency
Measures short-
term ability of the
company to pay its
maturing obligations
and to meet
unexpected needs
for cash.
Financial Ratio Classifications
Measures the
income or operating
success of a
company for a given
period of time.
Measures the ability
of the company to
survive over a long
period of time.
Ratio Analysis
LO 5
17. 14-17
The discussion of ratios include the following types of
comparisons.
1. Intracompany comparisons for two years for Quality
Department Store.
2. Industry average comparisons based on median ratios for
department stores.
3. Intercompany comparisons based on Macy’s, Inc. as Quality
Department Store’s principal competitor.
A single ratio by itself is not very meaningful.
Ratio Analysis
LO 5
18. 14-18
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.
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 by companies to detect fraud. The numeric relationships that can reveal
fraud can be such things as financial ratios that appear abnormal, or statistical abnormalities in
the numbers themselves. 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.
Advance slide in presentation mode to reveal missing control. LO 5
19. 14-19
Liquidity Ratios
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 acid-test ratio,
accounts receivable turnover, and inventory turnover.
Ratio Analysis
LO 5
20. 14-20
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 14-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
Advance slide in presentation mode to reveal solution. LO 5
21. 14-21
Ratio of 2.96:1 means that for every dollar of current liabilities, Quality
has $2.96 of current assets.
Ratio Analysis Liquidity Ratios
1. Current Ratio Illustration 14-12
LO 5
23. 14-23
Illustration 14-12
QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)
For the Years Ended December 31
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
LO 5
26. 14-26
QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)
For the Years Ended December 31
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
27. 14-27
Illustration 14-15
Ratio Analysis
3. Accounts Receivable Turnover
Liquidity Ratios
Measures the number of times, on average, the company collects
receivables during the period.
LO 5
28. 14-28
A variant of the accounts receivable turnover ratio is to convert it
to an average collection period in terms of days.
Accounts receivable are collected on average every 36 days.
$2,097,000
($180,000 + $230,000) / 2
= 10.2 times
365 days / 10.2 times = every 35.78 days
Ratio Analysis Liquidity Ratios
LO 5
3. Accounts Receivable Turnover
29. 14-29
Illustration 14-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)
For the Years Ended December 31
LO 5
31. 14-31
A variant of inventory turnover is the days in inventory.
Inventory turnover ratios vary considerably among industries.
365 days / 2.3 times = every 159 days
$1,281,000
($500,000 + $620,000) / 2
= 2.3 times
Ratio Analysis Liquidity Ratios
LO 5
4. Inventory Turnover
32. 14-32
Profitability Ratios
Measure the income or operating success of a company for a
given period of time.
Income affects the company’s ability to obtain debt and equity
financing, their liquidity position, and their ability to grow.
Ratios include the profit margin, asset turnover, return on
assets, return on common stockholders’ equity, earnings
per share, price-earnings ratio, and payout ratio.
Ratio Analysis
LO 5
33. 14-33
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
35. 14-35
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 14-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
37. 14-37
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 14-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
38. 14-38
Ratio Analysis
7. Return on Asset
An overall measure of profitability.
Profitability Ratios
Illustration 14-19
LO 5
39. 14-39
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 14-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
40. 14-40
Ratio Analysis
8. Return on Common Stockholders’ Equity
Shows how many dollars of net income the company earned for each
dollar invested by the owners.
Profitability Ratios
Illustration 14-20
LO 5
41. 14-41
Ratio Analysis
8. Return on Common Stockholders’ Equity
With Preferred Stock
Deduct preferred dividend from net income.
Profitability Ratios
LO 5
Illustration 14-21
Return on common stockholders’
equity with preferred stock
42. 14-42
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 14-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
43. 14-43
Ratio Analysis
9. Earnings Per Share (EPS)
A measure of the net income earned on each share of common stock.
Profitability Ratios
Illustration 14-22
LO 5
44. 14-44
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 14-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
46. 14-46
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 14-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
47. 14-47
Ratio Analysis
11. Payout Ratio
Measures the percentage of earnings distributed in the form of cash
dividends.
Profitability Ratios
Illustration 14-24
LO 5
48. 14-48
Solvency Ratios
Solvency ratios measure the ability of a company to survive
over a long period of time.
Debt to Assets and
Times Interest Earned
are two ratios that provide information about debt-paying
ability.
Ratio Analysis
LO 5
49. 14-49
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 14-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
50. 14-50
Ratio Analysis
12. Debt to Total Assets Ratio
Measures the percentage of the total assets that creditors provide.
Solvency Ratios
Illustration 14-25
LO 5
51. 14-51
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
For the Years Ended December 31
Illustration 14-12
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
LO 5
52. 14-52
Ratio Analysis
13. Times Interest Earned
Provides an indication of the company’s
ability to meet interest payments as they
come due.
Solvency Ratios
Illustration 14-25
LO 5
55. 14-55
14 Financial Statement Analysis
Learning Objectives
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.
[5] Identify and compute ratios used in analyzing a firm’s liquidity,
profitability, and solvency.
[6] Understand the concept of earning power, and how irregular items
are presented.
[7] Understand the concept of quality of earnings.
56. 14-56
Earning power means the normal level of income to be
obtained in the future.
“Irregular” items are separately identified on the income
statement. Two types are:
1. Discontinued operations.
2. Extraordinary items.
“Irregular” items are reported net of income taxes.
Earning Power and Irregular Items
LO 6
57. 14-57
(a) Disposal of a significant component of a business.
(b) Report the income (loss) from discontinued operations in
two parts:
1. income (loss) from operations (net of tax) and
2. gain (loss) on disposal (net of tax).
Earning Power and Irregular Items
Discontinued Operations
LO 6
58. 14-58
Illustration: During 2015 AE Inc. has income before income
taxes of $79,000,000. During 2015, AE Inc. discontinued and
sold its unprofitable chemical division. The loss in 2015 from
chemical operations (net of $135,000 taxes) was $315,000. The
loss on disposal of the chemical division (net of $81,000 taxes)
was $189,000. Assuming a 30% tax rate on income.
Earning Power and Irregular Items
LO 6
59. 14-59
Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations 55,000
Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Net income 54,496
$
Income Statement (in thousands)
Sales 285,000
$
Cost of goods sold 149,000
Discontinued
Operations are reported
after “Income from
continuing operations.”
Previously labeled as
“Net Income”.
Moved to
Earning Power and Irregular Items
LO 6
60. 14-60
Nonrecurring material items that differ significantly from a
company’s typical business activities.
Must be both of an
► Unusual Nature and
► Occur Infrequently.
Must consider the environment in which it operates.
Amounts reported “net of tax.”
Earning Power and Irregular Items
Extraordinary Items
LO 6
61. 14-61
Are these considered Extraordinary Items?
(a) A large portion of a tobacco manufacturer’s
crops are destroyed by a hail storm. Severe
damage from hail storms in the locality where the
manufacturer grows tobacco is rare.
(b) A citrus grower's Florida crop is damaged by
frost.
(c) Loss from sale of temporary investments.
(d) Loss attributable to a labor strike.
YES
NO
NO
NO
Earning Power and Irregular Items
LO 6
62. 14-62
(e) Loss from flood damage. (The nearby Black
River floods every 2 to 3 years.)
(f) An earthquake destroys one of the oil refineries
owned by a large multi-national oil company.
Earthquakes are rare in this geographical
location.
(g) Write-down of obsolete inventory.
(h) Expropriation of a property by a foreign
government.
NO
YES
YES
NO
Earning Power and Irregular Items
LO 6
Are these considered Extraordinary Items?
63. 14-63
Illustration: In 2015 a foreign government expropriated property
held as an investment by AE Inc. If the loss is $770,000 before
applicable income taxes of $231,000, the income statement will
report a deduction of $539,000.
Earning Power and Irregular Items
LO 6
64. 14-64
Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations 55,000
Extraordinary loss, net of tax 539
Net income 54,461
$
Extraordinary Items are
reported after “Income
from continuing
operations.”
Previously labeled as
“Net Income”.
Moved to
Earning Power and Irregular Items
Income Statement (in thousands)
Sales 285,000
$
Cost of goods sold 149,000
LO 6
65. 14-65
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations 55,000
Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Income before extraordinary item 54,496
Extraordinary loss, net of tax 539
Net income 53,957
$
Reporting when both
Discontinued
Operations and
Extraordinary Items
are present.
Discontinued
Operations
Extraordinary Item
Earning Power and Irregular Items
Income Statement (in thousands)
Sales 285,000
$
Cost of goods sold 149,000
LO 6
67. 14-67
When the principle used is different from the one used
in the preceding year.
Accounting rules permit a change if justified.
Changes are reported retroactively.
Example: Change from FIFO to average cost.
Earning Power and Irregular Items
Change in Accounting Principle
LO 6
68. 14-68
Unrealized gains and
losses on available-for-
sale securities.
Plus other items
+
Reported in
Stockholders’ Equity
Comprehensive Income All changes in stockholders’
equity except those resulting
from investments by
stockholders and distributions
to stockholders.
Earning Power and Irregular Items
Income Statement (in thousands)
Sales 285,000
$
Cost of goods sold 149,000
Gross profit 136,000
Operating expenses:
Advertising expense 10,000
Depreciation expense 43,000
Total operating expense 53,000
Income from operations 83,000
Other revenue:
Interest revenue 17,000
Total other 17,000
Income before taxes 100,000
Income tax expense 24,000
Net income 76,000
$
LO 6
69. 14-69
Why are gains and losses on available-for-sale securities
excluded from net income?
Disclosing them separately
1) reduces the volatility of net income due to fluctuations in fair
value, yet
2) informs the financial statement user of the gain or loss that
would be incurred if the securities were sold at fair value.
Earning Power and Irregular Items
Comprehensive Income
LO 6
70. 14-70
14 Financial Statement Analysis
Learning Objectives
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.
[5] Identify and compute ratios used in analyzing a firm’s liquidity,
profitability, and solvency.
[6] Understand the concept of earning power, and how irregular items are
presented.
[7] Understand the concept of quality of earnings.
71. 14-71
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 7
72. 14-72
Variations among companies in the application of GAAP may
hamper comparability and reduce quality of earnings.
Pro forma income usually excludes items that the company
thinks are unusual or non-recurring.
Many companies have abused the flexibility that pro forma
numbers allow.
Quality of Earnings
Alternative Accounting Methods
Pro Forma Income
LO 7
73. 14-73
Due to pressure from Wall Street some managers have
manipulated the earnings numbers to meet expectations.
Abuses include:
Channel stuffing, improper recognition of revenue (Bristol-
Myers Squibb).
Improper capitalization of operating expenses (WorldCom).
Failure to report all liabilities (Enron).
Quality of Earnings
Improper Recognition
LO 7
74. 14-74
The tools of financial statement analysis covered in this chapter are
universal and therefore no significant differences exist in the analysis
methods used.
The basic objectives of the income statement are the same under both
GAAP and IFRS. As indicated in the textbook, a very important objective
is to ensure that users of the income statement can evaluate the earning
power of the company. Earning power is the normal level of income to
be obtained in the future. Thus, both the IASB and the FASB are
interested in distinguishing normal levels of income from irregular items
in order to better predict a company’s future profitability.
LO 8 Compare financial statement analysis and income
statement presentation under GAAP and IFRS..
Key Points
75. 14-75
The basic accounting for discontinued operations is the same under
IFRS and GAAP.
Under IFRS, there is no classification for extraordinary items. In other
words, extraordinary item treatment is prohibited under IFRS. All
revenue and expense items are considered ordinary in nature.
Disclosure, however, is extensive for items that are considered material
to the financial results. Examples are write-downs of inventory or plant
assets, or gains and losses on the sale of plant assets.
The accounting for changes in accounting principles and changes in
accounting estimates are the same for both GAAP and IFRS.
Key Points
LO 8
76. 14-76
Both GAAP and IFRS follow the same approach in reporting
comprehensive income. The statement of comprehensive income can be
prepared under the one-statement approach or the two-statement
approach.
The issues related to quality of earnings are the same under both GAAP
and IFRS. It is hoped that by adopting a more principles-based
approach, as found in IFRS, that many of the earning quality issues will
disappear.
Key Points
LO 8
77. 14-77
The FASB and the IASB are working on a project that would rework the
structure of financial statements. Recently, the IASB decided to require a
statement of comprehensive income, similar to what was required under
GAAP. In addition, another part of this project addresses the issue of how to
classify various items in the income statement. A main goal of this new
approach is to provide information that better represents how businesses
are run. In addition, the approach draws attention away from one number—
net income.
Looking to the Future
LO 8
78. 14-78
The basic tools of financial analysis are the same under both GAAP and
IFRS except that:
a) horizontal analysis cannot be done because the format of the
statements is sometimes different.
b) analysis is different because vertical analysis cannot be done
under IFRS.
c) the current ratio cannot be computed because current liabilities
are often reported before current assets in IFRS statements of
position.
d) None of the above.
IFRS Self-Test Questions
LO 8
79. 14-79
Under IFRS:
a) the reporting of discontinued items is different than GAAP.
b) the reporting of extraordinary items is prohibited.
c) the reporting of changes in accounting principles is different than
under GAAP.
d) None of the above.
IFRS Self-Test Questions
LO 8
80. 14-80
Presentation of comprehensive income must be reported under IFRS in:
a) the statement of stockholders’ equity.
b) the income statement ending with net income.
c) the notes to the financial statements.
d) a statement of comprehensive income.
IFRS Self-Test Questions
LO 8
