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After studying this chapter, you should be able to: Discuss the need for comparative analysis, identify the tools of financial statement analysis, explain and apply horizontal analysis, describe and apply vertical analysis.
Chapter 18-1 CHAPTER CHAPTER 18 18 Financial Statement Analysis Accounting Principles, Eighth Edition Chapter 18-2 Study Objectives Study Objectives Discuss the need for comparative analysis Identify the tools of financial statement analysis Explain and apply horizontal analysis Describe and apply vertical analysis Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency Understand the concept of earning power, and how irregular items are presented Understand the concept of quality of earnings Chapter 18-3 Financial Statement Analysis Financial Statement Analysis Basics Basicsof of Financial Financial Statement Statement Analysis Analysis Need for comparative analysis Tools of analysis Horizontal Horizontaland and Vertical Vertical Analysis Analysis Balance sheet Income statement Retained earnings statement Ratio RatioAnalysis Analysis Liquidity Profitability Solvency Summary Earning EarningPower Power and andIrregular Irregular Items Items Discontinued operations Extraordinary items Changes in accounting principle Comprehensive income Chapter 18-4 Quality Qualityof of Earnings Earnings Alternative accounting methods Pro forma income Improper recognition Basics of Financial Statement Analysis Basics of Financial Statement Analysis Analyzing financial statements involves: Characteristics Chapter 18-5 Comparison Bases Tools of Analysis Liquidity Intracompany Horizontal Profitability Industry averages Vertical Solvency Intercompany Ratio LO 1 Discuss the need for comparative analysis LO 2 Identify the tools of financial statement analysis Horizontal Analysis Horizontal Analysis Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place Horizontal analysis is commonly applied to the balance sheet, income statement, and statement of retained earnings Chapter 18-6 LO 3 Explain and apply horizontal analysis Horizontal Analysis Horizontal Analysis Exercise: The comparative condensed balance sheets of Ramsey Corporation are presented below Current assets PP&E Intangibles Total assets 2009 $ 76,000 99,000 25,000 $ 200,000 2008 $ 80,000 90,000 40,000 $ 210,000 Current liabilities Long-term liabilties Stockholders' equity Total liabilities & equity $ 40,800 143,000 16,200 $ 200,000 $ 48,000 150,000 12,000 $ 210,000 Instructions: Prepare a horizontal analysis of the balance sheet data for Ramsey Corporation using 2008 as a base Chapter 18-7 LO 3 Explain and apply horizontal analysis Horizontal Analysis Horizontal Analysis Exercise: The comparative condensed balance sheets of Ramsey Corporation are presented below Current assets PP&E Intangibles Total assets 2009 $ 76,000 99,000 25,000 $ 200,000 2008 $ 80,000 90,000 40,000 $ 210,000 Current liabilities Long-term liabilties Stockholders' equity Total liabilities & equity $ 40,800 143,000 16,200 $ 200,000 $ 48,000 150,000 12,000 $ 210,000 Increase Percentage (Decrease) Change $ (4,000) -5.0% 9,000 10.0% (15,000) -37.5% $ (10,000) -4.8% $ (7,200) (7,000) 4,200 $ (10,000) -15.0% -4.7% 35.0% -4.8% Instructions: Prepare a horizontal analysis of the balance sheet data for Ramsey Corporation using 2008 as a base Chapter 18-8 LO 3 Explain and apply horizontal analysis Vertical Analysis Vertical Analysis Vertical analysis, also called commonsize 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 the income statement Chapter 18-9 LO 4 Describe and apply vertical analysis Vertical Analysis Vertical Analysis Exercise: The comparative condensed income statements of Hendi Corporation are shown below Net sales Cost of goods sold Gross profit Operating expense Net income 2009 Amount $ 600,000 483,000 117,000 57,200 $ 59,800 2008 Amount $ 500,000 420,000 80,000 44,000 $ 36,000 Instructions: Prepare a vertical analysis of the income statement data for Hendi Corporation in columnar form for both years Chapter 18-10 LO 4 Describe and apply vertical analysis Earning Power and Irregular Items Earning Power and Irregular Items Exercise: McCarthy Corporation had after tax income from continuing operations of $55,000,000 in 2008. During 2008, it disposed of its restaurant division at a pretax loss of $270,000. Prior to disposal, the division operated at a pretax loss of $450,000 in 2008. Assume a tax rate of 30%. Prepare a partial income statement for McCarthy. Chapter 18-37 Income from continuing operations Discontinued operations: Loss from operations, net of $135,000 tax Loss on disposal, net of $81,000 tax Total loss on discontinued operations $55,000,000 Net income $54,496,000 315,000 189,000 504,000 LO 6 Understand the concept of earning power, and how irregular items are presented Earning Power and Irregular Items Earning Power and Irregular Items I nc o m e S t a t e m e nt (in t h o us a nd s ) Discontinued Operations are reported after “Income from continuing operations.” Previously labeled as “Net Income”. Moved to Chapter 18-38 S a le s Co s t o f g o o d s s o ld $ 2 ,0 0 14 ,0 0 O t h e r r e ve nue (e x pe ns e ) : I nt e r e s t r e ve nue I nt e r e s t e x pe ns e T o t al o t h e r I nc o m e b e f o r e t ax e s I nc o m e t a x e x pe ns e I nc o m e f r o m c o nt inuing o pe r a t io ns 17 ,0 0 (2 1,0 0 ) (4 ,0 0 ) 7 ,0 0 2 ,0 0 5 ,0 0 Dis c o nt inue d o pe r a t io ns : Lo s s f r o m o pe r a t io ns , ne t o f t a x 3 Lo s s o n d is po s a l, ne t o f t a x 1 T o t a l lo s s o n d is c o nt inue d o pe r a t io ns 5 N e t inc o m e $ 5 ,4 LO 6 Understand the concept of earning power, and how irregular items are presented Earning Power and Irregular Items Earning Power and Irregular Items Extraordinary items are nonrecurring material items that differ significantly from a company’s typical business activities An extraordinary item must be both of an Unusual Nature and Occur Infrequently Company must consider the environment in which it operates Amounts reported “net of tax.” Chapter 18-39 LO 6 Understand the concept of earning power, and how irregular items are presented Earning Power and Irregular Items Earning Power and Irregular Items 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 YES (b) A citrus grower's Florida crop is damaged by frost. (c) Loss from sale of temporary investments NO (d) Loss attributable to a labor strike NO NO Chapter 18-40 LO 6 Understand the concept of earning power, and how irregular items are presented Earning Power and Irregular Items Earning Power and Irregular Items Are these considered Extraordinary Items? (d) Loss from flood damage. (The nearby Black River floods every 2 to 3 years.) NO (e) An earthquake destroys one of the oil refineries owned by a large multinational oil company. Earthquakes are rare in this geographical location YES (f) Writedown of obsolete inventory (g) Expropriation of a factory by a foreign government NO YES Chapter 18-41 LO 6 Understand the concept of earning power, and how irregular items are presented Earning Power and Irregular Items Earning Power and Irregular Items Exercise: McCarthy Corporation had after tax income from continuing operations of $55,000,000 in 2008. In addition, it suffered an unusual and infrequent pretax loss of $770,000 from a volcano eruption. The corporation’s tax rate is 30%. Prepare a partial income statement for McCarthy Corporation beginning with income from continuing operations Income from continuing operations Extraordinary loss, net of $231,000 tax $55,000,000 539,000 Net income $54,461,000 ($770,000 x 30% = $231,000 tax) Chapter 18-42 LO 6 Understand the concept of earning power, and how irregular items are presented Earning Power and Irregular Items Earning Power and Irregular Items I nc o m e S t a t e m e nt (in t h o us a nd s ) Extraordinary Items are reported after “Income from continuing operations.” Previously labeled as “Net Income”. S a le s Co s t o f g o o d s s o ld $ 2 ,0 0 14 ,0 0 O t h e r r e ve nue (e x pe ns e ) : I nt e r e s t r e ve nue I nt e r e s t e x pe ns e T o t a l o t h e r I nc o m e b e f o r e t ax e s I nc o m e t a x e x pe ns e I nc o m e f r o m c o nt inuing o pe r a t io ns Ex t r a o r d ina r y lo s s , ne t o f t a x 17 ,0 0 (2 1,0 0 ) (4 ,0 0 ) 7 ,0 0 2 ,0 0 5 ,0 0 5 N e t inc o m e $ 5 ,4 Moved to Chapter 18-43 LO 6 Understand the concept of earning power, and how irregular items are presented Earning Power and Irregular Items Earning Power and Irregular Items Reporting when both Discontinued Operations and Extraordinary Items are present. Discontinued Operations Extraordinary Item Chapter 18-44 I nc o m e S t a t e m e nt (in t h o us a nd s ) S a le s Co s t o f g o o d s s o ld $ 2 ,0 0 14 ,0 0 I nt e r e s t e x pe ns e T o t a l o t h e r I nc o m e b e f o r e t a x e s I nc o m e t a x e x pe ns e I nc o m e f r o m c o nt inuing o pe r a t io ns (2 1,0 0 ) (4 ,0 0 ) 7 ,0 0 2 ,0 0 5 ,0 0 Dis c o nt inue d o pe r a t io ns : Lo s s f r o m o pe r a t io ns , ne t o f t a x 3 Lo s s o n d is po s a l, ne t o f t a x 1 T o t a l lo s s o n d is c o nt inue d o pe r a t io ns 5 I nc o m e b e f o r e e x t r a o r d ina r y it e m Ex t r a o r d ina r y lo s s , ne t o f t a x 5 ,4 5 N e t inc o m e $ 5 ,9 LO 6 Understand the concept of earning power, and how irregular items are presented Earning Power and Irregular Items Earning Power and Irregular Items Change in Accounting Principle Occurs when the principle used in the current year is different from the one used in the preceding year Accounting rules permit a change if justified Changes are reported retroactively Example would include a change in inventory costing method such as FIFO to average cost Chapter 18-45 LO 6 Understand the concept of earning power, and how irregular items are presented Earning Power and Irregular Items Earning Power and Irregular Items Comprehensive Income All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders I nc o m e S t a t e m e nt (in t h o us and s ) S a le s Co s t o f g o o d s s o ld Gr o s s pr o f it O pe r a t ing e x pe ns e s : A d ve r t is ing e x pe ns e De pr e c iat io n e x pe ns e T o t al o pe r at ing e x pe ns e I nc o m e f r o m o pe r a t io ns $ 2 ,0 0 14 ,0 0 13 ,0 0 10 ,0 0 4 ,0 0 5 ,0 0 8 ,0 0 Reported in Stockholders’ Equity O t h e r r e ve nue : I nt e r e s t r e ve nue T o t al o t h e r I nc o m e b e f o r e t ax e s I nc o m e t ax e x pe ns e N e t inc o m e Chapter 18-46 17 ,0 0 17 ,0 0 10 ,0 0 2 ,0 0 $ 7 ,0 0 + Unrealized gains and losses on availableforsale securities Plus other items LO 6 Understand the concept of earning power, and how irregular items are presented Earning Power and Irregular Items Earning Power and Irregular Items Comprehensive Income Why are gains and losses on availableforsale securities excluded from net income? Because disclosing them separately reduces the volatility of net income due to fluctuations in fair value, yet informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value Chapter 18-47 LO 6 Understand the concept of earning power, and how irregular items are presented Quality of Earnings Quality of Earnings 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 Companies have incentives to manage income to meet or beat Wall Street expectations, so that the market price of stock increases and the value of stock options increase. Chapter 18-48 LO 7 Understand the concept of quality of earnings Quality of Earnings Quality of Earnings Alternative Accounting Methods Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings Pro Forma Income Pro forma income usually excludes items that the company thinks are unusual or nonrecurring Some companies have abused the flexibility that pro forma numbers allow Chapter 18-49 LO 7 Understand the concept of quality of earnings Quality of Earnings Quality of Earnings Improper Recognition Some managers have felt pressure to continually increase earnings and have manipulated the earnings numbers to meet these expectations Abuses include: Improper recognition of revenue (channel stuffing) Improper capitalization of operating expenses (WorldCom) Failure to report all liabilities (Enron) Chapter 18-50 LO 7 Understand the concept of quality of earnings Copyright Copyright “Copyright © 2008 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission 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 backup 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 18-51 ... Understand the concept of quality of earnings Chapter 18-3 Financial? ?Statement? ?Analysis Financial? ?Statement? ?Analysis Basics Basicsof of Financial Financial Statement Statement Analysis Analysis Need for comparative analysis Tools of analysis. . .CHAPTER? ? CHAPTER? ?18 18 Financial Statement Analysis Accounting? ?Principles, Eighth Edition Chapter 18-2 Study Objectives Study Objectives Discuss the need for comparative? ?analysis Identify the tools of? ?financial? ?statement? ?analysis. .. Basics of? ?Financial? ?Statement? ?Analysis Basics of? ?Financial? ?Statement? ?Analysis Analyzing? ?financial? ?statements involves: Characteristics Chapter 18-5 Comparison Bases Tools of Analysis Liquidity Intracompany