Financial Accounting: Tools for Business Decision Making, 2nd Ed. PowerPoint Slides Kimmel, Weygandt, Kieso Prepared by: Ellen L. Sweatt Georgia Perimeter College ELS 2

Chapter 14 ` Financial Analysis: The Big Picture

Chapter 14 Financial Analysis: The Big Picture PowerPoint Slides After studying Chapter 14, you should be able to: Understand the concept of earning power and indicate how irregular items are presented. Discuss the need for comparative analysis and identify the tools of financial statement analysis. Explain and apply horizontal analysis. Describe and apply vertical analysis. 1

Chapter 14 Financial Analysis: The Big Picture PowerPoint Slides Chapter 14 Financial Analysis: The Big Picture After studying Chapter 14, you should be able to: Identify and compute ratios and describe their purpose and use in analyzing a firm's liquidity, solvency, and profitability. Discuss the limitations of financial statement analysis. 2

Earning Power PowerPoint Slides The value of a company is a function of its future cash flows. 3

Earning Power... Is net income adjusted for irregular items. PowerPoint Slides Is net income adjusted for irregular items. Is the most likely level of income to be obtained in the future. 3

PowerPoint Slides Irregular Items Three types of irregular items are reported -- (all net of taxes) discontinued operations extraordinary items changes in accounting principle 5

Discontinued Operations... PowerPoint Slides Discontinued Operations... Refers to the disposal of a significant segment of a business... the elimination of a major class of customers or an entire activity. 6

Discontinued Operations PowerPoint Slides Discontinued Operations Assume Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million or net income of $800,000 from continuing operations in 2001. During 2001 the company discontinued and sold its unprofitable chemical division. The loss in 2001 from chemical operations (net of $60,000 taxes) was $140,000, and the loss on disposal of the chemical division (net of $30,000 taxes) was $70,000. 7

Income Statement (Partial) For the Year Ended December 31, 2001 PowerPoint Slides Illustration 14-1 Rozek Inc. Income Statement (Partial) For the Year Ended December 31, 2001 Income before income taxes $800,000 Income tax expense (30% Tax Rate) 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 before extraordinary item 350,000 14

Extraordinary Items... Unusual in nature Infrequent in occurrence PowerPoint Slides Extraordinary Items... Are events and transactions that meet two conditions: Unusual in nature Infrequent in occurrence 9

PowerPoint Slides Illustration 14-2 Extraordinary Items 2

PowerPoint Slides Illustration 14-2 Ordinary Items 2

PowerPoint Slides Extraordinary Items In 2001 a revolutionary foreign government expropriated property held as an investment by Rozek Inc. The loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000. 13

Income Statement(Partial) For the Year Ended December 31, 2001 PowerPoint Slides Illustration 14-3 Rozek Inc. Income Statement(Partial) For the Year Ended December 31, 2001 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 before extraordinary item 350,000 Extraordinary item Expropriation of investment, net of $21,000 income tax saving 49,000 Net income $301,000 14

Change in Accounting Principle PowerPoint Slides Occur when the principle used in the current year is different from the one used in the preceding year. Is permitted, when management can show that the new principle is preferable to the old and the effects of the change are clearly disclosed in the income statement. Examples: a change in depreciation methods (such as declining-balance to straight-line) a change in inventory costing methods (such as FIFO to average cost). 17

Change in Accounting Principle PowerPoint Slides Change in Accounting Principle The new principle should be used in reporting the results of operations of the current year. The cumulative effect of the change on all prior-year income statements should be disclosed net of applicable taxes in a special section immediately preceding Net Income. 19

Changes in Accounting Principle PowerPoint Slides Changes in Accounting Principle Rozek Inc. changes from the straight-line method to the declining-balance method for equipment purchased on January 1, 1998. The cumulative effect on prior-year income statements (statements for 1998-2000) is to increase depreciation expense and decrease income before income taxes by $24,000. If there is a 30% tax rate, the net-of-tax effect of the change is $16,800 ($24,000 x 70%). 20

Partial Income Statement For the Year Ended December 31, 2001 PowerPoint Slides Illustration 14-4 Rozek Inc. Partial Income Statement For the Year Ended December 31, 2001 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 before extraordinary item 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 tax 16,800 Net Income 284,200 14

PowerPoint Slides Comprehensive Income Most revenues, expenses, gains, and losses recognized during the period are included in net income. Specific exceptions to this practice have developed - these items bypass income and are reported directly in stockholders’ equity. 25

PowerPoint Slides Comprehensive Income Unrealized gains and losses on available-for-sale securities are 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. 26

PowerPoint Slides Comprehensive Income The FASB now requires that, in addition to reporting net income, a company must also report comprehensive income. 27

Comprehensive Income... Includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders.

PowerPoint Slides Comparative Analysis Any item reported in a financial statement has significance: Its inclusion indicates that the item exists at a given time and in a certain quantity. For example, when Kellogg Company reports $136.4 million on its balance sheet as cash, we know that Kellogg did have cash and that the quantity was $136.4 million. 28

PowerPoint Slides Comparative Analysis Whether the amount represents an increase over prior years, or whether it is adequate in relation to the company's needs, cannot be determined from the amount alone. The amount must be compared with other financial data to provide more information. 29

PowerPoint Slides Comparative Analysis There are three types of comparisons to provide decision usefulness of financial information: Intracompany basis Intercompany basis Industry averages 30

PowerPoint Slides Intracompany Basis Comparisons within a company are often useful to detect changes in financial relationships and significant trends. A comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. A comparison of Kellogg's year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash. 31

PowerPoint Slides Intercompany Basis Comparisons with other companies provide insight into a company's competitive position. Kellogg's total sales for the year can be compared with the total sales of its competitors such as Quaker Oats and General Mills. 32

PowerPoint Slides Industry Averages Comparisons with industry averages provide information about a company's relative position within the industry. Kellogg's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's. 33

Financial Statement Analysis PowerPoint Slides Financial Statement Analysis Three basic tools are used in financial statement analysis : 1. Horizontal analysis 2. Vertical analysis 3. Ratio analysis 34

PowerPoint Slides Horizontal Analysis Is a technique for evaluating a series of financial statement data over a period of time. Purpose is to determine whether an increase or decrease has taken place. The increase or decrease can be expressed as either an amount or a percentage. 35

Net Sales (in millions) PowerPoint Slides Illustration 14-7 Horizontal Analysis KELLOGG COMPANY Net Sales (in millions) Base Period 1994 1998 1997 1996 1995 1994 6,762.1 6,830.1 6,676.6 7,003.7 6,562.0 36

Horizontal Analysis 6,562.0 CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT PowerPoint Slides Illustration 14-6 Horizontal Analysis CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT BASE-YEAR AMOUNT 7,003.7 - 6,562.0 = 6.7% 6,562.0 Net sales for Kellogg company increased approximately 6.7% from 1994 to 1995. 37

Percentage Change in Sales PowerPoint Slides Illustration 14-7 Percentage Change in Sales The percentage change in sales for each of the 5 years, assuming 1994 as the base period is: Kellogg Company Net Sales (in millions) Base Period 1994 1998 1997 1996 1995 1994 6,762.1 6,830.1 6,676.6 7,003.7 6,562.0 103.0% 104.1% 101.7% 106.7% 100.0% 38

Horizontal Analysis of a Balance Sheet Illustration 14-8 PowerPoint Slides Horizontal Analysis of a Balance Sheet KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) Increase (Decrease) during 1998 1998 1997 Amount Percent Assets Current Assets $1,496.5 $1,467.7 $ 28.8 2.0 Plant assets 2,888.8 2,773.3 115.5 4.2 Other assets 666.2 636.6 27.6 4.6 Total assets $5,051.5 $4,877.6 $173.9 3.6 39

Horizontal Analysis of a Balance Sheet PowerPoint Slides Illustration 14-8 Increase (Decrease) during 1998 1998 1997 Amount Percent Liabilities and Stockholders' Equity Current liabilities $1,718.5 $1,657.3 61.2 3.7 Long-term liabilities 2,443.2 2,222.8 220.4 9.9 Total liabilities 4,161.7 3,880.1 281.6 7.3 Stockholders' equity Common stock 208.8 196.3 12.5 6.4 Retained earnings and other 1,075.3 958.5 116.8 12.2 Treasury stock (394.3) (157.3) 237.0 (150.7) Total stockholders' equity 889.8 997.5 (107.7) (10.8) Total liabilities and stockholders' equity $5,051.5 $4,877.6 $173.9 3.6 40

Condensed Income Statement For the Years Ended December 31 KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) Increase (Decrease) during 1998 1998 1997 Amount Percent Net sales $6,762.1 $6,830.1 ($68.0) (1.0) Cost of goods sold 3,282.6 3,270.1 12.5 0.4 Gross profit 3,479.5 3,560.0 (80.5) (2.3) Selling & Admin. 2,513.9 2,366.8 147.1 6.2 Nonrecurring charges 70.5 184.1 (113.6) (61.7) Income from operations 895.1 1,009.1 (114.0) (11.3) Interest expense 119.5 108.3 11.2 10.3 Other income (expense), net 6.9 3.7 3.2 86.5 Income before taxes 782.5 904.5 (122.0) (13.5) Income tax expense 279.9 340.5 (60.6) (17.8) Net income $502.6 $564.0 ($61.4) (10.9) PowerPoint Slides Illustration 14-9 42

PowerPoint Slides Vertical Analysis Is a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount. Total assets is always the base amount in vertical analysis of a balance sheet. Net sales is always the base amount in vertical analysis of an income statement. 45

Condensed Balance Sheets PowerPoint Slides Illustration 14-10 KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) 1998 1997 Assets Amount Percent Amount Percent Current Assets $1,496.5 29.6 $1,467.7 30.1 Plant assets 2,888.8 57.2 2,733.3 56.9 Other assets 666.2 13.2 636.6 13.0 Total assets $5,051.5 100.0% $4,877.6 100.0% 46

Condensed Balance Sheets PowerPoint Slides Illustration 14-10 KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) 1998 1997 Liabilities and Amount Percent Amount Percent Stockholders' Equity Current liabilities $1,718.5 34.0 $1,657.3 34.0 Long-term liabilities 2,443.2 48.4 2,222.8 45.5 Total liabilities 4,161.7 82.4 3,880.1 79.5 Stockholders' equity Common stock 208 8 4.1 196.3 4.0 Retained earnings and other 1,075.3 21.3 958.5 19.7 Treasury stock (394.3) ( 7.8) (157.3) (3.2) Total stockholders' equity 889.8 17.6 997.5 20.5 Total liabilities and stockholders' equity $5,051.5 100.0% $4,877.6 100.0% 48

Condensed Income Statement For the Years Ended December 31 PowerPoint Slides Illustration 14-11 KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) 1998 1997 Amount Percent Amount Percent Net sales $6,762.1 100.0 $6,830.1 100.0 Cost of goods sold 3,282.6 48.6 3,270.1 47.9 Gross profit 3,479.5 51.4 3,560.0 52.1 Selling & Admin. 2,513.9 37.2 2,366.8 34.6 Nonrecurring Chgs 70.5 1.0 184.1 2.7 Income operations 895.1 13.2 1,009.1 14.8 Interest expense 119.5 1.8 108.3 1.6 Other income (expense),net 6.9 0.1 3.7 0.1 Income before income taxes 782.5 11.5 904.5 13.3 Income tax expense 279.9 4.1 340.5 5.0 Net income $502.6 7.4 $564.0 8.3 51

PowerPoint Slides Condensed Income Statements For the Year Ended December 31,1998 (in millions) Illustration 14-12 The Quaker Kellogg Company, Inc. Oats Company Amount Percent Amount Percent Net sales $6,762.1 100.0 $4,842.5 100.0 Cost of goods sold 3,282.6 48.6 2,374.4 49.0 Gross profit 3,479.5 51.4 2,468.1 51.0 Selling and administrative expenses 2,513.9 37.2 1,872.5 38.7 Nonrecurring charges 70.5 1.0 128.5 2.6 Income from operations 895.1 13.2 467.1 9.7 Other expenses and revenues (including income taxes) 392.5 5.8 182.6 3.8 Net income $502.6 7.4 $284.5 5.9 55

PowerPoint Slides Ratio Analysis 57

Ratios Three types: Liquidity ratios Solvency ratios PowerPoint Slides Ratios Three types: Liquidity ratios Solvency ratios Profitability ratios Can provide clues to underlying conditions that may not be apparent from an inspection of the individual components. Single ratio by itself is not very meaningful 57

Liquidity Ratios WHO CARES? PowerPoint Slides Liquidity Ratios Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. WHO CARES? Short-term creditors such as bankers and suppliers 60

Liquidity Ratios Current ratio Acid-test ratio PowerPoint Slides Liquidity Ratios Current ratio Acid-test ratio Current cash debt coverage ratio Receivables turnover ratio Average collection period Inventory turnover Average days in inventory 61

Current Ratio Indicates short-term debt-paying ability Current Assets Illustration 14-17 Current Ratio Indicates short-term debt-paying ability Current Assets Current Liabilities 32

Acid-Test Ratio Indicates immediate short-term debt-paying ability Illustration 14-18 Acid-Test Ratio Indicates immediate short-term debt-paying ability Cash + Short-term Investments + Net Receivable Current Liabilities 32

Current Cash Debt Coverage Ratio PowerPoint Slides Current Cash Debt Coverage Ratio Illustration 14-19 Indicates short-term debt-paying ability (cash basis) Cash provided by operations Average current liabilities 92

Receivables Turnover Ratio PowerPoint Slides Illustration 14-20 Indicates liquidity of receivables Net Credit Sales Average Net Receivables 28

Average Collection Period PowerPoint Slides Illustration 14-21 Indicates liquidity of receivables and collection success 365 days Receivables Ratio Turnover 28

Inventory Turnover Ratio PowerPoint Slides Illustration 14-22 Inventory Turnover Ratio Indicates liquidity of inventory Cost of Goods Sold Average Inventory 73

Average Days in Inventory PowerPoint Slides Illustration 14-23 Average Days in Inventory Indicates liquidity of inventory and inventory management 365 days Inventory Turnover Ratio 35

Solvency Ratios WHO CARES? PowerPoint Slides Solvency Ratios Measure the ability of the enterprise to survive over a long period of time WHO CARES? Long-term creditors and stockholders 60

Solvency Ratios Debt to total assets ratio Times interest earned ratio PowerPoint Slides Solvency Ratios Debt to total assets ratio Times interest earned ratio Cash debt coverage ratio Free cash flow 61

Debt to Total Assets Ratio PowerPoint Slides Illustration 14-24 Indicates % of total assets provided by creditors Total Liabilities Total Assets 79

Times Interest Earned Ratio PowerPoint Slides Illustration 14-25 Indicates company’s ability to meet interest payments as they come due Interest Before Interest Expense & Income Tax Interest Expense 79

Cash Debt Coverage Ratio PowerPoint Slides Cash Debt Coverage Ratio Illustration 14-26 Indicates long-term debt-paying ability (cash basis) Cash provided by operations Average total liabilities 92

Free Cash Flow - Capital Expenditures - Dividends Paid Free Cash Flow PowerPoint Slides Illustration 14-27 Free Cash Flow Indicates cash available for paying dividends or expanding operations Cash Provided By Operations - Capital Expenditures - Dividends Paid Free Cash Flow 81

PowerPoint Slides Profitability Ratios Measure the income or operating success of an enterprise for a given period of time WHO CARES? Everybody WHY? A company’s income affects: its ability to obtain debt and equity financing its liquidity position its ability to grow 60

Profitability Ratios Return on common stockholders’ equity ratio PowerPoint Slides Profitability Ratios Return on common stockholders’ equity ratio Return on assets ratio Profit margin ratio Assets turnover ratio Gross profit rate Operating expenses to sales ratio Cash return on sales ratio Earnings per share (EPS) Price-earnings ratio Payout ratio 61

Relationships Among Profitability Measures PowerPoint Slides Illustration 14-28 Relationships Among Profitability Measures 2

Return on Common Stockholders’ Equity Ratio PowerPoint Slides Illustration 14-29 Return on Common Stockholders’ Equity Ratio Indicates profitability of common stockholders’ investment Net income -preferred stock dividends Average common stockholders’ equity 93

Return On Assets Ratio Net income Average total assets Illustration 14-30 Return On Assets Ratio Reveals the amount of net income generated by each dollar invested Net income Average total assets Higher value suggests favorable efficiency. 18

Profit Margin Ratio Net income Net sales Illustration 14-31 Profit Margin Ratio Indicates net income generated by each dollar of sales Net income Net sales Higher value suggests favorable return on each dollar of sales. 19

Asset Turnover Ratio Net sales Average total assets PowerPoint Slides Illustration 14-32 Asset Turnover Ratio Indicates how efficiently assets are used to generate sales Net sales Average total assets 45

Gross Profit Rate Gross profit Net sales PowerPoint Slides Illustration 14-34 Gross Profit Rate Indicates margin between selling price and cost of good sold Gross profit Net sales 45

Operating Expenses to Sales Ratio PowerPoint Slides Illustration 14-35 Operating Expenses to Sales Ratio Indicates the cost incurred to support each dollar of sales Operating expenses Net sales 45

Cash Return on Sales Ratio PowerPoint Slides Illustration 14-36 Cash Return on Sales Ratio Indicates net cash flow generated by each dollar of sales Cash provided by operations Net sales 101

Earnings Per Share (EPS) PowerPoint Slides Illustration 14-37 Earnings Per Share (EPS) Indicates net income earned on each share of common stock sales Income available to common stockholders Average number of outstanding common shares 101

Price Earnings Ratio Stock Price Earnings Per Share PowerPoint Slides Illustration 14-38 Price Earnings Ratio Indicates relationship between market price per share and earnings per share Stock Price Earnings Per Share 101

Payout Ratio Cash Dividends Net Income PowerPoint Slides Illustration 14-39 Payout Ratio Indicates % of earnings distributed in the form of cash dividends Cash Dividends Net Income 101

Limitations Of Financial Analysis PowerPoint Slides Limitations Of Financial Analysis Horizontal, vertical, and ratio analysis are frequently used in making significant business decisions. One should be aware of the limitations of these tools and the financial statements. 107

PowerPoint Slides Estimates Financial statements are based on estimates. allowance for uncollectible accounts depreciation costs of warranties contingent losses To the extent that these estimates are inaccurate, the financial ratios and percentages are also inaccurate. 108

PowerPoint Slides Cost Traditional financial statements are based on historical 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. 109

Alternative Accounting Methods PowerPoint Slides One company may use the FIFO method, while another company in the same industry may use LIFO. If the inventory is significant for both companies, it is unlikely that their current ratios are comparable. In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization. 110

PowerPoint Slides Atypical Data Fiscal year-end data may not be typical of a company's financial condition during the year. 111

PowerPoint Slides Diversification Diversification in American industry also limits the usefulness of financial analysis. Many firms are so diverse they cannot be classified by industry. 112