FINANCIAL ANALYSIS: The Big Picture Chapter 13 FINANCIAL ANALYSIS: The Big Picture

Chapter 13 After studying Chapter 13, you should be able to: PowerPoint Slides After studying Chapter 13, you should be able to: Understand the concept of sustainable income. Indicate how irregular items are presented. Explain the concept of comprehensive income. Describe and apply horizontal analysis. Describe and apply vertical analysis. 1

Chapter 13 After studying Chapter 13, you should be able to: PowerPoint Slides Chapter 13 After studying Chapter 13, you should be able to: Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability. Understand the concept of quality of earnings. 2

11 1 Sustainable Income... Is the most likely level of income to be obtained in the future. Does not include irregular revenues, expenses, gains, or losses.

Components of the Income Statement PowerPoint Slides 25

PowerPoint Slides Irregular Items 11 2 Two types of irregular items are reported -- (all net of taxes) discontinued operations extraordinary items 5

Discontinued Operations... PowerPoint Slides 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 Rozek net income of $800,000 from continuing operations in 2007. During 2007 the company discontinued and sold its unprofitable chemical division. The loss in 2007 from chemical operations (net of $90,000 taxes) was $210,000. The tax rate is 30%. 7

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

PowerPoint Slides Extraordinary Items In 20047 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

Presentation of Extraordinary Items... PowerPoint Slides Presentation of Extraordinary Items... 9

PowerPoint Slides Extraordinary Items 2

Estimating Sustainable Income PowerPoint Slides Estimating Sustainable Income When evaluating a company, it generally makes sense to eliminate all irregular items in estimating future sustainable income. 2

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 Most changes are reported retroactively – improves comparability Example: a change in inventory costing methods (such as FIFO to average cost). 17

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

11 3 Comprehensive Income Includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders.

Complete Income Statement PowerPoint Slides 28

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

Intracompany Basis PowerPoint Slides 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

Intercompany Basis PowerPoint Slides 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 11 4 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

Horizontal Analysis PowerPoint Slides 37

Horizontal Analysis- Balance Sheet PowerPoint Slides 38

PowerPoint Slides Horizontal Analysis – Income Statement 38

Review In horizontal analysis, each item is expressed as a percentage of the: a. net income amount. d. base-year amount. c. total assets amount. b. stockholders’ equity amount.

Review In horizontal analysis, each item is expressed as a percentage of the: a. net income amount. d. base-year amount. c. total assets amount. b. stockholders’ equity amount.

PowerPoint Slides Vertical Analysis 11 5 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 the base amount in vertical analysis of a balance sheet. Net sales is the base amount in vertical analysis of an income statement. 45

Vertical Analysis - Balance Sheet PowerPoint Slides 38

Intercompany Comparison by Vertical Analysis PowerPoint Slides Intercompany Comparison by Vertical Analysis 38

Review In vertical analysis, the base amount for depreciation expense is generally: a. net sales. d. fixed assets. c. gross profit. b. depreciation expense in a previous year.

Review In vertical analysis, the base amount for depreciation expense is generally: a. net sales. d. fixed assets. c. gross profit. b. depreciation expense in a previous year.

PowerPoint Slides 11 6 Ratio Analysis 57

Ratios Three types: Liquidity ratios Solvency ratios PowerPoint Slides 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 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 PowerPoint Slides 61

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 PowerPoint Slides 61

Profitability Ratios PowerPoint Slides 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 PowerPoint Slides 61

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

Estimates PowerPoint Slides 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 Quality of Earnings 11 7 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. 110

Alternative Accounting Methods PowerPoint Slides Alternative Accounting Methods 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 Pro Forma Income A measure of the net income generated that usually excludes items that the company thinks are unusual or nonrecurring. 112

Improper Recognition PowerPoint Slides Offering big discounts (channel stuffing) to companies to get them to buy early- Often leads to disaster in subsequent periods. Improper capitalization of operating expenses 112

PowerPoint Slides Price Earnings Ratio The P/E ratio reflects the investors’ assessment of a company’s future earnings. 112

Earnings Per Share and Price Earnings Ratio PowerPoint Slides Earnings Per Share and Price Earnings Ratio 112