John Wiley & Sons, Inc. Financial A ccounting, 5e Prepared by Kurt M. Hull, MBA CPA California State University, Los Angeles Weygandt, Kieso, & Kimmel

CHAPTER 15 FINANCIAL STATEMENT ANALYSIS CHAPTER 15 FINANCIAL STATEMENT ANALYSIS STUDY OBJECTIVES After studying this chapter, you should understand: Comparative analysis Tools used in financial statement analysis Horizontal analysis Vertical analysis Liquidity, profitability, & solvency ratios Earnings power Limitations of financial statement analysis

STUDY OBJECTIVE 1 COMPARATIVE ANALYSIS STUDY OBJECTIVE 1 COMPARATIVE ANALYSIS

STUDY OBJECTIVE 2 ANALYSIS TOOLS STUDY OBJECTIVE 2 ANALYSIS TOOLS HORIZONTAL (TREND) ANALYSIS evaluates a series of financial statement data over a period of time. VERTICAL ANALYSIS expresses each item in a financial statement as a percent of a base amount RATIO ANALYSIS expresses the relationship among selected items of financial statement data.

Changes are measured against a base year with the following formula. Change since base period STUDY OBJECTIVE 3 HORIZONTAL ANALYSIS STUDY OBJECTIVE 3 HORIZONTAL ANALYSIS

OF BALANCE SHEET HORIZONTAL ANALYSIS OF BALANCE SHEET

HORIZONTAL ANALYSIS OF INCOME STATEMENT HORIZONTAL ANALYSIS OF INCOME STATEMENT

HORIZONTAL ANALYSIS OF RETAINED EARNINGS STATEMENT HORIZONTAL ANALYSIS OF RETAINED EARNINGS STATEMENT 39.4% 525, , ,500 = The change in January 1 retained earnings is calculated as follows

STUDY OBJECTIVE 4 VERTICAL ANALYSIS STUDY OBJECTIVE 4 VERTICAL ANALYSIS Financial statement elements are measured as a percent of the total. Elements are a percent of total sales Elements are a percent of total assets Income StatementBalance Sheet

Common stock, $1 par 275, % 270, % Retained earnings 727, % 525, % Total stockholders’ equity 1,003, % 795, % Total liabilities and stockholders’ equity $ 1,835, % $1,595, % VERTICAL ANALYSIS OF BALANCE SHEET VERTICAL ANALYSIS OF BALANCE SHEET

Interest and dividends 9, % 11, % Other expenses and losses Interest expense 36, % 40, % Income before income taxes 432, % 347, % Income tax expense 168, % 139, % Net income $ 263, % $ 208, % VERTICAL ANALYSIS OF BALANCE SHEET VERTICAL ANALYSIS OF BALANCE SHEET

INTERCOMPANY COMPARISION OF INCOME STATEMENT INTERCOMPANY COMPARISION OF INCOME STATEMENT

REVIEW QUESTION Sammy Corporation reported net sales of $300,000 and $330,000 for 2004 and Calculate the percentage increase. 10% 330, , ,000 = Another way to express this change: 2005 sales are 110% of 2004 sales

STUDY OBJECTIVE 5 RATIO ANALYSIS STUDY OBJECTIVE 5 RATIO ANALYSIS

Quality Department Store $1,020,000 $945,000 ————— = 2.96:1 ———— = 3.12:1 $344,500 $303,000 Industry average Sears, Roebuck and Co. ———————— ———————————— 1.28:1 1.32:1 Evaluates liquidity and short-term debt-paying ability. CURRENT ASSETS CURRENT RATIO = ——————————— CURRENT LIABILITIES CURRENT RATIO A LIQUIDITY RATIO CURRENT RATIO A LIQUIDITY RATIO

CASH + MARKETABLE SECURITIES + RECEIVABLES (NET) ACID-TEST RATIO = ———————————————————————————— CURRENT LIABILITIES Measures short-term liquidity. ACID-TEST/QUICK RATIO A LIQUIDITY RATIO ACID-TEST/QUICK RATIO A LIQUIDITY RATIO

Quality Department Store $100,000 + $20,000 + $230,000 $155,000 + $70,000 + $180,000 —————————————— = 1.02 :1 —————————————— = 1.3:1 $344,500 $303,000 Industry average Sears, Roebuck and Co. ———————— ———————————— 0.33:1 0.85:1 ACID-TEST/QUICK RATIO

Measures the liquidity of receivables. Measures the number of times, on average, receivables are collected during the period. NET CREDIT SALES RECEIVABLES TURNOVER = ——————————————— AVERAGE NET RECEIVABLES RECEIVABLES TURNOVER A LIQUIDITY RATIO RECEIVABLES TURNOVER A LIQUIDITY RATIO

Quality Department Store Industry average Sears, Roebuck and Co. ———————— ———————————— 10.8 times 2.4 times [][] $2,097,000 $1,837,000 —————————— = 10.2 times —————————— = 9.7 times $180,000 + $230,000 $200,000 + $180,000 —————————— 2 2 RECEIVABLES TURNOVER

Measures the number of times, on average, the inventory is sold during the period. Measures the liquidity of the inventory. COST OF GOODS SOLD INVENTORY TURNOVER = ———————————— AVERAGE INVENTORY INVENTORY TURNOVER A LIQUIDITY RATIO INVENTORY TURNOVER A LIQUIDITY RATIO

Quality Department Store [][] $1,281,000 $1,140,000 —————————— = 2.3 times —————————— = 2.4 times $500,000 + $620,000 $450,000 + $500,000 —————————— 2 2 Industry average Sears, Roebuck and Co. ———————— ———————————— 6.7 times 5.0 times INVENTORY TURNOVER

Measures the percentage of each dollar of sales that results in net income. Measures how profitable the company is NET INCOME PROFIT MARGIN ON SALES = —————— NET SALES PROFIT MARGIN A PROFITABILITY RATIO PROFIT MARGIN A PROFITABILITY RATIO

Quality Department Store $263,800 $208,500 ————— = 12.6% ————— = 11.4% $2,097,000 $1,837,000 Industry average Sears, Roebuck and Co. ———————— ———————————— 3.57% 8.26% PROFIT MARGIN

Measures how efficiently a company uses its assets to generate sales. NET SALES ASSET TURNOVER = ————————— AVERAGE ASSETS ASSET TURNOVER A PROFITABILITY RATIO ASSET TURNOVER A PROFITABILITY RATIO

$2,097,000 $1,837,000 ——————————— = 1.22 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 and Co times 1.05 times ASSET TURNOVER

An overall measure of profitability. NET INCOME RETURN ON ASSETS = ————————— AVERAGE ASSETS RETURN ON ASSETS A PROFITABILITY RATIO RETURN ON ASSETS A PROFITABILITY RATIO

$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 and Co. ———————— ———————————— 8.29% 8.7% RETURN ON ASSETS

Measures profitability from the viewpoint of the common stockholder. RETURN ON COMMON NET INCOME STOCKHOLDERS’ EQUITY = ——————————————————————— AVERAGE COMMON STOCKHOLDERS’ EQUITY RETURN ON COMMON EQUITY A PROFITABILITY RATIO RETURN ON COMMON EQUITY A PROFITABILITY RATIO

$263,800 $208,500 ——————————— = 29.3% ——————————— = 28.5% $795,000 + $1,003,000 $667,000 + $795,000 ——————————— 2 2 [ ][ ] Quality Department Store RETURN ON COMMON EQUITY

EPS measures net income earned on each share of common stock. EARNINGS NET INCOME PER SHARE = ———————————————————————————— WEIGHTED AVERAGE COMMON SHARES OUTSTANDING EARNINGS PER SHARE A PROFITABILITY RATIO EARNINGS PER SHARE A PROFITABILITY RATIO

Quality Department Store $263,000 $208,500 ————————— = $.97————— = $ , , ,000 ————————— 2 [] EARNINGS PER SHARE

Measures the ratio of the market price of each share of common stock to the earnings per share. MARKET PRICE PER SHARE OF COMMON STOCK PRICE-EARNINGS RATIO = ————————————————————————— EARNINGS PER SHARE PRICE TO EARNINGS A PROFITABILITY RATIO PRICE TO EARNINGS A PROFITABILITY RATIO

Quality Department Store $12.00$ 8.00 ——— = 12.4 times——— = 10.4 times $.97$.77 Industry averageSears, Roebuck and Co. ——————————————————— 26 times3.8 times PRICE TO EARNINGS

Measures the percentage of earnings distributed in the form of cash dividends. CASH DIVIDENDS PAYOUT RATIO = ————————————————————————— NET INCOME PAYOUT RATIO A PROFITABILITY RATIO PAYOUT RATIO A PROFITABILITY RATIO

$61,200 $60,000 ————— = 23.2% ————— = 28.8% $263,800 $208,500 Industry averageSears, Roebuck and Co. ——————————————————— 16.0%9.6% Quality Department Store PAYOUT RATIO A PROFITABILITY RATIO PAYOUT RATIO A PROFITABILITY RATIO

Quality Department Store $468,000$388,000 ———— = 13 times———— = 9.6 times $36,000 $40,500 TIMES INTEREST EARNED A SOLVENCY RATIO TIMES INTEREST EARNED A SOLVENCY RATIO Income before Income Taxes and Interest Expense Interest Expense Measures ability to meet interest payments as they come due.

Industry average Sears, Roebuck and Co. ———————— ———————————— 40.1% 76.9% $832,000 =45.30%$800,000 =50.20% $1,835,000$1,595, Quality Department Store DEBT TO TOTAL ASSETS A SOLVENCY RATIO DEBT TO TOTAL ASSETS A SOLVENCY RATIO Measures % of total assets provided by creditors Total Debt Total Assets

2.22 = ( ) / REVIEW QUESTION Ace Ventura Pet Detective, Inc. reported the following: Cash $125,000 Marketable Securities $342,500 Accounts Receivable $780,000 Inventory $56,000 Prepaid Insurance $3,600 Prepaid Rent $4,900 Total Assets $1,729,000 Current Liabilities $562,000 Calculate the Quick Ratio.

Earnings power is the NORMAL LEVEL OF INCOME to be obtained in the future. Earnings power is affected by irregular items. Three types of “Irregular” items: 1) Discontinued operations 2) Extraordinary items 3) Changes in accounting principle STUDY OBJECTIVE 6 EARNINGS POWER & IRREGULAR ITEMS STUDY OBJECTIVE 6 EARNINGS POWER & IRREGULAR ITEMS

DISCONTINUED OPERATIONS The disposal of a significant segment of a business. –The income or (loss) form discontinued operations consists of two parts: The income or (loss) form operations and The gain/loss on the disposal of the segment The results are shown “net of tax”

DISCONTINUED OPERATIONS STATEMENT PRESENTATION DISCONTINUED OPERATIONS STATEMENT PRESENTATION For the year ended December 31, 2006

Extraordinary items are events and transactions that meet two conditions. –unusual in nature and –infrequent in occurrence –the results are shown “net of tax” EXTRAORDINARY ITEMS

STATEMENT PRESENTATION EXTRAORDINARY ITEMS STATEMENT PRESENTATION For the year ended December 31, 2006

ORDINARY VS. EXTRAORDINARY

Occurs when the principle used in the current year is different form the one used last year. When this happens: –The new principle is used to report the results of operations for current year –The cumulative effect of the change on all prior year income statements should be disclosed “net of tax” CHANGE IN ACCOUNTING PRINCIPLE CHANGE IN ACCOUNTING PRINCIPLE

CHANGE IN PRINCIPLE STATEMENT PRESENTATION CHANGE IN PRINCIPLE STATEMENT PRESENTATION For the year ended December 31, 2006

STUDY OBJECTIVE 7 LIMITATIONS OF F/S ANALYSIS STUDY OBJECTIVE 7 LIMITATIONS OF F/S ANALYSIS EstimatesDepreciation, allowances, contingencies CostHistorical data not adjusted for inflation/deflation Alternative methods FIFO, LIFO, Average Cost. Completed contract, percentage of completion Atypical dataSeasonal accounting data may not be representative Firm diversification Conglomerates hard to identify with single industry.

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