16 Financial Statement Analysis Principles of Financial Accounting 12e C H A P T E R Financial Statement Analysis Principles of Financial Accounting 12e Needles Powers ©human/iStockphoto

Concepts Underlying Financial Performance Measurement Financial statement analysis (or financial performance measurement) is used to show how items in a company’s financial statements relate to the company’s financial performance objectives. When analyzing financial statements, decision makers must judge whether the relationships they find in the statements are favorable or unfavorable. Many financial analysts, investors, and lenders apply general standards, or rule-of-thumb measures, to key financial ratios. Current ratio: The higher the ratio, the more likely the company will be able to meet its liabilities. A ratio of 2 to 1 (2.0) or higher is desirable. Current liabilities to net worth ratio (%): Normally a business starts to have trouble when this relationship exceeds 80%. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Past Performance and Industry Norms Comparing financial measures of the same company over time is an improvement over using rule-of-thumb measures. Such a comparison gives the analyst some basis for judging whether the measure or ratio is getting better or worse. However, using a company’s past performance is not helpful in judging its performance relative to that of other companies. Industry norms show how a company compares with other companies in the same industry, which overcomes some of the limitations of comparing a company’s measures over time. However, diversified companies (or conglomerates)—large companies that have multiple segments and operate in more than one industry—may not be comparable to any other company. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Sources of Information The major sources of information about public corporations include: Reports published by a corporation Annual reports Interim financial statements—condensed financial statements published each quarter and sometimes each month Reports filed with the Securities and Exchange Commission (SEC) Annual reports (Form 10-K) Quarterly reports (Form 10-Q) Current reports (Form 8-K) Business periodicals and credit and investment advisory services The Wall Street Journal Moody’s, Standard & Poor’s, and Dun and Bradstreet ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Horizontal Analysis To gain insight into year-to-year changes, analysts use horizontal analysis, in which changes from the previous year to the current year are computed in both dollar amounts and percentages. The percentage change is computed as follows: Percentage Change = 100 × Comparative Year Amount − Base Year Amount Base Year Amount The base year is the first year considered in any set of data. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Trend Analysis Trend analysis is a variation of horizontal analysis that calculates percentage changes for several successive years instead of for just two years. It uses an index number to show changes in related items over time. For an index number, the base year is set at 100 percent. Other years are measured in relation to that number. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Vertical Analysis Vertical analysis shows how the different components of a financial statement relate to a total figure in the statement. The analyst sets the total figure at 100 percent and computes each component’s percentage of that total. The resulting financial statement, which is expressed entirely in percentages, is called a common-size statement. Vertical analysis and common-size statements are useful in comparing the importance of specific components in the operation of a business and in identifying important changes in the components from one year to the next. They are often used to make comparisons between companies. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Financial Ratio Analysis Financial ratio analysis identifies key relationships between the components of the financial statements. Investors and creditors use profit margin to evaluate a company’s ability to earn a satisfactory income (profitability). They use asset turnover to determine whether the company uses assets in a way that maximizes revenue (total asset management). Their combined effect is overall earning power—that is, return on assets. Liquidity is a company’s ability to pay bills when they are due and to meet unexpected needs for cash. To evaluate a company’s liquidity, analysts compute: cash flow yield; cash flows to sales; cash flows to assets; and free cash flow. Financial risk refers to a company’s ability to survive in good times and bad. Ratios related to financial risk include debt to equity, return on equity, and interest coverage. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Profit Margin and Asset Turnover Profit margin measures the net income produced by each dollar of sales. Asset turnover measures how efficiently assets are used to produce sales. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Return on Assets and Cash Flow Yield Return on assets measures a company’s overall earning power, or profitability. Cash flow yield measures the ability to generate operating cash flows in relation to net income. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Cash Flows to Sales and Cash Flows to Assets Cash flows to sales refers to the ability of sales to generate operating cash flows. Cash flows to assets measures the ability of assets to generate operating cash flows. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Free Cash Flow Free cash flow is a measure of the cash remaining after providing for commitments. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Debt to Equity Ratio and Return on Equity The debt to equity ratio shows the amount of assets provided by creditors in relation to the amount provided by stockholders. Return on equity measures the return to stockholders. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Interest Coverage The interest coverage ratio is a supplementary ratio that measures the degree of protection creditors have from default on interest payments. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Operating Asset Management and Market Strength with Ratios The operating cycle spans the time it takes to purchase inventory, sell it, and collect for it. The financing cycle—the period between the time a supplier must be paid and the end of the operating cycle—defines how much financing the company must have to support its operations. Because debt increases a company’s risk, it is important to keep the financing period at a manageable level. Ratios that measure operating asset management include inventory turnover, days’ inventory on hand, receivables turnover, days’ sales uncollected, payables turnover, days’ payable, and current and quick ratio. Market price is the price at which stock is bought and sold. It must be related to earnings by considering the price/earnings (P/E) ratio and the dividend yield. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Inventory Turnover and Days’ Inventory on Hand Inventory turnover measures the relative size of inventories. Day’s inventory on hand measures the average number of days that it takes to sell inventory. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Receivables Turnover and Days’ Sales Uncollected Receivables turnover measures the relative size of accounts receivable and the effectiveness of credit policies. Days’ sales uncollected measures the average number of days it takes to collect receivables. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Payables Turnover and Days’ Payable Payables turnover measures the relative size of accounts payable and the credit terms extended to a company. Days’ payable measures the average number of days it takes to pay accounts payable. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Financing Period The financing period is computed by deducting the days’ payable from the operating cycle (days’ inventory on hand + days’ sales uncollected). ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Current Ratio and Quick Ratio The current ratio measures short-term debt-paying ability by comparing current assets with current liabilities. The quick ratio differs from the current ratio in that the numerator of the quick ratio excludes inventories and prepaid expenses. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Price/Earnings (P/E) and Dividend Yield Price/earnings (P/E) is the ratio of the market price per share to earnings per share. Dividend yield measures a stock’s current return to an investor in the form of dividends. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Evaluating Quality of Earnings The quality of earnings refers to the substance of earnings and their sustainability into future periods. It is affected by accounting method, accounting estimates, and one-time items. Different accounting methods have different effects on net income. The latitude that companies have in their choice of accounting method could cause problems in the interpretation of financial statements were it not for the conventions of full disclosure and consistency. Full disclosure requires management to explain, in a note to the financial statements, the significant accounting policies used. Consistency requires that the same accounting procedures be used from year to year. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounting Estimates and One-Time Items In allocating expenses among the periods that benefit from them, accountants must make estimates and exercise judgment, which will affect net income. Areas that require accounting estimates include: useful life of assets; residual value of assets; uncollectible accounts receivable; sales returns; total units of production; total recoverable units of natural resources; amortization periods; warranty claims; and environmental cleanup costs. If earnings increase because of one-time items, that portion of earnings will not be sustained in the future. Examples of one-time items include: gains and losses; write-downs and restructurings; and nonoperating items. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Gains and Losses and Write-Downs and Restructurings When a company sells or disposes of operating assets or marketable securities, a gain or loss generally results. These gains or losses appear in the operating section of the income statement, but they usually represent one-time events. From an analyst’s standpoint, they should be ignored when considering operating income. A write-down (or write-off) is a reduction in the value of an asset below its carrying value on the balance sheet. A restructuring is the estimated cost of a change in a company’s operations. Both write-downs and restructurings reduce current operating income and boost future income by shifting future costs to the current period. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

These items can significantly affect net income. Nonoperating Items The nonoperating items that appear on the income statement include discontinued operations—segments that are no longer part of a company’s operations—and gains or losses on the sale or disposal of these segments. These items can significantly affect net income. To make it easier to evaluate a company’s ongoing operations, GAAP requires that gains and losses from discontinued operations be reported separately on the income statement. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Management Compensation Under the Sarbanes-Oxley Act, a public corporation’s board of directors must establish a compensation committee made up of independent directors to determine how the company’s top executives will be compensated. Typical components of the compensation of executive officers include: Annual base salary Annual incentive bonuses—based on financial performance measures that the compensation committee identifies as important to the company’s long-term success Long-term incentive compensation (stock option awards)—usually based on how well the company is achieving its long-term strategic goals ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.