1. Analysis and interpretation of financial statements
Chapter 13
Analysis and interpretation of financial statements
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2. Persistent earnings and discuss the content and format of the income statement.
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3. Earnings Persistence
An important role for accounting information is to predict future cash flows used in valuation studies.
An important determinant of earning’s ability to predict future cash flows is the persistence of earnings.
Persistent earnings are earnings that are expected to continue (recurring) into the future. (also called sustainable or permanent earnings)
Transitory earnings are single-period events.
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4. Multi-Step Income Statement
The multi-step income statement is organized to present earnings information that separates items according to persistence, with more persistent items appearing higher in the statement.
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5. Transitory Items
Discontinued operations are reported separately when a company sells, abandons, or otherwise disposes of a segment of its operations.
The income or loss from the segment’s operation for the portion of the year before its discontinuance.
Any gain or loss from the disposal of the segment.
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6. Changes in Accounting Principles
Companies are allowed to change accounting principles from one generally accepted method to another generally accepted method as long as the change can be shown to better reflect financial results.
In order to enhance analysis, companies that change are required to restate prior financial statements as if the new method had been in use.
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7. Comprehensive Income
Includes items that generate wealth for the company, but are not allowed by GAAP to appear on the income statement.
Includes:
Net income from the income statement
Changes in market value of certain marketable securities (not sold yet)
Unrealized gains and losses from translating foreign currencies when consolidating financial statements
Comprehensive income can be reported by appending to the income statement, as a separate statement, or as part of the statement of stockholders’ equity.
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8. Select the correct answer.
Which of the following represents the correct order on a multi-step income statement?
Revenue, gross profit, income from continuing operations, net operating income, net income.
.Revenue, gross profit, net operating income, income from continuing operations, net income.
Revenue, income from continuing operations, net operating income, gross profit, net income.
Net income, Revenue, gross profit, income from continuing operations, net operating income.
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9. Sources of financial information and techniques used by investment professionals
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10. Analytical Techniques
Simply knowing the dollar level of financial statement items is insufficient without more information.
Techniques that can aid in analysis include:
Horizontal (trend) analysis
Vertical (common-size) analysis
Ratio analysis
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11. Coffee Roasters, Co. © Cambridge Business Publishers 2016 2015 Assets
(in thousands)
2016
2015
Assets
Current Assets
Cash and cash equivalents
$71,173
$40,512
Net receivables
448,327
364,810
Inventory
768,437
672,248
Other current assets
35,019
53,957
Total Current Assets
1,322,956
1,131,527
Property, plant and equipment
944,296
699,802
Goodwill
808,076
789,305
Intangible assets
498,352
529,494
Other long term assets
42,109
47,759
Total Assets
$3,615,789
$3,197,887
Liabilities
Current Liabilities
Accounts payable
$480,594
$410,751
Other current liabilities
39,393
60,623
Total Current Liabilities
519,987
471,374
Long-term liabilities
824,670
793,264
Total Liabilities
1,344,657
1,264,638
Stockholders’ Equity
Common stock
1,499,932
1,521,522
Retained earnings
771,200
411,727
Total Stockholders' Equity
2,271,132
1,933,249
Total Liabilities & Stockholders' Equity
(in thousands)
2016
2015
Net sales
$3,859,198
$2,650,899
Cost of goods sold
2,589,799
1,746,274
Gross profit
1,269,399
904,625
Selling and operating expenses
481,493
348,696
General and administrative expenses
219,010
187,016
Operating income
568,896
368,913
Interest expense
(22,983)
(57,657)
Other income (expense)
29,356
(10,056)
Income before tax
575,269
301,200
Income tax expense
212,641
101,699
Net income
$ 362,628
$ 199,501
(in thousands)
2016
2015
Operating Activities
Net income
$ 362,628
$199,501
Adjustments To Net Income
115,157
(198,716)
Net cash flow from operating activities
477,785
785
Investing Activities
Capital expenditures
(401,121)
(283,444)
Other cash flows from investing activities
135,476
(904,228)
Net cash flow from investing activities
(265,645)
(1,187,672)
Financing activities
Sale/purchase of stock
(64,378)
981,472
Net borrowings
(116,544)
223,325
Other cash flows from financing activities
(557)
17,846
Net cash flow from financing activities
(181,479)
1,222,643
Change In cash and cash equivalents
$ 30,661
$35,756
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12. Horizontal (trend) financial statement analysis.
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13. Comparative Financial Statements
Compare two or more years
Often compare both dollar changes and percentage changes between years
Care must be taken when comparing percentages
Small numbers in the denominator
Negative values
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14. Horizontal Analysis—Coffee Roasters, Co.
COFFEE ROASTERS, CO. — BALANCE SHEET
Assets
2016
2015
$ Change
% Change
Current Assets
Cash and cash equivalents
$71,173
$40,512
$30,661
75.7%
Net receivables
448,327
364,810
83,517
22.9%
Inventory
768,437
672,248
96,189
14.3%
Other current assets
35,019
53,957
(18,938)
-35.1%
Total Current Assets
1,322,956
1,131,527
191,429
16.9%
Property, plant and equipment
944,296
699,802
244,494
34.9%
Goodwill
808,076
789,305
18,771
2.4%
Intangible assets
498,352
529,494
(31,142)
-5.9%
Other long term assets
42,109
47,759
(5,650)
-11.8%
Total Assets
$3,615,789
$3,197,887
$ 417,902
13.1%
Liabilities
Current liabilities
Accounts payable
$480,594
$410,751
$69,843
17.0%
Other current liabilities
39,393
60,623
(21,230)
-35.0%
Total Current Liabilities
519,987
471,374
48,613
10.3%
Long-term liabilities
824,670
793,264
31,406
4.0%
Total Liabilities
1,344,657
1,264,638
80,019
6.3%
Stockholders’ Equity
Common stock
1,499,932
1,521,522
(21,590)
-1.4%
Retained earnings
771,200
411,727
359,473
87.3%
Total Stockholders' Equity
2,271,132
1,933,249
337,883
17.5%
Total Liabilities & Stockholders' Equity
$417,902
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15. Horizontal Analysis—Coffee Roasters, Co.
COFFEE ROASTERS, CO. — INCOME STATEMENT
2016
2015
$ Change
% Change
Net sales
$3,859,198
$2,650,899
$ 1,208,299
45.6%
Cost of goods sold
2,589,799
1,746,274
843,525
48.3%
Gross profit
1,269,399
904,625
364,774
40.3%
Selling and operating expenses
481,493
348,696
132,797
38.1%
General and administrative expenses
219,010
187,016
31,994
17.1%
Operating income
568,896
368,913
199,983
54.2%
Interest expense
-22,983
-57,657
34,674
-60.1%
Other income (expense)
29,356
-10,056
39,412
-391.9%
Income before tax
575,269
301,200
274,069
91.0%
Income tax expense
212,641
101,699
110,942
109.1%
Net income
$362,628
$199,501
$ 163,127
81.8%
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16. Trend Analysis—Coffee Roasters, Co.
2012
2013
2014
2015
2016
Thousands of Dollars
% of Base Year
Net sales
$492,517
100%
$786,135
160%
$1,356,775
275%
$2,650,899
538%
$3,859,198
784%
Net income
$21,669
$54,439
251%
$79,506
367%
$199,501
921%
$362,628
1,673%
Most companies provide 5-year trend data for key items such as sales, net income, and total assets.
Basing changes on the initial year allows one to see growth over the 5-year term in addition to year-to-year growth as seen in the previous table.
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17. Vertical (common-size) financial statement analysis.
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18. Common-Size Financial Statements
The relative importance of various accounts for a single year can be highlighted by showing them as a percentage of a key statement figure.
Total assets on the balance sheet
Net sales on the income statement
Common-size statements also aid in the analysis of different firms, especially when they differ in size.
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19. Common-Size Balance Sheet Coffee Roasters, Co.
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20. Common-Size Income Statement Coffee Roasters, Co.
2016
2015
Net sales
$3,859,198
$2,650,899
100.0%
Cost of goods sold
2,589,799
1,746,274
67.1%
65.9%
Gross profit
1,269,399
904,625
32.9%
34.1%
Selling and operating expenses
481,493
348,696
12.5%
13.2%
General and administrative expenses
219,010
187,016
5.7%
7.1%
Operating income
568,896
368,913
14.7%
13.9%
Interest expense
-22,983
-57,657
0.6%
2.2%
Other income (expense)
29,356
-10,056
0.8%
-0.4%
Income before tax
575,269
301,200
14.9%
11.4%
Income tax expense
212,641
101,699
5.5%
3.8%
Net income
$362,628
$199,501
9.4%
7.5%
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21. Financial ratios for analyzing a firm
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22. Ratio Analysis
Profitability analysis—how efficiently a firm has performed in its quest for profits
Gross profit percentage
Return on sales
Asset turnover
Return on assets
Return on common stockholders’ equity
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23. Ratio Analysis
Short-term liquidity analysis—the ability to satisfy current obligations
Working capital
Current ratio
Quick ratio
Operating-cash-flow-to-current-liabilities ratio
Accounts receivable turnover
Average collection period
Inventory turnover
Days’ sales in inventory
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24. Ratio Analysis
Long-term solvency analysis—a firm’s long-term debt repayment capability
Debt-to-equity ratio
Time-interest earned ratio
Operating-cash-flow-to-capital-expenditures ratio
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25. Ratio Analysis Ratios for common stockholders analysis
Earnings per share (EPS)
Price-earnings (PE) ratio
Dividend yield
Dividend payout ratio
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26. Profitability Analysis (Financial Statements)
Gross Profit Percentage =
Net sales – Cost of goods sold
Net sales
Indicates the percentage of income generated from sales after deducting the cost of goods sold.
Coffee Roasters =
$3,859,198 – $2,589,799
$3,859,198
= 32.9%
Coffee Roasters =
$2,650,899 – $1,746,274
$2,650,899
= 34.1%
Coffee Roasters, Co. generated 32.9 cents of gross profits from each sales dollar in 2016, down from 34.1 cents in 2015.
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27. Profitability Analysis (Financial Statements)
Return on Sales =
Net income
Net sales
Indicates the percentage of net income remaining from a dollar of sales after subtracting all expenses.
Coffee Roasters =
$362,628
$3,859,198
= 9.4%
Coffee Roasters =
$199,501
$2,650,899
= 7.5%
Coffee Roasters, Co. generated over 9 cents of profit per dollar of sales in 2016, up nearly 2 cents from just 7.5 cents in 2015.
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28. Profitability Analysis (Financial Statements)
Asset Turnover =
Net sales
Average total assets
Amount of sales generated from each dollar invested in assets.
Coffee Roasters =
$3,859,198
($3,615,789 + $3,197,887) / 2
= $1.13
Coffee Roasters =
$2,650,899
($3,197,887 + $1,370,574) / 2
= $1.16
Every dollar invested in Coffee Roasters’ assets generated $1.13 of sales revenue during 2016, down 3 cents from $1.16 in 2015.
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29. Profitability Analysis (Financial Statements)
Return on Assets =
Net income
Average total assets
Indicates the rate of return generated on a company’s investment in assets from all sources.
Coffee Roasters =
$362,628
($3,615,789 + $3,197,887) / 2
= 10.6%
Coffee Roasters =
$199,501
($3,197,887 + $1,370,574) / 2
= %
Coffee Roasters, Co. generated 10.6 cents of profit for every dollar invested in assets in 2016, up from 8.7 cents in 2015.
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30. Profitability Analysis (Financial Statements)
Return on Common
Stockholders’ Equity
Net income – Preferred stock dividends
Average common stockholders’ equity =
Indicates the rate of return generated by a business for its common stockholders.
Coffee Roasters =
$362,628 – $0
($2,271,132 + $1,933,249) / 2
= 17.3%
Coffee Roasters =
$199,501– $0
($1,933,249 + $699,245) / 2
= 15.2%
Coffee Roasters, Co. generated an increase in its return on equity, from 15.3% in 2015 to 17.2% in 2016, a favorable change.
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31. Short-Term Liquidity Analysis (Financial Statements)
Working Capital = Current assets – Current liabilities
Provides an indication of a company’s ability to satisfy its current obligations from its current resources.
Coffee Roasters = $1,322,956 – $519,987 = $802,969
Coffee Roasters = $1,131,527 – $471,374 = $660,153
Coffee Roasters’ working capital is a healthy $802,969 in 2016, increasing from $660,153 in 2015.
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32. Short-Term Liquidity Analysis (Financial Statements)
Current Ratio =
Current assets
Current liabilities
Amount of current assets available to service current liabilities.
Coffee Roasters =
$1,322,956
$519,987
= 2.5
Coffee Roasters =
$1,131,527
$471,374
= 2.4
Coffee Roasters’ current assets are 2.5 times as large as its current obligations at the end of 2016, up from 2.4 at the end of 2015, indicating adequate liquidity.
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33. Short-Term Liquidity Analysis (Financial Statements)
Quick Ratio =
Cash + Short-term investments + Accounts receivable
Current liabilities
Amount of liquid assets available to pay short-term liabilities.
Coffee Roasters =
$71,173 + $0 + $448,327
$519,987
= 1.00
Coffee Roasters =
$40,512 + $0 + $364,810
$471,374
= 0.86
Coffee Roasters’ liquid assets are approximately equal to its current obligations at the end of 2016, up from 0.86 at the end of 2015, indicating an increase in liquidity.
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34. Short-Term Liquidity Analysis (Financial Statements)=
Cash flow from operating activities
Average current liabilities
Operating-Cash-Flow-
to-Current-Liabilities Ratio
Indicates the company’s ability to pay current liabilities from operating cash flows.
Coffee Roasters =
$477,785
($519,987 + $471,374) / 2
= 0.96
Coffee Roasters =
$785
($471,374 + $238,055) / 2
= 0.00
Coffee Roasters’ operating cash flows are nearly equal to the company’s current obligations in 2016, up considerably from 2015.
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35. Short-Term Liquidity Analysis (Financial Statements)
Accounts Receivable Turnover =
Net sales
Average accounts receivable
Indicates the number of sales/collection cycles experienced by a firm.
Coffee Roasters =
$3,859,198
($448,327 + $364,810) / 2
= times
Coffee Roasters =
$2,650,899
($364,810 + $294,825) / 2
= times
Coffee Roasters’ sales/collections cycles numbered 9.49 in 2016, which is up from 8.04 in 2015.
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36. Short-Term Liquidity Analysis (Financial Statements)
Average Collection
Period =
365
Accounts receivable turnover
Indicates the number of days required, on average, to collect an outstanding account receivable.
Coffee Roasters =
365
9.49
= days
Coffee Roasters =
365
8.04
= days
Coffee Roasters required 38.5 days on average to collect an outstanding receivable in 2016, which is 6.9 days quicker than in 2015.
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37. Short-Term Liquidity Analysis (Financial Statements)
Inventory Turnover =
Cost of goods sold
Average inventory
Indicates the number of production/sales cycles experienced by a firm.
Coffee Roasters =
$2,589,799
($768,437 + $672,248) / 2
= 3.6 times
Coffee Roasters =
$1,746,274
($672,248 + $262,478) / 2
= 3.7 times
Coffee Roasters’ production/sales cycles numbered 3.6 in 2016, down slightly from 3.7 times in 2015.
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38. Short-Term Liquidity Analysis (Financial Statements)
Days’ Sales
in Inventory =
365
Inventory turnover
Indicates the number of days required, on average, to sell the inventory currently on hand.
Coffee Roasters =
365
3.6
= days
Coffee Roasters =
365
3.7
= days
Coffee Roasters required days, on average, to sell its inventory in 2016, a slight increase from 98.6 days in 2015.
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39. Long-Term Solvency Analysis (Financial Statements)
Debt-to-Equity
Ratio =
Total liabilities
Total stockholders’ equity
Relative investment of creditors versus shareholders in a business.
Coffee Roasters =
$1,344,657
$2,271,132
= 0.59
Coffee Roasters =
$1,264,638
$1,933,249
= 0.65
Coffee Roasters’ debt-to-equity ratio is 0.59 in 2016, down somewhat from 0.65 in 2015.
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40. Long-Term Solvency Analysis (Financial Statements)
Times-Interest-
Earned Ratio
Income before interest expense and income taxes
Interest expense =
Indicates the ability to pay current interest charges from operating income.
Coffee Roasters =
$362,628 + $22,983 + $212,641
$22,983 =
Coffee Roasters =
$199,501 + $57,657 + $101,699
$57,657 =
Coffee Roasters’ interest coverage increased from 6.2 times in 2015 to 26.0 times in 2016, indicating a high level of solvency.
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41. Long-Term Solvency Analysis (Financial Statements)
Operating-Cash-Flow- to-Capital-Expenditure Ratio
Cash flow from operating activities
Annual net capital expenditures =
The ability of a company’s operations to provide sufficient cash to replace and expand plant assets.
Coffee Roasters =
$477,785
$401,121 =
Coffee Roasters =
$785
$283,444 =
Coffee Roasters was unable to fund capital expenditures from operating cash flows in 2015, however they were able to fully fund them in 2016.
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42. Ratios for Common Stockholders (Financial Statements)
Earnings per Share
Net income – Preferred stock dividends
Weighted-average # of common shares outstanding =
The earnings of the company for common shareholders stated on a per share basis.
Coffee Roasters =
$362,628 – $0
154,934
= $2.34
Coffee Roasters =
$199,501 – $0
146,215
= $1.36
Coffee Roasters’ earnings per share increased from $1.36 in 2015 to $2.34 in 2016.
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43. Ratios for Common Stockholders (Financial Statements)
Price-Earnings
Ratio
Market price per share
Earnings per share =
An indication of the fair value of a company’s stock.
Coffee Roasters =
$23.74
$2.34
= times
Coffee Roasters =
$104.26
$1.36
= times
Coffee Roasters’ stock sold at a multiple of 10.1 times its earnings in 2016, down drastically from 76.7 times in 2015.
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44. Ratios for Common Stockholders (Financial Statements)
Dividend Yield
Annual dividend per share
Market price per share =
How much a company pays out in dividends relative to the company’s share price.
Coffee Roasters = Coffee Roasters does not pay a dividend
Coffee Roasters = Coffee Roasters does not pay a dividend
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45. Ratios for Common Stockholders (Financial Statements)
Dividend
Payout Ratio
Annual dividend per share
Earnings per share =
The percentage of earnings paid out as dividends.
Coffee Roasters = Coffee Roasters does not pay a dividend
Coffee Roasters = Coffee Roasters does not pay a dividend
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46. Select the correct answer.
Which of the following ratios are most useful for accessing a company’s profitability?
Debt-to-equity ratio, times-interest-earned ratio, operating-cash-flow-to-capital-expenditure ratio.
Price-earnings ratio, dividend yield, dividend payout ratio.
Current ratio, quick ratio, inventory turnover.
.Gross profit percentage, return on sales, return on assets.
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47. Limitations of financial statement analysis.
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48. Limitations of Financial Statement Analysis
Analysis must be interpreted with consideration of the general economic conditions and industry conditions.
Comparability of financial statement data is hampered by the use of different accounting methods.
Difficulty is often encountered when comparing companies of different sizes or modes of operations.
Comparability is often difficult for conglomerates that operate in multiple industries.
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49. Appendix 13A Learning Objective 6
Describe financial statement disclosures.
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50. Financial Statement Disclosures
Parenthetical disclosures are placed next to account titles to provide additional detail.
Notes to financial statements may include:
Significant accounting policies
Explanations of complex or special transactions
Details of reported amounts
Commitments
Contingencies
Segments
Quarterly data
Subsequent events
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51. Financial Statement Disclosures
Supplemental information included with the financial statements also includes:
Management discussion and analysis
Comparative selected financial data
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52. Corporate Social Responsibility
Leading firms have found many ways to show their social responsibility.
Social responsibility often takes the form of charitable giving, sometimes through contributions tied to product purchases.
Another form of social responsibility practiced by some companies is providing time off for their employees to do volunteer work with recognized not-for-profits.
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53. © Cambridge Business Publishers