2. Financial Accounting, Fifth Edition
Financial Analysis:
The Big Picture
Financial Accounting, Fifth Edition

3. Study Objectives 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.
Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.
Understand the concept of quality of earnings.

4. Financial Analysis: The Big Picture
Sustainable Income
Comparative Analysis
Ratio Analysis
Quality of Earnings
Irregular items
Changes in accounting principles
Comprehensive income
Horizontal analysis
Vertical analysis
Liquidity ratios
Solvency ratios
Profitability ratios
Alternative accounting methods
Pro forma income
Improper recognition
Price-earnings ratio

5. Sustainable Income
Sustainable Income - Net income adjusted for irregular items.
Irregular items are separately identified on the income statement. Two types are:
Discontinued operations.
Extraordinary items.
These “irregular” items are reported net of income taxes.
SO 1 Understand the concept of sustainable income.
SO 2 Indicate how irregular items are presented.

6. Sustainable Income Components of the income statement
Illustration 13-1
Components of the income statement
SO 2 Indicate how irregular items are presented.

7. Sustainable Income Discontinued Operations
Disposal of a significant component of a business.
Income statement should report a gain (or loss) from discontinued operations, net of tax.
SO 2 Indicate how irregular items are presented.

8. Sustainable Income
Illustration: Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in The company therefore has income before income taxes of $800,000. During 2010 the company discontinued and sold its unprofitable chemical division at a loss of $210,000 (net of $90,000 tax savings).
Illustration 13-2
SO 2 Indicate how irregular items are presented.

9. Sustainable Income
Extraordinary items are events and transactions that meet two conditions:
Both
Unusual in nature and
Infrequent in occurrence
Company must consider the environment in which it operates.
Amounts reported “net of tax.”
SO 2 Indicate how irregular items are presented.

10. Sustainable Income
Illustration: Assume that in 2010 a revolutionary foreign government expropriated property held as an investment by Rozek Inc. If the loss is $70,000 before applicable income tax savings of $21,000, how will the loss be presented in the income statement?
Illustration 13-3
Illustration 13-2
Solution on notes page

11. Sustainable Income Are these considered Extraordinary Items? YES NO NO
Effects of major natural casualties, if rare in the area.
Effects of major natural casualties, not uncommon in the area.
Write-down of inventories or write-off of receivables.
Expropriation (takeover) of property by a foreign government.
YES NO NO
YES
SO 2 Indicate how irregular items are presented.

12. Sustainable Income Are these considered Extraordinary Items? NO YES NO
Losses attributable to labor strikes.
Effects of a newly enacted law or regulation, such as a condemnation action.
Gains or losses from sales of property, plant, or equipment. NO
YES NO
SO 2 Indicate how irregular items are presented.

14. Sustainable Income Changes in Accounting Principle
Principle used in the current year is different from one used in the preceding year.
Example - change from FIFO to average cost.
Permissible when management can show new principle is preferable.
Most changes are reported retroactively.
SO 2 Indicate how irregular items are presented.

15. Sustainable Income Comprehensive Income
All changes in stockholders’ equity except those resulting from
investments by stockholders and
distributions to stockholders.
Certain gains and losses bypass net income and instead are reported as direct adjustments to stockholders’ equity.
Example – Unrealized gain or loss on Available-for-sale securities
SO 3 Explain the concept of comprehensive income.

16. Sustainable Income Illustration of Comprehensive Income
Accounting standards require companies to adjust most investments in stocks and bonds up or down to their market value at the end of each accounting period.
Illustration: During 2010 Stassi Company purchased IBM stock for $10,000 as an investment. At the end of 2010 Stassi was still holding the investment, but the stock’s market value was now $8,000.
How should Stassi account for the $2,000 unrealized loss?
SO 3 Explain the concept of comprehensive income.

17. (Comprehensive Income - Stockholders’ Equity)
Sustainable Income
Illustration of Comprehensive Income
How should Stassi account for the $2,000 unrealized loss?
Answer: Depends on whether Stassi classifies the IBM stock as a
Trading security or an
Available for-sale security.
Unrealized gains and losses
(Income Statement)
Unrealized gains and losses
(Comprehensive Income - Stockholders’ Equity)
SO 3 Explain the concept of comprehensive income.

18. Sustainable Income Format One – Comprehensive Income
Combined statement of income and comprehensive income.
Illustration 13-5
SO 3 Explain the concept of comprehensive income.

19. Sustainable Income Format Two - Comprehensive Income
Separate component of Stockholders’ Equity.
Illustration 13-6
SO 3 Explain the concept of comprehensive income.

20. Sustainable Income Format Three - Comprehensive Income
Illustration 13-7
Format Three - Comprehensive Income
Complete Income Statement
SO 3 Explain the concept of comprehensive income.

21. Sustainable Income
Illustration: In its draft 2010 income statement, AIR Corporation reports income before income taxes $400,000, extraordinary loss due to earthquake $100,000, income taxes $120,000 (not including irregular items), and loss on disposal of discontinued flower division $140,000. The income tax rate is 30%. Prepare a correct income statement, beginning with income before income taxes.
Solution on notes page

22. Comparative Analysis Analyzing financial statements involves:
Comparison
Bases
Basic Tools
Intracompany
Intercompany
Industry averages
Horizontal analysis
Vertical analysis
Ratio Analysis

23. Comparative Analysis Horizontal Analysis
Also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time.
Purpose - to determine increase or decrease that has taken place.
Commonly applied to the balance sheet and income statement.
SO 4 Describe and apply horizontal analysis.

24. changes and percentage changes.
Comparative Analysis
Illustration 13-11
Horizontal analysis of
balance sheets
Helpful Hint: When using horizontal analysis, be sure to examine both dollar amount
changes and percentage changes.
SO 4 Describe and apply horizontal analysis.

25. Comparative Analysis
Illustration 13-12
Horizontal analysis of
Income statements
Helpful Hint: In horizontal analysis, while the amount column is additive (the total is $99 million), the percentage column is not additive (9.9% is not a total).
SO 4 Describe and apply horizontal analysis.

26. Comparative Analysis Solution
Illustration: Summary financial information for Rosepatch Company is as follows.
Compute the amount and percentage changes in 2010 using horizontal analysis, assuming 2009 is the base year.
Solution
Solution on notes page
SO 4 Describe and apply horizontal analysis.

27. Comparative Analysis Vertical Analysis
Also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount.
Vertical analysis is commonly applied to the balance sheet and the income statement.
SO 5 Describe and apply vertical analysis.

28. These results indicate the company shifted
Comparative Analysis
These results indicate the company shifted
toward equity financing by relying less on debt and by increasing the amount
of retained earnings.
SO 5 Describe and apply vertical analysis.

29. Comparative Analysis
Illustration 13-14
Vertical analysis of an income statements
Kellogg’s increase in net income as a percentage of sales is due primarily to the decrease in interest expense and income tax expense
as a percent of sales.
SO 5 Describe and apply vertical analysis.

30. Comparative Analysis
Illustration 13-15
Intercompany comparison by vertical analysis
Vertical analysis also enables a comparison of companies of different sizes.
Although Kellogg’s net sales are less than those of General Mills, vertical analysis eliminates the impact of this size difference for our analysis.
SO 5 Describe and apply vertical analysis.

31. Financial Ratio Classifications
Ratio Analysis
Ratio analysis expresses the relationship among selected items of financial statement data.
Financial Ratio Classifications
Liquidity
Solvency
Profitability
Measures short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Measures the ability of the company to survive over a long period of time.
Measures the income or operating success of a company for a given period of time.
SO 6 Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

32. Ratio Analysis Liquidity Ratios
Illustration 13-16
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

33. Ratio Analysis Solvency Ratios
Illustration 13-17
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

34. Ratio Analysis Profitability Ratios
Illustration 13-18
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

36. Quality of Earnings
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.
Recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business.
SO 7 Understand the concept of quality of earnings.

37. Quality of Earnings Alternative Accounting Methods Pro Forma Income
Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings (FIFO vs. LIFO).
Pro Forma Income
Usually excludes items that are unusual or nonrecurring.
Some companies have abused the flexibility that pro forma numbers allow to put their companies in a more favorable light.
SO 7 Understand the concept of quality of earnings.

38. Quality of Earnings Improper Recognition
Some managers have felt pressure to continually increase earnings.
Abuses include:
Improper recognition of revenue (channel stuffing).
Improper capitalization of operating expenses (WorldCom).
Failure to report all liabilities (Enron).
SO 7 Understand the concept of quality of earnings.

39. Quality of Earnings Price-Earnings Ratio
Reflects investors’ assessment of a company’s future earnings.
P-E ratio will be higher if investors think that earnings will increase substantially in the future.
P-E ratio will be lower when there is the belief that a company has poor-quality earnings.
Illustration 13-19
SO 7 Understand the concept of quality of earnings.

40. Quality of Earnings Price-Earnings Ratio
Illustration 13-19
Illustration 13-20
Earnings per share and P-E
ratios of various companies
SO 7 Understand the concept of quality of earnings.

42. Quality of Earnings Solvency Pro forma Comprehensive income
Illustration: Match each of the following terms with the phrase that it best matches.
Comprehensive income Vertical analysis
Quality of earnings Pro forma income
Solvency ratio Extraordinary items
Measures the ability of the company to survive over a long period of time.
Usually excludes items that a company thinks are unusual or non-recurring.
Includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.
Solvency
Pro forma
Comprehensive income
SO 7 Understand the concept of quality of earnings.

43. Quality of Earnings Quality of earnings Extraordinary items
Illustration: Match each of the following terms with the phrase that it best matches.
Comprehensive income Vertical analysis
Quality of earnings Pro forma income
Solvency ratio Extraordinary items
Indicates the level of full and transparent information provided to users of the financial statements.
Describes events and transactions that are unusual in nature and infrequent in occurrence.
Expresses each item within a financial statement as a percent of a base amount.
Quality of earnings
Extraordinary items
Vertical analysis
SO 7 Understand the concept of quality of earnings.

44. Comprehensive Illustration of Ratio Analysis
Appendix
Analyzing financial statements involves:
Characteristics
Comparison
Bases
Liquidity
Profitability
Solvency
Intracompany
Industry averages
Intercompany
The financial information in Illustrations 13A-1 through 13A-4 will be used to calculate Kellogg’s 2007 ratios.

45. Comprehensive Illustration of Ratio Analysis
Illustration 13A-1

46. Comprehensive Illustration of Ratio Analysis
Illustration 13A-2
Illustration 13A-4

47. Comprehensive Illustration of Ratio Analysis
Illustration 13A-3

48. Comprehensive Illustration of Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.
Ratios include the current ratio, the current cash debt coverage ratio, the receivables turnover ratio, the average collection period, the inventory turnover ratio, and average days in inventory.

49. Comprehensive Illustration of Ratio Analysis
Current Ratio - Expresses the relationship of current assets to current liabilities. Calculate the current ratio for Kellogg for 2007 and 2006.
Illustration 13A-5
.67
.60
What do the measures tell us?
A current ratio of .67 means that for every dollar of current liabilities, Kellogg has $0.67 of current assets.

50. Comprehensive Illustration of Ratio Analysis
Cash Debt Coverage Ratio - Because it uses cash provided by operating activities, it may provide a better representation of liquidity. Calculate the ratio for Kellogg for 2007 and 2006
Illustration 13A-6
.37
.39
Is the coverage adequate?
Probably so. Kellogg’s coverage is better than that of General Mills, and it approximates a commonly accepted threshold of .40.

51. Comprehensive Illustration of Ratio Analysis
Receivables Turnover Ratio – Measures the number of times, on average, a company collects receivables during the period. Calculate the ratio for Kellogg for 2007 and 2006.
Illustration 13A-7
11.9
12.0
How does Kellogg’s turnover compare to General Mills’s?
The turnover of 11.9 times compares favorably with the industry average of 11.5 times, but is lower than General Mills’s turnover of 13.3 times.

52. Comprehensive Illustration of Ratio Analysis
Average Collection Period – Converts the receivable turnover ratio into days. Calculate the collection period for Kellogg for 2007 and 2006.
Illustration 13A-8
30.7
30.4
How effective is Kellogg’s credit and collection policies?
General rule - collection period should not greatly exceed the credit term period (i.e., the time allowed for payment).

53. Comprehensive Illustration of Ratio Analysis
Inventory Turnover Ratio - Measures the number of times average inventory was sold during the period.
Calculate the ratio for Kellogg for 2007 and 2006.
Illustration 13A-9
7.5
7.9
How does Kellogg’s turnover compare to General Mills’s?
The ratio of 7.5 times is higher than the industry average of 6.6 times and better than General Mills’s 7.1 times.

54. Comprehensive Illustration of Ratio Analysis
Days in Inventory - Measures the average number of days inventory is held. Calculate the days for Kellogg for 2007 and 2006.
Illustration 13A-10
48.7
46.2
How does Kellogg’s days compare to General Mills’s?
An average selling time of 49 days is faster than the industry average and faster than that of General Mills.

55. Comprehensive Illustration of Ratio Analysis
Solvency Ratios
Solvency ratios measure the ability of a company to survive over a long period of time.
Debt-Paying Ability
Debt to total assets ratio
Times interest earned ratio
Cash debt coverage ratio
Free cash flow provides information about solvency and ability to pay additional dividends or invest.

56. Comprehensive Illustration of Ratio Analysis
Debt to Total Assets Ratio – Indicates the degree of financial leveraging. Provides some indication of the company’s ability to withstand losses. Calculate the ratio for Kellogg for 2007 and 2006.
Illustration 13A-11
78%
81%
Has Kellogg’s solvency improved during the year?
Yes, slightly. The ratio of 78% says that Kellogg would have to liquidate 78% of its assets at their book value in
order to pay off all of its debts.

57. Comprehensive Illustration of Ratio Analysis
Times Interest Earned Ratio - (also called interest coverage) indicates the company’s ability to meet interest payments as they come due. Calculate the ratio for Kellogg for 2007 and 2006.
Illustration 13A-12
5.8
5.8
Is Kellogg better able to service its’ debt?
Yes, the debt to total assets ratio decreased during 2007 and the times interest earned ratio held constant.

58. Comprehensive Illustration of Ratio Analysis
Cash Debt Coverage Ratio - Indicates a company’s ability to repay its liabilities from cash generated from operating activities without having to liquidate the assets used in its operations. Calculate the ratio for Kellogg.
Illustration 13A-13
.17
.17
One way of interpreting this ratio is to say that net cash generated from one year of operations would be sufficient to pay off 17% of Kellogg’s total liabilities.

59. Comprehensive Illustration of Ratio Analysis
Free Cash Flow - Ability to pay dividends or expand operations. Calculate the ratio for Kellogg.
Illustration 13A-14
556
507
(in millions)
Cash provided by operations was more than enough to allow Kellogg to acquire additional productive assets and maintain dividend payments.

60. Comprehensive Illustration of Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for a given period of time.
Illustration 13A-15
Relationships among
profitability measures

61. Comprehensive Illustration of Ratio Analysis
Return on Common Stockholders’ Equity Ratio - Shows how many dollars of net income the company earned for each dollar invested by the owners. Calculate the ratio for Kellogg.
Illustration 13A-16
48%
46%
Kellogg’s 2007 rate of return on common stockholders’ equity is unusually high at 48%, considering an industry average of 23% and General Mills’s return of 21%.

62. Comprehensive Illustration of Ratio Analysis
Return on Assets Ratio - Measures the overall profitability of assets in terms of the income earned on each dollar invested in assets. Calculate the ratio.
Illustration 13A-17
10%
9.4%
Note that Kellogg’s rate of return on common stockholders’ equity (48%) is substantially higher than its rate of return on assets (10%). Kellogg has made effective use of leverage.

63. Comprehensive Illustration of Ratio Analysis
Profit Margin Ratio - Or rate of return on sales, is a measure of the percentage of each dollar of sales that
results in net income. Calculate the ratio for Kellogg.
Illustration 13A-18
9.4%
9.2%
High-volume (high inventory turnover) businesses such as grocery stores and pharmacy chains generally have low profit margins.

64. Comprehensive Illustration of Ratio Analysis
Asset Turnover Ratio - Measures how efficiently a company uses its assets to generate sales. Calculate the ratio for Kellogg.
Illustration 13A-19
1.07
1.02
The average asset turnover for utility companies is .45, for example, while the grocery store industry has an average asset turnover of 3.49.

65. Comprehensive Illustration of Ratio Analysis
You can analyze the combined effects of profit margin and asset turnover on return on assets for Kellogg as shown
Illustration 13A-20

66. Comprehensive Illustration of Ratio Analysis
Gross Profit Rate - Indicates a company’s ability to maintain an adequate selling price above its cost of goods sold. Calculate the ratio for Kellogg.
Illustration 13A-21
44%
44%
As an industry becomes more competitive, this ratio declines.

67. Comprehensive Illustration of Ratio Analysis
Earnings Per Share - A measure of the net income earned on each share of common stock. Calculate the ratio for Kellogg.
Illustration 13A-22
$2.63
$2.40

68. Comprehensive Illustration of Ratio Analysis
Price-Earnings (P-E) Ratio - Reflects investors’ assessments of a company’s future earnings. Calculate the ratio for Kellogg.
Illustration 13A-23
20.1
20.9
A higher P-E ratio suggests that the market is more optimistic about Kellogg. It might also signal that its stock is overpriced.

69. Comprehensive Illustration of Ratio Analysis
Payout Ratio - Measures the percentage of earnings distributed in the form of cash dividends. Calculate the ratio for Kellogg.
Illustration 13A-24
43%
45%
This ratio should be calculated over a longer period of time to evaluate any trends.

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