1. Financial Accounting: Tools for Business Decision Making, 2nd Ed.
PowerPoint Slides
Kimmel, Weygandt, Kieso
Prepared by:
Ellen L. Sweatt
Georgia Perimeter College
ELS 2

2. Chapter 14 `
Financial Analysis:
The Big Picture

3. Chapter 14 Financial Analysis: The Big Picture
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After studying Chapter 14, you should be able to:
Understand the concept of earning power and indicate how irregular items are presented.
Discuss the need for comparative analysis and identify the tools of financial statement analysis.
Explain and apply horizontal analysis.
Describe and apply vertical analysis. 1

4. Chapter 14 Financial Analysis: The Big Picture
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Chapter 14 Financial Analysis: The Big Picture
After studying Chapter 14, you should be able to:
Identify and compute ratios and describe their purpose and use in analyzing a firm's liquidity, solvency, and profitability.
Discuss the limitations of financial statement analysis. 2

5. Earning Power
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The value of a company is a function of its future cash flows. 3

6. Earning Power... Is net income adjusted for irregular items.
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Is net income adjusted for irregular items.
Is the most likely level of income to be obtained in the future. 3

7. PowerPoint Slides
Irregular Items
Three types of irregular items are reported -- (all net of taxes)
discontinued operations
extraordinary items
changes in accounting principle 5

8. Discontinued Operations...
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Discontinued Operations...
Refers to the disposal of a significant segment of a business...
the elimination of a major class of customers or an entire activity. 6

9. Discontinued Operations
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Discontinued Operations
Assume Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million or net income of $800,000 from continuing operations in 2001.
During 2001 the company discontinued and sold its unprofitable chemical division. The loss in 2001 from chemical operations (net of $60,000 taxes) was $140,000, and the loss on disposal of the chemical division (net of $30,000 taxes) was $70,000. 7

10. Income Statement (Partial) For the Year Ended December 31, 2001
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Illustration 14-1
Rozek Inc.
Income Statement (Partial)
For the Year Ended December 31, 2001
Income before income taxes $800,000
Income tax expense (30% Tax Rate) 240,000
Income from continuing operations ,000 Discontinued operations
Loss from operations of chemical division, net of $60,000 income tax saving $140,000
Loss from disposal of chemical division, net of $30,000 income tax saving 70, ,000
Net income before extraordinary item 350,000 14

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

12. PowerPoint Slides
Illustration 14-2
Extraordinary Items 2

13. PowerPoint Slides
Illustration 14-2
Ordinary Items 2

14. PowerPoint Slides
Extraordinary Items
In 2001 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

15. Income Statement(Partial) For the Year Ended December 31, 2001
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Illustration 14-3
Rozek Inc.
Income Statement(Partial)
For the Year Ended December 31, 2001
Income before income taxes $800,000
Income tax expense 240,000
Income from continuing operations ,000 Discontinued operations
Loss from operations of chemical division, net of $60,000 income tax saving $140,000
Loss from disposal of chemical division, net of $30,000 income tax saving 70, ,000
Net income before extraordinary item 350,000
Extraordinary item
Expropriation of investment, net of $21,000 income tax saving ,000
Net income $301,000 14

16. Change in Accounting Principle
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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
the effects of the change are clearly disclosed in the income statement.
Examples:
a change in depreciation methods (such as declining-balance to straight-line)
a change in inventory costing methods (such as FIFO to average cost). 17

17. Change in Accounting Principle
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Change in Accounting Principle
The new principle should be used in reporting the results of operations of the current year.
The cumulative effect of the change on all prior-year income statements should be disclosed net of applicable taxes in a special section immediately preceding Net Income. 19

18. Changes in Accounting Principle
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Changes in Accounting Principle
Rozek Inc. changes from the straight-line method to the declining-balance method for equipment purchased on January 1, 1998.
The cumulative effect on prior-year income statements (statements for ) is to increase depreciation expense and decrease income before income taxes by $24,000.
If there is a 30% tax rate, the net-of-tax effect of the change is $16,800 ($24,000 x 70%). 20

19. Partial Income Statement For the Year Ended December 31, 2001
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Illustration 14-4
Rozek Inc.
Partial Income Statement
For the Year Ended December 31, 2001
Income before income taxes $800,000
Income tax expense ,000
Income from continuing operations ,000 Discontinued operations
Loss from operations of chemical division, net of $60,000 income tax saving $140,000
Loss from disposal of chemical division, net of $30,000 income tax saving 70, ,000
Net income before extraordinary item 350,000
Extraordinary item
Expropriation of investment, net of $21,000 income tax saving ,000
Cumulative effect of change in accounting principle
Effect on prior years of change in depreciation method, net of $ 7,200 tax ,800
Net Income ,200 14

20. 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

21. PowerPoint Slides
Comprehensive Income
Unrealized gains and losses on available-for-sale securities are excluded from net income because disclosing them separately -
reduces the volatility of net income due to fluctuations in fair value, yet
informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value. 26

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

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

24. PowerPoint Slides
Comparative Analysis
Any item reported in a financial statement has significance:
Its inclusion indicates that the item exists at a given time and in a certain quantity.
For example, when Kellogg Company reports $136.4 million on its balance sheet as cash, we know that Kellogg did have cash and that the quantity was $136.4 million. 28

25. PowerPoint Slides
Comparative Analysis
Whether the amount represents an increase over prior years, or whether it is adequate in relation to the company's needs, cannot be determined from the amount alone.
The amount must be compared with other financial data to provide more information. 29

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

27. PowerPoint Slides
Intracompany Basis
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

28. PowerPoint Slides
Intercompany Basis
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

29. 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

30. Financial Statement Analysis
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Financial Statement Analysis
Three basic tools are used in financial statement analysis :
1. Horizontal analysis
2. Vertical analysis
3. Ratio analysis 34

31. PowerPoint Slides
Horizontal Analysis
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

32. Net Sales (in millions)
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Illustration 14-7
Horizontal Analysis
KELLOGG COMPANY
Net Sales (in millions)
Base Period 1994
6, , , , ,562.0 36

33. Horizontal Analysis 6,562.0 CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT
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Illustration 14-6
Horizontal Analysis
CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT
BASE-YEAR AMOUNT
7, ,562.0 = 6.7%
6,562.0
Net sales for Kellogg company increased approximately 6.7% from 1994 to 1995. 37

34. Percentage Change in Sales
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Illustration 14-7
Percentage Change in Sales
The percentage change in sales for each of the 5 years, assuming 1994 as the base period is:
Kellogg Company
Net Sales (in millions) Base Period 1994
6, , , , ,562.0
103.0% % % % % 38

35. Horizontal Analysis of a Balance Sheet
Illustration 14-8
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Horizontal Analysis of a Balance Sheet
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Increase (Decrease)
during Amount Percent
Assets
Current Assets $1, $1, $
Plant assets , ,
Other assets
Total assets $5, $4, $ 39

36. Horizontal Analysis of a Balance Sheet
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Illustration 14-8
Increase (Decrease)
during 1998
Amount Percent
Liabilities and
Stockholders' Equity
Current liabilities $1,718.5 $1,
Long-term liabilities 2, ,
Total liabilities 4, ,
Stockholders' equity
Common stock
Retained earnings
and other 1,
Treasury stock (394.3) (157.3) (150.7)
Total stockholders'
equity (107.7) (10.8)
Total liabilities and
stockholders' equity $5,051.5 $4, $ 40

37. Condensed Income Statement For the Years Ended December 31
KELLOGG COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
Increase (Decrease)
during Amount Percent
Net sales $6, $6, ($68.0) (1.0)
Cost of goods sold , ,
Gross profit , , (80.5) (2.3)
Selling & Admin , ,
Nonrecurring charges (113.6) (61.7)
Income from operations , (114.0) (11.3)
Interest expense
Other income
(expense), net
Income before taxes (122.0) (13.5)
Income tax expense (60.6) (17.8) Net income $ $ ($61.4) (10.9)
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Illustration 14-9 42

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

39. Condensed Balance Sheets
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Illustration 14-10
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Assets Amount Percent Amount Percent
Current Assets $1, $1,
Plant assets , ,
Other assets
Total assets $5, % $4, % 46

40. Condensed Balance Sheets
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Illustration 14-10
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Liabilities and Amount Percent Amount Percent
Stockholders' Equity
Current liabilities $1, $1,
Long-term liabilities , ,
Total liabilities , ,
Stockholders' equity
Common stock
Retained earnings
and other ,
Treasury stock (394.3) ( 7.8) (157.3) (3.2)
Total stockholders'
equity
Total liabilities and
stockholders' equity $5, % $4, % 48

41. Condensed Income Statement For the Years Ended December 31
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Illustration 14-11
KELLOGG COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
Amount Percent Amount Percent
Net sales $6, $6,
Cost of goods sold 3, ,
Gross profit , ,
Selling & Admin , ,
Nonrecurring Chgs
Income operations ,
Interest expense Other income
(expense),net
Income before
income taxes
Income tax expense
Net income $ $ 51

42. PowerPoint Slides
Condensed Income Statements For the Year Ended December 31,1998 (in millions)
Illustration 14-12
The Quaker
Kellogg Company, Inc. Oats Company
Amount Percent Amount Percent
Net sales $6, $4,
Cost of goods sold , ,
Gross profit , ,
Selling and administrative
expenses , ,
Nonrecurring charges
Income from operations
Other expenses and
revenues (including
income taxes)
Net income $ $ 55

43. PowerPoint Slides
Ratio Analysis 57

44. Ratios Three types: Liquidity ratios Solvency ratios
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Ratios
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

45. Liquidity Ratios WHO CARES?
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Liquidity Ratios
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

46. Liquidity Ratios Current ratio Acid-test ratio
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Liquidity Ratios
Current ratio
Acid-test ratio
Current cash debt coverage ratio
Receivables turnover ratio
Average collection period
Inventory turnover
Average days in inventory 61

47. Current Ratio Indicates short-term debt-paying ability Current Assets
Illustration 14-17
Current Ratio
Indicates short-term debt-paying ability
Current Assets
Current Liabilities 32

48. Acid-Test Ratio Indicates immediate short-term debt-paying ability
Illustration 14-18
Acid-Test Ratio
Indicates immediate short-term debt-paying ability
Cash + Short-term Investments
+ Net Receivable
Current Liabilities 32

49. Current Cash Debt Coverage Ratio
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Current Cash Debt Coverage Ratio
Illustration 14-19
Indicates short-term debt-paying ability (cash basis)
Cash provided by operations Average current liabilities 92

50. Receivables Turnover Ratio
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Illustration 14-20
Indicates liquidity of receivables
Net Credit Sales
Average Net Receivables 28

51. Average Collection Period
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Illustration 14-21
Indicates liquidity of receivables and collection success
365 days
Receivables Ratio Turnover 28

52. Inventory Turnover Ratio
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Illustration 14-22
Inventory Turnover Ratio
Indicates liquidity of inventory
Cost of Goods Sold
Average Inventory 73

53. Average Days in Inventory
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Illustration 14-23
Average Days in Inventory
Indicates liquidity of inventory and inventory management
365 days
Inventory Turnover Ratio 35

54. Solvency Ratios WHO CARES?
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Solvency Ratios
Measure the ability of the enterprise to survive over a long period of time
WHO CARES?
Long-term creditors and stockholders 60

55. Solvency Ratios Debt to total assets ratio Times interest earned ratio
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Solvency Ratios
Debt to total assets ratio
Times interest earned ratio
Cash debt coverage ratio
Free cash flow 61

56. Debt to Total Assets Ratio
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Illustration 14-24
Indicates % of total assets provided by creditors
Total Liabilities
Total Assets 79

57. Times Interest Earned Ratio
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Illustration 14-25
Indicates company’s ability to meet interest payments as they come due
Interest Before Interest
Expense & Income Tax
Interest Expense 79

58. Cash Debt Coverage Ratio
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Cash Debt Coverage Ratio
Illustration 14-26
Indicates long-term debt-paying ability (cash basis)
Cash provided by operations
Average total liabilities 92

59. Free Cash Flow - Capital Expenditures - Dividends Paid Free Cash Flow
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Illustration 14-27
Free Cash Flow
Indicates cash available for paying dividends or expanding operations
Cash Provided By Operations
Capital Expenditures
Dividends Paid
Free Cash Flow 81

60. PowerPoint Slides
Profitability Ratios
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

61. Profitability Ratios Return on common stockholders’ equity ratio
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Profitability Ratios
Return on common stockholders’ equity ratio
Return on assets ratio
Profit margin ratio
Assets turnover ratio
Gross profit rate
Operating expenses to sales ratio
Cash return on sales ratio
Earnings per share (EPS)
Price-earnings ratio
Payout ratio 61

62. Relationships Among Profitability Measures
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Illustration 14-28
Relationships Among Profitability Measures 2

63. Return on Common Stockholders’ Equity Ratio
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Illustration 14-29
Return on Common Stockholders’ Equity Ratio
Indicates profitability of common stockholders’ investment
Net income -preferred stock dividends
Average common stockholders’ equity 93

64. Return On Assets Ratio Net income Average total assets
Illustration 14-30
Return On Assets Ratio
Reveals the amount of net income generated by each dollar invested
Net income
Average total assets
Higher value suggests favorable efficiency. 18

65. Profit Margin Ratio Net income Net sales
Illustration 14-31
Profit Margin Ratio
Indicates net income generated by each dollar of sales
Net income
Net sales
Higher value suggests favorable return on each dollar of sales. 19

66. Asset Turnover Ratio Net sales Average total assets
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Illustration 14-32
Asset Turnover Ratio
Indicates how efficiently assets are used to generate sales
Net sales
Average total assets 45

67. Gross Profit Rate Gross profit Net sales
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Illustration 14-34
Gross Profit Rate
Indicates margin between selling price and cost of good sold
Gross profit
Net sales 45

68. Operating Expenses to Sales Ratio
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Illustration 14-35
Operating Expenses to Sales Ratio
Indicates the cost incurred to support each dollar of sales
Operating expenses
Net sales 45

69. Cash Return on Sales Ratio
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Illustration 14-36
Cash Return on Sales Ratio
Indicates net cash flow generated by each dollar of sales
Cash provided by operations
Net sales
101

70. Earnings Per Share (EPS)
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Illustration 14-37
Earnings Per Share (EPS)
Indicates net income earned on each share of common stock sales
Income available to common stockholders
Average number of outstanding common shares
101

71. Price Earnings Ratio Stock Price Earnings Per Share
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Illustration 14-38
Price Earnings Ratio
Indicates relationship between market price per share and earnings per share
Stock Price
Earnings Per Share
101

72. Payout Ratio Cash Dividends Net Income
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Illustration 14-39
Payout Ratio
Indicates % of earnings distributed in the form of cash dividends
Cash Dividends
Net Income
101

73. Limitations Of Financial Analysis
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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

74. PowerPoint Slides
Estimates
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

75. PowerPoint Slides
Cost
Traditional financial statements are based on historical cost and are not adjusted for price level changes.
Comparisons of unadjusted financial data from different periods may be rendered invalid by significant inflation or deflation.
109

76. Alternative Accounting Methods
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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

77. PowerPoint Slides
Atypical Data
Fiscal year-end data may not be typical of a company's financial condition during the year.
111

78. PowerPoint Slides
Diversification
Diversification in American industry also limits the usefulness of financial analysis.
Many firms are so diverse they cannot be classified by industry.
112