1. Accounting, Fifth Edition13
FINANCIAL ANALYSIS:
THE BIG PICTURE
Accounting, Fifth Edition

2. Learning Objectives
After studying this chapter, you should be able to:
Understand the concept of sustainable 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.*
* This is primarily a self-study/overview chapter.

3. Sustainable Income Irregular Items
Sustainable Income – Calculating an income amount to only include those items that are maintainable over time, as such net income is adjusted for one-time/irregular items.
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.
LO 1 Understand the concept of sustainable income.
LO 2 Indicate how irregular items are presented.

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

5. 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.
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.”
LO 2 Indicate how irregular items are presented.

6. 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
LO 2 Indicate how irregular items are presented.

7. 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
LO 2 Indicate how irregular items are presented.

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

10. 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 is to determine increase or decrease that has taken place.
Commonly applied to the balance sheet and income statement.
LO 4 Describe and apply horizontal analysis.

11. 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.
LO 4 Describe and apply horizontal analysis.

12. 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).
LO 4 Describe and apply horizontal analysis.

13. Advance slide in presentation mode to reveal solution.
Summary financial information for Rosepatch Company is as follows.
Compute the amount and percentage changes in 2012 using horizontal analysis, assuming 2011 is the base year.
Solution
Advance slide in presentation mode to reveal solution.
LO 4 Describe and apply horizontal analysis.

14. 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.
LO 5 Describe and apply vertical analysis.

15. These results indicate the company shifted
Comparative Analysis
Illustration 13-13
Vertical analysis of Income statements
These results indicate the company shifted
toward equity financing by relying less on debt and by increasing the amount
of retained earnings.
LO 5 Describe and apply vertical analysis.

16. Comparative Analysis
Illustration 13-14
Vertical analysis of an income statements
The increase in net income as a percentage of net sales is due primarily to the decrease in interest expense and income tax expense as a percentage of sales.
LO 5 Describe and apply vertical analysis.

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

18. 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.
LO 6 Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

19. Ratio Analysis Liquidity Ratios
Illustration 13-16
LO 6 Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

20. Ratio Analysis Solvency Ratios
Illustration 13-17
LO 6 Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

21. Ratio Analysis
Profitability Ratios
Illustration 13-18
LO 6

22. 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.
LO 7 Understand the concept of quality of earnings.

23. 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
LO 7 Understand the concept of quality of earnings.

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

25. Comprehensive Ratio Analysis
Appendix 13A
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 Chicago’s 2011 ratios.
LO 8 Evaluate a company comprehensively using ratio analysis.

26. Comprehensive Ratio Analysis
Appendix 13A
Illustration 13A-1
LO 8

27. Comprehensive Ratio Analysis
Appendix 13A
Illustration 13A-2 & 13A-4
LO 8

28. Comprehensive Ratio Analysis
Appendix 13A
Illustration 13A-3
LO 8

29. Comprehensive Ratio Analysis
Appendix 13A
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, the accounts receivables turnover, the average collection period, the inventory turnover, and days in inventory.
LO 8 Evaluate a company comprehensively using ratio analysis.

30. Comprehensive Ratio Analysis
Appendix 13A
Current Ratio - Expresses the relationship of current assets to current liabilities.
Illustration 13A-5
What do the measures tell us?
A current ratio of .67 means that for every dollar of current liabilities, the company has $0.67 of current assets.
LO 8 Evaluate a company comprehensively using ratio analysis.

31. Comprehensive Ratio Analysis
Appendix 13A
Current Cash Debt Coverage - Because it uses cash provided by operating activities, it may provide a better representation of liquidity.
Illustration 13A-6
Is the coverage adequate?
Probably so. Chicago’s coverage is better than that of General Mills, and it approximates an accepted threshold of .40.
LO 8 Evaluate a company comprehensively using ratio analysis.

32. Comprehensive Ratio Analysis
Appendix 13A
Accounts Receivables Turnover – Measures the number of times, on average, a company collects receivables during the period.
Illustration 13A-7
How does Chicago’s turnover compare to General Mills’s?
The turnover of 11.9 times is higher than the industry average of 11.2 times, and slightly lower than General Mills’ turnover of 12.4 times.
LO 8 Evaluate a company comprehensively using ratio analysis.

33. Comprehensive Ratio Analysis
Appendix 13A
Average Collection Period – Converts the receivable turnover ratio into days.
Illustration 13A-8
How effective is Chicago’s credit and collection policies?
General rule - collection period should not greatly exceed the credit term period (i.e., the time allowed for payment).
LO 8 Evaluate a company comprehensively using ratio analysis.

34. Comprehensive Ratio Analysis
Appendix 13A
Inventory Turnover - Measures the number of times average inventory was sold during the period.
Illustration 13A-9
How does Chicago’s turnover compare to General Mills’s?
The ratio of 7.5 times is higher than the industry average of 6.7 times and better than General Mills’s 6.5 times.
LO 8 Evaluate a company comprehensively using ratio analysis.

35. Comprehensive Ratio Analysis
Appendix 13A
Days in Inventory - Measures the average number of days inventory is held.
Illustration 13A-10
How does Chicago’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.
LO 8 Evaluate a company comprehensively using ratio analysis.

36. Comprehensive Ratio Analysis
Appendix 13A
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
Cash debt coverage
Free cash flow provides information about solvency and ability to pay additional dividends or invest.
LO 8 Evaluate a company comprehensively using ratio analysis.

37. Comprehensive Ratio Analysis
Appendix 13A
Debt to Assets Ratio – Indicates the degree of financial leveraging. Provides some indication of the company’s ability to withstand losses.
Illustration 13A-11
Has Chicago’s solvency improved during the year?
Yes, slightly. The ratio of 78% says that Chicago would have to liquidate 78% of its assets at their book value in order to pay off all of its debts.
LO 8 Evaluate a company comprehensively using ratio analysis.

38. Comprehensive Ratio Analysis
Appendix 13A
Times Interest Earned - (also called interest coverage) indicates the company’s ability to meet interest payments as they come due.
Illustration 13A-12
Is Chicago better able to service its’ debt?
Yes, the ratio indicates that income before interest and taxes was 5.8 times the amount needed for interest expense.
LO 8 Evaluate a company comprehensively using ratio analysis.

39. Comprehensive Ratio Analysis
Appendix 13A
Cash Debt Coverage - 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.
Illustration 13A-13
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 Chicago’s total liabilities.
LO 8 Evaluate a company comprehensively using ratio analysis.

40. Comprehensive Ratio Analysis
Appendix 13A
Free Cash Flow - Ability to pay dividends or expand operations. Calculate the ratio for Chicago.
Illustration 13A-14
(in millions)
Cash provided by operations was more than enough to allow Chicago to acquire additional productive assets and maintain dividend payments.
LO 8 Evaluate a company comprehensively using ratio analysis.

41. Comprehensive Ratio Analysis
Appendix 13A
Profitability Ratios
Measure the income or operating success of a company for a given period of time.
Illustration 13A-15
Relationships among
profitability measures
LO 8 Evaluate a company comprehensively using ratio analysis.

42. Comprehensive Ratio Analysis
Appendix 13A
Return on Common Stockholders’ Equity (ROE) - Shows how many dollars of net income the company earned for each dollar invested by the owners.
Illustration 13A-16
Chicago’s 2011 rate of return on common stockholders’ equity is unusually high at 48%, considering an industry average of 24% and General Mills’s return of 24%.
LO 8 Evaluate a company comprehensively using ratio analysis.

43. Comprehensive Ratio Analysis
Appendix 13A
Return on Assets - Measures the overall profitability of assets in terms of the income earned on each dollar invested in assets.
Illustration 13A-17
Note that Chicago’s rate of return on common stockholders’ equity (48%) is substantially higher than its rate of return on assets (10%). Chicago has made effective use of leverage.
LO 8 Evaluate a company comprehensively using ratio analysis.

44. Comprehensive Ratio Analysis
Appendix 13A
Profit Margin - Or rate of return on sales, is a measure of the percentage of each dollar of sales that results in net income.
Illustration 13A-18
High-volume (high inventory turnover) businesses such as grocery stores and pharmacy chains generally have low profit margins.
LO 8 Evaluate a company comprehensively using ratio analysis.

45. Comprehensive Ratio Analysis
Appendix 13A
Asset Turnover - Measures how efficiently a company uses its assets to generate sales.
Illustration 13A-19
The average asset turnover for utility companies is .45, for example, while the grocery store industry has an average asset turnover of 3.49.
LO 8 Evaluate a company comprehensively using ratio analysis.

46. Comprehensive Ratio Analysis
Appendix 13A
You can analyze the combined effects of profit margin and asset turnover on return on assets for Chicago as shown
Illustration 13A-20
LO 8 Evaluate a company comprehensively using ratio analysis.

47. Comprehensive Ratio Analysis
Appendix 13A
Gross Profit Rate - Indicates a company’s ability to maintain an adequate selling price above its cost of goods sold.
Illustration 13A-21
As an industry becomes more competitive, this ratio declines.
LO 8 Evaluate a company comprehensively using ratio analysis.

48. Comprehensive Ratio Analysis
Appendix 13A
Earnings Per Share - A measure of the net income earned on each share of common stock.
Illustration 13A-22
LO 8 Evaluate a company comprehensively using ratio analysis.

49. Comprehensive Ratio Analysis
Appendix 13A
Price-Earnings (P-E) Ratio - Reflects investors’ assessments of a company’s future earnings.
Illustration 13A-23
A higher P-E ratio suggests that the market is more optimistic about Chicago. It might also signal that its stock is overpriced.
LO 8 Evaluate a company comprehensively using ratio analysis.

50. Comprehensive Ratio Analysis
Appendix 13A
Payout Ratio - Measures the percentage of earnings distributed in the form of cash dividends.
Illustration 13A-24
This ratio should be calculated over a longer period of time to evaluate any trends.
LO 8 Evaluate a company comprehensively using ratio analysis.