1. FINANCIAL ANALYSIS: The Big Picture
Chapter 13
FINANCIAL ANALYSIS:
The Big Picture

2. Chapter 13 After studying Chapter 13, you should be able to:
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After studying Chapter 13, you should be able to:
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. 1

3. Chapter 13 After studying Chapter 13, you should be able to:
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Chapter 13
After studying Chapter 13, you should be able to:
Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.
Understand the concept of quality of earnings. 2

4. 11 1
Sustainable Income...
Is the most likely level of income to be obtained in the future.
Does not include irregular revenues, expenses, gains, or losses.

5. Components of the Income Statement
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6. PowerPoint Slides
Irregular Items 11 2
Two types of irregular items are reported -- (all net of taxes)
discontinued operations
extraordinary items 5

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

8. Discontinued Operations
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Discontinued Operations
Rozek net income of $800,000 from continuing operations in During 2007 the company discontinued and sold its unprofitable chemical division. The loss in 2007 from chemical operations (net of $90,000 taxes) was $210,000. The tax rate is 30%. 7

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

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Extraordinary Items
In 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

11. Presentation of Extraordinary Items...
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Presentation of Extraordinary Items... 9

12. PowerPoint Slides
Extraordinary Items 2

13. Estimating Sustainable Income
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Estimating Sustainable Income
When evaluating a company, it generally makes sense to eliminate all irregular items in estimating future sustainable income. 2

14. 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
Most changes are reported retroactively – improves comparability
Example: a change in inventory costing methods (such as FIFO to average cost). 17

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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

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

17. 11 3
Comprehensive Income
Includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders.

18. Complete Income Statement
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19. PowerPoint Slides
Comparative Analysis
There are three types of comparisons to improve decision usefulness of financial information:
Intracompany basis
Intercompany basis
Industry averages 30

20. Intracompany Basis
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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

21. Intercompany Basis
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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

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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

23. 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

24. PowerPoint Slides
Horizontal Analysis 11 4
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

25. Horizontal Analysis
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26. Horizontal Analysis- Balance Sheet
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27. PowerPoint Slides
Horizontal Analysis –
Income Statement 38

28. Review
In horizontal analysis, each item is expressed as a percentage of the:
a. net income amount.
d. base-year amount.
c. total assets amount.
b. stockholders’ equity amount.

29. Review
In horizontal analysis, each item is expressed as a percentage of the:
a. net income amount.
d. base-year amount.
c. total assets amount.
b. stockholders’ equity amount.

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Vertical Analysis 11 5
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 the base amount in vertical analysis of a balance sheet.
Net sales is the base amount in vertical analysis of an income statement. 45

31. Vertical Analysis - Balance Sheet
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32. Intercompany Comparison by Vertical Analysis
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Intercompany Comparison by Vertical Analysis 38

33. Review
In vertical analysis, the base amount for depreciation expense is generally:
a. net sales.
d. fixed assets.
c. gross profit.
b. depreciation expense in a previous year.

34. Review
In vertical analysis, the base amount for depreciation expense is generally:
a. net sales.
d. fixed assets.
c. gross profit.
b. depreciation expense in a previous year.

35. PowerPoint Slides 11 6
Ratio Analysis 57

36. Ratios Three types: Liquidity ratios Solvency ratios
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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

37. Liquidity Ratios WHO CARES?
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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

38. Liquidity Ratios
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39. 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

40. Solvency Ratios
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41. Profitability Ratios
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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

42. Profitability Ratios
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43. 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.
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44. Estimates
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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.
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Quality of Earnings 11 7
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.
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46. Alternative Accounting Methods
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Alternative Accounting Methods
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.
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Pro Forma Income
A measure of the net income generated that usually excludes items that the company thinks are unusual or nonrecurring.
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48. Improper Recognition
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Offering big discounts (channel stuffing) to companies to get them to buy early- Often leads to disaster in subsequent periods.
Improper capitalization of operating expenses
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49. PowerPoint Slides
Price Earnings Ratio
The P/E ratio reflects the investors’ assessment of a company’s future earnings.
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50. Earnings Per Share and Price Earnings Ratio
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Earnings Per Share and Price Earnings Ratio
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