managerial Accounting ch14

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Chapter 14

Financial Statement

AnalysisLearning Objectives

After studying this chapter, you should be able to:

1. Discuss the need for comparative analysis.

2. Identify the tools of financial statement analysis.

3. Explain and apply horizontal analysis.

4. Describe and apply vertical analysis.

5. Identify and compute ratios used in analyzing a firms liquidity, profitability, andsolvency.

6. Understand the concept of earning power, and how irregular items are presented.

7. Understand the concept of quality of earnings.


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Preview ofChapter 14

Managerial Accounting

Sixth Edition

Weygandt Kimmel Kieso


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Analyzing financial statements involves:

CharacteristicsComparison

BasesTools ofAnalysis

Liquidity

Profitability

Solvency

Intracompany

Industry

averages Intercompany

Horizontal

Vertical

Ratio

LO 1 Discuss the need for com parative analys is.LO 2 Identify the too ls of financ ial statement analysis .

Basics of Financial Statement Analysis


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14-5 LO 3 Expla in and apply hor izontal analys is.

Horizontal analysis, also called trend analysis:

Technique for evaluating a series of financial statement

data over a period of time.

Purposeis to determine the increase or decrease that hastaken place.

Commonly applied to the balance sheet, income statement,

and statement of retained earnings.

Horizontal Analysis


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14-6LO 3

These changes

suggest that the

company expanded its

asset base during2009 and financed

this expansion

primarily by retaining

income rather than

assuming additionallong-term debt.

Balance Sheet

Illustration 14-5

Horizontal analysis ofbalance sheets

Horizontal Analysis


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14-7 LO 3 Expla in and apply hor izontal analys is.

Overall, gross profit

and net income were

up substantially. Grossprofit increased

17.1%, and net

income, 26.5%.

Qualitys profit trend

appears favorable.

IncomeStatement

Illustration 14-6

Horizontal analysis ofIncome statements

Horizontal Analysis


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14-8LO 3

Ending retained earnings increased 38.6%. As indicated earlier, the company

retained a significant portion of net income to finance additional plant

facilities.

Illustration 14-7

Horizontal analysis ofretained earnings statementsRetained Earnings Statement

Horizontal Analysis


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Financial information for Rosepatch Company is as follows.

LO 3

Compute the amount and percentage changes in 2014 using

horizontal analysis, assuming 2013 is the base year.


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14-10 LO 4 Describ e and app ly vert ical analysis .

Vertical analysis, also called common-size analysis:

Technique that expresses each financial statement item as

a percent of a base amount.

On an income statement, we might say that selling

expenses are 16% of net sales.

Commonly applied to the balance sheet and the income

statement.

Vertical Analysis


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Illustration 14-8

These results

reinforce the earlier

observations thatQuality is

choosing to

finance its growth

through retention

of earnings ratherthan through

issuing additional

debt.

BalanceSheet

LO 4

Vertical Analysis


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Quality appears

to be a profitable

enterprise that is

becoming even

more successful.

IncomeStatement

Vertical Analysis

Illustration 14-9

LO 4


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Enables a comparison of companies of different sizes.

Vertical Analysis

LO 4

Illustration 14-10


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14-14 LO 5 Ident i fy and com pute ratios used in analyz ing afirms liquidity, profitability, and solvency.

Ratio analysisexpresses the relationship among selecteditems of financial statement data.

Liquidity Profitability Solvency

Measures short-term ability of the

company to pay itsmaturing obligations

and to meetunexpected needs

for cash.

Financial Ratio Classifications

Measures theincome or operating

success of acompany for agiven period of

time.

Measures the abilityof the company to

survive over a longperiod of time.

Ratio Analysis


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Ratios will include the following types of comparisons.

1. Intracompany comparisonsfor two years for Quality

Department Store.

2. Industry average comparisonsbased on median ratios for

department stores.

3. Intercompany comparisonsbased on J.C. Penney Companyas Quality Department Stores principal competitor.

A single ratioby itself is not very meaningful.

Ratio Analysis


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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 acid-test ratio,

receivables turnover, and inventory turnover.

Ratio Analysis


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14-17 LO 5

1. Current Ratio

The ratio of 2.96:1 means that for every dollar of current liabilities,

Quality has $2.96 of current assets.

Illustration 14-12

Ratio Analysis Liquidity Ratios


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2. Acid-Test RatioIllustration 14-13


LO 5


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Measures immediate short-term liquidity.

Illustration 14-14


2. Acid-Test Ratio


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3. Receivables Turnover

Number of times, on average, the company collects receivables.

Illustration 14-15


LO 5


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A variantof the receivables turnover ratio is to convert it to an

average collection period in terms of days.

This means that receivables are collected on average every 36days.

$2,097,000

($180,000 + $230,000) 2= 10.2 times

365 days 10.2 times = every 35.78 days

Receivables Turnover



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4. Inventory Turnover

Number of times, on average, the inventory is sold.

Illustration 14-16


LO 5


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A variantof inventory turnover is the days in inventory.

Inventory turnover ratios vary considerably among industries.

365 days 2.3 times = every 159 days

$1,281,000

($500,000 + $620,000) 2= 2.3 times

Inventory Turnover



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Profitability Ratios

Measure the income or operating success of a company for a

given period of time.

Income, or the lack of it, affects the companys ability to obtain

debt and equity financing, liquidity position, and the ability to

grow.

Ratios include the profit margin, asset turnover, return on

assets, return on common stockholders equity, earnings

per share, price-earnings, and payout ratio.

Ratio Analysis


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5. Profit Margin

Measures net income generated by each dollar of sales.

Illustration 14-17

Ratio Analysis Profitability Ratios

LO 5


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6. Asset Turnover

Measures how efficiently assets are used to generate sales.

Illustration 14-18


LO 5


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7. Return on Assets

An overall measure of profitability.

Illustration 14-19


LO 5


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8. Return on Common Stockholders Equity

Dollars of net income earned for each dollar invested by the owners.

Illustration 14-20


LO 5


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9. Earnings per Share (EPS)

Measures net income earned on each share of common stock.

Illustration 14-21


LO 5


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10. Price-Earnings RatioIllustration 14-22


Reflects investors assessments of a companys future earnings.

LO 5


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11. Payout Ratio

Measures the percentage of earnings distributed in the form of cashdividends.

* From analysis of retained earnings.

*

Illustration 14-23



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Solvency Ratios

Solvency ratios measure the ability of a company to survive

over a long period of time.

Debt to total assetsand times interest earnedare two

ratios that provide information about debt-paying ability.

Ratio Analysis


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12. Debt to Total Assets Ratio

Measures the percentage of the total assets provided by creditors.

Illustration 14-24

Ratio Analysis Solvency Ratios

LO 5


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13. Times Interest Earned

Provides an indication of the companys ability to meet interest

payments as they come due.

Illustration 14-25

Ratio Analysis Solvency Ratios

LO 5


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Illustration 14-26

Summary of Ratios

LO 5


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Illustration 14-26

Summary of Ratios

LO 5


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Illustration 14-26

Summary of Ratios

LO 5


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14-39 LO 6 Understand the conc ept of earning power,and how irregular i tems are presented.

Earning power means the normal level of income to beobtained in the future.

Irregular items are separately identified on the income

statement. Two types are:1. Discontinued operations.

2. Extraordinary items.

These irregular items are reported net of income taxes.

Earning Power and Irregular Items


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Discontinued Operations

(a) Refers to the disposal of a significant component of a

business.

(b) Report the income (loss) from discontinued operations in

two parts:

1. income (loss) from operations (net of tax) and

2. gain (loss) on disposal (net of tax).

LO 6 Understand the conc ept of earning power,and how irregular i tems are presented.



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Illustration: During 2014 Acro Energy Inc. has income before

income taxes of $800,000. During 2014, Acro discontinued and sold its

unprofitable chemical division. The loss in 2014 from chemical operations

(net of $60,000 taxes) was $140,000. The loss on disposal of the chemical

division (net of $30,000 taxes) was $70,000. Assuming a 30% tax rate on

income.


Illustration 14-27

LO 6


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DiscontinuedOperationsare reported

after Income from

continuing operations.

Previously labeled as

Net Income.

Moved to

Interest expense (21,000)

Total other (4,000)

Income before taxes 79,000

Income tax expense 24,000

Income from continuing operations 55,000

Discontinued operations:

Loss from operations, net of tax 315Loss on disposal, net of tax 189

Total loss on discontinued operations 504

Net income 54,496$

Income Statement (in thousands)

Sales 285,000$

Cost of goods sold 149,000

Gross profit 136,000


LO 6


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Extraordinary itemsare nonrecurring material items that differsignificantly from a companys typical business activities.

Extraordinary Item must be both of an

Unusual Nature and

Occur Infrequently

Company must consider the environment in which it operates.

Amount reported net of tax.


LO 6


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YES

NO

NO

NO

Are these considered Extraordinary Items?(a) A large portion of a tobacco manufacturers

crops are destroyed by a hail storm. Severe

damage from hail storms in the locality where

the manufacturer grows tobacco is rare.

(b) A citrus grower's Florida crop is damaged by

frost.

(c) Loss from sale of temporary investments.

(d) Loss attributable to a labor strike.


LO 6


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(e) Loss from flood damage. (The nearby Black

River floods every 2 to 3 years.)

(f) An earthquake destroys one of the oilrefineries owned by a large multi-national oil

company. Earthquakes are rare in this

geographical location.

(g) Write-down of obsolete inventory.

(h) Expropriation of a factory by a foreign

government.

NO

YES

YES

NO


Are these considered Extraordinary Items?

LO 6


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Illustration:In 2014 a foreign government expropriated property held asan investment by Acro Energy Inc. If the loss is $70,000 before applicable

income taxes of $21,000, the income statement will report a deduction of

$49,000.Illustration 14-29

LO 6



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Extraordinary Items

are reported after

Income from continuing

operations.

Other revenue (expense):Interest revenue 17,000


Total other (4,000)




Extraordinary loss, net of tax 539

Net income 54,461$

Income Statement (in thousands)Sales 285,000$



Previously labeled asNet Income.

Moved to


LO 6


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Reporting when bothDiscontinued

Operationsand

Extraordinary Items

are present.

Discontinued

Operations

Income before taxes 79,000Income tax expense 24,000


Discontinued operations:

Loss from operations, net of tax 315

Loss on disposal, net of tax 189

Total loss on discontinued operations 504

Income before extraordinary item 54,496

Extraordinary loss, net of tax 539

Net income 54,496$

Income Statement (in thousands)Sales 285,000$



Extraordinary Items


LO 6


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Change in Accounting Principle

Occurs when the principleused in the current year is

differentfrom the one used in the preceding year.

Accounting rules permit a change ifjustified.

Changes are reported retroactively.

Example would include a change in inventory costing

method such as FIFO to average cost.




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In its proposed 2014 income statement, AIR Corporationreports income before income taxes $400,000, extraordinary

loss due to earthquake $100,000, income taxes $120,000 (not

including irregular items), loss on operation of discontinued

flower division $50,000, and loss on disposal of discontinuedflower division $90,000. The income tax rate is 30%.

Prepare a correct income statement, beginning with Income

before income taxes.



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14-52 LO 6

Prepare a correct income statement


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Income Statement (in thousands)

Sales 285,000$



Operating expenses:

Selling expenses 10,000

Administrative expenses 43,000

Total operating expense 53,000

Income from operations 83,000

Other revenue (expense):

Interest revenue 17,000


Total other (4,000)



Net income 55,000$

Other Comprehensive

Income

Unrealized gains and

losses on available-for-

sale securities. Translation gains and

losses on foreign

currency.

Plus others

+

Reported in Stockholders

Equity

Comprehensive Income

LO 6


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Why are gains and losses on available-for-sale securitiesexcluded from net income?

Because disclosing them separately

1. reduces the volatility of net income due to fluctuations in fair

value,

2. yet informs the financial statement user of the gain or loss that

would be incurred if the securities were sold at fair value.


Comprehensive Income


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Companies have incentives to manage income to meet or beatWall Street expectations, so that

the market price of stock increases and

the value of stock options increase.

A company that has a high quality of earningsprovides fulland transparent information that will not confuse or mislead

users of the financial statements.

LO 7 Understand the conc ept of quali ty of earnings.

Quality of Earnings


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Alternative Accounting Methods

Variations among companies in the application of GAAP

may hamper comparability and reduce quality of earnings.


Pro Forma Income

Pro forma incomeusually excludes items that the company

thinks are unusual or nonrecurring.

Some companies have abused the flexibility that pro forma

numbers allow.

Quality of Earnings


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14-57 LO 7 Understand the conc ept of quali ty of earnings.

Quality of Earnings

Improper Recognition

Some managers have felt pressure to continually increase

earnings and have manipulated the earnings numbers to meet

these expectations. Abuses include:

Improper recognition of revenue (channel stuffing).

Improper capitalization of operating expenses (WorldCom).

Failure to report all liabilities (Enron).


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1. ___ Measures the ability of the company to survive over a long

period of time.

2. ___ Usually excludes items that a company thinks are unusualor non-recurring.

Match each of the following terms with the phrase that it bestmatches.


a. Comprehensive income

b. Quality of earnings

c. Solvency ratio

d. Vertical analysis

e. Pro forma income

f. Extraordinary item

e

c


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3. ___ Includes all changes in stockholders equity during a period

except those resulting from investments by stockholders and

distributions to stockholders.4. ___ Indicates the level of full and transparent information

provided to users of the financial statements.


a

b




c. Solvency ratio


e. Pro forma income



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5. ___ Describes events and transactions that are unusual in

nature and infrequent in occurrence.

6. ___ Expresses each item within a financial statement as apercent of a base amount.


f

d




c. Solvency ratio


e. Pro forma income



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