Mangerial Accounting VIII

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Managerial Accounting Ninth Edition

Weygandt Kimmel Mitchell

Chapter 14

Financial Analysis: The Big Picture

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Chapter Outline

Learning Objectives LO 1 Apply the concepts of sustainable income and

quality of earnings. LO 2 Apply horizontal analysis and vertical analysis. LO 3 Analyze a company’s performance using ratio

analysis.

Sustainable Income and Quality of Earnings LEARNING OBJECTIVE 1 Apply the concepts of sustainable income and quality of earnings.

Sustainable income is the most likely level of income to be obtained by a company in the future. It differs from actual net income by the amount of unusual revenues, expenses, gains, and losses included in the current year’s income. Information on unusual items such as gains or losses on discontinued items and components of other comprehensive income are disclosed. These unusual items are reported net of income taxes.

LO 1

Sustainable Income

A statement of comprehensive income includes • net income and • comprehensive income. The two major unusual items in this statement are

o discontinued operations and o other comprehensive income.

Discontinued operations and other comprehensive income are reported net of tax.

LO 1

Discontinued Operations

A. Disposal of a significant component of a business. B. Report 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 1

Discontinued Operations Illustration During 2022 Acro Energy Inc. has income before income taxes of $800,000. During 2022, Acro discontinued and sold its unprofitable chemical division. The loss in 2022 from chemical operations (net of $40,000 income tax savings) was $160,000. The loss on disposal of the chemical division (net of $20,000 income tax savings) was $80,000. Assume a 20% tax rate on income.

LO 1

Discontinued Operations Statement presentation of discontinued operations

Illustration 14.1

LO 1

Comprehensive Income

Comprehensive income is the sum of • net income and • other comprehensive income items as in certain gains

and losses that bypass net income. o Example: Unrealized gains or losses on available-for-

sale debt securities.

LO 1

Comprehensive Income Illustration During 2022, Stassi Corporation purchased IBM bonds for $10,500 as an investment, which it intends to sell sometime in the future. At the end of 2022, Stassi was still holding the investment, but the bonds’ market price was now $8,000. Stassi is required to reduce the recorded value of its IBM investment by the unrealized loss of $2,500. Should Stassi include this $2,500 “unrealized” loss in net income? Trading securities: Unrealized gains and losses are reported in the “Other expenses and losses” section of the income statement. Available-for-sale securities: Unrealized gains and losses are reported net of tax as “Other comprehensive income” in stockholders’ equity.

LO 1

Comprehensive Income Lower portion of comprehensive income statement If Stassi did not purchase the investment for trading purposes, it is classified as available-for-sale.

Illustration 14.2

LO 1

Comprehensive Income Unrealized loss in stockholders’ equity section

Assume Stassi has common stock of $3,000,000, retained earnings of $300,000, and accumulated other comprehensive loss of $2,000. This illustration shows the balance sheet presentation of the accumulated other comprehensive loss.

Illustration 14.3

LO 1

Comprehensive Income Complete income statement and statement of comprehensive income

Illustration 14.4

LO 1

Changes in Accounting Principle

Occurs when the principle used in the current year is different from the one used in the preceding year. • Example: Change in inventory costing methods (such

as FIFO to average-cost) Accounting rules permit a change when management can show that the new principle is preferable to the old principle. Companies report most changes in accounting principle retroactively.

LO 1

Quality of Earnings

A high quality of earnings provides full and transparent information that will not confuse or mislead users. Alternative Accounting Methods Variations among companies in the application of generally accepted accounting principles (GAAP) may hamper comparability and reduce quality of earnings. • FIFO versus LIFO inventory cost flow • Straight-line versus declining balance depreciation

LO 1

Quality of Earnings Pro Forma Income Companies whose stock is publicly traded are required to present their income statement following GAAP. Many companies have been also reporting pro forma income that usually excludes items that the company thinks are unusual or non-recurring (pro forma income). Many analysts and investors are critical of using pro forma income because these numbers often make companies look better than they really are.

LO 1

Quality of Earnings Improper Recognition Most common abuse is improper recognition of revenue. • Channel stuffing (Bristol-Myers Squibb)

Another practice is improper capitalization of operating expenses. • Capitalization of operating expenses (WorldCom) • Failure to report liabilities (Enron)

LO 1

DO IT! 1: Unusual Items Problem data In its proposed 2022 income statement, AIR Corporation reports income before income taxes $400,000, unrealized gain on available-for-sale securities $100,000, loss from operation of discontinued flower division $50,000, and loss on disposal of discontinued flower division $90,000. The income tax rate is 20%. Prepare a correct partial income statement, beginning with “Income before income taxes,” and a statement of comprehensive income.

LO 1

DO IT! 1: Unusual Items Solution

LO 1

Horizontal Analysis and Vertical Analysis

LEARNING OBJECTIVE 2

Apply horizontal analysis and vertical analysis.

Investors are interested in: • Core or sustainable earnings of a company • Making comparisons from period to period

o Three types of comparisons: • Intracompany basis • Intercompany basis • Industry averages

LO 2

Horizontal Analysis and Vertical Analysis Three basic tools in financial statement analysis: 1. Horizontal analysis 2. Vertical analysis 3. Ratio analysis

LO 2

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 • Expressed as either an amount or a percentage

LO 2

Horizontal Analysis Horizontal analysis of balance sheets

Illustration 14.8

LO 2

Horizontal Analysis Changes shown in comparative balance sheets In the assets section: • current assets increased $290,000, or 11.9% ($290 ÷ $2,427) • property assets (net) increased $174,000, or 6.2% • other assets increased $219,000, or 4.0%

In the liabilities section: • current liabilities increased $24,000, or 0.6% • long-term liabilities increased $202,000, or 4.4%

In the stockholders’ equity section: • retained earnings increased $806,000, or 31.2%

LO 2

Horizontal Analysis Horizontal analysis of income statements

Illustration 14.9

LO 2

Horizontal Analysis Changes shown in comparative income statements Analysis of the income statements shows the following changes. • Net sales increased $869,000, or 8.0% ($869 ÷ $10,907) • Cost of goods sold increased $515,000, or 8.5% • Selling and administrative expenses increased $252,000, or

8.2% • Gross profit increased 7.3% • Net income increased 9.9% The increase in net income can be attributed to the increase in net sales and a decrease in income tax expense.

LO 2

Vertical Analysis

Also called common-size analysis, is a technique that expresses each financial statement item as a percentage of a base amount. • On a balance sheet we might express current assets as

22% of total assets (total assets being the base amount)

• On an income statement we might say that selling expenses are 16% of net sales (net sales being the base amount)

LO 2

Vertical Analysis Vertical analysis of balance sheets

Illustration 14.10

LO 2

Vertical Analysis Changes shown by vertical analysis of bal. sheet • Current assets increased $290,000 from 2021 to 2022, and

they increased from 22.6% to 23.8% of total assets • Property assets (net) decreased from 26.3% to 26.2% of

total assets • Other assets decreased from 51.1% to 50.0% of total assets • Retained earnings increased by $806,000 from 2021 to

2022 • Total stockholders’ equity increased from 19.3% to 22.1%

of total liabilities and stockholders’ equity

LO 2

Vertical Analysis Vertical analysis of income statements

Illustration 14.11

LO 2

Vertical Analysis Changes shown by vertical analysis of income stmt.

Analysis of the income statements shows the following changes. • Cost of goods sold as a percentage of net sales increased from

55.8% to 56.0% • Selling and administrative expenses increased from 28.0% to

28.1% • Net income as a percentage of net sales increased from 9.2% to

9.4% Increase in net income as a percentage of sales is due primarily to the decrease in income tax expense as a percentage of sales.

LO 2

Vertical Analysis Intercompany comparison by vertical analysis

Illustration 14.12

LO 2

Vertical Analysis Vertical analysis used to compare companies • Chicago net sales are much less than those of Giant,

vertical analysis eliminates the impact of this size difference

• Chicago has a higher gross profit percentage 44.0%, compared to 35.6% for Giant

• But Chicago’s selling and administrative expenses are 28.1% of net sales, while those of Giant Mills are 19.4%

• Chicago’s net income as a percentage of net sales is 9.4%, compared to 10.2% for Giant

LO 2

DO IT! 2: Horizontal Analysis

Summary financial information for Rosepatch Company.

December 31, 2022 December 31, 2021

Current assets $234,000 $180,000

Plant assets (net) 756,000 420,000

Total assets $990,000 $600,000

Compute the amount and percentage changes in 2022 using horizontal analysis, assuming 2021 is the base year.

LO 2

Ratio Analysis LEARNING OBJECTIVE 3

Analyze a company’s performance using ratio analysis.

Ratio analysis expresses the relationship among selected items of financial statement data.

Illustration 14.13

LO 3

Ratio Analysis

A single ratio by itself is not very meaningful. We will use the following types of comparisons. 1. Intracompany comparisons for two years for Chicago

Cereal. 2. Industry average comparisons based on median ratios

for the industry. 3. Intercompany comparisons based on Giant Mills as

Chicago Cereal’s principal competitor.

LO 3

Comprehensive Ratio Analysis Chicago Cereal Company’s income statements

Illustration 14.18

LO 3

Comprehensive Ratio Analysis Chicago Cereal Company’s balance sheets

Illustration 14.17

LO 3

Comprehensive Ratio Analysis Chicago Cereal Company’s statements of cash flows

Illustration 14.19

LO 3

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.

LO 3

1. Current Ratio

Illustration 14.21

Chicago has $0.67 of current assets for every dollar of current liabilities.

LO 3

2. Accounts Receivable Turnover

Illustration 14.22

Measures the number of times, on average, the company collects receivables during the period.

LO 3

3. Average Collection Period

Illustration 14.23

Analysts frequently use average collection period to assess the effectiveness of a company’s credit and collection policies.

LO 3

4. Inventory Turnover

Illustration 14.24

The faster the inventory turnover, the less cash is tied up in inventory and less chance of inventory becoming obsolete.

LO 3

5. Days in Inventory

Illustration 14.25

Measures the average number of days inventory is held.

LO 3

Solvency Ratios

Measure the ability of a company to survive over a long period of time. • Debt to assets ratio and times interest earned provide

information about debt-paying ability • Free cash flow provides information about solvency

and ability to pay additional dividends or invest in new projects

LO 3

6. Debt to Assets Ratio

Illustration 14.26

Provides some indication of company’s ability to withstand losses without impairing the interests of its creditor.

LO 3

7. Times Interest Earned

Illustration 14.27

Provides an indication of company’s ability to meet interest payments as they come due.

LO 3

8. Free Cash Flow

Illustration 14.28

One indication of solvency is the amount of excess cash generated after investing in capital expenditures and paying dividends.

LO 3

Profitability Ratios

Measure the income or operating success of a company for a given period of time. • Income affects ability to obtain debt and equity

financing, liquidity, and ability to grow • Creditors and investors are interested in evaluating

profitability • Analysts use profitability as ultimate test of

management’s operating effectiveness

LO 3

Profitability Ratios Relationships among profitability measures

Illustration 14.29

LO 3

9. Return on Common Stockholders’ Equity

Illustration 14.30

Shows how many dollars of net income the company earned for each dollar invested by the owners.

LO 3

10. Return on Assets

Illustration 14.31

Measures the overall profitability of assets in terms of the income earned on each dollar invested in assets.

LO 3

11. Profit Margin

Illustration 14.32

Measures of the percentage of each dollar of sales that results in net income.

LO 3

12. Asset Turnover

Illustration 14.33

Measures how efficiently a company uses its assets to generate sales.

LO 3

Profitability Ratios Composition of return on assets

Illustration 14.34

LO 3

13. Gross Profit Rate

Illustration 14.35

Indicates a company’s ability to maintain an adequate selling price above its cost of goods sold.

LO 3

14. Earnings Per Share

Illustration 14.36

A measure of the net income earned on each share of common stock.

LO 3

15. Price Earnings Ratio

Illustration 14.37

Reflects investors’ assessments of a company’s future earnings.

LO 3

16. Payout Ratio

Illustration 14.38

Measures the percentage of earnings distributed in the form of cash dividends.

LO 3

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Managerial Accounting
Chapter Outline
Sustainable Income and Quality of Earnings
Sustainable Income
Discontinued Operations
Discontinued Operations�Illustration
Discontinued Operations�Statement presentation of discontinued operations
Comprehensive Income
Comprehensive Income�Illustration
Comprehensive Income�Lower portion of comprehensive income statement
Comprehensive Income�Unrealized loss in stockholders’ equity section
Comprehensive Income�Complete income statement and statement of comprehensive income
Changes in Accounting Principle
Quality of Earnings
Quality of Earnings�Pro Forma Income
Quality of Earnings�Improper Recognition
DO IT! 1: Unusual Items�Problem data
DO IT! 1: Unusual Items�Solution
Horizontal Analysis and Vertical Analysis
Horizontal Analysis and Vertical Analysis
Horizontal Analysis
Horizontal Analysis�Horizontal analysis of balance sheets
Horizontal Analysis�Changes shown in comparative balance sheets
Horizontal Analysis�Horizontal analysis of income statements
Horizontal Analysis�Changes shown in comparative income statements
Vertical Analysis
Vertical Analysis�Vertical analysis of balance sheets
Vertical Analysis�Changes shown by vertical analysis of bal. sheet
Vertical Analysis�Vertical analysis of income statements
Vertical Analysis�Changes shown by vertical analysis of income stmt.
Vertical Analysis�Intercompany comparison by vertical analysis
Vertical Analysis�Vertical analysis used to compare companies
DO IT! 2: Horizontal Analysis
Ratio Analysis
Ratio Analysis
Comprehensive Ratio Analysis�Chicago Cereal Company’s income statements
Comprehensive Ratio Analysis�Chicago Cereal Company’s balance sheets
Comprehensive Ratio Analysis�Chicago Cereal Company’s statements of cash flows
Liquidity Ratios
1. Current Ratio
2. Accounts Receivable Turnover
3. Average Collection Period
4. Inventory Turnover
5. Days in Inventory
Solvency Ratios
6. Debt to Assets Ratio
7. Times Interest Earned
8. Free Cash Flow
Profitability Ratios
Profitability Ratios�Relationships among profitability measures
9. Return on Common Stockholders’ Equity
10. Return on Assets
11. Profit Margin
12. Asset Turnover
Profitability Ratios�Composition of return on assets
13. Gross Profit Rate
14. Earnings Per Share
15. Price Earnings Ratio
16. Payout Ratio
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