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CHAPTER 13
Financial Analysis: The Big Picture
Chapter Preview We can all learn an important lesson from Warren Buffett: Study companies carefully if you wish to invest. Do not get caught up in fads but instead find companies that are financially healthy. Using some of the basic decision tools presented in this text, you can perform a rudimentary analysis on any company and draw basic conclusions about its financial health. Although it would not be wise for you to bet your life savings on a company's stock relying solely on your current level of knowledge, we strongly encourage you to practice your new skills wherever possible. Only with practice will you improve your ability to interpret financial numbers.
Before we unleash you on the world of high finance, we present a few more important concepts and techniques as well as one more comprehensive review of corporate financial statements. We use all of the decision tools presented in this text to analyze a single company, with comparisons to a competitor and industry averages.
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Feature Story It Pays to Be Patient
A recent issue of Forbes magazine listed Warren Buffett as the second richest person in the world. His estimated wealth was $69 billion, give or take a few million. How much is $69 billion? If you invested $69 billion in an investment earning just 4%, you could spend $7.6 million per day—every day—forever.
So, how does Buffett spend his money? Basically, he doesn't! He still lives in the same house that he purchased in Omaha, Nebraska, in 1958 for $31,500. He still drives his own car (a Cadillac DTS). And, in case you were thinking that his kids are riding the road to Easy Street, think again. Buffett has committed to donate virtually all of his money to charity before he dies.
How did Buffett amass this wealth? Through careful investing. Buffett epitomizes a “value investor.” He applies the basic techniques he learned in the 1950s from the great value investor Benjamin Graham. He looks for companies that have good long- term potential but are currently underpriced. He invests in companies that have low exposure to debt and that reinvest their earnings for future growth. He does not get caught up in fads or the latest trends.
For example, Buffett sat out on the dot-com mania in the 1990s. When other investors put lots of money into fledgling high-tech firms, Buffett didn't bite because he did not find dot-com companies that met his criteria. He didn't get to enjoy the stock price boom on the way up, but on the other hand, he didn't have to ride the price back down to Earth. When the dot-com bubble burst, everyone else was suffering from investment shock. Buffett swooped in and scooped up deals on companies that he had been following for years.
In 2012, the stock market had again reached near record highs. Buffett's returns had been significantly lagging the market. Only 26% of his investments at that time were in stock, and he was sitting on $38 billion in cash. One commentator noted that “if the past is any guide, just when Buffett seems to look most like a loser, the party is about to end.”
If you think you want to follow Buffett's example and transform your humble nest egg into a mountain of cash, be warned. His techniques have been widely circulated and emulated, but never practiced with the same degree of success. You should probably start by honing your financial analysis skills. A good way for you to begin your career as a successful investor is to master the fundamentals of financial analysis discussed in this chapter.
Source: Jason Zweig, “Buffett Is Out of Step,” Wall Street Journal (May 7, 2012).
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Chapter Outline LEARNING OBJECTIVES
LO 1 Apply the concepts of sustainable income and quality of earnings.
Sustainable income
Quality of earnings
DO IT! 1 Unusual Items
LO 2 Apply horizontal analysis and vertical analysis.
Horizontal analysis
Vertical analysis
DO IT! 2 Horizontal Analysis
LO 3 Analyze a company's performance using ratio analysis.
Liquidity ratios
Solvency ratios
Profitability ratios
Financial analysis and data analytics
Comprehensive example
DO IT! 3 Ratio Analysis
Go to the Review and Practice section at the end of the chapter for a targeted summary and practice applications with solutions.
Visit WileyPLUS for additional tutorials and practice opportunities.
Sustainable Income and Quality of Earnings
LEARNING OBJECTIVE 1
Apply the concepts of sustainable income and quality of earnings.
Sustainable Income The value of a company like Google is a function of the amount, timing, and uncertainty of its future cash flows. Google's current and past income statements are particularly useful in helping analysts predict these future cash flows. In using this approach, analysts must make sure that Google's past income numbers reflect its sustainable income, that is, do not include unusual (out-of-the-ordinary) revenues, expenses, gains, and losses. Sustainable income is, therefore, the most likely level of income to be obtained by a company in the future. Sustainable income differs from actual net income by the amount of unusual revenues, expenses, gains, and losses included in the current year's income. Analysts are interested in sustainable income because it helps them derive an estimate of future earnings without the “noise” of unusual items.
Fortunately, an income statement provides information on sustainable income by separating operating transactions from nonoperating transactions. This statement also highlights intermediate components of income such as income from operations, income before income taxes, and income from continuing operations. In addition, information on unusual items such as gains or losses on discontinued items and components of other comprehensive income are disclosed.
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Illustration 13.1 presents a statement of comprehensive income for Cruz Company for the year 2022. A statement of comprehensive income includes not only net income but a broader measure of income called comprehensive income. The two major unusual items in this statement are discontinued operations and other comprehensive income (highlighted in red). When estimating future cash flows, analysts must consider the implications of each of these components.
ILLUSTRATION 13.1 Statement of comprehensive income
Cruz Company
Statement of Comprehensive Income
For the Year Ended 2022 Sales revenue $900,000 Cost of goods sold 650,000 Gross profit 250,000 Operating expenses 100,000 Income from operations 150,000 Other revenues (expenses) and gains (losses) 20,000 Income before income taxes 170,000 Income tax expense 24,000 Income from continuing operations 146,000 Discontinued operations (net of tax) 30,000 Net income 176,000 Other comprehensive income items (net of tax) 10,000 Comprehensive income $186,000
In looking at Illustration 13.1, note that Cruz Company's two major types of unusual items, discontinued operations and other comprehensive income, are reported net of tax. That is, Cruz first calculates income tax expense before income from continuing operations. Then, it calculates income tax expense related to the discontinued operations and other comprehensive income, and displays each item separately, net of tax. The general concept is, “Let the tax follow the income or loss.” We discuss discontinued operations and other comprehensive income in more detail next.
Discontinued Operations
Discontinued operations refers to the disposal of a significant component of a business, such as the elimination of a major class of customers or an entire activity (see Decision Tools). For example, to downsize its operations, General Dynamics Corp. sold its missile business to Hughes Aircraft Co. for $450 million. In the net income section of its statement of comprehensive income, General Dynamics reported the sale in a separate section entitled “Discontinued operations.”
Decision Tools
The discontinued operations section alerts users to the sale of any of a company's major components of its business.
Following the disposal of a significant component, the company should report on its statement both income from continuing operations and income (or loss) from discontinued operations. The income (loss) from discontinued operations consists of two parts: the income (loss) from operations and the gain (loss) on disposal of the component.
To illustrate, assume that during 2022 Acro Energy Inc. has income before income taxes of $800,000. During 2022, Acro discontinued and sold its unprofitable chemical division. The
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loss in 2022 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 13.2 shows Acro's statement of comprehensive income presentation (see Helpful Hint).
ILLUSTRATION 13.2 Statement presentation of discontinued operations
Acro Energy Inc.
Statement of Comprehensive Income (partial)
For the Year Ended December 31, 2022 Income before income taxes $800,000 Income tax expense 240,000 Income from continuing operations 560,000 Discontinued operations Loss from operation of chemical division, net of $60,000 income tax savings
$140,000
Loss from disposal of chemical division, net of $30,000 income tax savings
70,000 210,000
Net income $350,000
HELPFUL HINT
Observe the dual disclosures: (1) the results of operation of the discontinued division must be separated from the results of continuing operations, and (2) the company must also report the gain or loss on disposal of the division.
Note that the statement uses the caption “Income from continuing operations” and adds a new section “Discontinued operations.” The new section reports both the operating loss and the loss on disposal net of applicable income taxes. This presentation clearly indicates the separate effects of continuing operations and discontinued operations on net income.
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Investor Insight
What Does “Non-Recurring” Really Mean?
Many companies incur restructuring charges as they attempt to reduce costs. They often label these items in the income statement as “non-recurring” charges, to suggest that they are isolated events, unlikely to occur in future periods. The question for analysts is, are these costs really one-time, “non-recurring events” or do they reflect problems that the company will be facing for many periods in the future? If they are one-time events, then they can be largely ignored when trying to predict future earnings.
But, some companies report “one-time” restructuring charges over and over again. For example, Procter & Gamble reported a restructuring charge in 12 consecutive quarters, and Motorola had “special” charges in 14 consecutive quarters. On the other hand, other companies have a restructuring charge only once in a 5- or 10-year period. There appears to be no substitute for careful analysis of the numbers that comprise net income.
If a company takes a large restructuring charge, what is the effect on the company's current income statement versus future ones? (Go to WileyPLUS for this answer and additional questions.)
Comprehensive Income
Most revenues, expenses, gains, and losses are included in net income. However, as discussed in earlier chapters, certain gains and losses that bypass net income are reported as part of a more inclusive earnings measure called comprehensive income. Comprehensive income is the sum of net income and other comprehensive income items.1
Illustration of Comprehensive Income
Accounting standards require that companies adjust most investments in stocks and bonds up or down to their market price at the end of each accounting period. For example, assume that during 2022, its first year of operations, 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. In this case, Stassi is required to reduce the recorded value of its IBM investment by $2,500. The $2,500 difference is an “unrealized” loss. A gain or loss is referred to as unrealized when as asset has experienced a change in value but the owner has not sold the asset. The sale of the asset results in “realization” of the gain or loss.
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Should Stassi include this $2,500 unrealized loss in net income? It depends on whether Stassi classifies the IBM bonds as a trading security or an available-for-sale security. A trading security is bought and held primarily for sale in the near term to generate income on short-term price differences. Companies report unrealized losses on trading securities in the “Other expenses and losses” section of the income statement. The rationale: It is likely that the company will realize the unrealized loss (or an unrealized gain), so the company should report the loss (gain) as part of net income.
If Stassi did not purchase the investment for trading purposes, it is classified as available- for-sale. Available-for-sale securities are held with the intent of selling them sometime in the future. Companies do not include unrealized gains or losses on available-for-sale securities in net income. Instead, they report them as part of “Other comprehensive income.” Other comprehensive income is not included in net income.
Format
One format for reporting other comprehensive income is to report a separate comprehensive income statement. For example, assuming that Stassi Corporation has a net income of $300,000 and a 20% tax rate, the unrealized loss would be reported below net income, net of tax, as shown in Illustration 13.3.
ILLUSTRATION 13.3 Lower portion of combined statement of income and comprehensive income
Stassi Corporation
Comprehensive Income Statement
For the Year Ended December 31, 2022 Net income $300,000 Other comprehensive income Unrealized loss on available-for-sale securities, net of $500 income tax savings
2,000
Comprehensive income $298,000
Companies report the cumulative amount of other comprehensive income from all years as a separate component of stockholders' equity. To illustrate, assume Stassi has common stock of $3,000,000, retained earnings of $300,000, and accumulated other comprehensive loss of $2,000. (To simplify, we are assuming that this is Stassi's first year of operations. Since it has only operated for one year, the cumulative amount of other comprehensive income is this year's loss of $2,000.) Illustration 13.4 shows the balance sheet presentation of the accumulated other comprehensive loss.
ILLUSTRATION 13.4 Unrealized loss in stockholders' equity section
Stassi Corporation
Balance Sheet (partial) Stockholders' equity Common stock $3,000,000 Retained earnings 300,000 Total paid-in capital and retained earnings 3,300,000 Accumulated other comprehensive loss (2,000) Total stockholders' equity $3,298,000
Note that the presentation of the accumulated other comprehensive loss is similar to the presentation of the cost of treasury stock in the stockholders' equity section. (An unrealized gain would be added in this section of the balance sheet.)
Complete Statement of Comprehensive Income
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As seen in Illustration 13.1, as an alternative to preparing a separate comprehensive income statement, many companies report net income and other comprehensive income in a combined statement of comprehensive income. (For your homework in this chapter, use this combined format.) The statement of comprehensive income for Pace Corporation in Illustration 13.5 presents the types of items found on this statement, such as net sales, cost of goods sold, operating expenses, and income taxes. In addition, it shows how companies report discontinued operations and other comprehensive income (highlighted in red).
ILLUSTRATION 13.5 Complete statement of comprehensive income
Pace Corporation
Statement of Comprehensive Income
For the Year Ended December 31, 2022 Net sales $440,000 Cost of goods sold 260,000 Gross profit 180,000 Operating expenses 110,000 Income from operations 70,000 Other revenues and gains 5,600 Other expenses and losses 9,600 Income before income taxes 66,000 Income tax expense ($ 66,000 × 30%) 19,800 Income from continuing operations 46,200 Discontinued operations Loss from operation of plastics division, net of income tax savings $18,000 ($ 60,000 × 30%)
$42,000
Gain on disposal of plastics division, net of $15,000 income taxes ($ 50,000 × 30%)
35,000 7,000
Net income 39,200 Other comprehensive income Unrealized gain on available-for-sale securities, net of income taxes ($ 15,000 × 30%)
10,500
Comprehensive income $ 49,700
Changes in Accounting Principle
For ease of comparison, users of financial statements expect companies to prepare their statements on a basis consistent with the preceding period. A change in accounting principle occurs when the principle used in the current year is different from the one used in the preceding year (see Decision Tools). An example is a 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.
Decision Tools
Informing users of a change in accounting principle helps them determine the effect of this change on current and prior periods.
Companies report most changes in accounting principle retroactively.2 That is, they report both the current period and previous periods using the new principle. As a result, the same principle applies in all periods. This treatment improves the ability to compare results across years.
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Investor Insight United Parcel Service (UPS)
More Frequent Ups and Downs
In the past, U.S. companies used a method to account for their pension plans that smoothed out the gains and losses on their pension portfolios by spreading gains and losses over multiple years. Many felt that this approach was beneficial because it reduced the volatility of reported net income. However, recently some companies have opted to adopt a method that comes closer to recognizing gains and losses in the period in which they occur. Some of the companies that have adopted this approach are United Parcel Service (UPS), Honeywell International, IBM, AT&T, and Verizon Communications. The CFO at UPS said he favored the new approach because “events that occurred in prior years will no longer distort current-year results. It will result in better transparency by eliminating the noise of past plan performance.” When UPS switched, it resulted in a charge of $827 million from the change in accounting principle.
Source: Bob Sechler and Doug Cameron, “UPS Alters Pension-Plan Accounting,” Wall Street Journal (January 30, 2012).
When predicting future earnings, how should analysts treat the one-time charge that results from a switch to the different approach for accounting for pension plans? (Go to WileyPLUS for this answer and additional questions.)
Quality of Earnings The quality of a company's earnings is of extreme importance to analysts. 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. Here are some of the factors affecting quality of earnings.
Alternative Accounting Methods
Variations among companies in the application of generally accepted accounting principles may hamper comparability and reduce quality of earnings. For example, suppose one company uses the FIFO method of inventory costing, while another company in the same industry uses LIFO. If inventory is a significant asset to both companies, it is unlikely that their current ratios are comparable. For example, if General Motors Corporation used FIFO instead of LIFO for inventory valuation, its inventories in a recent
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year would have been 26% higher, which significantly affects the current ratio (and other ratios as well).
In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation and amortization. Although these differences in accounting methods might be detectable from reading the notes to the financial statements, adjusting the financial data to compensate for the different methods is often difficult, if not impossible.
Pro Forma Income
Companies whose stock is publicly traded are required to present their income statement following generally accepted accounting principles (GAAP). In recent years, many companies have been also reporting a second measure of income, called pro forma income. Pro forma income usually excludes items that the company thinks are unusual or non-recurring. For example, in a recent year, Cisco Systems (a high-tech company) reported a quarterly net loss under GAAP of $2.7 billion. Cisco reported pro forma income for the same quarter as a profit of $230 million. This large difference in profits between GAAP income numbers and pro forma income is not unusual. For example, during one nine-month period, the 100 largest companies on the Nasdaq stock exchange reported a total pro forma income of $19.1 billion but a total loss as measured by GAAP of $82.3 billion—a difference of about $100 billion!
To compute pro forma income, companies generally exclude any items they deem inappropriate for measuring their performance. Many analysts and investors are critical of the practice of using pro forma income because these numbers often make companies look better than they really are. As the financial press noted, pro forma numbers might be called “earnings before bad stuff.” Companies, on the other hand, argue that pro forma numbers more clearly indicate sustainable income because they exclude unusual and non- recurring expenses. “Cisco's technique gives readers of financial statements a clear picture of Cisco's normal business activities,” the company said in a statement issued in response to questions about its pro forma income accounting.
Recently, the SEC provided some guidance on how companies should present pro forma information. Stay tuned: Everyone seems to agree that pro forma numbers can be useful if they provide insights into determining a company's sustainable income. However, many companies have abused the flexibility that pro forma numbers allow and have used the measure as a way to put their companies in a more favorable light.
Improper Recognition
Because some managers feel pressure from Wall Street to continually increase earnings, they manipulate earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue. One practice that some companies use is called channel stuffing. Offering deep discounts, companies encourage customers to buy early (stuff the channel) rather than later. This boosts the seller's earnings in the current period, but it often leads to a disaster in subsequent periods because customers have no need for additional goods. To illustrate, Bristol-Myers Squibb at one time indicated that it used sales incentives to encourage wholesalers to buy more drugs than they needed. As a result, the company had to issue revised financial statements showing corrected revenues and income.
Another practice is the improper capitalization of operating expenses. WorldCom capitalized over $7 billion of operating expenses in order to report positive net income. In other situations, companies fail to report all their liabilities. Enron promised to make payments on certain contracts if financial difficulty developed, but these guarantees were not reported as liabilities. In addition, disclosure was so lacking in transparency that it was impossible to understand what was happening at the company.
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DO IT! 1 | Unusual Items
In its proposed 2022 income statement, AIR Corporation reports income before income taxes $400,000, unrealized gain on available-for-sale securities $100,000, income taxes $120,000 (not including unusual items), loss from operation of discontinued flower division $50,000, and loss on disposal of discontinued flower division $90,000. The income tax rate is 30%. Prepare a correct statement of comprehensive income, beginning with “Income before income taxes.”
ACTION PLAN
Show discontinued operations and other comprehensive income net of tax.
Solution
AIR Corporation
Statement of Comprehensive Income (partial)
For the Year Ended December 31, 2022 Income before income taxes $400,000 Income tax expense 120,000 Income from continuing operations 280,000 Discontinued operations Loss from operation of flower division, net of $15,000 income tax savings
$35,000
Loss on disposal of flower division, net of $27,000 income tax savings
63,000 98,000
Net income 182,000 Other comprehensive income Unrealized gain on available-for-sale securities, net of $30,000 income taxes
70,000
Comprehensive income $252,000
Related exercise material: BE13.1, BE13.2, DO IT! 13.1, E13.1, and E13.2.
Horizontal Analysis and Vertical Analysis
LEARNING OBJECTIVE 2
Apply horizontal analysis and vertical analysis.
As indicated, in assessing the financial performance of a company, investors are interested in the core or sustainable earnings of a company. In addition, investors are interested in making comparisons from period to period. Throughout this text, we have relied on three types of comparisons to improve the decision-usefulness of financial information:
1. Intracompany basis. Comparisons within a company are often useful to detect changes in financial relationships and significant trends. For example, a comparison of
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Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. Likewise, a comparison of Kellogg's year-end cash amount with the amount of its total assets at year-end shows the proportion of total assets in the form of cash.
2. Intercompany basis. Comparisons with other companies provide insight into a company's competitive position. For example, investors can compare Kellogg's total sales for the year with the total sales of its competitors in the breakfast cereal area, such as General Mills.
3. Industry averages. Comparisons with industry averages provide information about a company's relative position within the industry. For example, financial statement readers can compare Kellogg's financial data with the averages for its industry compiled by financial rating organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's, or with information provided on the Internet by organizations such as Yahoo! on its financial site.
We use three basic tools in financial statement analysis to highlight the significance of financial statement data:
1. Horizontal analysis.
2. Vertical analysis.
3. Ratio analysis.
In previous chapters, we relied primarily on ratio analysis, supplemented with some basic horizontal and vertical analysis. In the remainder of this section, we introduce more formal forms of horizontal and vertical analysis. In the next section, we review ratio analysis in some detail.
Horizontal Analysis Horizontal analysis, also known as trend analysis, is a technique for evaluating a series of financial statement data over a period of time (see Decision Tools). Its purpose is to determine the increase or decrease that has taken place, expressed as either an amount or a percentage. For example, here are recent net sales figures (in thousands) of Chicago Cereal Company:
2022 2021 2020 2019 2018 $11,776 $10,907 $10,177 $9,614 $8,812
Decision Tools
Horizontal analysis helps users compare a company's financial position and operating results with those of the previous period.
If we assume that 2018 is the base year, we can measure all percentage increases or decreases relative to this base-period amount with the formula shown in Illustration 13.6.
ILLUSTRATION 13.6 Horizontal analysis—computation of changes since base period
For example, we can determine that net sales for Chicago Cereal increased approximately 9.1% [($ 9,614 − $ 8,812) ÷ $ 8,812] from 2018 to 2019. Similarly, we can also determine that net sales increased by 33.6% [($ 11,776 − $ 8,812) ÷ $ 8,812] from 2018 to 2022.
Alternatively, we can express current-year sales as a percentage of the base period. To do so, we would divide the current-year amount by the base-year amount, as shown in Illustration 13.7.
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ILLUSTRATION 13.7 Horizontal analysis—computation of current year in relation to base year
Current-period sales expressed as a percentage of the base period for each of the five years, using 2018 as the base period, are shown in Illustration 13.8.
ILLUSTRATION 13.8 Horizontal analysis of net sales
Chicago Cereal Company
Net Sales (in thousands)
Base Period 2018 2022 2021 2020 2019 2018
$11,776 $10,907 $10,177 $9,614 $8,812 133.6% 123.8% 115.5% 109.1% 100%
The large increase in net sales during 2019 would raise questions regarding possible reasons for such a significant change. Chicago Cereal's 2019 notes to the financial statements explain that the company completed an acquisition of Elf Foods Company during 2019. This major acquisition would help explain the increase in sales highlighted by horizontal analysis.
To further illustrate horizontal analysis, we use the financial statements of Chicago Cereal Company. Its two-year condensed balance sheets for 2022 and 2021, showing dollar and percentage changes, are presented in Illustration 13.9 (see Helpful Hint).
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ILLUSTRATION 13.9 Horizontal analysis of balance sheets
Chicago Cereal Company
Condensed Balance Sheets
December 31 (in thousands) Increase (Decrease)
during 2022 Assets 2022 2021 Amount Percent Current assets $ 2,717 $ 2,427 $ 290 11.9 Property assets (net) 2,990 2,816 174 6.2 Other assets 5,690 5,471 219 4.0 Total assets $11,397 $10,714 $683 6.4 Liabilities and Stockholders' Equity Current liabilities $ 4,044 $ 4,020 $ 24 0.6 Long-term liabilities 4,827 4,625 202 4.4 Total liabilities 8,871 8,645 226 2.6 Stockholders' equity Common stock 493 397 96 24.2 Retained earnings 3,390 2,584 806 31.2 Treasury stock (cost)
(1,357) (912) 445 48.8
Total stockholders' equity
2,526 2,069 457 22.1
Total liabilities and stockholders' equity
$11,397 $10,714 $ 683 6.4
HELPFUL HINT
When using horizontal analysis, be sure to examine both dollar amount changes and percentage changes. It is not necessarily bad if a company's earnings are growing at a declining rate. The amount of increase may be the same as or more than the base year, but the percentage change may be less because the base is greater each year.
The comparative balance sheets show that a number of changes occurred in Chicago Cereal's financial position from 2021 to 2022. In the assets section, current assets increased $290,000, or 11.9% ($ 290 ÷ $ 2,427), and 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%, while long-term liabilities increased $202,000, or 4.4%. In the stockholders' equity section, we find that retained earnings increased $806,000, or 31.2%.
Illustration 13.10 presents two-year comparative income statements of Chicago Cereal Company for 2022 and 2021, showing dollar and percentage changes (see Helpful Hint).
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ILLUSTRATION 13.10 Horizontal analysis of income statements
Chicago Cereal Company
Condensed Income Statements
For the Years Ended December 31 (in thousands) Increase (Decrease)
during 2022 2022 2021 Amount Percent
Net sales $11,776 $10,907 $869 8.0 Cost of goods sold 6,597 6,082 515 8.5 Gross profit 5,179 4,825 354 7.3 Selling and administrative expenses
3,311 3,059 252 8.2
Income from operations
1,868 1,766 102 5.8
Interest expense 321 294 27 9.2 Income before income taxes
1,547 1,472 75 5.1
Income tax expense 444 468 (24) (5.1) Net income $ 1,103 $ 1,004 $ 99 9.9
HELPFUL HINT
The increase in the Amount column of $99 results by adding and subtracting the amounts shown. In the Percent column, the 9.9% cannot be determined by adding and subtracting the percentages shown.
Horizontal 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 $515,000, or 8.5% ($ 515 ÷ $ 6,082). Selling and administrative expenses increased $252,000, or 8.2% ($ 252 ÷ $ 3,059). Overall, gross profit increased 7.3% and 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.
The measurement of changes from period to period in percentages is relatively straightforward and quite useful. However, complications can result in making the computations. If an item has no value in a base year or preceding year and a value in the next year, no percentage change can be computed.
Vertical Analysis Vertical analysis, also called common-size analysis, is a technique for evaluating financial statement data that expresses each item in a financial statement as a percentage of a base amount (see Decision Tools). For example, on a balance sheet we might express current assets as 22% of total assets (total assets being the base amount). Or, on an income statement we might express selling expenses as 16% of net sales (net sales being the base amount).
Decision Tools
Vertical analysis helps users compare relationships between financial statement items with those of last year or of competitors.
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Presented in Illustration 13.11 are the comparative balance sheets of Chicago Cereal for 2022 and 2021, analyzed vertically. The base for the asset items is total assets, and the base for the liability and stockholders' equity items is total liabilities and stockholders' equity.
ILLUSTRATION 13.11 Vertical analysis of balance sheets
Chicago Cereal Company
Condensed Balance Sheets
December 31 (in thousands) 2022 2021
Assets Amount Percent* Amount Percent* Current assets $ 2,717 23.8 $ 2,427 22.6 Property assets (net)
2,990 26.2 2,816 26.3
Other assets 5,690 50.0 5,471 51.1 Total assets $11,397 100.0 $10,714 100.0 Liabilities and Stockholders' Equity Current liabilities $ 4,044 35.5 $ 4,020 37.5 Long-term liabilities
4,827 42.4 4,625 43.2
Total liabilities
8,871 77.9 8,645 80.7
Stockholders' equity Common stock 493 4.3 397 3.7 Retained earnings
3,390 29.7 2,584 24.1
Treasury stock (cost)
(1,357) (11.9) (912) (8.5)
Total stockholders' equity
2,526 22.1 2,069 19.3
Total liabilities and stockholders' equity
$11,397 100.0 $10,714 100.0
* Numbers have been rounded to total 100%.
In addition to showing the relative size of each category on the balance sheets, vertical analysis can show the percentage change in the individual asset, liability, and stockholders' equity items. In this case, 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. Also, retained earnings increased by $806,000 from 2021 to 2022, and total stockholders' equity increased from 19.3% to 22.1% of total liabilities and stockholders' equity. This switch to a higher percentage of equity financing has two causes. First, while total liabilities increased by $226,000, the percentage of liabilities declined from 80.7% to 77.9% of total liabilities and stockholders' equity. Second, retained earnings increased by $806,000, from 24.1% to 29.7% of total liabilities and stockholders' equity. Thus, the company shifted toward equity financing by relying less on debt and by increasing the amount of retained earnings.
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Vertical analysis of the comparative income statements of Chicago Cereal, shown in Illustration 13.12, reveals that cost of goods sold as a percentage of net sales increased from 55.8% to 56.0%, and 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%. Chicago Cereal's increase in net income as a percentage of sales is due primarily to the decrease in income tax expense as a percentage of sales.
ILLUSTRATION 13.12 Vertical analysis of income statements
Chicago Cereal Company
Condensed Income Statements
For the Years Ended December 31 (in thousands) 2022 2021
Amount Percent* Amount Percent* Net sales $11,776 100.0 $10,907 100.0 Cost of goods sold 6,597 56.0 6,082 55.8 Gross profit 5,179 44.0 4,825 44.2 Selling and administrative expenses
3,311 28.1 3,059 28.0
Income from operations
1,868 15.9 1,766 16.2
Interest expense 321 2.7 294 2.7 Income before income taxes
1,547 13.2 1,472 13.5
Income tax expense 444
3.8 468 4.3
Net income $ 1,103 9.4 $ 1,004 9.2
* Numbers have been rounded to total 100%.
Vertical analysis also enables you to compare companies of different sizes. For example, one of Chicago Cereal's competitors is Giant Mills. Giant Mills' sales are 1,000 times larger than those of Chicago Cereal. Vertical analysis enables us to meaningfully compare the condensed income statements of Chicago Cereal and Giant Mills, as shown in Illustration 13.13.
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ILLUSTRATION 13.13 Intercompany comparison by vertical analysis
Condensed Income Statements
For the Year Ended December 31, 2022 Chicago
Cereal
(in thousands)
Giant
Mills, Inc.
(in millions) Amount Percent* Amount Percent*
Net sales $11,776 100.0 $17,910 100.0 Cost of goods sold 6,597 56.0 11,540 64.4 Gross profit 5,179 44.0 6,370 35.6 Selling and administrative expenses
3,311 28.1 3,474 19.4
Non-recurring charges and (gains)
0 — (62) (0.3)
Income from operations
1,868 15.9 2,958 16.5
Other expenses and revenues (including income taxes)
765
6.5 1,134 6.3
Net income $ 1,103 9.4 $ 1,824 10.2
* Numbers have been rounded to total 100%.
Although Chicago Cereal's net sales are much less than those of Giant Mills, vertical analysis eliminates the impact of this size difference for our analysis. Chicago Cereal has a higher gross profit percentage 44.0%, compared to 35.6% for Giant Mills. But, Chicago Cereal's selling and administrative expenses are 28.1% of net sales, while those of Giant Mills are 19.4% of net sales. Looking at net income, we see that Giant Mills' percentage is higher. Chicago Cereal's net income as a percentage of net sales is 9.4%, compared to 10.2% for Giant Mills.
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Anatomy of a Fraud
Sometimes relationships between numbers can be used to detect fraud. Financial ratios that appear abnormal or statistical abnormalities in the numbers themselves can reveal fraud. For example, the fact that WorldCom's line costs, as a percentage of either total expenses or revenues, differed very significantly from its competitors should have alerted people to the possibility of fraud. Or, consider the case of a bank manager, who cooperated with a group of his friends to defraud the bank's credit card department. The manager's friends would apply for credit cards and then run up balances of slightly less than $5,000. The bank had a policy of allowing bank personnel to write-off balances of less than $5,000 without seeking supervisor approval. The fraud was detected by applying statistical analysis based on Benford's Law. Benford's Law states that in a random collection of numbers, the frequency of lower digits (e.g., 1, 2, or 3) should be much higher than higher digits (e.g., 7, 8, or 9). In this case, bank auditors analyzed the first two digits of amounts written off. There was a spike at 48 and 49, which was not consistent with what would be expected if the numbers were random.
Total take: Thousands of dollars
The Missing Control
Independent internal verification. While it might be efficient to allow employees to write off accounts below a certain level, it is important that these write-offs be reviewed and verified periodically. Such a review would likely call attention to an employee with large amounts of write-offs, or in this case, write-offs that were frequently very close to the approval threshold.
Source: Mark J. Nigrini, “I've Got Your Number,” Journal of Accountancy Online (May 1999).
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DO IT! 2 | Horizontal Analysis
Summary financial information for Rosepatch Company is as follows.
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.
ACTION PLAN
Find the percentage change by dividing the amount of the increase by the 2021 amount (base year).
Solution
Increase in 2022 Amount Percent
Current assets $ 54,000 30% [($ 234,000 − $ 180,000) ÷ $ 180,000]
Plant assets (net)
336,000 80% [($ 756,000 − $ 420,000) ÷ $ 420,000]
Total assets $390,000 65% [($ 990,000 − $ 600,000) ÷ $ 600,000]
Related exercise material: BE13.4, BE13.6, BE13.7, BE13.9, DO IT! 13.2, E13.3, E13.5, and E13.6.
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 (see Decision Tools). A ratio expresses the mathematical relationship between one quantity and another. The relationship is expressed in terms of either a percentage, a rate, or a simple proportion. To illustrate, in a recent year, Nike, Inc. had current assets of $13,626 million and current liabilities of $3,926 million. We can find the relationship between these two measures by dividing current assets by current liabilities. The alternative means of expression are as follows.
Percentage: Current assets are 347% of current liabilities. Rate: Current assets are 3.47 times current liabilities.
Proportion: The relationship of current assets to liabilities is 3.47:1.
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Decision Tools
Ratio analysis helps users evaluate mathematical relationships between financial statement items and compare across years, competitors, and industry.
To analyze the primary financial statements, we can use ratios to evaluate liquidity, profitability, and solvency. Illustration 13.14 describes these classifications.
ILLUSTRATION 13.14 Financial ratio classifications
Ratios can provide clues to underlying conditions that may not be apparent from individual financial statement components. However, a single ratio by itself is not very meaningful. Thus, in the discussion of ratios 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.
Liquidity Ratios Liquidity ratios (Illustration 13.15) 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.
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ILLUSTRATION 13.15 Summary of liquidity ratios
Liquidity Ratios Working capital Current assets − Current liabilities
Current ratio
Inventory turnover
Days in inventory
Accounts receivable turnover
Average collection period
Investor Insight
How to Manage the Current Ratio
The apparent simplicity of the current ratio can have real-world limitations because adding equal amounts to both the numerator and the denominator causes the ratio to decrease.
Assume, for example, that a company has $2,000,000 of current assets and $1,000,000 of current liabilities. Its current ratio is 2:1. If it purchases $1,000,000 of inventory on account, it will have $3,000,000 of current assets and $2,000,000 of current liabilities. Its current ratio decreases to 1.5:1. If, instead, the company pays off $500,000 of its current liabilities, it will have $1,500,000 of current assets and $500,000 of current liabilities. Its current ratio increases to 3:1. Thus, any trend analysis should be done with care because the ratio is susceptible to quick changes and is easily influenced by management.
How might management influence a company's current ratio? (Go to WileyPLUS for this answer and additional questions.)
Solvency Ratios
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Solvency ratios (Illustration 13.16) measure the ability of the company to survive over a long period of time. Long-term creditors and stockholders are interested in a company's long-run solvency, particularly its ability to pay interest as it comes due and to repay the balance of debt at its maturity.
ILLUSTRATION 13.16 Summary of solvency ratios
Solvency Ratios
Debt to assets ratio
Times interest earned Free cash flow Net cash provided by operating activities − Capital expenditures
− Cash dividends
Profitability Ratios Profitability ratios (Illustration 13.17) measure the income or operating success of a company for a given period of time. A company's income, or lack of it, affects its ability to obtain debt and equity financing, its liquidity position, and its ability to grow. As a consequence, creditors and investors alike are interested in evaluating profitability. Profitability is frequently used as the ultimate test of management's operating effectiveness.
ILLUSTRATION 13.17 Summary of profitability ratios
Profitability Ratios
Earnings per share
Price-earnings ratio
Gross profit rate
Profit margin
Return on assets
Asset turnover
Payout ratio
Return on common stockholders' equity
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Investor Insight
High Ratings Can Bring Low Returns
Moody's, Standard & Poor's, and Fitch are three big firms that perform financial analysis on publicly traded companies and then publish ratings of the companies' creditworthiness. Investors and lenders rely heavily on these ratings in making investment and lending decisions. Some people feel that the collapse of the financial markets was worsened by inadequate research reports and ratings provided by the financial rating agencies. Critics contend that the rating agencies were reluctant to give large companies low ratings because they feared that by offending them they would lose out on business opportunities. For example, the rating agencies gave many so-called mortgage-backed securities ratings that suggested that they were low risk. Later, many of these very securities became completely worthless. Steps have been taken to reduce the conflicts of interest that lead to these faulty ratings.
Sources: Aaron Lucchetti and Judith Burns, “Moody's CEO Warned Profit Push Posed a Risk to Quality of Ratings,” Wall Street Journal Online (October 23, 2008); and Alan S. Binder, “A Better Way to Run Rating Agencies,” Wall Street Journal (April 17, 2014).
Why are credit rating agencies important to the financial markets? (Go to WileyPLUS for this answer and additional questions.)
Financial Analysis and Data Analytics In the age of “Big Data,” opportunities for investors to apply data analytics to financial data are boundless. Immense quantities and types of data are available to investors. Free financial data about corporations, for example, can be obtained from the SEC's Edgar database and other sources. Alternatively, database services such as Compustat and WorldScope sell financial and other information regarding a wide range of company and industry characteristics. In addition, each day massive amounts of trading data are collected from financial exchanges.
Professional analysts employ sophisticated computerized valuation models which use financial, nonfinancial, and trading data to identify investment opportunities. Since these valuation models frequently rely heavily on accounting data, it is important to have a sound understanding of the financial accounting standards on which the numbers used in the models are based. If you desire to someday use data analytics to evaluate companies, the accounting skills and financial analysis tools acquired in this course are a good start.
Comprehensive Example of Ratio Analysis In this section, we provide a comprehensive review of ratios used for evaluating the financial health and performance of a company. We use the financial information in Illustrations 13.18 through 13.21 to calculate Chicago Cereal Company's 2022 ratios. You can use these data to review the computations.
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ILLUSTRATION 13.18 Chicago Cereal Company's balance sheets
Chicago Cereal Company
Balance Sheets
December 31 (in thousands) Assets 2022 2021 Current assets Cash $ 524 $ 411 Accounts receivable 1,026 945 Inventory 924 824 Prepaid expenses and other current assets 243 247 Total current assets 2,717 2,427 Property assets (net) 2,990 2,816 Intangibles and other assets 5,690 5,471 Total assets $11,397 $10,714
Liabilities and Stockholders' Equity Current liabilities $ 4,044 $ 4,020 Long-term liabilities 4,827 4,625 Stockholders' equity—common 2,526 2,069 Total liabilities and stockholders' equity $11,397 $10,714
ILLUSTRATION 13.19 Chicago Cereal Company's income statements
Chicago Cereal Company
Condensed Income Statements
For the Years Ended December 31 (in thousands) 2022 2021
Net sales $11,776 $10,907 Cost of goods sold 6,597 6,082 Gross profit 5,179 4,825 Selling and administrative expenses 3,311 3,059 Income from operations 1,868 1,766 Interest expense 321 294 Income before income taxes 1,547 1,472 Income tax expense 444 468 Net income $ 1,103 $ 1,004
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ILLUSTRATION 13.20 Chicago Cereal Company's statements of cash flows
Chicago Cereal Company
Condensed Statements of Cash Flows
For the Years Ended December 31 (in thousands) 2022 2021
Cash flows from operating activities Cash receipts from operating activities $11,695 $10,841 Cash payments for operating activities 10,192 9,431 Net cash provided by operating activities 1,503 1,410 Cash flows from investing activities Purchases of property, plant, and equipment (472) (453) Other investing activities (129) 8 Net cash used in investing activities (601) (445) Cash flows from financing activities Issuance of common stock 163 218 Issuance of debt 2,179 721 Reductions of debt (2,011) (650) Payment of dividends (475) (450) Repurchase of common stock and other items (645) (612) Net cash provided (used) by financing activities (789) (773) Increase (decrease) in cash and cash equivalents 113 192 Cash and cash equivalents at beginning of year 411 219 Cash and cash equivalents at end of year $ 524 $ 411
ILLUSTRATION 13.21 Additional information for Chicago Cereal Company
Additional information: 2022 2021
Weighted-average number of shares (thousands) 418.7 418.5 Stock price at year-end $52.92 $50.06
As indicated in the chapter, we can classify ratios into three types for analysis of the primary financial statements:
1. Liquidity ratios. Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
2. Solvency ratios. Measures of the ability of the company to survive over a long period of time.
3. Profitability ratios. Measures of the income or operating success of a company for a given period of time.
As a tool of analysis, ratios can provide clues to underlying conditions that may not be apparent from an inspection of the individual components of a particular ratio. But, a single ratio by itself is not very meaningful. Accordingly, in this discussion we use the following three comparisons.
1. Intracompany comparisons covering two years for Chicago Cereal (using comparative financial information from Illustrations 13.18 through 13.21).
2. Intercompany comparisons using Giant Mills as one of Chicago Cereal's competitors.
3. Industry average comparisons based on MSN.com median ratios for manufacturers of flour and other grain mill products and comparisons with other
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sources. For some of the ratios that we use, industry comparisons are not available (denoted “na”).
Liquidity Ratios
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. The measures used to determine the company's short-term debt-paying ability are the current ratio, the accounts receivable turnover, the average collection period, the inventory turnover, and days in inventory.
1. Current ratio.
The current ratio expresses the relationship of current assets to current liabilities, computed by dividing current assets by current liabilities. It is widely used for evaluating a company's liquidity and short-term debt-paying ability. The 2022 and 2021 current ratios for Chicago Cereal and comparative data are shown in Illustration 13.22.
ILLUSTRATION 13.22 Current ratio
Chicago Cereal Giant Mills
2022
Industry
AverageRatio Formula 2022 2021
Current ratio
.67
.60
.67
1.06
What do the measures tell us? Chicago Cereal's 2022 current ratio of .67 means that for every dollar of current liabilities, it has $0.67 of current assets. We sometimes state such ratios as .67:1 to reinforce this interpretation. Its current ratio—and therefore its liquidity—increased significantly in 2022. It is well below the industry average but the same as that of Giant Mills.
2. Accounts receivable turnover.
Analysts can measure liquidity by how quickly a company converts certain assets to cash. A low value for the current ratio can sometimes be compensated for if some of the company's current assets are highly liquid.
How liquid, for example, are the receivables? The ratio used to assess the liquidity of the receivables is the accounts receivable turnover, which measure
