Indirect Method vs. Direct Method and Horizontal vs. Vertical Analysis

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Financial Accounting: Tools for Business Decision Making

Eighth Edition

Kimmel ● Weygandt ● Kieso

Chapter 13

Financial Analysis: The Big Picture

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Financial Accounting: Tools for Business Decision Making

Chapter Outline:

Learning Objectives

Apply the concepts of sustainable income and quality of earnings.

Apply horizontal analysis and vertical analysis.

Analyze a company’s performance using ratio analysis.

L O 1: Apply the Concepts of Sustainable Income and Quality of Earnings

Sustainable Income

The most likely level of income to be obtained by a company in the future.

Unusual Items

Separately identified on the income statement.

Discontinued operations.

Other comprehensive income.

These “irregular” items are reported net of income tax.

Sustainable Income (1 of 4)

Sustainable Income (2 of 4)

Discontinued Operations

(a) Disposal of a significant component of a business.

(b) Income statement should report a gain (or loss) from discontinued operations, net of tax.

Discontinued Operations (1 of 2)

Illustration: Assume that during 2017 Acro Energy Inc. has income before income taxes of $800,000. During 2017, Acro discontinued and sold its unprofitable chemical division. The loss in 2017 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.

Prepare Acro’s statement of comprehensive income for the year ended December 31, 2017.

Discontinued Operations (2 of 2)

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, “nonrecurring 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.

Sustainable Income (3 of 4)

Comprehensive Income

All changes in stockholders’ equity except those resulting from

investments by stockholders and

distributions to stockholders.

Certain gains and losses bypass net income and instead are reported as direct adjustments to stockholders’ equity.

Example – Unrealized gain or loss on Available-for-sale securities.

Comprehensive Income (1 of 5)

Illustration of Comprehensive Income

Accounting standards require companies to adjust most investments in stocks and bonds up or down to their market value at the end of each accounting period.

Illustration: During 2017 Stassi Company purchased IBM stock for $10,000 as an investment. At the end of 2017 Stassi was still holding the investment, but the stock’s market value was now $8,000.

How should Stassi account for the $2,000 unrealized loss?

Comprehensive Income (2 of 5)

Illustration of Comprehensive Income

How should Stassi account for the $2,000 unrealized loss?

Answer: Depends on whether Stassi classifies the IBM stock as a

Trading security or an → Unrealized gains and losses (Income Statement)

Available for-sale security. → Unrealized gains and losses (Comprehensive Income - Stockholders’ Equity)

Comprehensive Income (3 of 5)

Format One

Combined statement of income and comprehensive income.

Comprehensive Income (4 of 5)

Format Two

Separate component of Stockholders’ Equity.

Comprehensive Income (5 of 5)

Sustainable Income (4 of 4)

Changes in Accounting Principle

Principle used in the current year is different from one used in the preceding year.

Example - change from F I F O to average cost.

Permissible when management can show new principle is preferable.

Most changes are reported retroactively.

Investor Insight United Parcel Service (U P S)

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 (U P S), Honeywell International, IBM, AT&T, and Verizon Communications. The C FO at U P S 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 U P S switched, it resulted in a charge of $827 million from the change in accounting principle.

Source: Bob Sechler and Doug Cameron, “U P S Alters Pension-Plan Accounting,” Wall Street Journal (January 30, 2012).

Quality of Earnings (1 of 3)

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.

Quality of Earnings (2 of 3)

Alternative Accounting Methods

Variations among companies in the application of G A A P may hamper comparability and reduce quality of earnings (F I F O vs. L I F O).

Pro Forma Income

Usually excludes items that are unusual or nonrecurring.

Some companies have abused the flexibility that pro forma numbers allow to put their companies in a more favorable light.

Quality of Earnings (3 of 3)

Improper Recognition

Some managers have felt pressure to continually increase earnings.

Abuses include:

Improper recognition of revenue (channel stuffing).

Improper capitalization of operating expenses (WorldCom).

Failure to report all liabilities (Enron).

Do It! 1: Unusual Items (1 of 2)

In its proposed 2017 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.”

Do It! 1: Unusual Items (2 of 2)

L O 2: Apply Horizontal Analysis and Vertical Analysis

Analyzing financial statements involves:

Comparison Bases

Intracompany

Intercompany

Industry averages

Basic Tools

Horizontal analysis

Vertical analysis

Ratio Analysis

Horizontal Analysis (1 of 3)

Also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time.

Purpose is to determine increase or decrease that has taken place.

Commonly applied to the balance sheet and income statement.

Horizontal Analysis (2 of 3)

Horizontal Analysis (3 of 3)

Vertical Analysis (1 of 4)

Also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount.

Vertical analysis is commonly applied to the balance sheet and the income statement.

Vertical Analysis (2 of 4)

Vertical Analysis (3 of 4)

Vertical Analysis (4 of 4)

Anatomy of a Fraud (1 of 2)

This final Anatomy of a Fraud box demonstrates that 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

Anatomy of a Fraud (2 of 2)

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).

Do It! 2: Horizontal Analysis

Summary financial information for Rosepatch Company is as follows.

Blank	December 31, 2017	December 31, 2016
Current assets	$234,000	$180,000
Plain assets (net)	756,000	420,000
Total assets	$990,000 double underline	$600,000 double underline

Compute the amount and percentage changes in 2017 using horizontal analysis, assuming 2016 is the base year.

L O 3: Analyze a Company's Performance Using Ratio Analysis

Price-earnings Ratio

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

Will be higher if investors think that earnings will increase substantially in the future.

Will be lower when there is the belief that a company has poor-quality earnings.

Price-Earnings Ratio

Company	Earnings per Share	Price-Earnings Ratio
Southwest Airlines	$ 1.65	19.5
Google	29.80	27.0
Apple	6.49	15.6
Skechers USA	2.74	34.0
Nike	3.05	28.7

Liquidity Ratios (1 of 2)

Liquidity Ratios

Working capital

Current ratio

Inventory turnover

Days in inventory

Accounts receivable turnover

Average collection period

Investor Insight (1 of 2)

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.

Solvency Ratios (1 of 2)

Solvency Ratios

Debt to assets ratio

Times interest earned

Free cash flow

Profitability Ratios (1 of 3)

Profitability Ratios

Earnings per share

Price-earnings ratio

Gross profit rate

Profit margin

Profitability Ratios (2 of 3)

Return on assets

Asset turnover

Payout ratio

Return on common stockholders' equity

Investor Insight (2 of 2)

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.

Source: 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).

L O 4: Appendix 13A: Evaluate a Company Comprehensively Using Ratio Analysis

Analyzing financial statements involves:

Characteristics

Liquidity

Profitability

Solvency

Comparison Bases

Intracompany

Industry averages

Intercompany

The financial information in Illustrations 13A-1 through 13A-4 will be used to calculate Chicago’s 2014 ratios.

Evaluate a Company Comprehensively Using Ratio Analysis (1 of 3)

Evaluate a Company Comprehensively Using Ratio Analysis (2 of 3)

Evaluate a Company Comprehensively Using Ratio Analysis (3 of 3)

Ratio Analysis

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

Financial Ratio Classifications

Liquidity

Measures short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

Solvency

Measures the ability of the company to survive over a long period of time.

Profitability

Measures the income or operating success of a company for a given period of time.

Liquidity Ratios (2 of 2)

Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.

Ratios include the current ratio, the current cash debt coverage, the accounts receivables turnover, the average collection period, the inventory turnover, and days in inventory.

Current Ratio

Expresses the relationship of current assets to current liabilities.

What do the measures tell us?

A current ratio of .67 means that for every dollar of current liabilities, the company has $0.67 of current assets.

Accounts Receivable Turnover

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

How does Chicago’s turnover compare to General Mills’s?

The turnover of 11.9 times is higher than the industry average of 11.2 times, and slightly lower than General Mills’ turnover of 12.2 times.

Average Collection Period

Converts the receivable turnover ratio into days.

How effective is Chicago’s credit and collection policies?

General rule - collection period should not greatly exceed the credit term period (i.e., the time allowed for payment).

Inventory Turnover

Measures the number of times average inventory was sold during the period.

How does Chicago’s turnover compare to General Mills’s?

The ratio of 7.5 times is higher than the industry average of 6.7 times and similar to that of General Mills.

Days in Inventory

Measures the average number of days inventory is held.

How does Chicago’s days compare to General Mills’s?

An average selling time of 49 days is faster than the industry average and faster than that of General Mills.

Solvency Ratios (2 of 2)

Measure the ability of a company to survive over a long period of time.

Debt-Paying Ability

Debt to total assets ratio

Times interest earned

Free cash flow

Debt to Assets Ratio

Indicates the degree of financial leveraging. Provides some indication of the company’s ability to withstand losses.

Has Chicago’s solvency improved during the year?

Yes. The ratio of 78% says that Chicago would have to liquidate 78% of its assets at their book value in order to pay off all of its debts.

Times Interest Earned

Also called interest coverage, indicates the company’s ability to meet interest payments as they come due.

Is Chicago able to service its’ debt?

Yes, the ratio indicates that income before interest and taxes was 5.8 times the amount needed for interest expense.

Free Cash Flow

Ability to pay dividends or expand operations.

Cash provided by operations was more than enough to allow Chicago to acquire additional productive assets and maintain dividend payments.

Profitability Ratios (3 of 3)

Measure the income or operating success of a company for a given period of time.

Return on Common Stockholders’ Equity

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

Chicago’s 2014 rate of return on common stockholders’ equity is unusually high at 48%, considering an industry average of 19% and General Mills’s return of 25%.

Return on Assets (1 of 2)

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

Note that Chicago’s rate of return on common stockholders’ equity (48%) is substantially higher than its rate of return on assets (10%). Chicago has made effective use of leverage.

Profit Margin

Or rate of return on sales, is a measure of the percentage of each dollar of sales that results in net income.

High-volume (high inventory turnover) businesses such as grocery stores and pharmacy chains generally have low profit margins.

Asset Turnover

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

The average asset turnover for utility companies is .45, for example, while the grocery store industry has an average asset turnover of 3.49.

Return on Assets (2 of 2)

You can analyze the combined effects of profit margin and asset turnover on return on assets for Chicago as shown.

Gross Profit Rate

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

As an industry becomes more competitive, this ratio declines.

Earnings Per Share (EPS)

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

Price-Earnings (P-E) Ratio

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

A lower P-E ratio suggests that the market is less optimistic about Chicago cereal than about General Mills. It might also signal that its stock is underpriced.

Payout Ratio

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

This ratio should be calculated over a longer period of time to evaluate any trends.

A Look at I F R S- L O-5: Compare Financial Statement Analysis and Income Statement Presentation Under G A A P and I F R S

Relevant Facts

The tools of financial statement analysis covered in this chapter are universal and therefore no significant differences exist in the analysis methods used.

The accounting for changes in accounting principles and changes in accounting estimates are the same for both G A A P and I F R S.

Both G A A P and I F R S follow the same approach in reporting comprehensive income.

A Look at I F R S (1 of 8)

Relevant Facts

The basic objectives of the income statement are the same under both G A A P and I F R S. A very important objective is to ensure that users of the income statement can evaluate the sustainable income of the company. Thus, both the I A S B and the F A S B are interested in distinguishing normal levels of income from unusual items in order to better predict a company’s future profitability.

The basic accounting for discontinued operations is the same under I F R S and G A A P.

A Look at I F R S (2 of 8)

Looking to the Future

The F A S B and the I A S B are working on a project that would rework the structure of financial statements. Recently, the I A S B decided to require a statement of comprehensive income, similar to what was required under G A A P. In addition, another part of this project addresses the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, the approach draws attention away from one number—net income.

A Look at I F R S (3 of 8)

I F R S Practice

The basic tools of financial analysis are the same under both G A A P and I F R S except that:

a) horizontal analysis cannot be done because the format of the statements is sometimes different.

b) analysis is different because vertical analysis cannot be done under I F R S.

c) the current ratio cannot be computed because current liabilities are often reported before current assets in I F R S statements of position.

d) None of the above.

A Look at I F R S (4 of 8)

I F R S Practice

The basic tools of financial analysis are the same under both G A A P and I F R S except that:

a) horizontal analysis cannot be done because the format of the statements is sometimes different.

b) analysis is different because vertical analysis cannot be done under I F R S.

c) the current ratio cannot be computed because current liabilities are often reported before current assets in I F R S statements of position.

d) None of the above.

A Look at I F R S (5 of 8)

I F R S Practice

Presentation of comprehensive income must be reported under IFRS in:

a) the statement of stockholders’ equity.

b) the income statement ending with net income.

c) the notes to the financial statements.

d) a statement of comprehensive income.

A Look at I F R S (6 of 8)

I F R S Practice

Presentation of comprehensive income must be reported under IFRS in:

a) the statement of stockholders’ equity.

b) the income statement ending with net income.

c) the notes to the financial statements.

d) a statement of comprehensive income.

A Look at I F R S (7 of 8)

I F R S Practice

In preparing its income statement for 2017, Parmalane assembles the following information.

Sales revenue	$500,000
Cost of goods sold	300,000
Operating expenses	40,000
Loss on discontinued operations	20,000

Ignoring income taxes, what is Parmalane’s income from continuing operations for 2017 under I F R S?

a) $260,000.

b) $250,000.

c) $240,000.

d) $160,000.

A Look at I F R S (8 of 8)

I F R S Practice

In preparing its income statement for 2017, Parmalane assembles the following information.

Sales revenue	$500,000
Cost of goods sold	300,000
Operating expenses	40,000
Loss on discontinued operations	20,000

Ignoring income taxes, what is Parmalane’s income from continuing operations for 2017 under I F R S?

a) $260,000.

b) $250,000.

c) $240,000.

d) $160,000.

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$990,000

$600,000

Market Price per Share

Price-Earnings (P-E) Ratio

Earnings per Share

Stock Price per Share

Price-Earnings (P-E) Ratio

Earnings per Share

Current assetsCurrent liabilities

Current assets

Current liabilities

Cost of goods sold

Average inventory

365days

Inventory turnover

Net credit sales

Average net accounts receivable

365days

Accounts receivable turnover

Total liabilities

Total assets

Net income + Interest expense + Income t

ax expense

Interest expense

Net cash providedCapitalCash

by operating activitiesexpendituresdivid

ends

Net incomePreferred dividends

Weighted-average common shares outstandi

Market price per share

Earnings per share

Gross profit

Net sales

Net income

Net sales

Net income

Average total assets

Net sales

Average total assets

Cash dividends declared on common stock

Net income

Net incomePreferred dividends

Average common stockholders' equity