ACC 400 Week four assignment

financial_accounting_4e_ch13.pdf

Home >Business & Finance homework help >Accounting homework help >ACC 400 Week four assignment

ee eBook Collection

Making the Numbers

There it is again, perched near the top ofFortune’s “Most Admired Companies” list. But when the people who run General Electric go out in public these days, they don’t exactly get to bask in adulation. Instead, they have to explain how their company is not like Enron, or Global Crossing, or Tyco.

At one level, that’s a pretty easy argument to make. GE is not about to collapse or to break up. It has tons of cash, and its businesses generate upwards of a billion dollars every month. It is one of only a handful of companies with a triple-A credit rating. It makes real things like turbines and refrigerators that people spend real money to buy.

GE also has an enviable record of pleasing Wall Street. Quarter after quarter, year after year, GE’s earnings come gushing in, usually at least 10% higher than the year before, and almost invariably in line with analysts’ estimates.

This used to be seen as a good thing. “Making the numbers” became the most watched measure of corporate performance. By missing only once during a 10-year period (by a penny, in the fourth quarter of 1997), GE ensured itself a hallowed place in the corporate hall of fame.

But as one analyst noted, “Smoking used to be chic and fashionable and cool; now it’s not. The

Financial Analysis: The Big Picture

S T U D Y O B J E C T I V E S

13C H A P T E R 13

F E A T U R E S T O R Y

●❍ T H E N A V I G A T O R

● Scan Study Objectives

● Read Feature Story

● Read Preview

● Read text and answer Before You Go On p. 653 p. 661 p. 663

● Work Using the Decision Toolkit

● Review Summary of Study Objectives

● Work Demonstration Problem

● Answer Self-Study Questions

● Complete Assignments

✔✔

After studying this chapter, you should be able to:

1 Understand the concept of sustainable income.

2 Indicate how irregular items are presented.

3 Explain the concept of comprehensive income.

4 Describe and apply horizontal analysis.

5 Describe and apply vertical analysis.

6 Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

7 Understand the concept of quality of earnings.

●❍ THE NAVIGATOR ✓✓

joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka

Last #1 Head 645

companies that reliably deliver 15% earnings growth year after year are the new smokers.” All of which means that GE’s chief executive, Jeffrey Immelt, now finds himself having to tell interviewer after interviewer that no, he’s not an earnings cheat.

“Would a miss be more honest?” Immelt asks, with exasperation in his voice. “I think that’s terrible. That’s where the world has gotten totally turned on its head, where somewhere I’d walk up

to a podium and get a Nobel Peace Prize for saying ‘I missed my numbers—aren’t you proud of me?’ ”

Source: Adapted from Justin Fox, “What’s So Great About GE?” Fortune (March 4, 2002), pp. 65–66.

645

●❍ THE NAVIGATOR ✓✓

On the World Wide Web General Electric: www.ge.com

646 CHAPTER 13 Financial Analysis: The Big Picture

As indicated in our Feature Story, even the most admired companies in the United States are under attack for their earnings and disclosure practices. A climate of skepticism has caused many companies to lose billions of dollars in market value if there is even the slightest hint that the company is involved in some form of creative accounting. The purpose of this chapter is to explain the importance of performance measurement and to highlight the difficulties of developing high- quality earnings numbers, given the complexities of modern business trans- actions.

The content and organization of this chapter are as follows.

Sustainable Income Ultimately, the value of a company is a function of its future cash flows. When analysts use this year’s net income to estimate future cash flows, they must make sure that this year’s net income does not include irregular (i.e., out of the ordi- nary) revenues, expenses, gains, or losses. Net income adjusted for irregular items is referred to as sustainable income. Sustainable income is the most likely level of income to be obtained in the future. Sustainable income differs from actual net income by the amount of irregular revenues, expenses, gains, and losses included in this year’s net income.

Users are interested in sustainable income because it helps them derive an estimate of future earnings without the “noise” of irregular items. For example, suppose Rye Corporation reports that this year’s net income is $500,000 but in- cluded in that amount is a once-in-a-lifetime gain of $400,000. In estimating next year’s net income for Rye Corporation, we would likely ignore this $400,000 gain and estimate that next year’s net income will be in the neighborhood of $100,000. That is, based on this year’s results, the company’s sustainable income is roughly $100,000. Therefore, identifying irregular items is important if you are going to use reported earnings to estimate a company’s value.

In earlier chapters you learned how to prepare and use a basic multiple-step income statement. In this chapter we will explain additional components of the income statement as well as a broader measure of performance called compre- hensive income. Illustration 13-1 (page 647) presents the components of the income statement and comprehensive income; new items are presented in red. When estimating future cash flows, analysts must consider the implications that each of these components has for future cash flows.

FINANCIAL ANALYSIS: THE BIG PICTURE

• Irregular items

• Changes in accounting principle

• Comprehensive income

Sustainable Income

• Horizontal analysis

• Vertical analysis

Comparative Analysis

• Liquidity ratios

• Solvency ratios

• Profitability ratios

Ratio Analysis

• Alternative accounting methods

• Pro forma income

• Improper recognition

• Price-earnings ratio

Quality of Earnings

●❍ THE NAVIGATOR ✓✓

S T U D Y O B J E C T I V E

1 Understand the concept of

sustainable income.

P R E V I E W O F C H A P T E R 1 3 d ccccoomoo papapapanieseseses innn n thththeeee UnUnUnUnitititedededed

Sustainable Income 647

IRREGULAR ITEMS As an aid in determining sustainable income, we identify irregular items by type on the income statement. There, companies report two types of irregular items:

1. Discontinued operations

2. Extraordinary items

Irregular items are reported net of income taxes. That is, a company first calcu- lates income tax expense for the income before irregular items. Then it calculates income tax expense for each individual irregular item. The general concept is, “Let the tax follow the income or loss.”

Discontinued Operations To downsize its operations, General Dynamics Corp. sold its missile business to Hughes Aircraft Co. for $450 million. In its income statement, General Dynamics reported the sale in a separate section entitled “Discontinued operations.” Discon- tinued 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. When the disposal of a significant component occurs, the income statement should re- port the gain (or loss) from discontinued operations, net of tax.

To illustrate, assume that Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in 2007. The company there- fore has income before income taxes of $800,000. During 2007 the company discontinued and sold its unprofitable chemical division. The loss on disposal of the chemical division (net of $90,000 taxes) was $210,000. Illustration 13-2 shows the income statement presentation, assuming a 30% tax rate on income before income taxes.

Illustration 13-1 Components of the income statement

Income Statement Sales $XX Cost of goods sold XX

Gross profit XX Operating expenses XX

Income from operations XX Other revenues (expenses) and gains (losses) XX

Income before income taxes XX Income tax expense XX

Income before irregular items XX Irregular items (net of tax) XX Net income XX Other comprehensive income items (net of tax) XX Comprehensive income $XX

ROZEK INC. Income Statement (partial)

For the Year Ended December 31, 2007

Income before income taxes $ 800,000 Income tax expense 240,000

Income before irregular items 560,000 Discontinued operations

Loss from disposal of chemical division, net of $90,000 income tax savings (210,000)

Net income $ 350,000

Illustration 13-2 Statement presentation of discontinued operations

S T U D Y O B J E C T I V E

2 Indicate how irregular items

are presented.

Illustration 13 1 CoCCC mpmpmpmponennnntstsss oooof fff thhhheeee innncooomme staaateeeememmm nt

648 CHAPTER 13 Financial Analysis: The Big Picture

This presentation clearly indicates the separate effects of continuing opera- tions and discontinued operations on net income.

Extraordinary Items Extraordinary items are events and transactions that meet two conditions: They are unusual in nature and infrequent in occurrence. To be considered un- usual, the item should be abnormal and only incidentally related to the custom- ary activities of the entity. To be regarded as infrequent, the event or transaction should not be reasonably expected to recur in the foreseeable future.

A company must evaluate both criteria in terms of the environment in which it operates. Thus, Weyerhaeuser Co. reported the $36 million in damages to its timberland caused by the eruption of Mount St. Helens as an extraordinary item because the event was both unusual and infrequent. In contrast, Florida Citrus Company does not report frost damage to its citrus crop as an extraordinary item because frost damage is not viewed as infrequent.

Companies report extraordinary items net of taxes in a separate sec- tion of the income statement, immediately below discontinued operations. To illustrate, assume that in 2007 a revolutionary foreign government expropri- ated property held as an investment by Rozek Inc. If the loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000, as in Illustration 13-3.

If a transaction or event meets one but not both of the criteria for an ex- traordinary item, a company should report it in a separate line item in the up- per half of the income statement, rather than in the bottom half as an extraor- dinary item. Usually companies report these items under either “Other revenues and gains” or “Other expenses and losses” at their gross amount (not net of tax). This is true, for example, of gains (losses) resulting from the sale of property,

Helpful Hint Ordinary gains and losses are reported at pretax amounts in arriving at income before income taxes.

ROZEK INC. Income Statement (partial)

For the Year Ended December 31, 2007

Income before income taxes $ 800,000 Income tax expense 240,000

Income before irregular items 560,000 Discontinued operations: Loss from disposal of

chemical division, net of $90,000 income tax savings (210,000) Extraordinary item: Expropriation of investment,

net of $21,000 income tax savings (49,000)

Net income $ 301,000

Illustration 13-3 Statement presentation of extraordinary items

Has the company sold any major components of its business?

Discontinued operations section of income statement

Anything reported in this section indicates that the company has discontinued a major component of its business.

If a major component has been discontinued, its results during the current period should not be included in estimates of future net income.

Decision Toolkit Decision Checkpoints Info Needed for Decision Tool to Use for Decision How to Evaluate Results

ffffecececects oooof cococoontinuing opera

Sustainable Income 649

In summary, in evaluating a company, it generally makes sense to elim- inate all irregular items in estimating future sustainable income.

Extraordinary items

1. Effects of major natural casualties, if rare in the area.

2. Expropriation (takeover) of property by a foreign government.

3. Effects of a newly enacted law or regulation, such as a condemnation action.

Ordinary items

1. Effects of major natural casualties, not uncommon in the area.

2. Write-down of inventories or write-off of receivables.

3. Losses attributable to labor strikes.

4. Gains or losses from sales of property, plant, or equipment.

unco llecti

ble XYZ

INVOICE

Illustration 13-4 Classification of extraordi- nary and ordinary items

Many companies these days are incurring restructuring charges as a result of attempting to reduce costs. Are these costs ordinary or extraordinary? Some companies report “one-time” restructuring charges over and over. Case in point: Toothpaste and diapers giant Procter & Gamble Co. reported a restructuring charge in 12 consecutive quarters, and Motorola had “special” charges 14 quar- ters in a row. On the other hand, some companies take a restructuring charge only once in five years. The one-size-fits-all classification therefore will not work. There appears to be no substitute for a careful analysis of the numbers that com- prise net income.

If a company takes a large restructuring charge, what is the effect on the company’s current income statements versus future ones?

Business Insight I n v e s t o r P e r s p e c t i v e

plant, and equipment, as explained in Chapter 9. Illustration 13-4 shows the appropriate classification of extraordinary and ordinary items.

IIIlluststrationnn 1113-3-3-3-4 CClCC asssssisisififificacacacatitititiononono ooo off f f extttrt aaaoa r

hohohohowwsw theee

650 CHAPTER 13 Financial Analysis: The Big Picture

CHANGES IN ACCOUNTING PRINCIPLE For ease of comparison, users of financial statements expect companies to pre- pare such statements on a basis consistent with the preceding period. A change in accounting principle occurs when the principle used in the current year is dif- ferent from the one used in the preceding year. Accounting rules permit a change when management can show that the new principle is preferable to the old prin- ciple. An example is a change in inventory costing methods (such as FIFO to av- erage cost).

Companies report most changes in accounting principle retroactively.1 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.

Has the company experienced any extraordinary events or transactions?

Extraordinary item section of in- come statement

Anything reported in this section indicates that the company expe- rienced an event that was both unusual and infrequent.

These items should usually be ignored in estimating future net income.

Decision Toolkit Decision Checkpoints Info Needed for Decision Tool to Use for Decision How to Evaluate Results

Has the company changed any of its accounting principles?

Effect of change in accounting principle on current and prior periods.

Management indicates that the new principle is preferable to the old principle.

Examine current and prior years reported, using new-principle ba- sis to assess trends for estimat- ing future income.

Decision Toolkit Decision Checkpoints Info Needed for Decision Tool to Use for Decision How to Evaluate Results

1 An exception to the general rule is a change in depreciation methods. The effects of this change

are reported in current and future periods. Discussion of this approach in left for more advanced courses.

COMPREHENSIVE INCOME Most revenues, expenses, gains, and losses are included in net income. However, certain gains and losses bypass net income. Instead, companies record these items as direct adjustments to stockholders’ equity. Many analysts have expressed concern about this practice because they believe it reduces the usefulness of the income statement. To address this concern, the FASB requires companies to re- port not only net income, but also comprehensive income. Comprehensive in- come includes all changes in stockholders’ equity during a period except those

S T U D Y O B J E C T I V E

3 Explain the concept of

comprehensive income.

Sustainable Income 651

changes resulting from investments by stockholders and distributions (dividends) to stockholders.

Illustration of Comprehensive Income Accounting standards require that companies adjust most investments in stocks and bonds up or down to their market value at the end of each accounting pe- riod. For example, assume that during 2007 Stassi Company purchased IBM stock for $10,000 as an investment. At the end of 2007 Stassi was still holding the investment, but the stock’s market value was now $8,000. In this case, Stassi is required to reduce the recorded value of its IBM investment by $2,000. The $2,000 difference is an unrealized loss.

Should Stassi include this $2,000 unrealized loss in net income? It depends on whether Stassi classifies the IBM stock 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 in- come statement. The rationale: It is likely that the company will realize the unre- alized 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 classi- fied 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 re- port them as part of “Other comprehensive income.” For example, if Stassi does not intend to sell its IBM stock in the near term, it may not ever have to real- ize the loss. By the time Stassi sells the IBM stock, its value may have recov- ered, and Stassi may actually end up with a gain.

Format One format for reporting comprehensive income is to report a combined state- ment of income and comprehensive income.2 For example, assuming that Stassi Company has a net income of $300,000, the unrealized loss would adjust net income as follows.

2 Computation of comprehensive income is sometimes shown in a separate statement of

comprehensive income or as a section in the stockholders’ equity statement.

STASSI CORPORATION Combined Statement of Income and

Comprehensive Income (partial)

Net income $300,000 Unrealized loss on available-for-sale securities 2,000

Comprehensive income $298,000

Illustration 13-5 Lower portion of combined statement of income and comprehensive income

Companies also report the unrealized loss on available-for-sale securities as a sep- arate component of stockholders’ equity. To illustrate, assume Stassi Corporation has common stock of $3,000,000, retained earnings of $1,500,000, and an unre- alized loss on available-for-sale securities of $2,000. Illustration 13-6 (page 652) shows the balance sheet presentation of the unrealized loss.

iiiivivivividendnnn s)))

652 CHAPTER 13 Financial Analysis: The Big Picture

Note that the presentation of the 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.) Reporting the unrealized gain or loss in the stockholders’ equity section serves two important purposes: (1) It reduces the volatility of net income due to fluctuations in fair value, and (2) it informs the financial statement user of the gain or loss that would occur if the company sold the securities at fair value.

Complete Income Statement The income statement for Pace Corporation in Illustration 13-7 presents the types of items found on this statement, such as net sales, cost of goods sold, operat- ing expenses, and income taxes. In addition, it shows how companies report irregular items and comprehensive income (highlighted in red).

Illustration 13-6 Unrealized loss in stockholders’ equity section

STASSI CORPORATION Balance Sheet (partial)

Stockholders’ equity Common stock $3,000,000 Retained earnings 1,500,000

Total paid-in capital and retained earnings 4,500,000 Less: Unrealized loss on available-for-sale

securities (2,000)

Total stockholders’ equity $4,498,000

Illustration 13-7 Complete income statement

PACE CORPORATION Income Statement and

Statement of Comprehensive Income For the Year Ended December 31, 2007

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) (4,000)

Income before income taxes 66,000 Income tax expense ($66,000 � 30%) 19,800

Income before irregular items 46,200 Discontinued operations: Gain on disposal of

Plastics Division, net of $15,000 income taxes ($50,000 � 30%) 35,000

Extraordinary item: Tornado loss, net of income tax savings $18,000 ($60,000 � 30%) (42,000)

Net income 39,200 Add: Unrealized gain on available-for-sale securities 10,000

Comprehensive income $ 49,200

CONCLUDING REMARKS We have shown that the computation of the correct net income number can be elusive. In assessing the future prospects of a company, some investors focus on income from operations and therefore ignore all irregular and other items.

Comparative Analysis 653

Others use measures such as net income, comprehensive income, or some mod- ified version of one of these amounts.

B E F O R E Y O U G O O N . . .

� Review It

1. What is sustainable income? 2. What are irregular items, and what effect might they have on the estimation

of future earnings and future cash flows? 3. What amount did Tootsie Roll Industries report as “Other comprehensive

earnings” in 2004? By what percentage did Tootsie Roll’s “Comprehensive earnings” differ from its “Net earnings”? The answer to this question appears on page 703.

Comparative 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 book, we have relied on three types of comparisons to improve the decision use- fulness of financial information.

1. Intracompany basis. Comparisons within a company are often useful to de- tect changes in financial relationships and significant trends. For example, a comparison of Kellogg’s current year’s cash amount with the prior year’s cash amount shows either an increase or a decrease. Likewise, a compari- son 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 Quaker Oats and General Mills.

3. Industry averages. Comparisons with industry averages provide informa- tion 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 ratings organizations such as Dun & Bradstreet, Moody’s, and Standard & Poor’s, or with informa- tion 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 sig- nificance 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.

●❍ THE NAVIGATOR ✓✓

memememe mmmmod

654 CHAPTER 13 Financial Analysis: The Big Picture

HORIZONTAL ANALYSIS Horizontal analysis, also known as trend analysis, is a technique for evaluat- ing a series of financial statement data over a period of time. 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 mil- lions) of Kellogg Company:

2004 2003 2002 2001 2000

$9,613.9 $8,811.5 $8,304.1 $7,548.4 $6,086.7

Alternative Terminology Horizontal analysis is also often referred to as trend analysis.

Illustration 13-8 Horizontal analysis— Computation of changes since base period

� Current-Year Amount � Base-Year Amount ��

Base-Year Amount Change Since Base Period

S T U D Y O B J E C T I V E

4 Describe and apply horizontal analysis.

If we assume that 2000 is the base year, we can measure all percentage increases or decreases relative to this base-period amount with the formula shown in Illustration 13-8.

For example, we can determine that net sales for Kellogg Company increased approximately 24.0% [($7,548.4 � $6,086.7) � $6,086.7] from 2000 to 2001. Sim- ilarly, we can also determine that net sales increased by 57.9% [($9,613.9 � $6,086.7) � $6,086.7] from 2000 to 2004.

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 13-9.

Illustration 13-9 Horizontal analysis— Computation of current year in relation to base year

� Current-Year Amount ��

Base-Year Amount Current Results in

Relation to Base Period

Current-period sales expressed as a percentage of the base period for each of the five years, using 2000 as the base period, are shown in Illustration 13-10.

KELLOGG COMPANY Net Sales (in millions)

Base Period 2000

2004 2003 2002 2001 2000

$9,613.9 $8,811.5 $8,304.1 $7,548.4 $6,086.7 157.95% 144.77% 136.43% 124.01% 100%

Illustration 13-10 Horizontal analysis of net sales

The large increase in net sales during 2001 would raise questions regarding possible reasons for such a significant change. Kellogg’s 2001 notes to the fi- nancial statements explain that “the Company completed its acquisition of Keebler Foods Company” during 2001. 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 Kellogg Company. Its two-year condensed balance sheets for 2004 and 2003, showing dollar and percentage changes, are presented in Illustration 13-11.

s aaaa ttttecececechnhnhnhniqueuu fffoor evaaalululul ataaa - of fff tttit memememe. Ittts sss pupupupurprprposososose e e e isisisi tt ttoooo

Comparative Analysis 655

The comparative balance sheet shows that a number of changes occurred in Kellogg’s financial position from 2003 to 2004. In the assets section, current as- sets increased $333.9 million, or 18.7% ($333.9 � $1,787.9), and property assets (net) decreased $65.1 million, or 2.3%. Other assets increased $378.9, or 6.8%. In the liabilities section, current liabilities increased $80.0 million, or 2.9%, while long-term liabilities decreased $246.3 million, or 4.2%. In the stockholders’ equity section, we find that retained earnings increased $742.9 million, or 48.9%.

Illustration 13-12 presents a two-year comparative income statement of Kellogg Company for 2004 and 2003, showing dollar and percentage changes.

Illustration 13-11 Horizontal analysis of a balance sheet

KELLOGG COMPANY, INC. Condensed Balance Sheets

December 31 (in millions)

Increase (Decrease) during 2004

Assets 2004 2003 Amount Percent

Current assets $ 2,121.8 $ 1,787.9 $333.9 18.7 Property assets (net) 2,715.1 2,780.2 (65.1) (2.3) Other assets 5,953.5 5,574.6 378.9 6.8

Total assets $10,790.4 $10,142.7 $647.7 6.4

Liabilities and Stockholders’ Equity

Current liabilities $ 2,846.0 $ 2,766.0 $ 80.0 2.9 Long-term liabilities 5,687.2 5,933.5 (246.3) (4.2)

Total liabilities 8,533.2 8,699.5 (166.3) (1.9)

Stockholders’ equity Common stock 103.8 128.3 (24.5) (19.1) Retained earnings 2,261.4 1,518.5 742.9 48.9 Treasury stock (cost) (108.0) (203.6) (95.6) (47.0)

Total stockholders’ equity 2,257.2 1,443.2 814.0 56.4

Total liabilities and stockholders’ equity $10,790.4 $10,142.7 $647.7 6.4

Illustration 13-12 Horizontal analysis of an income statement

KELLOGG COMPANY, INC. Condensed Income Statements

For the Years Ended December 31 (in millions)

Increase (Decrease) during 2004

2004 2003 Amount Percent

Net sales $9,613.9 $8,811.5 $802.4 9.1 Cost of goods sold 5,298.7 4,898.9 399.8 8.2

Gross profit 4,315.2 3,912.6 402.6 10.3 Selling and administrative expenses 2,634.1 2,368.5 265.6 11.2

Income from operations 1,681.1 1,544.1 137.0 8.9 Interest expense 308.6 371.4 (62.8) (16.9) Other income (expense), net (6.6) (3.2) 3.4 106.3

Income before income taxes 1,365.9 1,169.5 196.4 16.8 Income tax expense 475.3 382.4 92.9 24.3

Net income $ 890.6 $ 787.1 $103.5 13.1

Helpful Hint Note that, in a horizontal analysis, while the amount column is additive (the total is $103.5 million), the per- centage column is not additive (13.1% is not a total).

Helpful Hint When using hori- zontal 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.

Illustration 13 11 HoHHH ririririzozozozontal a aaanananaalylylylysisisisis s ss of aaaa bbbalaaannce shhheeeeeeeetttt

656 CHAPTER 13 Financial Analysis: The Big Picture

Horizontal analysis of the income statements shows the following changes: Net sales increased $802.4 million, or 9.1% ($802.4 � $8,811.5). Cost of goods sold increased $399.8 million, or 8.2% ($399.8 � $4,898.9). Selling and admin- istrative expenses increased $265.6 million, or 11.2% ($265.6 � $2,368.5). Over- all, gross profit increased 10.3% and net income increased 13.1%. The increase in net income can be attributed to the increase in net sales and a decrease in interest expense.

The measurement of changes from period to period in percentages is rela- tively 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. Like- wise, no percentage change can be computed if a negative amount appears in the base or preceding period and a positive amount exists the following year.

How do the company’s finan- cial position and operating re- sults compare with those of the previous period?

Income statement and balance sheet

Comparative financial statements should be prepared over at least two years, with the first year reported being the base year. Changes in each line item rela- tive to the base year should be presented both by amount and by percentage. This is called horizontal analysis.

Significant changes should be investigated to determine the reason for the change.

Decision Toolkit Decision Checkpoints Info Needed for Decision Tool to Use for Decision How to Evaluate Results

VERTICAL ANALYSIS Vertical analysis, also called common-size analysis, is a technique for evaluat- ing financial statement data that expresses each item in a financial statement as a percent of a base amount. For example, on a balance sheet we might say that current assets are 22% of total assets (total assets being the base amount). Or on an income statement we might say that selling expenses are 16% of net sales (net sales being the base amount).

Presented in Illustration 13-13 (page 657) is the comparative balance sheet of Kellogg for 2004 and 2003, 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.

In addition to showing the relative size of each category on the balance sheet, vertical analysis may show the percentage change in the individual asset, liabil- ity, and stockholders’ equity items. In this case, current assets increased $333.9 million from 2003 to 2004, and they increased from 17.6% to 19.7% of total assets. Property assets (net) decreased from 27.4% to 25.1% of total assets. Other assets increased from 55% to 55.2% of total assets. Also, retained earnings increased by $742.9 million from 2003 to 2004, and total stockholders’ equity increased from 14.2% to 20.9% of total liabilities and stockholders’ equity. This switch to a higher percentage of equity financing has two causes: First, total liabilities decreased by $166.3 million, going from 85.8% to 79.1% of total liabilities and stockholders’ equity. Second, retained earnings increased by $742.9 million, going from 15.0% to 20.9% of total liabilities and stockholders’ equity. Thus, the

S T U D Y O B J E C T I V E

5 Describe and apply vertical

analysis.

Alternative Terminology Vertical analysis is sometimes referred to as common-size analysis.

wswswsws theeee foolollloll wing changes: $8$8$8$8,8,8,8,811111 .5.5.5.5). C C CCossstt tt of gggoooodsdsdsds

98888.9.9.9.9). SSSSeeele lingngngg aaannd aaaadmdmdmmiinii - $266665 6 $2$$ 368 5))) O

Comparative Analysis 657

company shifted toward a heavier reliance on equity financing both by using less long-term debt and by increasing the amount of retained earnings.

Vertical analysis of the comparative income statements of Kellogg, shown in Illustration 13-14, reveals that cost of goods sold as a percentage of net sales decreased from 55.6% to 55.1%, and selling and administrative expenses increased from 26.9% to 27.4%. Net income as a percent of net sales increased from 8.9% to 9.3%. Kellogg’s increase in net income as a percentage of sales is due prima- rily to the decrease in interest expense as a percent of sales.

Illustration 13-13 Vertical analysis of a balance sheet

KELLOGG COMPANY, INC. Condensed Balance Sheets

December 31 (in millions)

2004 2003

Assets Amount Percent* Amount Percent*

Current assets $ 2,121.8 19.7 $ 1,787.9 17.6 Property assets (net) 2,715.1 25.1 2,780.2 27.4 Other assets 5,953.5 55.2 5,574.6 55.0

Total assets $10,790.4 100.0 $10,142.7 100.0

Liabilities and Stockholders’ Equity

Current liabilities $ 2,846.0 26.4 $ 2,766.0 27.3 Long-term liabilities 5,687.2 52.7 5,933.5 58.5

Total liabilities 8,533.2 79.1 8,699.5 85.8

Stockholders’ equity Common stock 103.8 1.0 128.3 1.2 Retained earnings 2,261.4 20.9 1,518.5 15.0 Treasury stock (cost) (108.0) (1.0) (203.6) (2.0)

Total stockholders’ equity 2,257.2 20.9 1,443.2 14.2

Total liabilities and stockholders’ equity $10,790.4 100.0 $10,142.7 100.0

*Numbers have been rounded to total 100%.

Illustration 13-14 Vertical analysis of an income statement

KELLOGG COMPANY, INC. Condensed Income Statements

For the Years Ended December 31 (in millions)

2004 2003

Amount Percent* Amount Percent*

Net sales $9,613.9 100.0 $8,811.5 100.0 Cost of goods sold 5,298.7 55.1 4,898.9 55.6

Gross profit 4,315.2 44.9 3,912.6 44.4 Selling and administrative expenses 2,634.1 27.4 2,368.5 26.9

Income from operations 1,681.1 17.5 1,544.1 17.5 Interest expense 308.6 3.2 371.4 4.2 Other income (expense), net (6.6) .1 (3.2) .1

Income before income taxes 1,365.9 14.2 1,169.5 13.2 Income tax expense 475.3 4.9 382.4 4.3

Net income $ 890.6 9.3 $ 787.1 8.9

*Numbers have been rounded to total 100%.

Illustration 13 13 VeVVV rtititit cccac l annnnalalala ysyssysisisisis oooofff f a bbbalaaannce shhheeeeeeeetttt

658 CHAPTER 13 Financial Analysis: The Big Picture

Vertical analysis also enables you to compare companies of different sizes. For example, one of Kellogg’s main competitors is General Mills. Using vertical analysis, we can more meaningfully compare the condensed income statements of Kellogg and General Mills, as shown in Illustration 13-15.

CONDENSED INCOME STATEMENTS For the Year Ended December 31, 2004

(in millions)

Kellogg General Company, Inc. Mills, Inc.

Amount Percent* Amount Percent*

Net sales $9,613.9 100.0 $11,070.0 100.0 Cost of goods sold 5,298.7 55.1 6,584.0 59.5

Gross profit 4,315.2 44.9 4,486.0 40.5 Selling and administrative expenses 2,634.1 27.4 2,443.0 22.1 Nonrecurring charges 0.0 — 26.0 .2

Income from operations 1,681.1 17.5 2,017.0 18.2 Other expenses and revenues

(including income taxes) 790.5 8.2 962.0 8.7

Net income $ 890.6 9.3 $ 1,055.0 9.5

*Numbers have been rounded to total 100%.

Illustration 13-15 Intercompany comparison by vertical analysis

Although Kellogg’s net sales are 13% less than those of General Mills, vertical analysis eliminates the impact of this size difference for our analysis. Kellogg has a higher gross profit, 44.9%, compared to 40.5% for General Mills, but Kellogg’s selling and administrative expenses are 27.4% of net sales, while those of General Mills are 22.1% of net sales. Looking at net income, we see that the companies report similar percentages: Kellogg’s net income as a percentage of net sales is 9.3%, compared to 9.5% for General Mills.

How do the relationships be- tween items in this year’s fi- nancial statements compare with those of last year or those of competitors?

Income statement and balance sheet

Each line item on the income statement should be presented as a percentage of net sales, and each line item on the balance sheet should be presented as a percentage of total assets or to- tal liabilities and stockholders’ equity. These percentages should be investigated for differences either across years in the same company or in the same year across different companies. This is called vertical analysis.

Any differences either across years or between companies should be investigated to deter- mine the cause.

Decision Toolkit Decision Checkpoints Info Needed for Decision Tool to Use for Decision How to Evaluate Results

mpmpmpmpanieeiees ofofoff different sizes. neeeerarararal l l l MiMiMiMilllllllls. UUUsU ininini g vertrtrtrtiicalalalal densnsnsnsedededed i i i innncn omome statemememe entstststs

13333 15

Ratio Analysis 659

Ratio Analysis In previous chapters we presented many ratios used for evaluating the financial health and performance of a company. Here we provide a summary listing of those ratios. (Page references to prior discussions are provided if you feel you need to review any individual ratios.) The appendix to this chapter provides an example of a comprehensive financial analysis employing these ratios.

LIQUIDITY RATIOS Liquidity ratios (Illustration 13-16) measure the short-term ability of the en- terprise 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.

S T U D Y O B J E C T I V E

6 Identify and compute ratios

used in analyzing a company’s liquidity,

solvency, and profitability.

Illustration 13-16 Summary of liquidity ratiosLiquidity Ratios

Working capital Current assets � Current liabilities p. 59

Current ratio p. 59

Current cash debt coverage ratio p. 607

Inventory turnover ratio p. 281

Days in inventory p. 281

Receivables turnover ratio p. 388

Average collection period p. 388 365 days

�� Receivables turnover ratio

Net credit sales �� Average net receivables

365 days �� Inventory turnover ratio

Cost of goods sold �� Average inventory

Cash provided by operations ��

Average current liabilities

Current assets �� Current liabilities

SOLVENCY RATIOS Solvency ratios (Illustration 13-17) measure the ability of the enterprise to sur- vive over a long period of time. Long-term creditors and stockholders are inter- ested in a company’s long-run solvency, particularly its ability to pay interest as it comes due and to repay the face value of debt at maturity.

Illustration 13-17 Summary of solvency ratios

Solvency Ratios

Debt to total assets ratio p. 60

Cash debt coverage ratio p. 608

Times interest earned p. 493ratio

Free cash flow � � p. 63 Cash

dividends Capital

expenditures Cash provided by

operations

Net income � Interest expense � Tax expense ��

Interest expense

Cash provided by operations ��

Average total liabilities

Total liabilities ��

Total assets

finanananancnccciaiaiaial

660 CHAPTER 13 Financial Analysis: The Big Picture

PROFITABILITY RATIOS Profitability ratios (Illustration 13-18) measure the income or operating suc- cess of an enterprise 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 in- terested in evaluating profitability. Profitability is frequently used as the ultimate test of management’s operating effectiveness.

Illustration 13-18 Summary of profitability ratios

Profitability Ratios

Earnings per share p. 55

Price-earnings ratio p. 662

Gross profit rate p. 234

Profit margin ratio p. 235

Return on assets ratio p. 437

Asset turnover ratio p. 439

Payout ratio p. 556

p. 558 Net income � Preferred stock dividends ��

Average common stockholders’ equity Return on common stockholders’ equity ratio

Cash dividends declared on common stock ��

Net income

Net sales �� Average total assets

Net income �� Average total assets

Net income ��

Net sales

Gross profit ��

Net sales

Stock price per share ��

Earnings per share

Net income � Preferred stock dividends ��

Average common shares outstanding

The apparent simplicity of the current ratio can have real-world limitations be- cause 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 as- sets 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?

Business Insight I n v e s t o r P e r s p e c t i v e

incncncncomomomomeee e orooo oopeeraatinggg ssssucucucuc- mpanananany’s sss iinii coooomemememe, ,, ororor ll l lacacacack k k ofofofof

Quality of Earnings 661

B E F O R E Y O U G O O N . . .

� Review It

1. What different bases can be used to compare financial information? 2. What is horizontal analysis? 3. What is vertical analysis? 4. Describe ratios that measure liquidity, solvency, and

profitability. ●❍ THE NAVIGATOR ✓✓

Quality of Earnings In evaluating the financial performance of a company, 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.

The issue of quality of earnings has taken on increasing importance because 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 account- ing principles may hamper comparability and reduce quality of earnings. For example, one company may use the FIFO method of inventory costing, while another company in the same industry may use 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 had used FIFO instead of LIFO for inventory valuation, its inventories in a recent 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 ex- ist in reporting such items as depreciation, depletion, 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 nonrecurring. 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 these days. For example, during one re- cent 9-month period the 100 largest firms on the Nasdaq stock exchange re- ported 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 can 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

S T U D Y O B J E C T I V E

7 Understand the concept of

quality of earnings.

662 CHAPTER 13 Financial Analysis: The Big Picture

press noted, pro forma numbers might be called EBS, which stands for “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 state- ment issued in response to questions about its pro forma income accounting.

Recently, the SEC provided some guidance on how companies should pre- sent 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 com- panies in a good light.

IMPROPER RECOGNITION Because some managers have felt pressure from Wall Street to continually in- crease earnings, they have manipulated the earnings numbers to meet these ex- pectations. The most common abuse is the improper recognition of revenue. One practice that companies are using is channel stuffing: Offering deep discounts on their products to customers, companies encourage their customers to buy early (stuff the channel) rather than later. This lets the company report good earnings in the current period, but it often leads to a disaster in subsequent pe- riods because customers have no need for additional goods. To illustrate, Bristol- Myers Squibb recently indicated that it used sales incentives to encourage whole- salers to buy more drugs than needed to meet patients’ demands. As a result, the company had to issue revised financial statements showing corrected rev- enues and income.

Another practice is the improper capitalization of operating expenses. The classic case is WorldCom. It capitalized over $7 billion dollars of operating ex- penses so that it would report positive net income. In other situations, compa- nies fail to report all their liabilities. Enron had 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.

PRICE-EARNINGS RATIO Earnings per share is net income available to common stockholders divided by the average number of common shares outstanding. The market value of a com- pany’s stock changes based on investors’ expectations about a company’s future earnings per share. In order to make a meaningful comparison of market val- ues and earnings across firms, investors calculate the price-earnings (P-E) ratio. The P-E ratio divides the market price of a share of common stock by earnings per share.

Illustration 13-19 Formula for price-earnings (P-E) ratio �

Stock Price per Share �� Earnings per Share

Price-Earnings (P-E) Ratio

The P-E ratio reflects investors’ assessment of a company’s future earnings. The ratio of price to earnings will be higher if investors think that earnings will increase substantially in the future and therefore are willing to pay more per

whwhwhwhich h h h stananannds for earnings e ththththatatatat p p p prorororo ffffororo mamama nummmbebbeb rsrsss exxxxclclclcludududude e ee unusuu uaaall annndd d d nnnon- f fifff i ll

Quality of Earnings 663

share of stock. A low price-earnings ratio often signifies that investors think the company’s future earnings will not be strong. In addition, sometimes a low P-E ratio reflects the market’s belief that a company has poor-quality earnings.

To illustrate, assume that two identical firms each have earnings per share of $5, but that one of the companies manipulated its accounting numbers to achieve the $5 figure. If investors perceive that one firm has lower-quality earn- ings, this perception will be reflected in a lower stock price, and consequently, a lower P-E.

Illustration 13-20 shows earnings per share and P-E ratios for five compa- nies for 2004. Note the extreme difference in the P-E ratio of United States Steel versus Google Inc.

Illustration 13-20 Earnings per share and P-E ratios of various companies

Company Earnings Per Share Price-Earnings Ratio

Kellogg Company $ 2.22 20.5 Google Inc. 3.41 86.6 United States Steel 11.40 3.9 eBay Inc. 0.68 62.4 Nike 19.50 4.3

B E F O R E Y O U G O O N . . .

� Review It

1. Explain what is meant by pro forma income. 2. Describe factors that reduce the quality of earnings. 3. Give an example of improper recognition. 4. What is the purpose of the P-E ratio?

Many company managers preparing their annual reports are piling on the paper in order to ease Enron-type worries on the part of investors. Natural-gas pro- ducer Williams Companies, Inc. turned out an eye-glazing annual report 1,234 pages in length. Nortel Networks Corporation added an extra two dozen pages to its annual report. Other companies have followed suit.

The trend to fuller disclosure has been a long time coming, observers say. But they caution that more paper does not necessarily mean more information that the average investor will understand. In addition, it is important to re- member that annual reports are just one piece of the puzzle as to how compa- nies present information to decision-makers.

Source: Elizabeth Church, “No Item Too Small as Firms Cave to Enron Disclosure Craze,” The (Toronto) Globe and Mail (April 1, 2002), p. B1.

Why might adding extra pages to the annual report not be beneficial to investors and analysts? What should be management’s overriding objec- tive in financial reporting?

A c c o u n t i n g a c r o s s t h e O r g a n i z a t i o n

●❍ THE NAVIGATOR ✓✓

thththt iinii k theee a llllowowowow P P P P-E-E-E-E inggggs.s.s.s.

664 CHAPTER 13 Financial Analysis: The Big Picture

Using the Decision Toolkit In analyzing a company, you should always investigate an extended period of time in order to determine whether the condition and performance of the company are changing. The condensed financial statements of Kellogg Company for 2002 and 2001 are presented here. (The appendix to this chapter provides a complete analy- sis of Kellogg’s 2004 and 2003 financial statements.)

KELLOGG COMPANY, INC. Balance Sheets December 31 (in millions)

Assets 2002 2001

Current assets Cash and short-term investments $ 100.6 $ 231.8 Accounts receivable (net) 741.0 762.3 Inventories 603.2 574.5 Prepaid expenses and other current assets 318.6 333.4

Total current assets 1,763.4 1,902.0 Property assets (net) 2,840.2 2,952.8 Intangibles and other assets 5,615.7 5,513.8

Total assets $10,219.3 $10,368.6

Liabilities and Stockholders’ Equity

Current liabilities $ 3,014.9 $ 2,207.6 Long-term liabilities 6,309.3 7,289.5 Stockholders’ equity—common 895.1 871.5

Total liabilities and stockholders’ equity $10,219.3 $10,368.6

KELLOGG COMPANY, INC. Condensed Income Statements

For the Years Ended December 31 (in millions)

2002 2001

Net sales $8,304.1 $7,548.4 Cost of goods sold 4,569.0 4,211.4

Gross profit 3,735.1 3,337.0 Selling and administrative expenses 2,227.0 2,135.8 Nonrecurring charges 0 33.3

Income from operations 1,508.1 1,167.9 Interest expense 391.2 351.5 Other income (expense), net 27.4 (24.9)

Income before income taxes 1,144.3 791.5 Income tax expense 423.4 317.9

Net income $ 720.9 $ 473.6

Instructions Compute the following ratios for Kellogg for 2002 and 2001 and discuss your findings.

1. Liquidity: (a) Current ratio. (b) Inventory turnover ratio. (Inventory on December 31, 2000, was $443.8 million.)

n extxtxtxtendedededed pepepeperrirr oddodod ooofff tittt memmeme

Using the Decision Toolkit 665

2. Solvency: (a) Debt to total assets ratio. (b) Times interest earned ratio.

3. Profitability: (a) Return on common stockholders’ equity ratio. (Stockholders’ equity on December

31, 2000, was $897.5 million.) (b) Return on assets ratio. (Assets on December 31, 2000, were $4,886 million.) (c) Profit margin ratio.

Solution

1. Liquidity (a) Current ratio:

2002: � .58:1

2001: � .86:1

(b) Inventory turnover ratio:

2002: � 7.8 times

2001: � 8.3 times

We see that between 2001 and 2002 the current ratio decreased. The inventory turnover ratio also decreased. Both measures indicate that the company was less liquid in 2002.

2. Solvency (a) Debt to total assets ratio:

2002: � 91%

2001: � 92%

(b) Times interest earned ratio:

2002: � 3.9 times

2001: � 3.3 times

Kellogg’s solvency as measured by the debt to total assets ratio improved slightly in 2002. We also can see that the times interest earned ratio increased.

3. Profitability (a) Return on common stockholders’ equity ratio:

2002: � 82%

2001: � 54%

(b) Return on assets ratio:

2002: � 7%

2001: � 6% $473.6

�� ($10,368.6 � $4,886.0)�2

$720.9 �� ($10,219.3 � $10,368.6)�2

$473.6 �� ($871.5 � $897.5)�2

$720.9 �� ($895.1 � $871.5)�2

$473.6 � $317.9 � $351.5 ��

$351.5

$720.9 � $423.4 � $391.2 ��

$391.2

$9,497.1 �� $10,368.6

$9,324.2 �� $10,219.3

$4,211.4 �� ($574.5 � $443.8)�2

$4,569.0 �� ($603.2 � $574.5)�2

$1,902.0 � $2,207.6

$1,763.4 � $3,014.9

666 CHAPTER 13 Financial Analysis: The Big Picture

2002: � 9%

2001: � 6%

Kellogg’s return on common stockholders’ equity ratio increased sharply. This increase was the result of increases in both its return on assets and its profit margin ratios.

$473.6 � $7,548.4

$720.9 � $8,304.1

●❍ THE NAVIGATOR ✓✓

Summary of Study Objectives

1 Understand the concept of sustainable income. Sus- tainable income refers to a company’s ability to sus- tain its profits from operations.

2 Indicate how irregular items are presented. Irregular items—discontinued operations and extraordinary items—are presented on the income statement net of tax below “Income before irregular items” to high- light their unusual nature. Changes in accounting principle are reported retroactively.

3 Explain the concept of comprehensive income. Com- prehensive income includes all changes in stock- holders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders. “Other comprehensive income” is added to net income to arrive at comprehensive in- come.

4 Describe and apply horizontal analysis. Horizontal analysis is a technique for evaluating a series of data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage.

5 Describe and apply vertical analysis. Vertical analysis is a technique that expresses each item in a finan- cial statement as a percentage of a relevant total or a base amount.

6 Identify and compute ratios used in analyzing a com- pany’s liquidity, solvency, and profitability. Financial ratios are provided in Illustration 13-16 (liquidity), Illustration 13-17 (solvency), and Illustration 13-18 (profitability).

7 Understand the concept of quality of earnings. A high quality of earnings provides full and transparent in- formation that will not confuse or mislead users of the financial statements. Issues related to quality of earnings are (1) alternative accounting methods, (2) pro forma income, and (3) improper recognition. The price-earnings (P-E) ratio reflects investors’ assessment of a company’s future earnings potential.

●❍ THE NAVIGATOR ✓✓

Decision Toolkit—A Summary 667

Has the company sold any major components of its business?

Has the company experienced any extraordinary events or transactions?

Has the company changed any of its accounting principles?

How do the company’s finan- cial position and operating results compare with those of the previous period?

How do the relationships be- tween items in this year’s fi- nancial statements compare with those of last year or those of competitors?

Discontinued operations section of income statement

Extraordinary item section of income statement