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Financial Analysis: The Big

Picture

Kimmel ● Weygandt ● Kieso

Accounting, Sixth Edition
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 CHAPTER OUTLINE
LEARNING OBJECTIVES

Apply the concepts of sustainable income and

1 quality of earnings.

Apply horizontal analysis and vertical

2 analysis.

Analyze a company’s performance using ratio

3 analysis.

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 Apply the concepts of sustainable
LEARNING
OBJECTIVE 1 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.

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 SUSTAINABLE INCOME ILLUSTRATION 13-1
Statement of comprehensive
income

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 SUSTAINABLE INCOME

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.

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 Discontinued Operations

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. Assume a 30% tax rate on
income.
Prepare Acro’s statement of comprehensive income for the year
ended December 31, 2017.

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 Discontinued Operations

ILLUSTRATION 13-2
Statement presentation of discontinued operations

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 SUSTAINABLE INCOME

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.

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 Comprehensive Income

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?

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 Comprehensive Income

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
Unrealized gains
 Trading security or an and losses
(Income Statement)
 Available for-sale security.

Unrealized gains and losses

(Comprehensive Income - Stockholders’ Equity)

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 Comprehensive Income

Format One
Combined statement of income and comprehensive income.
Illustration 13-5

ILLUSTRATION 13-3
Lower portion of combined statement of
income and comprehensive income

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 Comprehensive Income

Format Two
Separate component of Stockholders’ Equity.

ILLUSTRATION 13-4
Unrealized loss in stockholders’ equity section

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 ILLUSTRATION 13-5
Complete statement of
comprehensive income

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 SUSTAINABLE INCOME

Changes in Accounting Principle

 Principle used in the current year is different from one
used in the preceding year.
 Example - change from FIFO to average cost.
 Permissible when management can show new principle is
preferable.
 Most changes are reported retroactively.

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 QUALITY OF EARNINGS

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.

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 QUALITY OF EARNINGS

Alternative Accounting Methods

 Variations among companies in the application of GAAP
may hamper comparability and reduce quality of
earnings (FIFO vs. LIFO).

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.

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 QUALITY OF EARNINGS

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).

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 KEEPING AN EYE ON CASH

Earnings have high quality if they provide a full and

transparent depiction of how a company performed.

► A measure significantly less than 1 suggests that a

company may be using more aggressive accounting
techniques in order to accelerate income recognition.
► A measure significantly greater than 1 suggests that a
company is using conservative accounting techniques
which cause it to delay the recognition of income.
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 DO IT! 1 Unusual Items

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.”

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 Apply horizontal analysis and vertical
LEARNING
OBJECTIVE 2 analysis.

Analyzing financial statements involves:

Comparison
Basic Tools
Bases

 Intracompany  Horizontal analysis

 Intercompany  Vertical analysis
 Industry averages  Ratio Analysis

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 HORIZONTAL ANALYSIS

Also called trend analysis, is a technique for evaluating a

series of financial statement data over a period of time.
 Purpose is to determine increase or decrease that has
taken place.
 Commonly applied to the balance sheet and income
statement.

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ILLUSTRATION 13-9
Horizontal analysis of
balance sheets

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ILLUSTRATION 13-10
Horizontal analysis of income statements

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 DO IT! 2 Horizontal Analysis

Summary financial information for Rosepatch Company is as

follows.

Compute the amount and percentage changes in 2017 using

horizontal analysis, assuming 2016 is the base year.

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 VERTICAL ANALYSIS

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.

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ILLUSTRATION 13-11
Vertical analysis of
balance sheets

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 ILLUSTRATION 13-12
Vertical analysis of income statements

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 ILLUSTRATION 13-13
Intercompany comparison by vertical analysis

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 Analyze a company’s performance
LEARNING
OBJECTIVE 3 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. ILLUSTRATION 13-14
Formula for price-earnings (P-E) ratio

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 PRICE-EARNINGS RATIO

ILLUSTRATION 13-14
Formula for price-earnings (P-E) ratio

ILLUSTRATION 13-15
Earnings per share and P-E ratios of various companies

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 LIQUIDITY RATIOS

ILLUSTRATION 13-16
Summary of liquidity ratios

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 INVESTOR INSIGHT

How to Manage the Current Ratio

The apparent simplicity of the current ratio can have real-world
limitations because adding equal amounts to both the numerator
and the denominator causes the ratio to decrease.
Assume, for example, that a company has $2,000,000 of current
assets and $1,000,000 of current liabilities. Its current ratio is 2:1. If
it purchases $1,000,000 of inventory on account, it will have
$3,000,000 of current assets and $2,000,000 of current liabilities. Its
current ratio decreases to 1.5:1. If, instead, the company pays off
$500,000 of its current liabilities, it will have $1,500,000 of current
assets and $500,000 of current liabilities. Its current ratio increases
to 3:1. Thus, any trend analysis should be done with care because
the ratio is susceptible to quick changes and is easily influenced by
management.
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 SOLVENCY RATIOS

ILLUSTRATION 13-17
Summary of solvency ratios

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 PROFITABILITY RATIOS
ILLUSTRATION 13-18
Summary of profitability ratios

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 APPENDIX 13A: Evaluate a company
LEARNING
OBJECTIVE 4 comprehensively using ratio analysis.

Analyzing financial statements involves:

Comparison
Characteristics
Bases

 Liquidity  Intracompany
 Profitability  Industry averages
 Solvency  Intercompany

The financial information in Illustrations 13A-1 through 13A-4 will be used to

calculate Chicago’s 2014 ratios.

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 ILLUSTRATION 13A-1
13-42 Chicago Cereal Company’s balance sheets LO 4
ILLUSTRATION 13A-2
Chicago Cereal Company’s income statements

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 ILLUSTRATION 13A-3
Chicago Cereal Company’s
statements of cash flows

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 RATIO ANALYSIS

Ratio analysis expresses the relationship among selected

items of financial statement data.
Financial Ratio Classifications

Liquidity Solvency Profitability

Measures short- Measures the Measures the

term ability of the ability of the income or
company to pay company to operating success
its maturing survive over a of a company for
obligations and to long period of a given period of
meet unexpected time. time.
needs for cash.

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 LIQUIDITY RATIOS

Measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for
cash.
 Short-term creditors such as bankers and suppliers are
particularly interested in assessing liquidity.
 Ratios include the current ratio, the current cash debt
coverage, the accounts receivables turnover, the
average collection period, the inventory turnover,
and days in inventory.

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 Current Ratio

Expresses the relationship of current assets to current

liabilities. ILLUSTRATION 13A-5
Current ratio

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.

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 Accounts Receivable Turnover

Measures the number of times, on average, a company

collects receivables during the period. ILLUSTRATION 13A-6
Accounts receivable turnover

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.
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 Average Collection Period

Converts the receivable turnover ratio into days.

ILLUSTRATION 13A-7
Average collection period

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).

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 Inventory Turnover

Measures the number of times average inventory was sold

during the period. ILLUSTRATION 13A-8
Inventory turnover

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.

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 Days in Inventory

Measures the average number of days inventory is held.

ILLUSTRATION 13A-9
Days in inventory

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.

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 SOLVENCY RATIOS

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

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 Debt to Assets Ratio

Indicates the degree of financial leveraging. Provides

some indication of the company’s ability to withstand
ILLUSTRATION 13A-10
losses. Debt to assets ratio

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.
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 Times Interest Earned

Also called interest coverage, indicates the company’s

ability to meet interest payments as they come due.
ILLUSTRATION 13A-11
Times interest earned

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.

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 Free Cash Flow

Ability to pay dividends or expand operations. ILLUSTRATION 13A-12

Free cash flow

Cash provided by operations was more than enough to

allow Chicago to acquire additional productive assets and
maintain dividend payments.

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 PROFITABILITY RATIOS

Measure the income or operating success of a company for

a given period of time.

ILLUSTRATION 13A-13
Relationships among
profitability measures

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 Return on Common Stockholders’ Equity

Shows how many dollars of net income the company

earned for each dollar invested by the owners.

ILLUSTRATION 13A-14
Return on common
stockholders’ equity 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%.
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 Return on Assets

Measures the overall profitability of assets in terms of the

income earned on each dollar invested in assets.

ILLUSTRATION 13A-15
Return on 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.

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 Profit Margin

Or rate of return on sales, is a measure of the percentage

of each dollar of sales that results in net income.

ILLUSTRATION 13A-16
Profit margin

High-volume (high inventory turnover) businesses such as

grocery stores and pharmacy chains generally have low
profit margins.

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 Asset Turnover

Measures how efficiently a company uses its assets to

generate sales. ILLUSTRATION 13A-17
Asset turnover

The average asset turnover for utility companies is .45, for

example, while the grocery store industry has an average
asset turnover of 3.49.

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 Return on Assets

You can analyze the combined effects of profit margin and

asset turnover on return on assets for Chicago as shown.

ILLUSTRATION 13A-18
Composition of return on assets

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 Gross Profit Rate

Indicates a company’s ability to maintain an adequate

selling price above its cost of goods sold. ILLUSTRATION 13A-19
Gross profit rate

As an industry becomes more competitive, this ratio

declines.

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 Earnings Per Share (EPS)

A measure of the net income earned on each share of

common stock.

ILLUSTRATION 13A-20
Earnings per share

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 Price-Earnings (P-E) Ratio

Reflects investors’ assessments of a company’s future

earnings. ILLUSTRATION 13A-21
Price-earnings ratio

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.

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 Payout Ratio

Measures the percentage of earnings distributed in the

form of cash dividends. ILLUSTRATION 13A-22
Payout ratio

This ratio should be calculated over a longer period of time

to evaluate any trends.

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 A Look at IFRS

Compare financial statement analysis

LEARNING
OBJECTIVE 5 and income statement presentation
under GAAP and IFRS.

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 GAAP
and IFRS.
 Both GAAP and IFRS follow the same approach in reporting
comprehensive income.
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 A Look at IFRS

RELEVANT FACTS
 The basic objectives of the income statement are the same
under both GAAP and IFRS. A very important objective is to
ensure that users of the income statement can evaluate the
sustainable income of the company. Thus, both the IASB and
the FASB 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 IFRS and GAAP.

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 A Look at IFRS

LOOKING TO THE FUTURE

The FASB and the IASB are working on a project that would rework the
structure of financial statements. Recently, the IASB decided to require
a statement of comprehensive income, similar to what was required
under GAAP. 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.

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 A Look at IFRS

IFRS Practice
The basic tools of financial analysis are the same under both
GAAP and IFRS 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 IFRS.
c) the current ratio cannot be computed because current
liabilities are often reported before current assets in IFRS
statements of position.
d) None of the above.
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 A Look at IFRS

IFRS 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.

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 A Look at IFRS

IFRS 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 IFRS?
a) $260,000. c) $240,000.
b) $250,000. d) $160,000.
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 COPYRIGHT

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