CH 18

18-1
CHAPTER18
Financial Statement
Analysis
18-2
PreviewofCHAPTER18
18-3
Basics of Financial Statement Analysis
Analyzing financial statements involves:
Comparison Tools of
Characteristics
Bases Analysis
 Liquidity  Intracompany  Horizontal

 Profitability  Industry  Vertical
 Solvency averages  Ratio
 Intercompany
SO 1 Discuss the need for comparative analysis.

18-4
SO 2 Identify the tools of financial statement
Horizontal Analysis
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 the increase or decrease that

has taken place.
 Commonly applied to the balance sheet, income

statement, and statement of retained earnings.
18-5 SO 3 Explain and apply horizontal analysis.

Horizontal Analysis
Illustration 18-5
Horizontal analysis of
balance sheets
Changes suggest
that the company
expanded its asset
base during 2009
and financed this
expansion primarily
by retaining income
rather than assuming
additional long-term
debt.

Horizontal Analysis
Illustration 18-6
Horizontal analysis of
Income statements
Overall, gross profit

and net income were
up substantially.
Gross profit
increased
17.1%, and net
income, 26.5%.
Quality’s profit trend
appears favorable.

Horizontal Analysis
Illustration 18-7
Horizontal analysis of In the horizontal analysis of the balance sheet the ending
retained earnings
statements retained earnings increased 38.6%. As indicated earlier, the
company retained a significant portion of net income to
finance additional plant facilities.

Vertical Analysis
Vertical analysis, also called common-size analysis, is a

technique that expresses each financial statement item as
a percent of a base amount.
 On an income statement, we might say that selling

expenses are 16% of net sales.
 Vertical analysis is commonly applied to the balance

sheet and the income statement.
18-9 SO 4 Describe and apply vertical analysis.

Vertical Analysis
Illustration 18-8
Vertical analysis of
balance sheets
These results
reinforce the earlier
observations that
Quality is
choosing to
finance its growth
through retention
of earnings rather
than through
issuing additional
debt.

Vertical Analysis
Illustration 18-9
Vertical analysis of
Income statements
Quality appears
to be a profitable
enterprise that is
becoming even
more successful.

Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 18-10
Intercompany income
statement comparison

Ratio Analysis
Ratio analysis expresses the relationship among selected

items of financial statement data.
Financial Ratio Classifications
Liquidity Profitability Solvency
Measures short- Measures the Measures the

term ability of the income or ability of the
company to pay its operating success company to
maturing of a company for a survive over a long
obligations and to given period of period of time.
meet unexpected time.
needs for cash.
18-13
SO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
Ratio Analysis
A single ratio by itself is not very meaningful.
The discussion of ratios will include the

following types of comparisons.
18-14
18-15
Ratio Analysis
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 acid-test ratio,

receivables turnover, and inventory turnover.
18-16
Ratio Analysis Liquidity Ratios
1. Current Ratio Illustration 18-12
Ratio of 2.96:1 means that for every dollar of current liabilities,

Quality has $2.96 of current assets.
18-17
2. Acid-Test Ratio
Illustration 18-13
18-18
2. Acid-Test Ratio
Illustration 18-14
Acid-test ratio measures immediate liquidity.
18-19
18-20
3. Receivables Turnover
Illustration 18-15
Measures the number of times, on average, the company collects

receivables during the period.
18-21 SO 5
Receivables Turnover
$2,097,000
= 10.2 times
($180,000 + $230,000) / 2
A variant of the receivables turnover ratio is to convert it to

an average collection period in terms of days.
365 days / 10.2 times = every 35.78 days
Receivables are collected on average every 36 days.
18-22
4. Inventory Turnover
Illustration 18-16
Measures the number of times, on average, the inventory is sold

during the period.
18-23 SO 5
$1,281,000 Inventory Turnover

= 2.3 times
($500,000 + $620,000) / 2
A variant of inventory turnover is the days in inventory.
365 days / 2.3 times = every 159 days
Inventory turnover ratios vary considerably among

industries.
18-24
Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for a

given period of time.
 Income, or the lack of it, affects the company’s ability to

obtain debt and equity financing, liquidity position, and the
ability to grow.
 Ratios include the profit margin, asset turnover, return

on assets, return on common stockholders’ equity,
earnings per share, price-earnings, and payout ratio.
18-25
Ratio Analysis Profitability Ratios
5. Profit Margin
Illustration 18-17
Measures the percentage of each dollar of sales that results in

net income.
18-26
6. Asset Turnover
Illustration 18-18
Measures how efficiently a company uses its assets to generate

sales.
18-27
7. Return on Asset
Illustration 18-19
An overall measure of profitability.
18-28
8. Return on Common Stockholders’ Equity

Illustration 18-20
Shows how many dollars of net income the company earned for
each dollar invested by the owners.
18-29 SO 5
9. Earnings Per Share (EPS)

Illustration 18-22
A measure of the net income earned on each share of common

stock.
18-30 SO 5
10. Price-Earnings Ratio

Illustration 18-23
Measures the net income earned on each share of common stock.

18-31 SO 5
11. Payout Ratio

Illustration 18-24
Measures the percentage of earnings distributed in the form of

cash dividends.
18-32 SO 5
Ratio Analysis
Solvency Ratios
Solvency ratios measure the ability of a company to survive

over a long period of time.
 Debt to Total Assets and
 Times Interest Earned
are two ratios that provide information about debt-paying

ability.
18-33
Ratio Analysis Solvency Ratios
12. Debt to Total Assets Ratio

Illustration 18-25
Measures the percentage of the total assets that creditors provide.

18-34 SO 5
Ratio Analysis Solvency Ratios
13. Times Interest Earned

Illustration 18-26
Provides an indication of the company’s ability to meet interest

payments as they come due.
18-35 SO 5
Ratio Analysis
Summary of Ratios
Illustration 18-27
18-36 SO 5
Summary of Ratios
Illustration 18-27
18-37 SO 5
Earning Power and Irregular Items
Earning power means the normal level of income to be

obtained in the future.
“Irregular” items are separately identified on the income

statement. Two types are:
1. Discontinued operations.
2. Extraordinary items.
“Irregular” items are reported net of income taxes.
18-38
SO 6 Understand the concept of earning power,
and how irregular items are presented.
Discontinued Operations
(a) Disposal of a significant component of a business.
(b) Report the income (loss) from discontinued operations

in two parts:
1. income (loss) from operations (net of tax) and
2. gain (loss) on disposal (net of tax).
18-39
SO 6 Understand the concept of earning power,
Illustration: During 2012 BD Inc. has income before income

taxes of $79,000,000. During 2012, BD discontinued and sold
its unprofitable chemical division. The loss in 2012 from
chemical operations (net of $135,000 taxes) was $315,000. The
loss on disposal of the chemical division (net of $81,000 taxes)
was $189,000. Assuming a 30% tax rate on income.
18-40 SO 6
Income Statement (in thousands)
Discontinued Sales $ 285,000
Operations are reported Cost of goods sold 149,000
after “Income from
continuing operations.” Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Previously labeled as
Income from continuing operations 55,000
“Net Income”. Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Moved to
Net income $ 54,496
18-41 SO 6 Understand the concept of earning power,

Extraordinary Items
Nonrecurring material items that differ significantly from a
company’s typical business activities.
 Must be both of an
► Unusual Nature and
► Occur Infrequently.
 Must consider the environment in which it operates.
 Amounts reported “net of tax.”

Are these considered Extraordinary Items?
(a) A large portion of a tobacco manufacturer’s crops

are destroyed by a hail storm. Severe damage
YES
from hail storms in the locality where the
manufacturer grows tobacco is rare.
(b) A citrus grower's Florida crop is damaged by NO

frost.
(c) Loss from sale of temporary investments. NO
(d) Loss attributable to a labor strike. NO

Are these considered Extraordinary Items?
(d) Loss from flood damage. (The nearby Black River

NO
floods every 2 to 3 years.)
(e) An earthquake destroys one of the oil refineries

owned by a large multi-national oil company. YES
Earthquakes are rare in this geographical location.
(f) Write-down of obsolete inventory. NO
(g) Expropriation of a factory by a foreign YES

government.

Illustration: In 2012 a foreign government expropriated property

held as an investment by DB Inc. If the loss is $770,000 before
applicable income taxes of $231,000, the income statement will
report a deduction of $539,000.

Extraordinary Items are Sales $ 285,000
reported after “Income Cost of goods sold 149,000
from continuing
operations.” Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Previously labeled as
“Net Income”. Extraordinary loss, net of tax 539
Net income $ 54,461
Moved to

Reporting when both Sales $ 285,000
Discontinued Cost of goods sold 149,000
Operations and
Extraordinary Items Interest expense (21,000)
Total other (4,000)
are present. Income before taxes 79,000
Discontinued operations:
Discontinued Loss from operations, net of tax 315
Operations Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Income before extraordinary item 54,496
Extraordinary Item Extraordinary loss, net of tax 539
Net income $ 53,957

18-48
Change in Accounting Principle

 Occurs when the principle used in the current year is
different from the one used in the preceding year.
 Accounting rules permit a change if justified.
 Changes are reported retroactively.
 Example would include a change in inventory costing

method such as FIFO to average cost.

Comprehensive Income All changes in stockholders’

equity except those resulting
Sales $ 285,000
from investments by
Cost of goods sold 149,000 stockholders and distributions
Gross profit 136,000
Operating expenses:
to stockholders.
Advertising expense 10,000
Depreciation expense 43,000
Total operating expense 53,000 Reported in Stockholders’
Income from operations 83,000 Equity
Other revenue:
Interest revenue 17,000 Unrealized gains and
Total other
Income before taxes
17,000
100,000
+ losses on available-for-
sale securities.
Net income $ 76,000 Plus other items

Comprehensive Income
Why are gains and losses on available-for-sale securities
excluded from net income?
Because disclosing them separately
1) reduces the volatility of net income due to fluctuations in

fair value,
2) yet informs the financial statement user of the gain or loss

that would be incurred if the securities were sold at fair
value.

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.
Companies have incentives to manage income to meet or

beat Wall Street expectations, so that
 the market price of stock increases and
 the value of stock options increase.
18-52 SO 7 Understand the concept of quality of earnings.

Quality of Earnings
Comprehensive Income
 Variations among companies in the application of GAAP
may hamper comparability and reduce quality of earnings.
Pro Forma Income

 Pro forma income usually excludes items that the
company thinks are unusual or nonrecurring.
 Some companies have abused the flexibility that pro
forma numbers allow.

Quality of Earnings
Improper Recognition
Some managers have felt pressure to continually increase
earnings and have manipulated the earnings numbers to meet
these expectations.
Abuses include:
 Improper recognition of revenue (channel stuffing).
 Improper capitalization of operating expenses
(WorldCom).
 Failure to report all liabilities (Enron).

Key Points
 The tools of financial statement analysis covered in this chapter
are universal and therefore no significant differences exist in
the analysis methods used.
 The basic objectives of the income statement are the same
under both GAAP and IFRS. Thus, both the IASB and the FASB
are interested in distinguishing normal levels of income from
irregular items in order to better predict a company’s future
profitability.
 The basic accounting for discontinued operations is the same
under IFRS and GAAP.
18-55
Key Points
 Under IFRS, there is no classification for extraordinary items. In
other words, extraordinary item treatment is prohibited under
IFRS. All revenue and expense items are considered ordinary in
nature.
 The accounting for changes in accounting principles and
changes in accounting estimates are the same for both GAAP
and IFRS.
 The income statement under IFRS is referred to as a statement
of comprehensive income. The statement of comprehensive
income can be prepared under the one-statement approach or
the two-statement approach.
18-56
Key Points
 The issues related to quality of earnings are the same under
both GAAP and IFRS. It is hoped that by adopting a more
principles-based approach, as found in IFRS, many of the
earnings’ quality issues will disappear.
18-57
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.
18-58
IFRS Self-Test Questions
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.
18-59
Under IFRS:
a) the reporting of discontinued items is different than GAAP.
b) the reporting of extraordinary items is prohibited.
c) the reporting of changes in accounting principles is different

than under GAAP.
d) None of the above.
18-60
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.
18-61
Copyright
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Reproduction or translation of this work beyond that permitted in
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express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.”
18-62

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18-1

Analyzing financial statements involves:

 Liquidity  Intracompany  Horizontal

SO 1 Discuss the need for comparative analysis.

Horizontal analysis, also called trend analysis, is a

 Purpose is to determine the increase or decrease that

 Commonly applied to the balance sheet, income

18-5 SO 3 Explain and apply horizontal analysis.

18-6 SO 3 Explain and apply horizontal analysis.

Overall, gross profit

18-7 SO 3 Explain and apply horizontal analysis.

18-8 SO 3 Explain and apply horizontal analysis.

Vertical analysis, also called common-size analysis, is a

 On an income statement, we might say that selling

 Vertical analysis is commonly applied to the balance

18-9 SO 4 Describe and apply vertical analysis.

18-10 SO 4 Describe and apply vertical analysis.

18-11 SO 4 Describe and apply vertical analysis.

18-12 SO 4 Describe and apply vertical analysis.

Ratio analysis expresses the relationship among selected

Financial Ratio Classifications

Liquidity Profitability Solvency

Measures short- Measures the Measures the

A single ratio by itself is not very meaningful.

The discussion of ratios will include the

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

 Short-term creditors such as bankers and suppliers are

 Ratios include the current ratio, the acid-test ratio,

1. Current Ratio Illustration 18-12

Ratio of 2.96:1 means that for every dollar of current liabilities,

Acid-test ratio measures immediate liquidity.

Measures the number of times, on average, the company collects

A variant of the receivables turnover ratio is to convert it to

365 days / 10.2 times = every 35.78 days

Receivables are collected on average every 36 days.

Measures the number of times, on average, the inventory is sold

$1,281,000 Inventory Turnover

A variant of inventory turnover is the days in inventory.

365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among

Measure the income or operating success of a company for a

 Income, or the lack of it, affects the company’s ability to

 Ratios include the profit margin, asset turnover, return

Measures the percentage of each dollar of sales that results in

Measures how efficiently a company uses its assets to generate

An overall measure of profitability.

8. Return on Common Stockholders’ Equity

9. Earnings Per Share (EPS)

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

10. Price-Earnings Ratio

Measures the net income earned on each share of common stock.

11. Payout Ratio

Measures the percentage of earnings distributed in the form of

Solvency ratios measure the ability of a company to survive

 Debt to Total Assets and

 Times Interest Earned

are two ratios that provide information about debt-paying

12. Debt to Total Assets Ratio