CH 14

Slide
14-1
Chapter 14
Financial Statement
Analysis
Financial Accounting, IFRS Edition

Weygandt Kimmel Kieso
Slide
14-2
Study
Study Objectives
Objectives
1. Discuss the need for comparative analysis.

2. Identify the tools of financial statement analysis.
3. Explain and apply horizontal analysis.
4. Describe and apply vertical analysis.
5. Identify and compute ratios used in analyzing a firms
liquidity, profitability, and solvency.
6. Understand the concept of earning power, and how
discontinued operations are presented.
7. Understand the concept of quality of earnings.
Slide
14-3
Financial
Financial Statement
Statement Analysis
Analysis
Basics of
Horizontal and Earning
Financial Quality of
Vertical Ratio Analysis Power and
Statement Earnings
Analysis Irregular Items
Analysis
Need for Statement of Liquidity Discontinued Alternative

comparative financial Profitability operations accounting
analysis position Changes in methods
Solvency
Tools of Income accounting Pro forma
Summary
analysis statement principle income
Retained Comprehensive Improper
earnings income recognition
statement
Slide
14-4
Basics
Basics of
of Financial
Financial Statement
Statement Analysis
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.

Slide
14-5 SO 2 Identify the tools of financial statement analysis.
Horizontal
Horizontal Analysis
Analysis
Horizontal analysis, also called trend analysis
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 statement of financial position,

income statement, and statement of retained earnings.
Slide
14-6
SO 3 Explain and apply horizontal analysis.
Horizontal
Horizontal Analysis
Analysis
Statement of
Financial
Position
These changes
suggest that the
company expanded
its asset base during
2011 and financed
this expansion
primarily by
retaining income
rather than assuming
additional long-term
debt.
Illustration 14-5
Slide
14-7
Horizontal
Horizontal Analysis
Analysis
Income
Statement
Overall, gross profit
and net income were
up substantially.
Gross profit
increased
17.1%, and net
income, 26.5%.
Qualitys profit trend
appears favorable.
Illustration 14-6
Slide
14-8
Horizontal
Horizontal Analysis
Analysis
Retained
Earnings
Statement
Illustration 14-7
We saw in the horizontal analysis of the statement of financial position that

ending retained earnings increased 38.6%. As indicated earlier, the company
retained a significant portion of net income to finance additional plant facilities.
Slide
14-9
Horizontal
Horizontal Analysis
Analysis
Illustration: Summary financial information for
Rosepatch Company is as follows.
Compute the amount and percentage changes in 2011 using

horizontal analysis, assuming 2010 is the base year.
Solution
Slide
14-10
SO 4 Describe and apply horizontal analysis.
Vertical
Vertical Analysis
Analysis
Vertical analysis, also called common-size analysis
Expresses each financial statement item as a percent of

a base amount.
For example, selling expenses could be expressed as

16% of net sales.
Commonly applied to the statement of financial position

and the income statement.
Slide
14-11
SO 4 Describe and apply vertical analysis.
Vertical
Vertical Analysis
Analysis
Statement of
Financial
Position
These results
reinforce the earlier
observations that
Quality is
choosing to
finance its growth
through retention
of earnings rather
than through
issuing additional
debt.
Illustration 14-8
Slide
14-12
Vertical
Vertical Analysis
Analysis
Income
Statement
Quality appears
to be a profitable
enterprise that is
becoming even
more successful.
Illustration 14-9
Slide
14-13
Vertical
Vertical Analysis
Analysis
Enables a comparison of companies of different sizes.
Illustration 14-10
Intercompany income
statement comparison
Park Street earned net income more than 4,208 times larger than Qualitys, Park
Streets net income as a percent of each sales euro (5.6%) is only 44% of
Qualitys (12.6%).
Slide
14-14
Ratio
Ratio Analysis
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.
Slide SO 5 Identify and compute ratios used in analyzing a
14-15 firms liquidity, profitability, and solvency.
Ratio
Ratio Analysis
Analysis
A single ratio by itself is not very meaningful.
The discussion of ratios will

include the following types of
comparisons.

Ratio
Ratio Analysis
Analysis
Liquidity Ratios
Measures short-term ability of the company to pay its

maturing obligations and to meet 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.

Ratio
Ratio Analysis
Analysis Liquidity Ratios
The 2011 ratio of 2.96:1 means that for every euro of current
liabilities, Quality has 2.96 of current assets.

Slide
14-19
Ratio
Ratio Analysis
Compute the Acid-Test Ratio for 2011.

Illustration 14-13

Ratio
Ratio Analysis
The acid-test ratio measures immediate liquidity.

Ratio
Ratio Analysis
It measures the number of times, on average, the company

collects receivables during the period.

Ratio
Ratio Analysis
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
This means that receivables are collected on average every

36 days.

Ratio
Ratio Analysis
Inventory turnover measures the number of times, on average,

the inventory is sold during the period.

Ratio
Ratio Analysis
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.

Ratio
Ratio Analysis
Illustration 14-27
Summary of liquidity ratios

Ratio
Ratio Analysis
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 companys 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 ordinary shareholders
equity, earnings per share, price-earnings, and
payout ratio.
Ratio
Ratio Analysis
Analysis Profitability Ratios
Measures the percentage of each dollar of sales that results

in net income.

Ratio
Ratio Analysis
Measures how efficiently a company uses its assets to

generate sales.

Ratio
Ratio Analysis
An overall measure of profitability.

Ratio
Ratio Analysis
Shows how many euros of net income the company earned

for each dollar invested by the owners.

Ratio
Ratio Analysis
A measure of the amount of net income applicable to each

ordinary share.

Ratio
Ratio Analysis
The price-earnings (PE) ratio reflects investors assessments

of a companys future earnings.

Ratio
Ratio Analysis
Measures the percentage of earnings distributed in the form of

cash dividends.
Ratio
Ratio Analysis
Illustration 14-27
Summary of profitability ratios

Ratio
Ratio Analysis
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.

Ratio
Ratio Analysis
Analysis Solvency Ratios
Measures the percentage of the total assets that creditors

provide.

Ratio
Ratio Analysis
Provides an indication of the companys ability to meet

interest payments as they come due.

Ratio
Ratio Analysis
Illustration 14-27
Summary of solvency ratios

Slide
14-40
Earning
Earning Power
Power and
and Irregular
Irregular Items
Items
Earning power means the normal level of income to be

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

statement as Discontinued Operations.
These irregular items are reported net of income taxes.
Slide SO 6 Understand the concept of earning power, and how

14-41 discontinued operations are presented.
Earning
Earning Power
Power and
and Irregular
Irregular Items
Items
Discontinued Operations
(a) Refers to the 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).

Earning
Earning Power
Power and
and Irregular
Irregular Items
Items
Illustration: During 2011 Acro Energy Inc. has income before
taxes of $800,000. During 2011 Acro discontinued and sold its
unprofitable chemical division. The loss in 2011 from chemical
operations (net of $60,000 taxes) was $140,000. The loss on
disposal of the chemical division (net of $30,000 taxes) was
$70,000. Assuming a 30% tax rate.

Earning
Earning Power
Power and
and Irregular
Irregular Items
Items
Income Statement (in thousands)
Discontinued Operations Sales $ 285,000
are reported after Cost of goods sold 149,000
Income 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 Income tax expense 24,000
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
Slide
14-44 SO 6
Slide
14-45
Earning
Earning Power
Power and
and Irregular
Irregular Items
Items
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.

Earning
Earning Power
Power and
and Irregular
Irregular Items
Items
Comprehensive Income All changes in equity except

those resulting from
Income Statement (in thousands)
investments by shareholders
Sales $ 285,000
Cost of goods sold 149,000 and distributions to
Gross profit 136,000 shareholders.
Operating expenses:
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-
Income tax expense 24,000
sale securities.
Net income $ 76,000 Plus other items

Earning
Earning Power
Power and
and Irregular
Irregular Items
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
Quality of
of Earnings
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 the shares increase and
the value of share options increase.
Slide
14-49
SO 7 Understand the concept of quality of earnings.
Quality
Quality of
of Earnings
Earnings
Alternative Accounting Methods

Variations among companies in the application of IFRS
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.
Slide
14-50
Quality
Quality of
of Earnings
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).
Slide
14-51
Understanding
Understanding U.S.
U.S. GAAP
GAAP
Key Differences Financial Statement

Analysis
Under GAAP, items that are considered to be both unusual in
nature and infrequent in occurrence are reported as
extraordinary items in a separate line item at the bottom of
the income statement, net of tax. Under IFRS, there is no
classification for extraordinary items. In other words,
extraordinary item treatment is prohibited under IFRS. In recent
years, the types of items that can receive extraordinary item
treatment under GAAP has been reduced to the point where the
classification is rarely used.
The accounting for changes in accounting principles and

changes in accounting estimates are the same for both GAAP
and IFRS.
Slide
14-52
Understanding
Understanding U.S.
U.S. GAAP
GAAP
Key Differences Financial Statement

Analysis
Under IFRS, comprehensive income is either presented in a
single statement, combined with net income, or as a separate
statement, immediately after the income statement. GAAP also
permits the one-statement or two-statement approach as well.
In addition, GAAP permits a third alternative, which is to show
the computation of comprehensive income in the statement of
shareholders equity.
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 that many of the
earnings quality issues will be reduced.
Slide
14-53
Understanding
Understanding U.S.
U.S. GAAP
GAAP
Looking to the Future Financial Statement

Analysis
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 numbernet
income. Instead, this approach provides more information about the
components of net income and comprehensive income.
Slide
14-54
Copyright
Copyright
Copyright 2011 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
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Request for further information should be addressed to the
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errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.
Slide
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Slide

Financial Accounting, IFRS Edition

1. Discuss the need for comparative analysis.

Need for Statement of Liquidity Discontinued Alternative

Analyzing financial statements involves:

Liquidity Intracompany Horizontal

SO 1 Discuss the need for comparative analysis.

Horizontal analysis, also called trend analysis

Technique for evaluating a series of financial statement

Purpose is to determine the increase or decrease that

Commonly applied to the statement of financial position,

We saw in the horizontal analysis of the statement of financial position that

Compute the amount and percentage changes in 2011 using

Vertical analysis, also called common-size analysis

Expresses each financial statement item as a percent of

For example, selling expenses could be expressed as

Commonly applied to the statement of financial position

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

Slide SO 5 Identify and compute ratios used in analyzing a

Measures 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,

Slide SO 5 Identify and compute ratios used in analyzing a

Slide SO 5 Identify and compute ratios used in analyzing a

Compute the Acid-Test Ratio for 2011.

Slide SO 5 Identify and compute ratios used in analyzing a

The acid-test ratio measures immediate liquidity.

Slide SO 5 Identify and compute ratios used in analyzing a

It measures the number of times, on average, the company

Slide SO 5 Identify and compute ratios used in analyzing a

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

365 days / 10.2 times = every 35.78 days

This means that receivables are collected on average every

Slide SO 5 Identify and compute ratios used in analyzing a

Inventory turnover measures the number of times, on average,

Slide SO 5 Identify and compute ratios used in analyzing a

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.

Slide SO 5 Identify and compute ratios used in analyzing a

Slide SO 5 Identify and compute ratios used in analyzing a

Measure the income or operating success of a company

Ratios include the profit margin, asset turnover,

Measures the percentage of each dollar of sales that results

Slide SO 5 Identify and compute ratios used in analyzing a

Measures how efficiently a company uses its assets to

Slide SO 5 Identify and compute ratios used in analyzing a

An overall measure of profitability.

Slide SO 5 Identify and compute ratios used in analyzing a

Shows how many euros of net income the company earned

Slide SO 5 Identify and compute ratios used in analyzing a

A measure of the amount of net income applicable to each

Slide SO 5 Identify and compute ratios used in analyzing a

The price-earnings (PE) ratio reflects investors assessments

Slide SO 5 Identify and compute ratios used in analyzing a

Measures the percentage of earnings distributed in the form of

Slide SO 5 Identify and compute ratios used in analyzing a

Solvency ratios measure the ability of a company to

Debt to total assets and times interest earned are two