copyright 2003 prentice hall publishing company1 chapter 11 financial statement analysis

Copyright 2003 Prentice Hall Publishing Company

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Chapter 11Chapter 11

Financial Statement AnalysisFinancial Statement Analysis


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More About The Income StatementMore About The Income Statement

To make the information on the income statement clearer, there are several special items that are separated from the regular earnings of a business: Gains and losses from discontinued

operations, Extraordinary items, and Cumulative effect of a change in

accounting principle


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Discontinued OperationsDiscontinued Operations

If a segment or division of a business is eliminated, the gain or loss from the disposal must be shown after income from continuing operations, net of taxes.

Any current gain or loss from the operations of that discontinued segment must also be shown separately.


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How Discontinued Operations How Discontinued Operations Are ShownAre Shown

Containers, Inc. Income Statement

For the year ended December 31, 2003

Income before taxes $400,000 Income tax expense 160,000 Income from continuing operations 240,000 Discontinued operations

Income from discontinued operations net of taxes of $2,300

$ 10,100

Gain on disposal of mailing packages segment net of taxes of $25,000

35,000 45,100

Net Income $ 285,100


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Extraordinary Items Extraordinary Items

Events that are unusual in nature and infrequent in occurrence are called extraordinary items.

The accounting rules are very strict about what types of events may be classified as extraordinary.

Any gain or loss from these events are shown, net of taxes, after income from continuing operations and after income from discontinued operations.


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How Extraordinary Items How Extraordinary Items Are ShownAre Shown


For the year ended December 31, 2003 Income before taxes $400,000 Income tax expense 160,000 Income from continuing operations 240,000 Discontinued operations Income less taxes of $2,500 $ 10,100 Gain on disposal less taxes of $20,000 35,000

45,100 Income before extraordinary item $ 285,100 Extraordinary item Expropriation of foreign operation net of tax

savings of $35,000

70,000 Net Income $215,100


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Cumulative Effect Cumulative Effect Of A Change In Accounting PrincipalOf A Change In Accounting Principal

The cumulative effect of a change in accounting principle is the amount of gain or loss from changing accounting methods.

It must be shown separately on the income statement, net of taxes, after income from continuing operations, discontinued operations, and any extraordinary items.


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ExampleExample

Suppose the company changed from depreciating equipment using the straight-line method to depreciating the equipment using the double declining balance method.

The equipment was purchased on January 1, 2001, at a cost of $10,000, has a useful life of 10 years, with no salvage value.


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Depreciation SchedulesDepreciation SchedulesMethod Straight-line Double-declining

balance Year ended: December 31, 2001

$1,000

$2,000

December 31, 2002 $1,000 $1,600 Total for two years $2,000 $3,600

The income for Containers, Inc. would have been lower by $1,600 if double-declining balance had been used from the beginning.

A switch now means the company will have to subtract $1,600, net of any tax effect, as a cumulative effect of a change in accounting principle.


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How The Cumulative Effect Is Shown How The Cumulative Effect Is Shown On The Income StatementOn The Income Statement


For the year ended December 31, 2003 Income before taxes $400,000 Income tax expense 160,000 Income from continuing operations 240,000 Discontinued operations Income less taxes of $2,500 $ 10,100 Gain on disposal less taxes of $20,000 35,000

45,100 Income before extraordinary item and cumulative effect of change in accounting principle

$ 285,100

Extraordinary item Expropriation of foreign operation net of tax

saving of $35,000

70,000 Cumulative effect of a change in accounting principle

Effect on prior years of change in depreciation method, net of $400 tax savings

1,200 Net Income $213,900


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Comprehensive IncomeComprehensive Income The income statement shows all of the effects of

revenues, expenses, gains, and losses on net income.

Net income, in turn, affects owners’ equity. Other items, not included on the income

statement, may affect owners’ equity. The total of all items that affect owners’ equity,

not including contributions from owners and dividends, is called comprehensive income.


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Items that effect Shareholders’ Equity

Owners’ contributions

Paid-in Capital (Contributed

Capital)

Net income

Retained Earnings

Dividends

Other comprehensive income: A few other items including unrealized gains and losses from foreign currency translation and from available for sale securities

Cumulative other comprehensive income (may be labeled as a single item if it has only one component, e.g. foreign currency translation)

Comprehensive income

Diagram Showing the Items that Affect Owners’ EquityDiagram Showing the Items that Affect Owners’ Equity


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OtherOther Comprehensive Income Comprehensive Income Total comprehensive income = net income

plus other comprehensive income Items included in other comprehensive

income include: unrealized gains and losses from foreign

currency translation unrealized gains and losses on certain types of

investments.


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One More New Financial One More New Financial Statement Item: Investments In Statement Item: Investments In SecuritiesSecurities

A company may use some of its extra cash to invest in the debt or equity securities of another company.

These investments must be classified as one of three types: Securities held to maturity Trading securities Securities available for sale

A company may use some of its extra cash to invest in the debt or equity securities of another company.

These investments must be classified as one of three types: Securities held to maturity Trading securities Securities available for sale


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Securities Held To MaturitySecurities Held To Maturity

Debt securities Intent and ability to

hold to maturity Measured at cost on

the balance sheet


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Trading SecuritiesTrading Securities

Debt and equity securities Readily determinable fair values Actively and frequently traded

(profit!) Measured at fair value and

classified as a current asset Unrealized gains and losses,

included in determination of net income


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Securities Available For SaleSecurities Available For Sale Debt and equity securities Readily determinable fair values Not classified as either securities held

to maturity or trading securities Measured at fair value on

balance sheet May be either current or noncurrent May have holding gains or losses, to be

reported net as a separate component of owners’ equity, usually as part of other comprehensive income.


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In addition to the financial statements, annual reports contain the following: Notes to the financial statements, including

a summary of the accounting methods used

Management’s discussion and analysis (MD&A) of the financial results

The auditor’s report Comparative financial data for a series of

years

Financial Statement AnalysisFinancial Statement Analysis


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Horizontal AnalysisHorizontal Analysis

2003 2002 2001 2000Sales $41,500 $37,850 $36,300 $35,000

18.6% 8.1% 3.7%

This shows 2000 as the base year. The base year’s sales are subtracted from each year’s sales. Then, this difference is expressed as a percentage of the base year’s sales.

Base year


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Vertical AnalysisVertical Analysis

– compares each item in a financial statement to a base number set to 100%.

Every item on the financial statement is then reported as a percentage of that base.


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Vertical AnalysisVertical Analysis

2002 %Sales $38,303 100.0Cost of goods sold 19,688 51.4Gross margin $18,615 48.6Total operating expenses 13,209 34.5Operating income $ 5,406 14.1Other income 2,187 5.7Income before taxes $ 7,593 19.8Income taxes 2,827 7.4Net income $ 4,766 12.4


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Ratio ClassificationRatio Classification

Liquidity: Can a company pay the bills as they come due?

Solvency: Can the company survive over a long period of time?

Profitability: Can a company earn a satisfactory rate of return?

Market indicators: Is the stock a good investment?


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Current ratio =Total current assets ÷ Total current liabilities

Liquidity: Measuring Ability Liquidity: Measuring Ability to Pay Current Liabilitiesto Pay Current Liabilities

This ratio measures a company’s ability to pay current liabilities with current assets.


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Acid-test ratio =(Cash + Short-term investments

+ Net current receivables)÷ Total current liabilities


The acid-test ratio shows the company’s ability to pay all current liabilities if they come due immediately.


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Working capital =Total current assets -

Total current liabilities


Working capital is not a ratio, but it is often computed to evaluate a the company’s ability to pay its current liabilities.


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Inventory turnover = Cost of goods sold÷ Average inventory

Liquidity: Measuring Liquidity: Measuring Ability to Sell InventoryAbility to Sell Inventory

This ratio measures how quickly a company is turning over its inventory. A high number indicates an ability to quickly sell inventory.


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Accounts receivable turnover =Net credit sales

÷ Average accounts receivable

Liquidity: Measuring Ability Liquidity: Measuring Ability to Collect Receivablesto Collect Receivables

This ratio measure’s a company’s ability to collect the cash from its credit customers.


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Solvency: Measuring Ability to Solvency: Measuring Ability to Pay Long-term DebtPay Long-term Debt

The debt to equity ratio compares the amount of debt a company has with the amount the owners have invested in the company.

Debt-to-equity ratio =Total liabilities ÷ Total equity


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Return on assets =Net income + interest expense

÷ Average total assets

Measuring Profitability: Measuring Profitability: Return on assetsReturn on assets

This ratio measures a company’s success in using its assets to earn income for the persons who are financing the business.


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Rate of return on common stockholders’ equity= (Net income – preferred dividends)

÷ Average common stockholders’ equity

Measuring Profitability: Measuring Profitability: Return on EquityReturn on Equity

This ratio measures how much income is earned with the common shareholders’ investment in the company.


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Gross margin ratio = Gross margin ÷ Sales

Measuring Profitability: Measuring Profitability: Gross Margin RatioGross Margin Ratio

This ratio measures percentage of sales price that is gross profit. A small shift usually indicates a big change in the profitability of the company’s sales.


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Measuring Profitability: Measuring Profitability: Earnings Per ShareEarnings Per Share

Earnings per share of common stock= (Net income – Preferred dividends)

÷ Number of shares of common stock outstanding

This ratio gives the amount of net income per share of common stock. It is one of the most widely-used measures of a company’s profitability.


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Market Indicators: PE RatioMarket Indicators: PE Ratio

Price/earning ratio is the ratio of market price per share to earnings per share. This ratio indicates the market price for $1 of earnings.

Price/Earnings Ratio =Market price per share of common

stock ÷ Earnings per share


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Dividend per share of common(or preferred) stock ÷ Market price per share

of common (or preferred) stock

Market Indicators: Dividend Market Indicators: Dividend Yield Yield

Dividend yield gives the percentage of a stock’s market value returned as dividends to stockholders each period.


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Making Ratios UsefulMaking Ratios Useful

A ratio by itself does not give much information.

To be useful, a ratio must be compared to other ratios from previous periods, compared to ratios of other companies in the industry, or compared to industry averages.

copyright 2003 prentice hall publishing company1 chapter 11 financial statement analysis

Documents

income statement

net income

accounting principle

continuing operations

n extraordinary items

special items

n cumulative effect

net of taxes