Ch15

Principles of Financial Accounting with Conceptual Emphasis on IFRS

Reeve Warren Duchac Wang

Financial Statement Analysis

Learning Objective 13-1

Describe the nature of the adjusting process.

Learning Objective 13-1

Describe the nature of the adjusting process.

Insert Chapter Objectives

Financial Statement Analysis

1 Describe basic financial statement analytical methods.

2 Use financial statement analysis to assess the solvency of a business.

After studying this chapter, you should be able to:

3 Use financial statement analysis to assess the profitability of a business.

4 Describe the contents of corporate annual reports.

Describe basic financial statement analytical methods.

Basic Analytical Methods

Users analyze a company’s financial statements using a variety of analytical methods. Three such methods are as follows:1. Horizontal analysis

2. Vertical analysis

3. Common-sized statements

Horizontal Analysis

The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis.

Comparative Statement of Financial Position—Horizontal Analysis

Exhibit 1

Horizontal Analysis: Horizontal Analysis:

Difference $17,000

Base year (2009) $533,000= 3.2%

Exhibit 1

Comparative Statement of Financial Position—Horizontal Analysis

Comparative Schedule of Current Assets—Horizontal Analysis

Exhibit 2

Horizontal Analysis: Horizontal Analysis:

Difference $25,800

Base year (2009) $64,700= 39.9%

1Comparative Schedule of Current Assets—Horizontal AnalysisExhibit 2

Comparative Statement of Comprehensive Income—Horizontal Analysis

1Exhibit 3

Horizontal Analysis:Horizontal Analysis:

Increase amount $296,500

Base year (2009) $1,234,000

= 24.0%

1Comparative Statement of Comprehensive Income—Horizontal AnalysisExhibit 3

Comparative Statement of Retained Earnings—Horizontal Analysis

Horizontal Analysis:Horizontal Analysis:

Increase amount $37,500

Base year (2009) $100,000= 37.5%

1Exhibit 4

1 Example Exercise 15-1

Horizontal AnalysisThe comparative cash and accounts receivable balances for a company are provided below.

2010 2009Cash $62,500 $50,000Accounts receivable (net) 74,400 80,000

Based on this information, what is the amount and percentage of increase or decrease that would be shown in a statement of financial position with horizontal analysis?

For Practice: PE 15-1A, PE 15-1B

Follow My Example 6-1

Cash $12,500 increase ($62,500 – $50,000), or 25%Accounts receivable $5,600 decrease ($74,400 – $80,000), or (7%)

Vertical Analysis

The percentage analysis of the relationship of each component in a financial statement to a total within the statement is called vertical analysis.

In a vertical analysis of the statement of comprehensive income, each asset item is stated as a percent of the total assets. Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.

Vertical Analysis of Statement of Financial Position

Comparative Statement of Financial Position—Vertical Analysis

Exhibit 5

Vertical Analysis: Vertical Analysis:

Current assets $550,000

Total assets $1,139,500= 48.3%

Exhibit 5

Comparative Statement of Financial Position—Vertical Analysis

In a vertical analysis of the statement of comprehensive income, each item is stated as a percent of net sales.

Vertical Analysis of the Statement of Comprehensive Income

Comparative Statement of Comprehensive Income—Vertical Analysis

1Exhibit 6

Vertical Analysis: Vertical Analysis:

Selling expenses $191,000

Net sales $1,498,000= 12.8%

1Exhibit 6

Comparative Statement of Comprehensive Income—Vertical Analysis

Common-Size Statements

In a common-sized statements, all items are expressed as a percentage. Common-sized statements are useful in comparing the current period with prior periods, individual businesses, or one business with with industry percentages.

Common-Sized Statement of Comprehensive Income

1Exhibit 7

Example Exercise 15-2

Vertical Analysis

Statement of comprehensive income information for Lee Corporation is provided below.

$100,000Cost of goods sold

65,000Gross profit

$ 35,000

Prepare a vertical analysis of the statement of comprehensive income for Lee Corporation.

Example Exercise 15-2 (continued) 1

Sales $100,000 100% ($100,000 ÷ $100,000)Cost of goods

sold 65,000 65 ($65,000 ÷ $100,000)Gross profit 35,000 35% ($35,000 ÷ $100,000)

Amount Percentage

15-2515-25

Use financial statement analysis to assess the solvency of a business.

Solvency Analysis

All users of financial statements are interested in the ability of a company to do the following:1. Meet its financial obligations (debts), called

solvency.2. Earn income, called profitability.

Current Position Analysis

Using measures to assess a business’s ability to pay its current liabilities is called current position analysis. Such analysis is of special interest to short-term creditors.

Working Capital

The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company’s ability to pay current liabilities.

Working Capital = Current Assets – Current Liabilities

2010 2009

Current assets $550,000 $533,000Less current liabilities –210,000 –243,000Working capital $340,000$290,000

Current Ratio

The current ratio, sometimes called the working capital ratio or bankers’ ratio measures a company’s ability to pay its current liabilities.

2010 2009Current assets $550,000 $533,000Current liabilities $210,000 $243,000Current ratio 2.6 2.2

$550,000

$210,000

$533,000

$243,000

Current Ratio =Current Assets

Current Liabilities

Quick Ratio

A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio or acid-test ratio.

2010 2009

Quick ratio (a ÷ b) 1.3 1.0

Quick assets:Cash $ 90,500 $ 64,700Temporary Investments 75,000 60,000Accounts receivable (net) 115,000 120,000 a. Total quick assets $280,500 $244,700

b. Current liabilities $210,000 $243,000

Quick assets are cash and other current assets

that can be quickly converted to cash.

Current Position Analysis

The following items are reported on a company’s statement of financial position:

$300,000Temporary investments

100,000Accounts receivable (net)

200,000Inventory

200,000Accounts payable

400,000

Determine (a) the current ratio and (b) the quick ratio.

b. Quick Ratio = Quick Assets ÷ Current Liabilities

Quick Ratio = ($300,000 + $100,000 + $200,000) ÷ $400,000

Quick Ratio = 1.5

a. Current Ratio = Current Assets/Current Liabilities

Current Ratio = ($300,000 + $100,000 + $200,000 + $200,000) ÷ $400,000

Current Ratio = 2.0

Accounts Receivable Turnover

The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. Collecting accounts receivable as quickly as possible improves a company’s solvency.

Accounts receivable turnover (a ÷ b) 12.7 9.2

a. Net sales $1,498,000$1,200,000

Accounts receivable (net):Beginning of year $ 120,000$ 140,000End of year 115,500 120,000

Total$ 235,000 $ 260,000

b. Average (Total ÷ 2) $ 117,500$ 130,000

2010 2009

Accounts Receivable Turnover = Net Sales

Average Accounts Receivable

Number of Days’ Sales in Receivables

The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding.

Number of Days’ Sales in Receivables

Average Accounts Receivable

Average Daily Sales

Net Sales

Number of days’ sales in receivables (a ÷ b) 28.6 39.5

a. Average accounts receivable(Total accounts receivable ÷ 2) $ 117,500

$ 130,000Net sales $1,498,000

$1,200,000b. Average daily sales

(Sales ÷ 365) $ 4,104$ 3,288

2010 2009

Accounts Receivable Analysis

A company reports the following:

Net sales

$960,000Average accounts receivable (net)

48,000

Determine (a) the accounts receivable turnover and (b) the number of days’ sales in receivables. Round to one decimal place.

a. Accounts Receivable Turnover = Sales ÷ Average Accounts Receivable

Accounts Receivable Turnover = $960,000 ÷ $48,000

Accounts Receivable Turnover = 20.0

b. Number of Days’ Sales in Receivables = Average Accounts Receivable ÷ Average Daily Sales

Number of Days’ Sales in Receivables = $48,000 ÷ ($960,000/365) $48,000 ÷ $2,630

Number of Days’ Sales in Receivables = 18.3 days=

Inventory Turnover

The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory.

Inventory Turnover = Cost of Goods Sold

Average Inventory

Inventory turnover (a ÷ b) 3.8 2.8

2010 2009

a. Cost of goods sold $1,043,000$ 820,000

Inventories:Beginning of year $ 283,000

$ 311,000End of year 264,000

283,000Total $ 547,000

$ 594,000

b. Average (Total ÷ 2) $ 273,500$ 297,000

Number of Days’ Sales in Inventory

The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory.

Number of Days’ Sales in Inventory

Average Inventory

Average Daily Cost of Goods Sold

Cost of Goods Sold

Number of days’ sales in inventory (a ÷ b) 95.7 132.2

a. Average inventory (Total ÷ 2) $ 273,500 $ 297,000Cost of goods sold $1,043,000 $ 820,000

b. Average daily cost of goodssold (COGS ÷ 365 days) $2,858 $2,247

2010 2009

Inventory Analysis

Cost of goods sold

$560,000Average inventory

112,000

Determine (a) the inventory turnover and (b) the number of days’ sales in inventory. Round to one decimal place.

a. Inventory Turnover = Cost of Goods Sold ÷ Average InventoryInventory Turnover = $560,000 ÷ $112,000Inventory Turnover = 5.0

b. Number of Days’ Sales in Inventory = Average Inventory ÷ Average Daily Cost of Goods Sold Number of Days’ Sales in Inventory = $112,000 ÷ ($560,000/365) Number of Days’ Sales in Inventory = $112,000 ÷ $1,534 Number of Days’ Sales in Inventory = 73.0 days

Ratio of Fixed Assets to Long-Term Liabilities

The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis.

Ratio of Fixed Assets to Long-Term Liabilities

Fixed Assets (net)

Long-Term Liabilities

2010 2009

Ratio of fixed assets to non-current liabilities (a ÷ b) 4.4 2.4

a. Fixed assets (net) $444,500 $470,000b. Non-current liabilities $100,000 $200,000

Ratio of Liabilities to Stockholders’ Equity

The relationship between the total claims of the creditors and owners—the ratio of liabilities to stockholders’ equity—is a solvency measure that indicates the margin of safety for creditors.

Ratio of Liabilities to Stockholders’ Equity

Total Liabilities

Total Stockholders’

Equity

Ratio of liabilities to stockholders’ equity ( a÷ b) 0.4 0.6

a. Total liabilities $310,000 $443,000b. Total stockholders’ equity $829,500 $787,500

2010 2009

Long-Term Solvency Analysis

The following information was taken from Acme Company’s statement of financial position:

Fixed assets (net)

$1,400,000Non-current liabilities

400,000Total liabilities

560,000Total stockholders’ equity

1,400,000

Determine the company’s (a) ratio of fixed assets to non-current liabilities and (b) ratio of liabilities to total stockholders’ equity.

a. Ratio of Fixed Assets to Long-Term Liabilities = Fixed Assets ÷ Non- Current

LiabilitiesRatio of Fixed Assets to Long-Term Liabilities = $1,400,000 ÷ $400,000Ratio of Fixed Assets to Long-Term Liabilities = 3.5

b. Ratio of Liabilities to Total Stockholders’ Equity = Total Liabilities ÷ Total

Stockholders’ EquityRatio of Liabilities to Total Stockholders’ Equity = $560,000 ÷ $1,400,000 Ratio of Liabilities to Total Stockholders’ Equity = 0.4

Number of Times Interest Charges Are Earned

Corporations in some industries normally have high ratios of debt to stockholders’ equity. For such corporations, the relative risk of the debtholders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge coverage ratio.

Number of Times Interest Charges Are

Earned

Income Before Income Tax + Interest Expense

Interest Expense=

2010 2009

Income before income tax $162,500$134,600

a. Add interest expense 6,000 12,000

b. Amount available to payinterest $168,500

$146,600Number of times interest charges earned (b ÷ a) 28.1 12.2

Number of Times Preferred Dividends Are Earned

The number of times interest charges are earned can be adapted for use with

dividends on preferred stock.

Number of Times Preferred Dividends

Are Earned

Net Income

Preferred Dividends=

15-5715-57

Times Interest Charges Are Earned

A company reports the following:Income before income tax

$250,000Interest expense

100,000

Determine the number of times interest charges are earned.

Number of Times Interest Charges Are Earned = (Income Before Income Tax + Interest Expense) ÷ Interest Expense

Number of Times Interest Charges Are Earned = ($250,000 + $100,000) ÷ $100,000

Number of Times Interest Charges Are Earned = 3.5

Use financial statement analysis to assess the profitability of a business.

Profitability Analysis

Profitability analysis focuses primarily on the relationship between operating results and the resources available to a business.

Ratio of Net Sales to Assets

The ratio of net sales to assets is a profitability measure that shows how effectively a company utilizes its assets.

Ratio of Net Sales to Assets Net Sales

Average Total Assets

2010 2009

a. Net sales $1,498,000 $1,200,000Total assets:

Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000

b. Average (Total ÷ 2) $1,048,750 $1,031,500

Excludes long-term investments

Ratio of Net Sales to Assets Net Sales

Average Total Assets

2010 2009

a. Net sales $1,498,000 $1,200,000Total assets:

b. Average (Total ÷ 2) $1,048,750 $1,031,500

Ratio of net sales to assets (a ÷ b) 1.4 1.2

15-6315-63

Net Sales to AssetsA company reports the following:

Net sales

$2,250,000Average total assets

1,500,000

Determine the ratio of net sales to assets.

Ratio of Net Sales to Assets = Net Sales ÷ Average Total Assets

Ratio of Net Sales to Assets = $2,250,000 ÷ $1,500,000

Ratio of Net Sales to Assets = 1.5

Rate Earned on Total Assets

The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed.

Rate Earned on Total Assets

Net Income + Interest Expense

Average Total Assets=

Rate earned on total assets (a ÷ b) 8.2% 7.3%

2010 2009

Net income $ 91,000 $ 76,500Plus interest expense 6,000 12,000a. Total $ 97,000 $ 88,500Total assets:

b. Average (Total ÷ 2) $1,185,000 $1,209,000

15-6615-66

Rate Earned on Total AssetsA company reports the following statement of comprehensive income and statement of financial position information for the current year:

Net income

$ 125,000Interest expense

25,000Average total assets

2,000,000

Rate Earned on Total Assets = (Net Income + Interest Expense) ÷ Average Total AssetsRate Earned on Total Assets = ($125,000 + 25,000) ÷ $2,000,000Rate Earned on Total Assets = 7.5%

Determine the rate earned on total assets.

Rate Earned on Stockholders’ Equity

The rate earned on stockholders’ equity measure emphasizes the rate of income earned on the amount invested by the stockholders.

Rate Earned on Stockholders’ Equity

Net Income

Average Total Stockholders’ Equity

Rate earned on stockholders’equity (a ÷ b) 11.3% 10.0%

a. Net income $ 91,000 $ 76,500Stockholders’ equity:

Beginning of year $ 787,500 $ 750,000End of year 829,500 787,500Total $1,617,000 $1,537,500

b. Average (Total ÷ 2) $ 808,500 $ 768,750

2010 2009

The difference in the rate earned on stockholders’ equity and the rate earned on total assets is called leverage.

Leverage

Exhibit 8 Effect of Leverage

The rate earned on common stockholders’ equity focuses only on the rate of profits earned on the amount invested by the common stockholders.

Rate Earned on Common Stockholders’ Equity

Net Income – Preferred Dividends

Average Common Stockholders’ Equity

Rate earned on common stockholders’ equity (a ÷ b) 12.5% 10.9%

2010 2009

Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000

a. Remainder—common stock $ 82,000 $ 67,500Common stockholders’ equity:

Beginning of year $ 637,500 $ 600,000End of year 679,500 637,500Total $1,317,000 $1,237,500

b. Average (Total ÷ 2) $ 658,500 $ 618,750

Common Stockholders’ Profitability Analysis

Net income $ 125,000Preferred dividends 5,000Average stockholders’ equity 1,000,000Average common stockholders’ equity 800,000

Determine (a) the rate earned on stockholders’ equity and (b) the rate earned on common stockholders’ equity.

a. Rate Earned on Stockholders’ Equity = Net Income ÷ Average Stockholders’ Equity

Rate Earned on Stockholders’ Equity = $125,000 ÷ $1,000,000Rate Earned on Stockholders’ Equity = 12.5%

b. Rate Earned on Common Stockholders’ Equity = (Net Income – Preferred Dividends) ÷

Average Common Stockholders’ EquityRate Earned on Common Stockholders’ Equity = ($125,000 – $5,000) ÷ $800,000Rate Earned on Common

Stockholders’ Equity = 15%

Earnings per Share on Common Stock

Earnings per share (EPS) on common stock measures the share of profits that are earned by a share of common stock. GAAP require the reporting of earnings per share in the statement of comprehensive income.

Earnings per Share (EPS) on Common Stock

Net Income – Preferred Dividends

Shares of Common Stock Outstanding

Earnings per share on common stock (a ÷ b) $1.64 $1.35

2010 2009

Net income $91,000$76,500

Preferred dividends 9,000 9,000

a. Remainder—identified with common stock $82,000$67,500

b. Shares of common stock 50,00050,000

Price-Earnings Ratio

Another profitability measure quoted by the financial press is the price-earnings (P/E) ratio on common stock. The price-earnings ratio on common stock measures a company’s future earnings prospects.

Price-Earnings (P/E) Ratio

Market Price per Share of Common Stock

Earnings per Share on Common Stock

Price-earnings ratio on common stock 25 20

2010 2009

Market price per share of common stock $41.00 $27.00

Earnings per share on commonstock ÷ 1.64 ÷ 1.35

Earnings per Share and Price-Earnings Ratio

Net income$250,000

Preferred dividends$15,000

Shares of common stock

outstanding20,000

Market price per share of common stock

$35.00

a. Determine the company’s earnings per share on common stock.

b. Determine the company’s price-earnings ratio. Round to one decimal place.

b. Price-Earnings Ratio = Market Price per Share of Common Stock ÷ Earnings per Share on Common Stock

Price-Earnings Ratio = $35.00 ÷ $11.75

Price-Earnings Ratio = 3.0

a. Earnings per Share on Common Stock = (Net Income – Preferred Dividends) ÷ Shares of Common Stock Outstanding

Earnings per Share = ($250,000 – $15,000) ÷ 20,000

Earnings per Share = $11.75

Dividends per Share

Dividends per share can be reported with earnings per share to indicate the relationship between dividends and earnings. Comparing these two per share amounts measures the extent to which earnings are being distributed to common shareholders.

Dividends per Share Dividends

Shares of Common Stock Outstanding

Dividends per share of common stock (a ÷ b) $0.80 $0.60

2010 2009

a. Dividends $40,000 $30,000b. Shares of common stock outstanding 50,000 50,000

Dividends and Earnings per Share of Common Stock

Exhibit 9

The dividend yield on common stock measures the rate of return to common stockholders from cash dividends.

Dividend Yield

Dividends per Share of Common Stock

Market Price per Share of Common Stock

Dividend yield on common stock 2.0% 2.2%

2010 2009

a. Dividends per share of common stock $ 0.80$ 0.60

b. Market price per share of common stock 41.0027.00

Summary of Analytical MeasuresExhibit 10

Solvency Measures (continued)

Summary of Analytical Methods (continued)Exhibit 10

Profitability Measures

15-8815-88

Describe the contents of corporate annual reports

Corporate Annual Reports

In addition to the financial statements and the accompanying notes, corporate annual reports usually include the following sections:• Management discussion and analysis

• Report on internal control

• Report on fairness of financial statements

The Management Discussion and Analysis (MD&A) includes an analysis of the results of operations and discusses management’s opinion about future performance. It compares the prior year’s statement of comprehensive income with the current year’s. It also contains an analysis of the firm’s financial condition.

Management Discussion and Analysis

The Sarbanes-Oxley Act of 2002 requires a report stating management’s responsibility for establishing and maintaining internal control. In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report.

Report on Internal Control

All publicly held corporations are required to have an independent audit (examination) of their financial statements. The CPA firm that conducts the audit renders an opinion on the fairness of the statements.

Report on Fairness of Financial Statements

15-9315-93

Appendix: Unusual Items on the Statement of Comprehensive Income

Unusual Items Affecting the Current Period’s Statement of Comprehensive

Income

Unusual items affecting the current period’s statement of comprehensive income include the following:

• Discontinued operations• Extraordinary items

Discontinued Operations

A company may discontinue a segment of its operations by selling or abandoning the operations. A note accompanying the statement of comprehensive income should describe the operations sold including such details as the date operations were discontinued, the assets sold, and the effect (if any) on current and future operations.

Extraordinary Items

An extraordinary item is defined as an event or transaction with the following characteristics:• Unusual in nature• Infrequent in occurrence

Unusual Items in the Statement of Comprehensive Income

Exhibit 11

Statement of Comprehensive Income with Earnings per Share

Exhibit 12

Spotlight on IFRS:IFRS and Financial Statement Analysis

15-100

Impact of IFRS on Financial Statements

• The impacts fall not just on the preparers but also on the users of financial statements.

15-101

Difference across Countries

• The bank-oriented continental European countries are now shifting toward the capital market-oriented perspective of financial reporting with the globalization of the financial environments.

• Countries in this area will experience a higher level of adjustments in financial reporting. For the market-oriented countries the impact will somewhat be lower.

• Users of financial statements of the companies need to make the same adjustments.

15-102

Quality of Financial Information

• IFRS adoption is perceived to improve the financial transparency and comparability of financial statements.

• Research shows that financial statements under the market-oriented perspective raise the quality of financial information and benefit investors:– IFRS improves investor protection, makes capital

markets more accessible to foreign investors, and improves the comparativeness and comprehensiveness of financial information.

15-103

Impact on Financial Ratios

• Differences between IFRS and US GAAP that contribute to the differences in financial analysis:1. Recognition

2. Classification

3. Presentation

4. Timeliness

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