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Financial Accounting: Tools for Business Decision Making

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  1. Financial Accounting:Tools for Business Decision Making Kimmel, Weygandt, Kieso ELS Prepared by: Ellen L. Sweatt Georgia Perimeter College

  2. Chapter 14 ` Financial Analysis: The Big Picture

  3. Chapter 14Financial Analysis:The Big Picture After studying Chapter 14, you should be able to: • Understand the concept of earning power and indicate how irregular items are presented. • Discuss the need for comparative analysis and identify the tools of financial statement analysis. • Explain and apply horizontal analysis. • Describe and apply vertical analysis. • Identify and compute ratios and describe their purpose and use in analyzing a firm's liquidity, solvency, and profitability. • Discuss the limitations of financial statement analysis. 3

  4. Earning Power The value of a company is a function of its future cash flows. 4

  5. Earning Power The most likely level of income to be obtained in the future - that is, to the extent this year’s net income is a good predictor of future years’ net income. 5

  6. Earning Power • Earning power differs from actual net income by the amount of irregular revenues, expenses, gains, and losses included in this year's net income. • Users are interested in earning power because it helps them derive an estimate of future earnings without the "noise" of irregular items. 6

  7. Irregular Items Three types of irregular items are reported - (all net of taxes): • discontinued operations • extraordinary items • changes in accounting principle 7

  8. Discontinued Operations Refers to the disposal of a significant segment of a business • the elimination of a major class of customers or an entire activity 8

  9. Discontinued Operations • Assume Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million or net income of $800,000 from continuing operations in 1998. • During 1998 the company discontinued and sold its unprofitable chemical division. The loss in 1998 from chemical operations (net of $60,000 taxes) was $140,000, and the loss on disposal of the chemical division (net $30,000 taxes) was $70,000. 9

  10. Page 649 in book Discontinued Operations Assuming a 30% tax rate on the income. Rozek Inc. Partial Income Statement For the Year Ended December 31, 1998 Income before income taxes $800,000 Income tax expense 240,000 Income from continuing operations 560,000 Discontinued operations Loss from operations of chemical division, net of $60,000 income tax saving $140,000 Loss from disposal of chemical division, net $30,000 income tax saving 70,000210,000 Net income $350,000 10

  11. Extraordinary Items Events and transactions that meet two conditions: • Unusual in nature • Infrequent in occurrence

  12. Extraordinary Items • To be considered unusual, the item should be abnormal and only incidentally related to customary activities of the entity. • To be regarded as infrequent, the event or transaction should not be reasonably expected to recur in the foreseeable future. • Both criteria must be evaluated in terms of the environment in which the entity operates. 12

  13. Page 651 in book Extraordinary Items

  14. Page 651 in book Ordinary Items

  15. Extraordinary Items • In 1998 a revolutionary foreign government expropriated property held as an investment by Rozek Inc. • If the loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000. 15

  16. Page 651 in book Rozek Inc. Partial Income Statement For the Year Ended December 31, 1998 Income before income taxes $800,000 Income tax expense - 240,000 Income from continuing operations 560,000 Discontinued operations Loss from operations of chemical division, net of $60,000 income tax saving $140,000 Loss from disposal of chemical division, net $30,000 income tax saving 70,000210,000 Net income before extraordinary item 350,000 Extraordinary item Expropriation of investment, net of $21,000 income tax saving 49,000 Net income $301,000 16

  17. Changes in Accounting Principle • For ease of comparison, financial statements are expected to be prepared on a basis consistent with that used for the preceding period. • When a choice of principles is available, the principal initially chosen should be applied consistently from period to period. • A change in accounting principle occurs when the principle used in the current year is different from the one used in the preceding year. 17

  18. Changes in Accounting Principle • A change is permitted, when • management can show that the new principle is preferable to the old; • the effects of the change are clearly disclosed in the income statement. • Examples: • a change in depreciation methods (such as declining-balance to straight-line) • a change in inventory costing methods (such as FIFO to average cost) 18

  19. Changes in Accounting Principle A change in accounting principle affects reporting in two ways: • The new principle should be used in reporting the results of operations of the current year. • The cumulative effect of the change on all prior-year income statements should be disclosed net of applicable taxes in a special section immediately preceding Net Income. 19

  20. Changes in Accounting Principle • Rozek Inc. changes from the straight-line method to the declining-balance method for equipment purchased on January 1, 1995. • The cumulative effect on prior-year income statements (statements for 1995-1997) is to increase depreciation expense and decrease income before income taxes by $24,000. • If there is a 30% tax rate, the net-of-tax effect of the change is $16,800 ($24,000 x 70%). 20

  21. Page 653 in book Rozek Inc. Partial Income Statement For the Year Ended December 31, 1998 Income before income taxes $800,000 Income tax expense 240,000 Income from continuing operations 560,000Discontinued operations Loss from operations of chemical division, net of $60,000 income tax saving $140,000 Loss from disposal of chemical division, net $30,000 income tax saving 70,000210,000 Net income before extraordinary item 350,000 Extraordinary item Expropriation of investment, net of $21,000 income tax saving 49,000 Cumulative effect of change in accounting principle Effect on prior years of change in depreciation method, net of $ 7,200 tax 16,800 Net Income 284,200

  22. Changes in Accounting Principle • Although most revenues, expenses, gains, and losses recognized during the period are included in net income, specific exceptions to this practice have developed. • Certain items such as unrealized gains and losses on available-for-sale securities, now bypass income and are reported directly in stockholders' equity. 22

  23. Changes in Accounting Principle Unrealized gains and losses on available-for-sale securities are excluded from net income because disclosing them separately: • reduces the volatility of net income due to fluctuations in fair value, yet • informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value. 23

  24. Changes in Accounting Principle • Analysts have expressed concern that the number of items bypassing the income statement has increased significantly. • The FASB now requires that, in addition to reporting net income, a company must also report comprehensive income. 24

  25. Comprehensive Income Includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders. 25

  26. Comparative Analysis • Any item reported in a financial statement has significance: • Its inclusion indicates that the item exists at a given time and in a certain quantity. • For example, when Kellogg Company reports $243.8 million on its balance sheet as cash, we know that Kellogg did have cash and that the quantity was $243.8 million. 26

  27. Comparative Analysis • Whether the amount represents an increase over prior years, or whether it is adequate in relation to the company's needs, cannot be determined from the amount alone. • The amount must be compared with other financial data to provide more information. 27

  28. Comparative Analysis There are three types of comparisons to provide decision usefulness of financial information: • Intracompany basis • Intercompany basis • Industry averages 28

  29. Intracompany Basis • Comparisons within a company are often useful to detect changes in financial relationships and significant trends. • A comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. • Likewise, a comparison of Kellogg's year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash. 29

  30. Intercompany Basis • Comparisons with other companies provide insight into a company's competitive position. • Kellogg's total sales for the year can be compared with the total sales of its competitors such as Quaker Oats and General Mills. 30

  31. Industry Averages • Comparisons with industry averages provide information about a company's relative position within the industry. • Kellogg's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's. 31

  32. Financial Statement Analysis Three basic tools are used in financial statement analysis : 1. Horizontal analysis 2. Vertical analysis 3. Ratio analysis

  33. Horizontal Analysis • Horizontal analysis is a technique for evaluating a series of financial statement data over a period of time. • The purpose of horizontal analysis is to determine whether an increase or decrease has taken place. • The increase or decrease can be expressed as either an amount or a percentage. 33

  34. Page 656 in book Horizontal Analysis KELLOGG COMPANY Net Sales (in millions) Base Period 1992 19961995199419931992 6,676.6 7,003.7 6,562.0 6,295.4 6,190.6 34

  35. Page 656 in book Horizontal Analysis • If we assume that 1992 is the base year, we can measure all percentage increases or decreases from this base-period amount with the following formula: CURRENT-YEAR AMOUNT – BASE-YEAR AMOUNT BASE-YEAR AMOUNT • We can determine that net sales for Kellogg company increased approximately 1.7% [($6,295.4 – $6,190.6)/$6,190.6] from 1992 to 1993. 35

  36. Page 656 in book Percentage Change in Sales The percentage change in sales for each of the 5 years, assuming 1992 as the base period is: 19961995199419931992 6,676.6 7,003.7 6,562.0 6,295.4 6,190.6 107.8% 113.1% 106.0% 100.2% 100% 36

  37. Page 657 in book Horizontal Analysis of a Balance Sheet The financial statements of Kellogg Company are used to illustrate horizontal analysis: KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) Increase (Decrease) during 1996 19961995AmountPercent Assets Current Assets $1,528.6 $1,428.8 $ 99.8 7.0%Plant assets 2,932.9 2,784.8 148.1 5.3 Other assets 588 .5 201.0387.5 192.8 Total assets 5,050.0 4,414.6 635.4 14.4%

  38. Page 657 in book Horizontal Analysis of a Balance Sheet Increase (Decrease) during 1996 19961995AmountPercent Liabilities and Stockholders' Equity Current liabilities $2,199.0 $1,265.4 $933.6 73.8% Long-term liabilities 1,568.6 1,558.3 10.3 .7 Total liabilities 3,767.6 2,823.7 943.9 33.4% Stockholders' equity Common stock 201.8 183.0 18.8 10.3 Retained earnings and other 3,984.0 3,769.1 214.9 5.7 Treasury stock (2,903.4)(2,361.2) 542.2 23.0 Total stockholders' equity 1,282.4 1,590.9(308.5) (19.4) Total liabilities and stockholders' equity $5,050.0 $4,414.6 $635.4 14.4%

  39. Horizontal Analysis of an Income Statement Page 657 in book The following is a 2-year comparative income statement of Kellogg Company for 1996 and 1995 (in condensed format): KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) Increase (Decrease) during 1996 19961995AmountPercent Net sales $6,676.6 $7.003.7 ($327.1) (4.7%) Cost of goods sold 3,122.9 3,177.7 (54.8) (1.7) Gross profit 3,553.7 3,826.0 (272.3) (7.1)

  40. Page 657 in book Horizontal Analysis of an Income Statement Increase (Decrease) during 1996 19961995AmountPercent Gross profit 3,553.7 3,826.0 (272.3) (7.1) Selling and administrative expenses 2,458.7 2,566.7 (108.0) (4.2) Nonrecurring charges 136.1 421.8 285.7 (67.7) Income from operations 958.9 837.5 121.4 14.5 Interest expense 65.6 62.6 3.0 4.8 Other income (expense), net (33.4) 21.1 54.5 n/a Income before income taxes 859.9 796.0 63.9 8.0% Income tax expense 328.9 305.7 32.2 7.6 Net income $531.0 $490.3 $40.7 8.3%

  41. Horizontal Analysis of an Income Statement Horizontal analysis of the income statements on Page 657shows these changes: • Net sales decreased $327.1, or 4.7% ($327.1 ÷ $7,003.7). • Cost of goods sold increased $54.8, or 1.7% ($54.8 ÷ $3,177.7). • Selling and administrative expenses decreased $108.0, or 4.2% ($108.0 ÷ $2,566.7). 41

  42. Horizontal Analysis of an Income Statement • Although gross profit decreased by 7.2%, net income increased by 8.3%. • The increase in net income can be attributed almost entirely to the decrease in nonrecurring charges due to the restructuring of the company. 42

  43. Vertical Analysis • Vertical analysis is a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount. • Total assets is always the base amount in vertical analysis of a balance sheet. • Net sales is always the base amount in vertical analysis of an income statement. 43

  44. Page 659 in book Vertical Analysis of a Balance Sheet Presented below is the comparative balance sheet of Kellogg for 1996 and 1995, analyzed vertically. KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) 19961995 AssetsAmountPercentAmountPercent Current Assets $1,528.6 30.3% $1,428.8 32.4% Plant assets (net) 2,932.9 58.1 2,784.8 63.1 Other assets 588.511.7 201.0 4.6 Total assets $5,050.0 100.0% $4,414.6 100.0% 44

  45. Page 659 in book Vertical Analysis of a Balance Sheet 19961995 AmountPercentAmountPercent Liabilities and Stockholders' Equity Current liabilities $2,199.0 43.5% $1,265.4 28.7% Long-term liabilities 1,568.6 31.1 1,558.3 35.3 Total liabilities 3,767.6 74.6 2,823.7 64.0 45

  46. Page 659 in book Vertical Analysis of a Balance Sheet 19961995 AmountPercentAmountPercent Total liabilities 3,767.6 74.6 2,823.7 64.0 Stockholders' equity Common stock 201.8 4.0 183.0 4.1 Retained earnings and other 3,984.0 78.9 3,769.1 85.4 Treasury stock (2,903.4) 57.5(2,361.2) 53.5 Total stockholders' equity 1,282.4 25.4 1,590.9 36.0 Total liabilities and stockholders' equity $5,050.0 100.0% $4,414.6 100.0% 46

  47. Vertical Analysis of a Balance Sheet • In addition to showing the relative size of each category on the balance sheet, vertical analysis may show the percentage change in the individual asset, liability, and stockholders' equity items. • Although, Kellogg's current assets increased $99.8 million from 1995 to 1996, they decreased from 32.4% to 30.3% of total assets. 47

  48. Vertical Analysis of a Balance Sheet • Plant assets decreased from 63.1% to 58.1% of total assets. • Current liabilities increased by $933.6 million, going from 28.7% to 43.5% of total liabilities and stockholders' equity.

  49. Page 660 in book Vertical Analysis of an Income Statement KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) 1996 1995 AmountPercentAmountPercent Net sales $6,676.6 100.0% $7,003.7 100.0% Cost of goods sold 3,122.9 46.8 3,177.7 45.4 Gross profit 3,553.7 53.2 3,826.0 54.6 Selling and administrative expenses 2,458.7 36.8 2,566.7 36.6 Nonrecurring charges 136.1 2.0 421.8 6.0 Income from operations 958.9 14.4 837.5 12.0

  50. Page 660 in book Vertical Analysis of an Income Statement 1996 1995 AmountPercentAmountPercent Income from operations 958.9 14.4 837.5 12.0 Interest expense 65.6 1.0 62.6 .9 Other income (expense),net (33.4) .5 21.1 .3 Income before income taxes 859.9 12.9 796.0 11.4 Income tax expense 328.9 4.9 305.7 43.6 Net income $531.0 8.0% $490.3 7.0%