CHAPTER 14

Financial Statement Analysis

OBJECTIVES
1.

Discuss the need for comparative analysis and identify

the tools of financial statement analysis.

2.

Explain and apply horizontal and vertical analysis.

3.

Identify and compute ratios used in analyzing a firms

liquidity, profitability, and solvency.

4.

Understand the concept of earning power, and how

irregular items are presented.

5.

Understand the concept of quality of earnings.

OBJECTIVES OF FS ANALYSIS
Forensic. . . Assessment of Past
Performance and Current position
Future. . . Assessment of Future potential
and related Risk

SOURCES
Inside the company
Outside the company
Really outside the company

SOURCES
Inside the company 10K, website, press releases
Outside the company external analysts, Standard

and Poors, Valueline, Hoovers, Dun & Bradstreet, Moodys,

etc.

FINANCIAL STATEMENT ANALYSIS

Three basic tools are used in financial statement
analysis :
1. Horizontal (also called trend)analysis
2. Vertical analysis
3. Ratio analysis

HORIZONTAL ANALYSIS

Looking at the Trends over time.

In $$$$$$$$$$ or %%%%%%%%%%

From the base year

Shows growth or decline

Used with Balance Sheet and Income
Statement

HORIZONTAL ANALYSIS
OF A INCOME STATEMENT ITEMS
Kellogg ($ in millions)
Selected Income Statement Items - Horizontal Analysis

Period Ending
Total Revenue (Sales

Gross Profit

Total Operating Expenses

Net Income

2-Jan-10

12,575

3-Jan-09

12,822

29-Dec-07

11,776

106.78%

108.88%

100.00%

5,391

5,367

5,179

104.09%

103.63%

100.00%

3,390

3,414

3,311

102.39%

103.11%

100.00%

1,212

1,148

1,103

109.88%

104.08%

100.00%

Analysis:
Look at the Trends, all of
them
What can you say about them?

HORIZONTAL ANALYSIS
OF A INCOME STATEMENT ITEMS
Kellogg ($ in millions)
Selected Income Statement Items - Horizontal Analysis

Period Ending
Total Revenue (Sales

Gross Profit

Total Operating Expenses

Net Income

2-Jan-10

12,575

3-Jan-09

12,822

29-Dec-07

11,776

106.78%

108.88%

100.00%

5,391

5,367

5,179

104.09%

103.63%

100.00%

3,390

3,414

3,311

102.39%

103.11%

100.00%

1,212

1,148

1,103

109.88%

104.08%

100.00%

Analysis:
Sales grew in 2009 compared
to 2008, however dipped in
2010. Net income grew each
year; reviewing costs, Kelloggs
Operating Expenses grew at
a much slower pace, which
contributed to the Net Income
growth. Also Kelloggs gross
profit improved in 2010, even
though its sales did not. This
suggests that Kelloggs is
controlling costs.
Note: with more space, you
would quote actual numbers
and % for evidence.

Horizontal Analysis Income Statement

CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT

BASE-YEAR AMOUNT

12,822.0 11,776= 108.88%

11,776.0
Net sales for Kellogg company increased 8.88% in
2011 compared to 2011.
10

HORIZONTAL ANALYSIS OF A BALANCE

SHEET ITEMS
Kellogg ($ in millions)
Selected Balance Sheet Items - Horizontal Analysis

Period Ending
Current assets

Total Assets

Current Liabliities

Long Term Liabilities

Retained Earnings

2-Jan-10

2,558

3-Jan-09

2,521

29-Dec-07

2,717

94.15%

92.79%

100.00%

11,200

10,946

11,397

98.27%

96.04%

100.00%

2,288

3,552

4,044

56.58%

87.83%

100.00%

8,928

9,498

8,871

100.64%

107.07%

100.00%

5,461

4,836

4,217

129.50%

114.68%

100.00%

Analysis:
Look at the Trends, all of
them
What can you say about them?

11

HORIZONTAL ANALYSIS OF A BALANCE

SHEET ITEMS
Kellogg ($ in millions)
Selected Balance Sheet Items - Horizontal Analysis

Period Ending
Current assets

Total Assets

Current Liabliities

Long Term Liabilities

Retained Earnings

2-Jan-10

2,558

3-Jan-09

2,521

29-Dec-07

2,717

94.15%

92.79%

100.00%

11,200

10,946

11,397

98.27%

96.04%

100.00%

2,288

3,552

4,044

56.58%

87.83%

100.00%

8,928

9,498

8,871

100.64%

107.07%

100.00%

5,461

4,836

4,217

129.50%

114.68%

100.00%

Analysis: Total Assets are

decreasing; Current Assets
are decreasing at a faster rate,
suggesting more funds are
being dedicated to Long Term
Assets. However, Long Term
Liabilities are stable,
suggesting that the company is
maintaining the same debt
levels. Retained Earnings
has grown by almost 30% over
the base year, indicating that
the company has been
profitable.

12

WHAT DOES IT TELL YOU?

BALANCE SHEET:
What

changed and in what direction?

How was it financed?

INCOME STATEMENT:
Are

sales increasing?
Are costs following sales? (growth, decline)

13

WHAT DOES IT TELL YOU?

Tracks changes over time
Tracks changes in one area (sales)
compared to other areas (net income)

14

VERTICAL ANALYSIS
Common

size analysis
What is your basis?
Balance

Sheet: Total Assets

Income Statement: Net Sales (net
revenues)

15

VERTICAL ANALYSIS INCOME STATEMENT

Note that Net
Sales is always
the 100% base
figure for
Vertical Analysis
and all other
items are a
percentage of
this

Kellogg ($ in millions)
Selected Income Statement Items - Vertical Analysis

Period Ending

2-Jan-10
Amount

Total Revenue (Sales

12,575

Gross Profit

5,391

Total Operating Expenses

3,390

Net Income

1,212

3-Jan-09

Percent
100.00%
42.87%
26.96%
9.64%

Amount
12,822
5,367
3,414
1,148

29-Dec-07

Percent
100.00%
41.86%
26.63%
8.95%

Amount
11,776

Percent
100.00%

5,179

43.98%

3,311

28.12%

1,103

9.37%

Analysis:
Look at the Trends, all of
them
What can you say about them?

16

VERTICAL ANALYSIS INCOME STATEMENT

Note that
Net Sales is
always the
100% base
figure for
Vertical
Analysis and
all other
items are a
percentage
of this

Kellogg ($ in millions)
Selected Income Statement Items - Vertical Analysis

Period Ending

2-Jan-10
Amount

Total Revenue (Sales

3-Jan-09

Percent

12,575

100.00%

Cost of Goods Sold

Gross Profit

Amount

29-Dec-07

Percent

Amount

Percent

12,822

100.00%

11,776

100.00%

7,184

57.13%

7,455

58.14%

6,597

56.02%

5,391

42.87%

5,367

41.86%

5,179

43.98%

Total Operating Expenses

3,390

26.96%

3,414

26.63%

3,311

28.12%

Net Income

1,212

9.64%

1,148

8.95%

1,103

9.37%

Analysis: You cant analyze

Sales much, as it is the 100%
number; so talk about the other
numbers: Net Income as a
percent of sales increased in
2009 compared to 2008. It
dipped slightly in 2010
compared to 2009, but is still
above 2008s percentage level.

Analysis:
The improvements in Net Income were caused by
reduction in Operating Expenses which reduced
almost 1.5%, as a percentage of net sales) and Gross
Profit (declined in 2008, but improved) in 2010

17

VERTICAL ANALYSIS BALANCE SHEET

Note that Total
Assets are the
100% base figure
and all other items
are a percentage
of this

Kellogg ($ in millions)
Selected Balance Sheet Items - Vertical Analysis

Period Ending

2-Jan-10
Amount

Current assets

3-Jan-09

Percent

Amount

29-Dec-07

Percent

Amount

Percent

2,558

22.84%

2,521

23.03%

2,717

23.84%

11,200

100.00%

10,946

100.00%

11,397

100.00%

Current Liabliities

2,288

20.43%

3,552

32.45%

4,044

35.48%

Long Term Liabilities

8,928

79.71%

9,498

86.77%

8,871

77.84%

Retained Earnings

5,461

48.76%

4,836

44.18%

4,217

37.00%

Total Assets

18

LETS GO BACK AND LOOK AT KELLOGGS

HISTORY

The years were 1998 and 1997

19

KELLOGG COMPANY, INC.

Condensed Income Statement Vertical Analysis
For the Years Ended December 31
(In millions)

1998
Amount Percent
$6,762.1
100.0

Net sales
Cost of goods sold 3,282.6
Gross profit
3,479.5
Selling & Admin.
2,513.9
Nonrecurring Chgs
70.5
Income operations
895.1
Interest expense
119.5
Other income
(expense),net
6.9
Income before
income taxes
782.5
Income tax expense 279.9
Net income
$502.6

48.6
51.4
37.2
1.0
13.2
1.8

1997
Amount
Percent
$6,830.1
100.0

3,270.1
3,560.0
2,366.8
184.1
1,009.1
108.3

0.1

3.7

11.5
4.1
7.4

904.5
340.5
$564.0

47.9
52.1
34.6
2.7
14.8
1.6
0.1

13.3
5.0
8.3
20

WHAT IS WRONG WITH THIS PICTURE

Look at the changes in each
year?
What is the trend in Sales?
Does Cost of Goods Sold
follow the same trend?
What about other costs?
You may not know the reason,
but what are your questions
as to WHY things do not look
right?

See end of slides for

solution

21

WHAT DOES IT TELL YOU?

Relative size of things on the statement. . .
.Over time
Allows comparisons between companies

22

END OF PART 1

23

LIMITATIONS OF
FINANCIAL ANALYSIS
Estimates
Cost
Alternative Accounting
Methods
Atypical Data
Diversification

24

ESTIMATES

Financial statements are based on estimates.

allowance

for uncollectible accounts

depreciation
costs of warranties
contingent losses

To the extent that these estimates are inaccurate,

the financial ratios and percentages are also
inaccurate.

25

COST
Traditional financial statements are based on
historical cost and are not adjusted for price
level changes.
Comparisons of unadjusted financial data from
different periods may be rendered invalid by
significant inflation or deflation.

26

ALTERNATIVE ACCOUNTING
METHODS
One company may use the FIFO method, while
another company in the same
industry may
use LIFO.
If the inventory is significant for both
companies, it is unlikely that their current ratios
are comparable.
In addition to differences in inventory costing
methods, differences also exist in reporting
such items as depreciation, depletion, and
amortization.

27

ATYPICAL DATA

Fiscal year-end data may not be typical of

a company's financial condition during the
year.

28

DIVERSIFICATION
Diversification in American industry also
limits the usefulness of financial analysis.
Many firms are so diverse they cannot be
classified by industry.

29

RATIO ANALYSIS

30

RATIOS

Types:
Liquidity

ratios

Profitability
Solvency

ratios

ratios

Can provide clues to underlying conditions that may not be

apparent from an inspection of the individual components.

Single ratio by itself is not very meaningful

31

RATIO Analysis Galore!

32

LIQUIDITY RATIOS
Measure the short-term ability of
the enterprise to pay its maturing
obligations and to meet unexpected
needs for cash.

WHO CARES?
Short-term creditors such as banks,
suppliers, employees

33

Liquidity Ratios
Current ratio
Acid-test ratio
Receivables turnover ratio
Inventory turnover

34

CURRENT RATIO
Indicates short-term debt-paying
ability
Current Assets
Current Liabilities

35

ACID-TEST RATIO
Indicates immediate short-term debtpaying ability
Cash + Short-term Investments
+ Net Receivables
Current Liabilities
36

RECEIVABLES TURNOVER RATIO

Indicates liquidity of receivables
Net Credit Sales
Average Net Receivables

37

AVERAGE COLLECTION PERIOD

Indicates liquidity of receivables and
collection success

365 days
Receivables Ratio Turnover

38

INVENTORY TURNOVER RATIO

Indicates liquidity of
inventory

Cost of Goods Sold

Average Inventory

39

AVERAGE DAYS IN INVENTORY

Indicates liquidity of inventory and
inventory management
365 days
Inventory Turnover Ratio

40

PROFITABILITY RATIOS
Measure the income or operating success of an
enterprise for a given period of time
WHO CARES? Everybody
WHY? A companys income affects:
its ability to obtain debt and equity financing
its liquidity position
its ability to grow

41

Profitability Ratios
Return on common stockholders equity
ratio
Return on assets ratio
Profit margin ratio
Assets turnover ratio
Gross profit rate
Operating expenses to sales ratio
Cash return on sales ratio
Earnings per share (EPS)
Price-earnings ratio
Payout ratio

42

RETURN ON COMMON STOCKHOLDERS

EQUITY RATIO

Indicates profitability of common stockhold

investment
Net income -preferred stock dividends

Average common stockholders equity

43

RETURN ON ASSETS RATIO

Reveals the amount of net
income generated by each dollar
invested
Net income
Average total assets
Higher value suggests favorable
efficiency.
44

PROFIT MARGIN RATIO

Indicates net income generated by
each dollar of sales

Net income
Net sales
Higher value suggests favorable
return on each dollar of sales.
45

ASSET TURNOVER RATIO

Indicates how efficiently assets
are used to generate sales

Net sales
Average total assets

46

GROSS PROFIT RATE

Indicates margin between selling
price and cost of good sold

Gross profit
Net sales

47

OPERATING EXPENSES
TO SALES RATIO
Indicates the cost incurred to
support each dollar of sales
Operating expenses
Net sales

48

CASH RETURN ON SALES RATIO

Indicates net cash flow generated
by each dollar of sales

Cash provided by operations

Net sales
49

EARNINGS PER SHARE (EPS)

Indicates net income earned on each
share of common stock sales
Income available to common
stockholders
Average number of outstanding common
shares
50

PRICE EARNINGS RATIO

Indicates relationship between market
price per share and earnings per share

Stock Price
Earnings Per Share

51

PAYOUT RATIO
Indicates % of earnings distributed in
the form of cash dividends

Cash Dividends
Net Income

52

SOLVENCY RATIOS
Measure the ability of the
enterprise to survive over a long
period of time

WHO CARES?
Long-term creditors and
stockholders

53

Solvency Ratios
Debt

to total assets ratio

Times interest earned ratio

54

DEBT TO TOTAL ASSETS RATIO

Indicates % of total assets provided by
creditors

Total Liabilities
Total Assets
55

TIMES INTEREST EARNED RATIO

Indicates companys ability to meet
interest payments as they come due

Income before* Interest Expense & Income

Tax

Interest Expense
* Also called Operating Income
56

Review and STOP HERE!

57

END OF PART 2

58

EARNING POWER
The value of a company is a function
of its future cash flows at normal
income levels.

59

AFFECTED BY. . . .

Accounting methods & estimates

Industry

dependent
Requires FULL DISCLOSURE &
CONSISTENCY

Non operating items on the Income

Statement
Look

at the D-E-A

60

IRREGULAR ITEMS
Three types of irregular items are
reported -- (all net of taxes)

61

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.

62

EXAMPLES:
Pepsi spun off: Taco Bell, Pizza Hut, and
KFC
Quaker Oats spun off: Gatorade
Western Wireless spun off: Voicestream
PACCAR spun off: Paccar Automotive and
Trico (oil well digging manufacturer)

63

Discontinued Operations
Assume

a company, Agroworld Inc. During

2001 the company discontinued and sold
its chemical division.
The

income in 2001 from chemical operations

was $200,000, and
The loss on disposal of the chemical division
$130,000.
Apply a 30% tax rate

64

Discontinued Operations
Or, I could word this:
During 2001 the company discontinued
and sold its chemical division.
The

income in 2001 from chemical operations

(net of $60,000 taxes) was $140,000, and
The loss on disposal of the chemical division
(net of $39,000 taxes) was $91,000.

65

Agroworld Inc.
Income Statement (Partial)
For the Year Ended December 31, 2001
Income before income taxes
Income tax expense (30% Tax Rate)
Income from continuing operations
Discontinued operations:
1) Income from operations of chemical division,
net of taxes, $60,000
2) Loss from disposal of chemical
division, net of $39,000 income
tax saving
Net income before extraordinary item

$800,000
240,000
560,000

$140,000
(91,000)
49,000
609,000

66

EXTRAORDINARY ITEMS...
Are events and
transactions that
meet two
conditions:
Unusual in nature
Infrequent in
occurrence

67

Illustration 14-2

EXTRAORDINARY ITEMS

68

Illustration 14-2

ORDINARY ITEMS

69

Extraordinary Items
In 2001 a revolutionary foreign government
expropriated property held as an
investment by Agroworld Inc.
The loss is $70,000 before applicable
income taxes of $21,000, the income
statement presentation will show a
deduction of $49,000.

70

Agroworld Inc.
Income Statement(Partial)
For the Year Ended December 31, 2001
Income before income taxes
Income tax expense
Income from continuing operations
Discontinued operations:
Income from operations of chemical
division, net of taxes, $60,000
Loss from disposal of chemical
division, net of $39,000 income
tax saving
Net income before extraordinary item
Extraordinary item
Expropriation of investment, net of
$21,000 income tax saving
Net income

$800,000
240,000
560,000

$140,0

(91,000)
49,000
609,000
49,000
$560,000

71

CHANGE IN
ACCOUNTING PRINCIPLE
Is

permitted, when
New principle is PREFERABLE to the
old and
Effects are clearly DISCLOSED in the
income statement.

72

CHANGE IN
ACCOUNTING PRINCIPLE
Examples:

a change in depreciation methods

(such as declining-balance to straightline)
a change in inventory costing methods
(such as FIFO to average cost).

73

Change in
Accounting Principle

Use new principle in 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 below Net
Income.

74

Comprehensive Income

Most revenues, expenses, gains, and losses

recognized during the period are included in
net income.

Plus:
Discontinued

Operations
Extraordinary Items
Accounting Changes.

Plus changes in unrealized investment gains and

losses
75

QUALITY OF EARNINGS
The

substance of earnings
And their sustainability into the future.

76

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.

77

Quality of Earnings
Alternative Accounting Methods
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.

78

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).

79

End of Chapter 14
Good Bye and Good Luck. solutions follow

KELLOGGS DISCUSSION OF 1998 AND 1997

TREND ANALYSIS

81

KELLOGGS 1998 AND 1997 RESULTS

COGS increased, but Sales went down this is
reverse trend as Costs should directly
proportional to Sales (when sales go up, COGS
should go up, when sales go down, COGS
should go down)what happened?
Selling & Admin dramatically went up 2.6%,
why?
Most alarming, Net Income went down a full
point (0.9%)
Why????????

82

KELLOGGS IN 1998 AND 1997

Big, generic bags of cereal hit the

supermarkets in 1997 and 1998.
Kelloggs made the management decision not
to participate in the big bags of cereal line

Argument: Our corn flake cereal is premium,

fresh, in a box. Customer will pay more for a
better product.

It didnt work. Customers switched to the

cheaper cereal.
Kelloggs spent more on advertising (reflected
in growth in Selling & Admin costs).
Kelloggs finally reduced its prices (reflected in
lower sales but no corresponding reduction in
Cost of Goods Sold
The end result Lower Net Income

83