Chapter

13-1

Financial Analysis:
The Big Picture
Chapter
13-2

Accounting, Third Edition

Study
Study Objectives
Objectives
1.

Understand the concept of sustainable income.

2.

Indicate how irregular items are presented.

3.

Explain the concept of comprehensive income.

4.

Describe and apply horizontal analysis.

5.

Describe and apply vertical analysis.

6.

Identify and compute ratios used in analyzing a

companys liquidity, solvency, and profitability.

7.

Understand the concept of quality of earnings.

Chapter
13-3

Financial
Financial Analysis:
Analysis: The
The Big
Big Picture
Picture

Sustainable
Income
Irregular items
Changes in
accounting
principles
Comprehensive
income

Chapter
13-4

Comparative
Analysis
Horizontal
analysis
Vertical
analysis

Ratio Analysis

Liquidity ratios
Solvency ratios
Profitability
ratios

Quality of
Earnings
Alternative
accounting
methods
Pro forma
income
Improper
recognition
Price-earnings
ratio

Sustainable
Sustainable Income
Income
Sustainable Income - Net income adjusted for
irregular items.
Irregular items are separately identified on the
income statement. Two types are:
1. Discontinued operations.
2. Extraordinary items.
These irregular items are reported net of income
taxes.
Chapter
13-5

SO 1 Understand the concept of sustainable income.

SO 2 Indicate how irregular items are presented.

Sustainable
Sustainable Income
Income
Illustration 13-1

Components of
the income
statement

Chapter
13-6

SO 2 Indicate how irregular items are presented.

Sustainable
Sustainable Income
Income
Discontinued Operations
(a) Disposal of a significant component of a

business.

(b) Income statement should report a gain (or loss)

from discontinued operations, net of tax.

Chapter
13-7

SO 2 Indicate how irregular items are presented.

Sustainable
Sustainable Income
Income
Illustration: Rozek Inc. has revenues of $2.5 million and
expenses of $1.7 million from continuing operations in
2010. The company therefore has income before income
taxes of $800,000. During 2010 the company discontinued
and sold its unprofitable chemical division at a loss of
$210,000 (net of $90,000 tax savings).
Illustration 13-2

Chapter
13-8

SO 2 Indicate how irregular items are presented.

Sustainable
Sustainable Income
Income
Extraordinary items are events and transactions
that meet two conditions:

Both
Unusual in nature and
Infrequent in occurrence
Company must consider the environment in which it
operates.
Amounts reported net of tax.
Chapter
13-9

SO 2 Indicate how irregular items are presented.

Sustainable
Sustainable Income
Income
Illustration: Assume that in 2010 a revolutionary foreign
government expropriated property held as an investment
by Rozek Inc. If the loss is $70,000 before applicable
income tax savings of $21,000, how will the loss be
presented in the income statement?
Illustration 13-3
Illustration 13-2

Chapter
13-10

Solution on notes page

Sustainable
Sustainable Income
Income
Are these considered Extraordinary Items?

Chapter
13-11

Effects of major natural casualties, if rare

in the area.

YES

Effects of major natural casualties, not

uncommon in the area.

NO

Write-down of inventories or write-off of

receivables.

NO

Expropriation (takeover) of property by a

foreign government.

YES

SO 2 Indicate how irregular items are presented.

Sustainable
Sustainable Income
Income
Are these considered Extraordinary Items?

Chapter
13-12

Losses attributable to labor strikes.

NO

Effects of a newly enacted law or

regulation, such as a condemnation action.

YES

Gains or losses from sales of property,

plant, or equipment.

NO

SO 2 Indicate how irregular items are presented.

Chapter
13-13

Sustainable
Sustainable Income
Income
Changes in Accounting Principle
Principle used in the current year is different
from one used in the preceding year.
Example - change from FIFO to average cost.
Permissible when management can show new
principle is preferable.
Most changes are reported retroactively.

Chapter
13-14

SO 2 Indicate how irregular items are presented.

Sustainable
Sustainable Income
Income
Comprehensive Income
All changes in stockholders equity except those resulting
from
investments by stockholders and
distributions to stockholders.
Certain gains and losses bypass net income and instead are
reported as direct adjustments to stockholders equity.
Example Unrealized gain or loss on Available-forsale securities
Chapter
13-15

SO 3 Explain the concept of comprehensive income.

Sustainable
Sustainable Income
Income
Illustration of Comprehensive Income
Accounting standards require companies to adjust most
investments in stocks and bonds up or down to their market
value at the end of each accounting period.
Illustration: During 2010 Stassi Company purchased IBM
stock for $10,000 as an investment. At the end of 2010
Stassi was still holding the investment, but the stocks
market value was now $8,000.
How should Stassi account for the $2,000 unrealized loss?

Chapter
13-16

SO 3 Explain the concept of comprehensive income.

Sustainable
Sustainable Income
Income
Illustration of Comprehensive Income
How should Stassi account for the $2,000 unrealized loss?
Answer: Depends on whether Stassi classifies the IBM
stock as a
Trading security or an
Available for-sale security.

Unrealized gains and

losses
(Income Statement)

Unrealized gains and losses

(Comprehensive Income - Stockholders Equity)
Chapter
13-17

SO 3 Explain the concept of comprehensive income.

Sustainable
Sustainable Income
Income
Format One Comprehensive Income
Combined statement of income and comprehensive income.
Illustration 13-5

Chapter
13-18

SO 3 Explain the concept of comprehensive income.

Sustainable
Sustainable Income
Income
Format Two - Comprehensive Income
Separate component of Stockholders Equity.
Illustration 13-6

Chapter
13-19

SO 3 Explain the concept of comprehensive income.

Sustainable
Sustainable Income
Income
Format Three Comprehensive
Income

Illustration 13-7

Complete
Income
Statement

Chapter
13-20

SO 3 Explain the concept of comprehensive income.

Sustainable
Sustainable Income
Income
Illustration: In its draft 2010 income statement,
AIR Corporation reports income before income
taxes $400,000, extraordinary loss due to earthquake $100,000,
income taxes $120,000 (not including irregular items), and loss on
disposal of discontinued flower division $140,000. The income tax
rate is 30%. Prepare a correct income statement, beginning with
income before income taxes.

Chapter
13-21

Solution on notes page

Comparative
Comparative Analysis
Analysis
Analyzing financial statements involves:
Comparison
Bases

Chapter
13-22

Basic Tools

Intracompany

Horizontal analysis

Intercompany

Vertical analysis

Industry averages

Ratio Analysis

Comparative
Comparative Analysis
Analysis
Horizontal Analysis
Also called trend analysis, is a technique for
evaluating a series of financial statement data over a
period of time.
Purpose - to determine increase or decrease that has
taken place.
Commonly applied to the balance sheet and income
statement.

Chapter
13-23

SO 4 Describe and apply horizontal analysis.

Comparative
Comparative Analysis
Analysis
Illustration 13-11
Horizontal analysis of
balance sheets

Helpful Hint:

When using
horizontal
analysis, be sure
to examine both
dollar amount
changes and
percentage
changes.

Chapter
13-24

SO 4 Describe and apply horizontal analysis.

Comparative
Comparative Analysis
Analysis
Illustration 13-12
Horizontal analysis of
Income statements

Helpful Hint: In horizontal analysis, while the amount column is

additive (the total is $99 million), the percentage column is not
additive (9.9% is not a total).
Chapter
13-25

SO 4 Describe and apply horizontal analysis.

Comparative
Comparative Analysis
Analysis
Illustration: Summary financial information for
Rosepatch Company is as follows.

Compute the amount and percentage changes in 2010 using

horizontal analysis, assuming 2009 is the base year.

Solution

Solution on notes page

Chapter
13-26

SO 4 Describe and apply horizontal analysis.

Comparative
Comparative Analysis
Analysis
Vertical Analysis
Also called common-size analysis, is a technique that
expresses each financial statement item as a percent
of a base amount.
Vertical analysis is commonly applied to the balance
sheet and the income statement.

Chapter
13-27

SO 5 Describe and apply vertical analysis.

Comparative
Comparative Analysis
Analysis

These results
indicate the
company shifted
toward equity
financing by relying
less on debt and by
increasing the
amount
of retained
earnings.

Chapter
13-28

SO 5 Describe and apply vertical analysis.

Comparative
Comparative Analysis
Analysis
Illustration 13-14
Vertical analysis of an
income statements

Kelloggs increase in net income as a percentage of sales is due

primarily to the decrease in interest expense and income tax expense
as a percent of sales.
Chapter
13-29

SO 5 Describe and apply vertical analysis.

Comparative
Comparative Analysis
Analysis
Illustration 13-15
Intercompany
comparison by vertical
analysis

Vertical analysis
also enables a
comparison of
companies of
different sizes.

Although Kelloggs net sales are less than those of General Mills, vertical
analysis eliminates the impact of this size difference for our analysis.
Chapter
13-30

SO 5 Describe and apply vertical analysis.

Ratio
Ratio Analysis
Analysis
Ratio analysis expresses the relationship among
selected items of financial statement data.
Financial Ratio Classifications

Chapter
13-31

Liquidity

Solvency

Profitability

Measures shortterm ability of

the company to
pay its maturing
obligations and to
meet unexpected
needs for cash.

Measures the
ability of the
company to
survive over a
long period of
time.

Measures the
income or
operating success
of a company for
a given period of
time.

SO 6 Identify and compute ratios used in analyzing a

companys liquidity, solvency, and profitability.

Ratio
Ratio Analysis
Analysis
Liquidity Ratios

Chapter
13-32

Illustration 13-16

SO 5 Identify and compute ratios used in analyzing

a firms liquidity, profitability, and solvency.

Ratio
Ratio Analysis
Analysis
Solvency Ratios

Chapter
13-33

Illustration 13-17

SO 5 Identify and compute ratios used in analyzing

a firms liquidity, profitability, and solvency.

Ratio
Ratio Analysis
Analysis
Profitability Ratios

Chapter
13-34

Illustration 13-18

SO 5 Identify and compute ratios used in analyzing

a firms liquidity, profitability, and solvency.

Chapter
13-35

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.
Recent accounting scandals suggest that some
companies are spending too much time managing
their income and not enough time managing their
business.

Chapter
13-36

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
GAAP may hamper comparability and reduce
quality of earnings (FIFO vs. LIFO).

Pro Forma Income

Usually excludes items that are unusual or
nonrecurring.

Chapter
13-37

Some companies have abused the flexibility that

pro forma numbers allow to put their companies in
a more favorable light.
SO 7 Understand the concept of quality of earnings.

Quality
Quality of
of Earnings
Earnings
Improper Recognition
Some managers have felt pressure to continually
increase earnings.
Abuses include:
Improper recognition of revenue (channel stuffing).
Improper capitalization of operating expenses
(WorldCom).
Failure to report all liabilities (Enron).

Chapter
13-38

SO 7 Understand the concept of quality of earnings.

Quality
Quality of
of Earnings
Earnings
Price-Earnings Ratio
Reflects investors assessment of a companys future
earnings.
P-E ratio will be higher if investors think that
earnings will increase substantially in the future.
P-E ratio will be lower when there is the belief that
a company has poor-quality earnings.
Illustration 13-19

Chapter
13-39

SO 7 Understand the concept of quality of earnings.

Quality
Quality of
of Earnings
Earnings
Price-Earnings Ratio
Illustration 13-19

Illustration 13-20
Earnings per share and P-E
ratios of various companies

Chapter
13-40

SO 7 Understand the concept of quality of earnings.

Chapter
13-41

Quality
Quality of
of Earnings
Earnings
Illustration: Match each of the following
with the phrase that it best matches.
Comprehensive income
Quality of earnings
Solvency ratio
1.

Vertical analysis
Pro forma income
Extraordinary items

Measures the ability of the company to survive

over a long period of time.

2. Usually excludes items that a company thinks

are unusual or non-recurring.
3. Includes all changes in stockholders equity
during a period except those resulting from
investments by stockholders and distributions
to stockholders.

Chapter
13-42

terms

Solvency
Pro forma
Comprehensive
income

SO 7 Understand the concept of quality of earnings.

Quality
Quality of
of Earnings
Earnings
Illustration: Match each of the following
with the phrase that it best matches.
Comprehensive income
Quality of earnings
Solvency ratio

terms

Vertical analysis
Pro forma income
Extraordinary items

4. Indicates the level of full and transparent

information provided to users of the financial
statements.

Quality of
earnings

5. Describes events and transactions that are

unusual in nature and infrequent in occurrence.

Extraordinary
items

6. Expresses each item within a financial

statement as a percent of a base amount.
Chapter
13-43

Vertical analysis

SO 7 Understand the concept of quality of earnings.

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Analyzing financial statements involves:
Characteristics

Appendix

Comparison
Bases

Liquidity

Intracompany

Profitability

Industry averages

Solvency

Intercompany

The financial information in Illustrations 13A-1 through 13A-4

will be used to calculate Kelloggs 2007 ratios.
Chapter
13-44

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Illustration 13A-1

Chapter
13-45

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Illustration 13A-2

Illustration 13A-4

Chapter
13-46

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Illustration 13A-3

Chapter
13-47

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for
cash.
Short-term creditors such as bankers and suppliers
are particularly interested in assessing liquidity.
Ratios include the current ratio, the current cash
debt coverage ratio, the receivables turnover ratio,
the average collection period, the inventory turnover
ratio, and average days in inventory.
Chapter
13-48

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Current Ratio - Expresses the relationship of current
assets to current liabilities. Calculate the current ratio
for Kellogg for 2007 and 2006.

Illustration 13A-5

.67

.60

What do the measures tell us?

A current ratio of .67 means that for every dollar of
current liabilities, Kellogg has $0.67 of current assets.
Chapter
13-49

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Cash Debt Coverage Ratio - Because it uses cash

provided by operating activities, it may provide a better

representation of liquidity. Calculate the ratio for Kellogg
for 2007 and 2006
Illustration 13A-6

.37

.39

Is the coverage adequate?

Probably so. Kelloggs coverage is better than that of General
Mills, and it approximates a commonly accepted threshold of .40.
Chapter
13-50

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Receivables Turnover Ratio Measures the number of

times, on average, a company collects receivables during

the period. Calculate the ratio for Kellogg for 2007 and
2006.
Illustration 13A-7

11.9 12.0
How does Kelloggs turnover compare to General Millss?
The turnover of 11.9 times compares favorably with the
industry average of 11.5 times, but is lower than General
Millss turnover of 13.3 times.
Chapter
13-51

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Average Collection Period Converts the receivable

turnover ratio into days. Calculate the collection period

for Kellogg for 2007 and 2006.

Illustration 13A-8

30.7 30.4
How effective is Kelloggs credit and collection policies?
General rule - collection period should not greatly exceed
the credit term period (i.e., the time allowed for payment).
Chapter
13-52

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Inventory Turnover Ratio - Measures the number of
times average inventory was sold during the period.
Calculate the ratio for Kellogg for 2007 and 2006.

Illustration 13A-9

7.5

7.9

How does Kelloggs turnover compare to General Millss?

The ratio of 7.5 times is higher than the industry average
of 6.6 times and better than General Millss 7.1 times.
Chapter
13-53

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Days in Inventory - Measures the average number of

days inventory is held. Calculate the days for Kellogg for

2007 and 2006.

Illustration 13A-10

48.7 46.2

How does Kelloggs days compare to General Millss?

An average selling time of 49 days is faster than the
industry average and faster than that of General Mills.
Chapter
13-54

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Solvency Ratios
Solvency ratios measure the ability of a company to
survive over a long period of time.
Debt-Paying Ability
Debt to total assets ratio
Times interest earned ratio
Cash debt coverage ratio
Free cash flow provides information about solvency
and ability to pay additional dividends or invest.
Chapter
13-55

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Debt to Total Assets Ratio Indicates the degree of

financial leveraging. Provides some indication of the

companys ability to withstand losses. Calculate the ratio
for Kellogg for 2007 and 2006.
Illustration 13A-11

78% 81%
Has Kelloggs solvency improved during the year?
Yes, slightly. The ratio of 78% says that Kellogg would
have to liquidate 78% of its assets at their book value in
order to pay off all of its debts.

Chapter
13-56

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Times Interest Earned Ratio - (also called interest

coverage) indicates the companys ability to meet interest

payments as they come due. Calculate the ratio for Kellogg
for 2007 and 2006.
Illustration 13A-12

5.8 5.8
Is Kellogg better able to service its debt?
Yes, the debt to total assets ratio decreased during 2007
and the times interest earned ratio held constant.
Chapter
13-57

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Cash Debt Coverage Ratio - Indicates a companys

ability to repay its liabilities from cash generated from

operating activities without having to liquidate the assets
used in its operations. Calculate the ratio for Kellogg.
Illustration 13A-13

.17

.17

One way of interpreting this ratio is to say that net cash

generated from one year of operations would be sufficient
to pay off 17% of Kelloggs total liabilities.
Chapter
13-58

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Free Cash Flow - Ability to pay dividends or expand
operations. Calculate the ratio for Kellogg.

Illustration 13A-14

556

507

(in millions)

Cash provided by operations was more than enough to allow

Kellogg to acquire additional productive assets and maintain
dividend payments.
Chapter
13-59

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Profitability Ratios
Measure the income or operating success of a company
for a given period of time.
Illustration 13A-15
Relationships among
profitability measures

Chapter
13-60

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Return on Common Stockholders Equity Ratio -

Shows how many dollars of net income the company earned

for each dollar invested by the owners. Calculate the ratio
for Kellogg.

Illustration 13A-16

48% 46%

Kelloggs 2007 rate of return on common stockholders

equity is unusually high at 48%, considering an industry
average of 23% and General Millss return of 21%.
Chapter
13-61

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Return on Assets Ratio - Measures the overall

profitability of assets in terms of the income earned on

each dollar invested in assets. Calculate the ratio.
Illustration 13A-17

10% 9.4%

Note that Kelloggs rate of return on common stockholders

equity (48%) is substantially higher than its rate of return
on assets (10%). Kellogg has made effective use of
leverage.
Chapter
13-62

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Profit Margin Ratio - Or rate of return on sales, is a
measure of the percentage of each dollar of sales that
results in net income. Calculate the ratio for Kellogg.

Illustration 13A-18

9.4% 9.2%

High-volume (high inventory turnover) businesses such as

grocery stores and pharmacy chains generally have low
profit margins.
Chapter
13-63

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Asset Turnover Ratio - Measures how efficiently a

company uses its assets to generate sales. Calculate the

ratio for Kellogg.
Illustration 13A-19

1.07

1.02

The average asset turnover for utility companies is .45, for

example, while the grocery store industry has an average
asset turnover of 3.49.
Chapter
13-64

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
You can analyze the combined effects of profit margin and
asset turnover on return on assets for Kellogg as shown
Illustration 13A-20

Chapter
13-65

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Gross Profit Rate - Indicates a companys ability to

maintain an adequate selling price above its cost of goods

sold. Calculate the ratio for Kellogg.
Illustration 13A-21

44% 44%

As an industry becomes more competitive, this ratio

declines.

Chapter
13-66

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Earnings Per Share - A measure of the net income

earned on each share of common stock. Calculate the ratio

for Kellogg.
Illustration 13A-22

$2.63 $2.40

Chapter
13-67

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Price-Earnings (P-E) Ratio - Reflects investors

assessments of a companys future earnings. Calculate the

ratio for Kellogg.
Illustration 13A-23

20.1

20.9

A higher P-E ratio suggests that the market is more

optimistic about Kellogg. It might also signal that its stock
is overpriced.
Chapter
13-68

Comprehensive
Comprehensive Illustration
Illustration of
of Ratio
Ratio Analysis
Analysis
Payout Ratio - Measures the percentage of earnings

distributed in the form of cash dividends. Calculate the

ratio for Kellogg.
Illustration 13A-24

43% 45%

This ratio should be calculated over a longer period of time

to evaluate any trends.

Chapter
13-69

Copyright
Copyright
Copyright 2009 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 express written permission of the copyright owner
is unlawful. Request for further information should be
addressed to the Permissions Department, John Wiley & Sons,
Inc. The purchaser may make back-up copies for his/her own
use only and not for distribution or resale. The Publisher
assumes no responsibility for errors, omissions, or damages,
caused by the use of these programs or from the use of the
information contained herein.

Chapter
13-70