Financial Accounting: Tools for Business Decision Making, 2nd Ed.

1. Financial Accounting:Tools for Business Decision Making, 2nd Ed. ELS Kimmel, Weygandt, Kieso 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.

4. Chapter 14Financial Analysis: The Big Picture After studying Chapter 14, you should be able to: • 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.

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

6. Earning Power... • Is net income adjusted for irregular items. • Is the most likely level of income to be obtained in the future.

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

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.

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 2001. • During 2001 the company discontinued and sold its unprofitable chemical division. The loss in 2001 from chemical operations (net of $60,000 taxes) was $140,000, and the loss on disposal of the chemical division (net of $30,000 taxes) was $70,000.

10. Illustration 14-1 Rozek Inc. Income Statement (Partial) For the Year Ended December 31, 2001 Income before income taxes $800,000 Income tax expense (30% Tax Rate) 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 of $30,000 income tax saving 70,000210,000 Net income before extraordinary item 350,000

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

12. Illustration 14-2 Extraordinary Items

13. Illustration 14-2 Ordinary Items

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

15. Illustration 14-3 Rozek Inc. Income Statement(Partial) For the Year Ended December 31, 2001 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 of $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. Change in Accounting Principle • Occur when the principle used in the current year is different from the one used in the preceding year. • Is permitted, when • management can show that the new principle is preferable to the old and • 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).

17. Change in Accounting Principle • 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.

18. Changes in Accounting Principle • Rozek Inc. changes from the straight-line method to the declining-balance method for equipment purchased on January 1, 1998. • The cumulative effect on prior-year income statements (statements for 1998-2000) 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%).

19. Illustration 14-4 Rozek Inc. Partial Income Statement For the Year Ended December 31, 2001 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 of $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

20. Comprehensive Income • Most revenues, expenses, gains, and losses recognized during the period are included in net income. • Specific exceptions to this practice have developed - these items bypass income and are reported directly in stockholders’ equity.

21. Comprehensive Income 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.

22. Comprehensive Income • The FASB now requires that, in addition to reporting net income, a company must also report comprehensive income.

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

24. 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 $136.4 million on its balance sheet as cash, we know that Kellogg did have cash and that the quantity was $136.4 million.

25. 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.

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

27. 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. • 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.

28. 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.

29. 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.

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

31. Horizontal Analysis • Is a technique for evaluating a series of financial statement data over a period of time. • Purpose 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.

32. Illustration 14-7 Horizontal Analysis KELLOGG COMPANY Net Sales (in millions) Base Period 1994 1998 1997199619951994 6,762.1 6,830.1 6,676.6 7,003.7 6,562.0

33. Illustration 14-6 Horizontal Analysis CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT BASE-YEAR AMOUNT 7,003.7 - 6,562.0 = 6.7% 6,562.0 Net sales for Kellogg company increased approximately 6.7% from 1994 to 1995.

34. Illustration 14-7 Percentage Change in Sales The percentage change in sales for each of the 5 years, assuming 1994 as the base period is: Kellogg Company Net Sales (in millions) Base Period 1994 1998 1997199619951994 6,762.1 6,830.1 6,676.6 7,003.7 6,562.0 103.0% 104.1% 101.7% 106.7% 100.0%

35. Illustration 14-8 Horizontal Analysis of a Balance Sheet KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) Increase (Decrease) during 1998 19981997AmountPercent Assets Current Assets $1,496.5 $1,467.7 $ 28.8 2.0 Plant assets 2,888.8 2,773.3 115.5 4.2 Other assets 666.2 636.6 27.6 4.6 Total assets $5,051.5 $4,877.6 $173.9 3.6

36. Horizontal Analysis of a Balance Sheet Illustration 14-8 Increase (Decrease) during 1998 19981997AmountPercent Liabilities and Stockholders' Equity Current liabilities $1,718.5 $1,657.3 61.2 3.7 Long-term liabilities 2,443.2 2,222.8 220.4 9.9 Total liabilities 4,161.7 3,880.1 281.6 7.3 Stockholders' equity Common stock 208.8 196.3 12.5 6.4 Retained earnings and other 1,075.3 958.5 116.8 12.2 Treasury stock (394.3) (157.3) 237.0 (150.7) Total stockholders' equity 889.8 997.5(107.7) (10.8) Total liabilities and stockholders' equity $5,051.5 $4,877.6 $173.9 3.6

37. KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) Increase (Decrease) during 1998 19981997AmountPercent Net sales $6,762.1 $6,830.1 ($68.0) (1.0) Cost of goods sold 3,282.63,270.112.5 0.4 Gross profit 3,479.5 3,560.0 (80.5) (2.3) Selling & Admin. 2,513.9 2,366.8 147.1 6.2 Nonrecurring charges 70.5 184.1(113.6) (61.7) Income from operations 895.1 1,009.1 (114.0) (11.3) Interest expense 119.5 108.3 11.2 10.3 Other income (expense), net 6.9 3.7 3.2 86.5 Income before taxes 782.5 904.5 (122.0) (13.5) Income tax expense 279.9 340.5 (60.6) (17.8) Net income $502.6 $564.0 ($61.4) (10.9) Illustration 14-9

38. 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.

39. Illustration 14-10 KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) 1998 1997 AssetsAmountPercentAmountPercent Current Assets $1,496.5 29.6 $1,467.7 30.1 Plant assets 2,888.8 57.2 2,733.3 56.9 Other assets 666.2 13.2 636.6 13.0 Total assets $5,051.5 100.0% $4,877.6 100.0%

40. Illustration 14-10 KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) 1998 1997 Liabilities andAmountPercent AmountPercent Stockholders' Equity Current liabilities $1,718.5 34.0 $1,657.3 34.0 Long-term liabilities 2,443.248.4 2,222.845.5 Total liabilities 4,161.782.43,880.1 79.5 Stockholders' equity Common stock 208 8 4.1 196.3 4.0 Retained earnings and other 1,075.3 21.3 958.5 19.7 Treasury stock (394.3) ( 7.8) (157.3) (3.2) Total stockholders' equity 889.8 17.6 997.5 20.5 Total liabilities and stockholders' equity $5,051.5 100.0% $4,877.6 100.0%

41. Illustration 14-11 KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) 1998 1997 AmountPercentAmountPercent Net sales $6,762.1 100.0 $6,830.1 100.0 Cost of goods sold 3,282.6 48.6 3,270.1 47.9 Gross profit 3,479.5 51.4 3,560.0 52.1 Selling & Admin. 2,513.9 37.2 2,366.8 34.6 Nonrecurring Chgs 70.51.0 184.1 2.7 Income operations 895.1 13.2 1,009.1 14.8 Interest expense 119.5 1.8 108.3 1.6 Other income (expense),net 6.9 0.1 3.7 0.1 Income before income taxes 782.5 11.5 904.5 13.3 Income tax expense 279.9 4.1 340.55.0 Net income $502.6 7.4 $564.0 8.3

42. Illustration 14-12 Condensed Income StatementsFor the Year Ended December 31,1998(in millions) The Quaker Kellogg Company, Inc.Oats Company AmountPercent AmountPercent Net sales $6,762.1 100.0 $4,842.5 100.0 Cost of goods sold 3,282.648.62,374.4 49.0 Gross profit 3,479.5 51.4 2,468.1 51.0 Selling and administrative expenses 2,513.9 37.2 1,872.5 38.7 Nonrecurring charges 70.5 1.0 128.5 2.6 Income from operations 895.1 13.2 467.1 9.7 Other expenses and revenues (including income taxes) 392.5 5.8 182.6 3.8 Net income $502.6 7.4 $284.5 5.9

43. Ratio Analysis

44. Ratios • Three types: • Liquidity ratios • Solvency ratios • Profitability 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

45. 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 bankers and suppliers

46. Liquidity Ratios • Current ratio • Acid-test ratio • Current cash debt coverage ratio • Receivables turnover ratio • Average collection period • Inventory turnover • Average days in inventory

47. Illustration 14-17 Current Ratio Indicates short-term debt-paying ability Current Assets Current Liabilities

48. Illustration 14-18 Acid-Test Ratio Indicates immediate short-term debt-paying ability Cash + Short-term Investments + Net Receivable Current Liabilities

49. Illustration 14-19 Current Cash Debt Coverage Ratio Indicates short-term debt-paying ability (cash basis) Cash provided by operations Average current liabilities

50. Illustration 14-20 Receivables Turnover Ratio Indicates liquidity of receivables Net Credit Sales Average Net Receivables