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What we do now determines the future. James M. Sugden – (right now). Chapter 14. FINANCIAL STATEMENT ANALYSIS: The Big Picture. Chapter 14. After studying Chapter 14, you should be able to: Understand the concept of sustainable income. Indicate how irregular items are presented.
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What we do now determines the future. James M. Sugden – (right now)
Chapter 14 FINANCIAL STATEMENT ANALYSIS: The Big Picture
Chapter 14 After studying Chapter 14, you should be able to: • Understand the concept of sustainable income. • Indicate how irregular items are presented. • Explain the concept of comprehensive income. • Describe and apply horizontal analysis. • Describe and apply vertical analysis.
Chapter 14 After studying Chapter 14, you should be able to: • Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability. • Understand the concept of quality of earnings.
Irregular Items Two types of irregular items are reported -- (all net of taxes) • discontinued operations • extraordinary items
Discontinued Operations... The disposal of a significant segment of a business... • the elimination of a major class of customers or • an entire activity.
Discontinued Operations Rozek net income of $800,000 from continuing operations in 2007.During 2007 the company discontinued and sold its unprofitable chemical division. The loss in 2007 from chemical operations (net of $90,000 taxes) was $210,000. The tax rate is 30%.
Extraordinary Items... Are events and transactions that meet two conditions: • Unusual in nature • Infrequent in occurrence
Extraordinary Items • In 2007 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.
Earning Power and Irregular Items Are these considered Extraordinary Items? • (a) A large portion of a tobacco manufacturer’s crops are destroyed by a hail storm. Severe damage from hail storms in the locality where the manufacturer grows tobacco is rare. • A citrus grower's Florida crop is damaged by frost. • Loss from sale of temporary investments. • Loss attributable to a labor strike. YES NO NO NO
Earning Power and Irregular Items Are these considered Extraordinary Items? (e) Loss from flood damage. (The nearby Black River floods every 2 to 3 years.) (f) An earthquake destroys one of the oil refineries owned by a large multi-national oil company. Earthquakes are rare in this geographical location. Write-down of obsolete inventory. Expropriation of a factory by a foreign government. NO YES NO YES
Sustainable Income... • Is the most likely level of income to be obtained in the future. • Does not include irregular revenues, expenses, gains, or losses.
Estimating Sustainable Income When evaluating a company, it generally makes sense to eliminate all irregular items in estimating future sustainable income.
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 • Most changes are reported retroactively – improves comparability • Example: a change in inventory costing methods (such as FIFO to average cost).
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.
ComprehensiveIncome • The FASB now requires that, in addition to reporting net income, a company must also report comprehensive income.
Comprehensive Income Includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders.
Financial Statement Analysis There are three types of comparisons to improve decision usefulness of financial information: • Intracompany basis • Intercompany basis • Industry averages
Financial Statement Analysis Three basic tools are used in financial statement analysis : 1. Horizontal analysis 2. Vertical analysis 3. Ratio analysis
Changes within the firm • Industry trends • Consumer tastes • Technological changes • Economic factors Analysts should look beyond the ratios. Limitations of Financial Statement Analysis
Limitations of Financial Statement Analysis 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.
Statements in Comparative and Common-Size Form • Dollar and percentage • changes on statements Analytical techniques used to examine relationships among financial statement items • Common-size • statements • Ratios
Trend analysis Horizontal analysis Dollar and Percentage Changes on Statements Comparing statements underscores movements and trends and may provide valuable clues about what to expect in the future.
Horizontal Analysis Horizontal analysis shows the changes between years in the financial data in both dollarandpercentageform.
Dollar Change Current Year Figure Base Year Figure = – The dollar amounts for 2007 become the “base” year figures. Horizontal Analysis Calculating Change in Dollar Amounts
Percentage Change Dollar Change Base Year Figure × 100% = Horizontal Analysis Calculating Change as a Percentage
$12,000 – $23,500 = $(11,500) ($11,500 ÷ $23,500) × 100% = 48.9% Horizontal Analysis
Sales increased by 8.3% yet net income decreased by 21.9%. Horizontal Analysis
There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income. Horizontal Analysis
Trend percentages state several years’ financial data in terms of abase year, which equals 100 percent. Trend Percentages
Example Look at the income information for Berry Products for the years 2007 through 2011. We will do a trend analysis on these amounts to see what we can learn about the company. Trend Analysis
The base year is 2007, and its amounts will equal 100%. Trend Analysis Berry Products Income Information For the Years Ended December 31,
Trend Analysis Berry Products Income Information For the Years Ended December 31, 2008 ÷ 2007 ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
Trend Analysis Berry Products Income Information For the Years Ended December 31, By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.
We can use the trend percentages to construct a graph so we can see the trend over time. Trend Analysis
Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis. Common-Size Statements
Example Let’s take another look at the information from the comparative income statements of Clover Corporation for 2011 and 2010. This time let’s prepare common-size statements. Common-Size Statements
Net sales is usually the base and is expressed as 100%. Common-Size Statements
Common-Size Statements 2011 COGS ÷ 2011 Net Sales ( $360,000 ÷ $520,000 ) = 69.2% 2010 COGS ÷ 2010 Net Sales ( $315,000 ÷ $480,000 ) = 65.6%
Common-Size Statements What conclusions can we draw?
a.net income amount. b.stockholders’ equity amount. c. total assets amount. d.base-year amount. Review In horizontal analysis, each item is expressed as a percentage of the:
a.net income amount. b.stockholders’ equity amount. c. total assets amount. d.base-year amount. Review In horizontal analysis, each item is expressed as a percentage of the:
a.net sales. b.depreciation expense in a previous year. c. gross profit. d.fixed assets. Review In vertical analysis, the base amount for depreciation expense is generally: