Professional Documents
Culture Documents
Coby Harmon
University of California, Santa Barbara
Westmont College
18-1
18
Financial Statement
Analysis
Learning Objectives
After studying this chapter, you should be able to:
[1] Discuss the need for comparative analysis.
[2] Identify the tools of financial statement analysis.
[3] Explain and apply horizontal analysis.
[4] Describe and apply vertical analysis.
[5] Identify and compute ratios used in analyzing a firms liquidity, profitability,
and solvency.
[6] Understand the concept of earning power, and how irregular items are
presented.
[7] Understand the concept of quality of earnings.
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Preview of Chapter 18
Accounting Principles
Eleventh Edition
Weygandt Kimmel Kieso
18-3
Characteristics
Liquidity
Intracompany
Horizontal
Profitability
Vertical
Solvency
Industry
averages
Ratio
18-4
Tools of
Analysis
Intercompany
Horizontal Analysis
Horizontal analysis, also called trend analysis, is a
technique for evaluating a series of financial statement data
over a period of time.
18-5
Horizontal Analysis
Illustration 18-5
Horizontal analysis of
balance sheets
Changes suggest
that the company
expanded its asset
base during 2011
and financed this
expansion primarily
by retaining income
rather than assuming
additional long-term
debt.
18-6
Horizontal Analysis
Illustration 18-6
Horizontal analysis of
Income statements
18-7
Horizontal Analysis
Illustration 18-7
Horizontal analysis of
retained earnings
statements
18-8
Vertical Analysis
Vertical analysis, also called common-size analysis, is a
technique that expresses each financial statement item as
a percent of a base amount.
18-9
Vertical Analysis
Illustration 18-8
Vertical analysis of
balance sheets
18-10
Vertical Analysis
Illustration 18-9
Vertical analysis of
Income statements
Quality appears
to be a profitable
enterprise that is
becoming even more
successful.
18-11
Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 18-10
Intercompany income
statement comparison
18-12
Ratio Analysis
Ratio analysis expresses the relationship among selected
items of financial statement data.
18-13
Liquidity
Profitability
Solvency
Measures the
income or
operating success
of a company for a
given period of
time.
Measures the
ability of the
company to
survive over a long
period of time.
Ratio Analysis
A single ratio by itself is not very meaningful.
The discussion of ratios will include the following types of
comparisons.
1. Intracompany comparisons for two years for Quality
Department Store.
2. Industry average comparisons based on median ratios for
department stores.
3. Intercompany comparisons based on Macys, Inc. as Quality
Department Stores principal competitor.
18-14
ANATOMY OF A FRAUD
This final Anatomy of a Fraud box demonstrates that sometimes relationships between
numbers can be used by companies to detect fraud. The numeric relationships that can reveal
fraud can be such things as financial ratios that appear abnormal, or statistical abnormalities in
the numbers themselves. For example, the fact that WorldComs line costs, as a percentage of
either total expenses or revenues, differed very significantly from its competitors should have
alerted people to the possibility of fraud. Or, consider the case of a bank manager, who
cooperated with a group of his friends to defraud the banks credit card department. The
managers friends would apply for credit cards and then run up balances of slightly less than
$5,000. The bank had a policy of allowing bank personnel to write-off balances of less than
$5,000 without seeking supervisor approval. The fraud was detected by applying statistical
analysis based on Benfords Law. Benfords Law states that in a random collection of
numbers, the frequency of lower digits (e.g., 1, 2, or 3) should be much higher than higher
digits (e.g., 7, 8, or 9). In this case, bank auditors analyzed the first two digits of amounts
written off. There was a spike at 48 and 49, which was not consistent with what would be
expected if the numbers were random.
LO 5
Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for cash.
18-16
Illustration 18-12
18-17
LO 5
Ratio Analysis
Current Ratio
Liquidity Ratios
Illustration 18-12
Ratio of 2.96:1 means that for every dollar of current liabilities, Quality
has $2.96 of current assets.
18-18
Ratio Analysis
Liquidity Ratios
Acid-Test Ratio
Illustration 18-13
18-19
Illustration 18-12
18-20
LO 5
Ratio Analysis
Liquidity Ratios
Acid-Test Ratio
Illustration 18-14
18-21
18-22
18-23
LO 5
Ratio Analysis
Accounts Receivable Turnover
Liquidity Ratios
Illustration 18-15
LO 5
Ratio Analysis
Liquidity Ratios
$2,097,000
= 10.2 times
($180,000 + $230,000) / 2
A variant of the accounts receivable turnover ratio is to convert it
to an average collection period in terms of days.
18-25
Illustration 18-12
18-26
LO 5
Ratio Analysis
Inventory Turnover
Liquidity Ratios
Illustration 18-16
LO 5
Ratio Analysis
Liquidity Ratios
$1,281,000
Inventory Turnover
= 2.3 times
($500,000 + $620,000) / 2
A variant of inventory turnover is the days in inventory.
18-28
Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for a
given period of time.
18-29
18-30
LO 5
Ratio Analysis
Profitability Ratios
Profit Margin
Illustration 18-17
Illustration 18-12
18-32
LO 5
Ratio Analysis
Profitability Ratios
Asset Turnover
Illustration 18-18
Illustration 18-12
18-34
LO 5
Ratio Analysis
Profitability Ratios
Return on Asset
Illustration 18-19
Illustration 18-12
18-36
LO 5
Ratio Analysis
Profitability Ratios
Shows how many dollars of net income the company earned for each
dollar invested by the owners.
18-37
LO 5
Illustration 18-12
18-38
LO 5
Ratio Analysis
Profitability Ratios
18-39
LO 5
Illustration 18-12
18-40
LO 5
Ratio Analysis
Profitability Ratios
Price-Earnings Ratio
Illustration 18-23
18-41
LO 5
Illustration 18-12
18-42
LO 5
Ratio Analysis
Profitability Ratios
Payout Ratio
Illustration 18-24
LO 5
Ratio Analysis
Solvency Ratios
Solvency ratios measure the ability of a company to survive
over a long period of time.
18-44
Illustration 18-12
18-45
LO 5
Ratio Analysis
Solvency Ratios
18-46
LO 5
Illustration 18-12
18-47
LO 5
Ratio Analysis
Solvency Ratios
LO 5
Ratio Analysis
Summary of Ratios
Illustration 18-27
18-49
LO 5
Summary of Ratios
Illustration 18-27
18-50
LO 5
18-51
18-52
18-53
LO 6
Previously labeled as
Net Income.
Moved to
18-54
LO 6
18-55
Must be both of an
Occur Infrequently.
YES
NO
NO
NO
18-56
NO
YES
NO
YES
18-57
18-58
Previously labeled as
Net Income.
Moved to
18-59
Discontinued
Operations
Extraordinary Item
18-60
18-61
18-62
18-63
18-64
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.
The issue of quality of earnings has taken on increasing
importance because recent accounting scandals suggest that
some companies are spending too much time managing their
income and not enough time managing their business.
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Quality of Earnings
Alternative Accounting Methods
18-66
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:
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A Look at IFRS
Key Points
18-68
The basic objectives of the income statement are the same under both
GAAP and IFRS. Thus, both the IASB and the FASB are interested in
distinguishing normal levels of income from irregular items in order to
better predict a companys future profitability.
A Look at IFRS
Key Points
18-69
A Look at IFRS
Key Points
18-70
The issues related to quality of earnings are the same under both GAAP
and IFRS. It is hoped that by adopting a more principles-based
approach, as found in IFRS, many of the earnings quality issues will
disappear.
A Look at IFRS
Looking to the Future
The FASB and the IASB are working on a project that would rework the
structure of financial statements. Recently, the IASB decided to require a
statement of comprehensive income, similar to what was required under
GAAP. In addition, another part of this project addresses the issue of how to
classify various items in the income statement. A main goal of this new
approach is to provide information that better represents how businesses
are run. In addition, the approach draws attention away from one number
net income.
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A Look at IFRS
IFRS Self-Test Questions
The basic tools of financial analysis are the same under both GAAP and
IFRS except that:
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a)
b)
c)
d)
A Look at IFRS
IFRS Self-Test Questions
Under IFRS:
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a)
b)
c)
d)
A Look at IFRS
IFRS Self-Test Questions
Presentation of comprehensive income must be reported under IFRS in:
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a)
b)
c)
d)
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18-75