BA213: Chapter 15—Financial Statement Analysis

Study Objectives:

  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 and describe their purpose and use in analyzing a firm’s 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.

1.BASIC OF FINANCIAL STATEMENT ANALYSIS

  1. Introduction: The definition of accountingwhich is introduced in the first chapter of the accounting textbook accounting process involves identifying and analyzing business transactions; classifying the transactions according to the section(s) of the accounting equation involved and if a particular account is increased or decreased; recording transactions in the permanent record; summarizing the transactions in the form of financial statements; and finally interpreting where conclusions and decisions are made from the financial statements. Throughout the chapters in the textbook, ratios have been computed to analyze financial statements or sections of the financial statements. This chapter brings the entire process together of “Financial Statement Analysis” where we look for relationships among the many figures on the financial statements.
  2. Analyzing financial statements involves evaluating three characteristics of a company: its liquidity, its solvency, and its profitability.
  3. Define liquidity: the ability of a business to pay its debts when they fall due. It is the ability of a business to convert its assets into cash, which is the most liquid asset. In this chapter, this topic will be covered under the heading RATIO ANALYSIS and under the subheading LIQUIDITY RATIOS.
  4. Define solvency: the ability of a business to survive over a long period of time. In this chapter, this topic will be covered under the heading RATIO ANALYSIS and under the subheading SOLVENCY RATIOS.
  5. Define profitability: the ability of a business to earn a reasonable return on the owners’ investments. It measures the income or operating success of an enterprise for a given period of time. Income, or the lack of it, affects the company’s ability to obtain debt and equity financing. In this chapter, this topic will be covered under the heading RATIO ANALYSIS and the subheading PROFITABILITY RATIOS.
  1. NEED FOR COMPARATIVE ANALYSIS
  2. Financial statements are analyzed to gain greater insights into the firm to provide information from which the users of that information can make good judgments and decisions. The accounting process involvestransforming the data into useful information for decision-making and communicating information to users. Users include owners and managers of the business, creditors, tax agencies, governmental bodies, and others.
  3. Users of the financial statements are interested in the characteristics of a company’s liquidity, its solvency, and its profitability.

a)A short-term creditor, such as a bank, is primarily interested in the ability of the borrower to pay obligations when they come due. The liquidityof the borrower is extremely important is evaluating the safety of a loan.

b)A long-term creditor, such as a bondholder, however looks to profitability and solvency measures that indicate the company’s ability to survive over a long period of time. Long-term creditors consider such measures as the amount of debt in the company’s capital structure and its ability to meet interest payments.

c)Owners/stockholders are interested in profitability and solvency of the company. They want to access the likelihood of dividends and the growth potential of the stock.

  1. In order to obtain information as to whether the amount of cash a company reports such as Sears, Roebuck and Co. (1) represents an increase over prior years or (2) is adequate in relation to the company’s need for cash, theamount of cash must be compared with other financial statement data. Comparisons can be made on anumber of different bases such as the following:
  2. Intracompany basis compares an item or financial relationship within a company in the current year with the same item or relationship in one or more prior years. Intracompany comparisons are useful in detecting changes in financial relationships and significant trends.
  3. Industry averagescompares an item or financial relationship of a company with industry averages (or norms) published by financial ratings. Industry averages comparisons are useful to provide information as to a company’s relative performance within the industry.
  4. Intercompany basiscompares an item or financial relationship of one company with the same item or relationship in one or more competing companies. Intercompany comparisons are useful in determining a company’s competitive position.
  1. TOOLS OF FINANCIAL STATEMENT ANALYSIS
  2. Three commonly used tools are utilized to evaluate the significance of financial statement data.

a)Horizontal analysis (trend analysis) evaluates a series of financial statement data over a period of time.

b)Vertical analysis evaluates financial statement data expressing each item in a financial statement as a percent of a base amount.

c)Ratio analysis expresses the relationship among selected items of financial statement data.

  1. Horizontal analysis is used primarily in intracompany comparisons. Published financial statements facilitate this type of comparison because:

a)Each of the basic financial statements shows a minimum of 2 years.

b)Summary of selected data will show 5 – 10 years or more.

  1. Vertical analysis is used in both intra- and intercompany comparisons.
  2. Ratio analysis is used in all three types of comparisons.

II. HORIZONTAL ANALYSIS

  1. Horizontal analysis is the comparison of each item in a company’s financial statements in the current period with the same item from a previous accounting period or periods. Horizontal analysis compares one year to another and is also called trend analysis.
  2. The purpose of horizontal analysis is to determine the increase or decrease that has taken place this change may be expressed as either an amount or a percentage. The recent net sales figures of J.C. Penney Company.
  3. Given that 2013 is the base year, we can measure all percentage increases or decreases from this base period amount as follows where CY is Current Year and BY is Base Year or can use PY for Prior year:

CY / - / BY or PY / ÷ / BY or PY / = / “CHANGE” since BY or PY

An easy way to remember how to calculate change is using IS and WAS as follows:

IS / - / WAS / ÷ / WAS / = / “CHANGE” since WAS

Applying the formula to JC. Penney’s net sales from 2013 to 2014:

$18,096 / - / $17,513 / ÷ / $17,513 / = / 3.3% increase from 2013 to 2014

HORIZONTAL ANALYSIS example:

$150,000 / - / $100,000 / ÷ / $100,000 / = / 50% increase in 2013 from 2015
CY / - / BY / ÷ / BY / “CHANGE” since BY
IS / - / WAS / ÷ / WAS / “CHANGE” since WAS
  1. Alternatively, we can express current year sales as a percentage of the base period. This is done by dividing the current year amount. Part of horizontal analysis is determining, “Trend Percentages” which are measures used to compare financial data over a period of years, in which one year is selected as the base year, and every other year’s amount is expressed as a percent of the base year’s amount. In horizontal analysis, the earlier year is always the base year in calculating percent increase or percent decrease. Percentage expressions are more meaningful than dollar amounts.

CY Amount / ÷ / BY Amount / = / CY results in relation to BY
  1. The percentage of the base period for each of the 3 years, assuming 2013 as the base period, is shown where 2015 is calculated as follows:

CY Amount / ÷ / BY Amount / = / CY results in relation to BY
$18,781 / ÷ / $`17,513 / = / 107.24% for 7.24% inc. (change)
  1. BALANCE SHEET
  2. The two-year condensed balance sheet of Quality Department Store Inc. for 2015 and 2014 would show dollar and percentage changes.
  3. The comparative balance sheets show a number of significant changes that occurred in Quality Department Store’s financial structure from 2014 to 2015:

a)In the asset section, plant assets (net) increased $167,500 or 26.5%.

b)In the liabilities section, current liabilities increased $41,500 or 13.7%.

c)In the stockholders’ equity section, retained earnings increased $202,600 or 38.6%.

d)ANALYSIS: It appears the company expanded its asset base during 2015 and financed the expansion by retaining income in the firm.

  1. INCOME STATEMENT
  2. The two-year comparative income statements of Quality Department Store Inc. for 2015 and 2014.
  3. HORIZONTAL ANALYSISof the comparative income statement shows the following changes:

a)Net sales increased $260,000, or 14.2% ($260,000 ÷ $1,837,000).

b)Cost of goods sold increased $141,000, or 12.4% ($141,000 ÷ $1,140,000).

c)Total operating expenses increased $37,000, or 11.6% ($37,000 ÷ $320,000).

d)ANALYSIS: Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality’s profit trend appears favorably.

  1. RETAINED EARNINGS STATEMENT
  2. A horizontal analysis of Quality Department Store’s comparative retained earnings statements.
  3. Analyzed horizontally:

a)Net income increased $55,300, or 26.5%.

b)Common dividends increased only $1,200, or 2%.

c)Ending retained earnings increased 38.6%.

  1. ANALYSIS: As indicated above the company retained a significant portion of net income to finance additional plant facilities.
  1. COMMENTS ON HORIZONTAL ANALYSIS:
  2. When using horizontal analysis, both dollar amount changes and percentage changes need to be examined.

a)It is not necessarily bad if a company’s earnings are growing at a declining rate.

b)The amount of increase may be the same as or more than the base year.

c)The percentage change may be less because the base is greater each year.

  1. Complications can occur in making the computations:

a)If an item has no value in a base year and a value in the next year, no percentage change can be computed.

b)If a negative amount appears in the base or preceding period, and a positive amount exists the following year (or vice versa), no percentage change can be computed

  1. VERTICAL ANALYSIS
  1. Describe and applyvertical analysis, also called common size analysis. Vertical analysiscompares each item on the statement to an item considered to be the base. VERTICAL ANALYSIS of the income statement reflects the size of each item relative to a base amount (Net Sales) where each item is divided by Net Sales. The COMMON SIZE ANALYSIS restates each item on a financial statement in terms of percentage of a base amount which enables the comparison of companies of different sizes (BIG COMPANY vs. SMALL COMPANY).
  1. For the income statement, net sales is the base.
  2. For the balance sheet, total assets (or total liabilities and owner’s equity) is the base.
  3. Once percents are calculated for one year, they can be compared to the same calculations for another year to see if the relative importance of an item has changed.
  1. BALANCE SHEET
  2. The two-year comparative balance sheet of Quality Department Store Inc. for 2015 and 2014.
  3. The base for asset items is total assets and the base for the liability and stockholders’ equity items are total liabilities and owner’s equity. Vertical analysis shows the relative size of each category in the balance sheet as well as percentage change in the individual asset, liability, and stockholders’ equity items.

a)The formula to compute the percentage with Vertical Analysis:

Asset item / ÷ / Total Assets / = / “PERCENT” of Base for relative importance
or Asset section / ÷ / Total Assets / = / “PERCENT” of Base for relative importance

For Quality Department stores:

Current Assets / ÷ / Total Assets / = / “PERCENT” of Base for relative importance
$945,000 / ÷ / $1,595,000 / = / 59.25%
$1,020,000 / ÷ / $1,835,000 / = / 55.59%

b)Current assets increased $75,000 from 2014 to 2015; but they decreased from 59.2% to 55.6% of total assets.

c)Plant assets (net) increased from 39.7% to 43.6% of total assets.

d)Retained earnings increased from 32.9% to 39.7% of total liabilities and stockholders’ equity.

e)ANALYSIS: These results reinforce earlier observations that Quality is financing its growth through retention of earnings rather than from issuing additional debt.

  1. INCOME STATEMENT
  1. Vertical analysis of the two-year comparative income statement of Quality Department Store Inc. for 2015 and 2014.

2.For the income statement, net sales is the base.

a)of goods sold as a percentage of net sales declined 1% (62.1% versus 61.1%).

b)Total operating expenses declined 0.4% (17.4% versus 17.0%).

c)Net income as a percent of net sales therefore increased from 11.4% to 12.6%.

3.ANALYSIS: Quality appears to be a profitable enterprise that is becoming more successful.

4.An associated benefit of vertical analysis is that Vertical analysis enables you to compare companies of different sizes.

a)Quality’s major competitor is a JC Penney store in a nearby town.

b)Using vertical analysis, the small Quality Department Store Inc. can be meaningfully compared to the much larger J.C. Penney.Intercompanyincome statement comparison where Vertical Analysiseliminates this difference in size:

1)Gross profit rates were somewhat comparable at 38.9% and 39.3%.

2)Income from operations percentages weresignificantly different at 21.9% and 8.4%.

3)Quality’s selling and administrative expense percentage (17%) is much lower than JC Penney’s (30.9%).

4)JC Penney’s net income as a percentage of sales (percent of each sales dollar) was much lower than Quality’s (5.8% to 12.6 %.)

  1. RATIO ANALYSIS
  2. INTRODUCTION—Ratio analysisexpresses the relationship among selected items of the financial statement data. A ratio expresses a mathematical relationship between one quantity and another. The relationship is expressed in terms of either apercentage, a rate, or a simple proportion. A single ratio by itself is not very meaningful, in the illustrations that will be used. Therefore the following types of comparisons will be used:
  3. Intracompany comparisons for two years for the Quality Department Store.
  4. Industry average comparisons based on median ratios for department stores from Dun & Bradstreet and Robert Morris Associates’ median ratios.
  5. Intercompany comparisons based on the J.C. Penney Company, as Quality Department Store’s principal competitor.
  6. The three financial ratio classifications: Liquidity Ratios; Profitability Ratios; and Solvency Ratios.
  1. LIQUIDITY RATIOS.
  2. Introduction: Liquidity is the ability of a business to pay its debts when they fall due Liquidity ratios measure the short-term ability of the enterprise to pay its maturity obligations and to meet unexpected needs for cash.
  3. Current Ratio

a)The current ratio (working capital ratio) is a widely used measure for evaluating a company’s liquidity and short-term debt-paying ability. Working capital = current assets - current liabilities. The current ratio is a more dependable indicator of liquidity than working capital.

b)A standard or benchmark for this ratio is 2 to 1 or $2.00 in current assets for every $1.00 in current liabilities.

c)It is computed by dividing current assets by current liabilities and is a more dependable indicator of liquidity than working capital where formula shown below applying it to Quality and compared to the Industry average and to J.C. Penney (NOTE: the ratio is taken two places which indicated in dollars and cents the amount of current assets to current liabilities):

Current Assets / ÷ / Current Liabilities / = / Current Ratio
Quality Department Store for 2015
$1,020,000 / ÷ / $344,500 / = / 2.96:1
J.C. Penney Company / = / 5.72:1
Industry average / = / 1.28:1

d)ANALYSIS:

1)For 2015, the current ratio of 2.96:1 means that there is $2.96 of current assets for every $1.00 of current liabilities.

2)The current ratio for 2015 has decreased from 2014.

3)But compared to the benchmark of 2:1 and the industry average, Quality appears to be reasonably liquid. J.C. Penney has an unusually high current ratio which means it has considerable current assets to current liabilities.

  1. Acid-Test Ratio

a)A disadvantage of the current ratio is that it does not take into account the composition of the current assets. For example, a satisfactory current ratio does not disclose the fact that a portion of the current assets may be tied up in slow-moving inventory.

b)The acid-test ratio (quick ratio) is a measure of a company’s short-term liquidity. Since the current ratio does not deal with the composition of current assets, the quick ratio shows the ability of the firm to convert current assets to cash to pay the current liabilities so this ratio shows the immediate debt-paying ability of the company.

c)A standard or benchmark for this ratio is 1 to 1 or $1.00 of quick assets to every $1.00 of current liabilities.

d)It is computed by dividing the sum of cash, marketable securities, and net receivables by current liabilities:

Cash + S/T Investments +”Net” Rec. / ÷ / C. Liabilities / = / Acid-Test Ratio

e)The acid-test ratios for Quality Department Store and comparative data shows this ANALYSIS:

1)The ratio has declined in 2015.

2)But when compared with the industry average and JC Penney’s, Quality’s acid-test ratio seems adequate.

  1. Receivables Turnover

a)The receivables turnover ratio is used to assess the liquidity of the receivables. It measures the number of times, on average; receivables are collected during the period.

b)The ratio is computed by dividing net credit sales by average net receivables shown as follows for Quality Department Store for 2015:

Net Credit Sales / ÷ / Average “NET” Receivables / = / Receivables Turnover
$2,097,000 / ÷ / $180,000 / + / $230,000 / = / 10.2 Times
2

c)The receivables turnover for Quality Department Store and comparative data shows this ANALYSIS:

1)The ratio has increased from 2014 to 2015.

2)Even though it is substantially lower than JC Penney’s ratio, it is similar to the department store’s industry’s average of 10.8 times.

d)The average collection period converts the receivables turnover in terms of days by dividing the receivables turnover ratio into 365 days.

For example the above receivables turnover of 10.2 times is converted into the average collection period as follows:

365 days. / ÷ / Receivables Turnover / = / Average Collection Period
365 / ÷ / 10.2 / = / 35.8 days or 36 days

The average collection period is frequently used to assess the effectiveness of a company’s credit and collection policies. The general rule is that the collection period should NOT greatly exceed the credit term period (the time allowed for payment).

  1. Inventory Turnover

a)The inventory turnover ratiomeasures the number of times, on average; the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory.

b)It is computed by dividing cost of goods sold by average inventory during the yearshown as follows for Quality Department Store for 2015:

COGS / ÷ / Average Inventory / = / Inventory Turnover
$1,281,000 / ÷ / $500,000 / + / $620,000 / = / 2.3 Times
2

c)The inventory turnover is showing forQuality Department Store and comparative data this ANALYSIS:

1)The ratio has declined slightly in 2015.

2)It is relatively low compared to the industry average and JC Penney’s.

3)Generally, the faster the inventory turnover, the less cash that is tied up in inventory and the less chance of inventory obsolescence.

d)The average days to sell inventory converts the inventory turnover in term of days and is calculated by dividing the inventory turnover into 365 days.