Chapter 14 Power Point Review

Chapter 14: Financial Analysis: The Big Picture

Learning Objectives

  • LO 1: Apply the concepts of sustainable income and quality of earnings.

  • LO 2: Apply horizontal analysis and vertical analysis.

  • LO 3: Analyze a company’s performance using ratio analysis.

Learning Objective 1: Sustainable Income and Quality of Earnings

Sustainable Income

  • Definition: The most likely level of income a company can achieve in the future.

  • Difference from net income: Sustainable income excludes unusual revenues, expenses, gains, and losses.

  • Reporting of unusual items: Includes gains or losses on discontinued items disclosed net of income taxes.

Statement of Comprehensive Income

  • Contains:

    • Net income

    • Comprehensive income

    • Key unusual items:

      • Discontinued operations

      • Other comprehensive income (OCI)

  • Both unusual items are reported net of tax.

Discontinued Operations

  • Definition: Disposal of a significant component of a business.

  • Reporting structure:

    • Income (loss) from operations (net of tax)

    • Gain (loss) on disposal (net of tax)

Illustration: Acro Energy Inc.

  • Income before taxes: $800,000

  • Loss from chemical division (net of tax): $160,000

  • Loss on disposal (net of tax): $80,000

  • Reported net income after adjustments related to discontinued operations.

Comprehensive Income

  • Definition: Total of net income and OCI items that bypass net income.

  • Example: Unrealized gains/losses on available-for-sale securities.

  • Reporting guidelines:

    • Trading securities: Unrealized amounts reported in the income statement.

    • Available-for-sale securities: Reported net of tax in OCI.

Changes in Accounting Principles

  • Occurs when switching accounting methods.

  • Example: Change in inventory costing (FIFO to average-cost).

  • Reporting requirements: Companies must justify new principles as preferable and report changes retroactively.

Quality of Earnings

  • Characteristics of high-quality earnings: Full transparency, no misleading information.

  • Accounting method variability: Variations in GAAP application, such as inventory costing and depreciation methods, can impact earnings quality.

  • Pro forma income: Companies may report income excluding unusual/non-recurring items, but these can mislead analysts and investors.

Improper Recognition Practices

  • Common abuses include:

    • Channel stuffing (Example: Bristol-Myers Squibb)

    • Improper capitalization of operating expenses (Example: WorldCom)

    • Failure to report liabilities (Example: Enron)

Learning Objective 2: Horizontal and Vertical Analysis

Horizontal Analysis

  • Technique for evaluating financial statements over periods.

  • Purpose: Identify trends expressed as amounts or percentages.

Example: Chicago Cereal Company

  • Key findings from balance sheet:

    • Current assets increased by $290,000 (11.9%)

    • Total liabilities increased by 226,000 (2.6%)

    • Common stock increased by $96,000 (24.2%)

Vertical Analysis

  • Technique: Each item expressed as a percentage of a base.

    • Balance sheet: Current assets may be presented as a percentage of total assets.

    • Income statement: Selling expenses can be a percentage of net sales.

Example: Chicago Cereal Balance Sheet Analysis

  • Current assets increased to 23.8% of total assets.

  • Long-term liabilities decreased as a percentage of total liabilities.

Learning Objective 3: Ratio Analysis

Overview of Ratio Analysis

  • Expresses relationships among financial statement items.

  • Types of comparisons: Intracompany, intercompany, and industry average comparisons.

Key Ratios

  1. Liquidity Ratios: Measure short-term financial health.

    • Current ratio: Indicates the dollar amount of current assets per dollar of current liabilities.

  2. Solvency Ratios: Measure long-term stability and debt repayment ability.

    • Debt to assets ratio: Shows the proportion of a company's assets financed through debt.

    • Times interest earned: Indicates ability to meet interest payments.

  3. Profitability Ratios: Measure operating success over time.

    • Return on common shareholders' equity: Shows income earned per dollar invested by owners.

    • Profit margin: Percentage of sales translating to net income.

    • Earnings per share: Net income allocated to each share of common stock.

    • Price-earnings ratio: Reflects market expectations of future earnings.

Conclusion

  • Financial analysis through sustainable income, quality of earnings, horizontal and vertical analyses, and ratio analysis provides crucial insights into company performance. Understanding these methodologies aids investors and management decisions.