Financial Statement Analysis Notes

Chapter 17: Financial Statement Analysis

Learning Objectives

LO1: Describe the techniques and tools used to analyze financial statement information.
LO2: Describe and illustrate basic financial statement analytical methods.
LO3: Describe and illustrate how to use financial statement analysis to assess liquidity.
LO4: Describe and illustrate how to use financial statement analysis to assess solvency (Times Interest Owned).
LO5: Describe and illustrate how to use financial statement analysis to assess profitability (Not Covered).
LO6: Describe the contents of corporate annual reports.
App: Define and describe the reporting of unusual items on the income statement. (Not Covered)

LO1 – Analyzing Financial Information: The Value of Financial Statement Information

General-purpose financial statements are distributed to a wide range of potential users.
These statements provide valuable information about a company’s economic performance and financial condition.
Users typically evaluate this information along three dimensions:
- Liquidity
- Solvency
- Profitability

LO1 – Analyzing Financial Information: Analyzing and Interpreting Financial Statements

Liquidity:
- Short-term creditors (banks, financial institutions) are concerned with a company’s ability to repay short-term borrowings (loans, notes).
- They evaluate a company’s ability to convert assets into cash (liquidity).
Solvency:
- Long-term creditors (bondholders) loan money for long periods.
- They evaluate a company’s ability to make periodic interest payments and repay the face amount of debt at maturity (solvency).
- Short-term creditors are also interested in solvency because an insolvent company cannot meet its debt obligations.
Profitability:
- Investors (stockholders) evaluate the potential for the company’s stock price to increase.
- They focus on evaluating a company’s ability to generate earnings (profitability).

LO1 – Analyzing Financial Information: Techniques for Analyzing Financial Statements

Financial statement users rely on the following techniques to analyze and interpret a company’s financial performance and condition:
- Analytical Methods:
  - Examine changes in the amount and percentage of financial statement items within and across periods.
- Ratios:
  - Express a financial statement item or set of financial statement items as a percentage of another financial statement item.
  - Help measure an important economic relationship as a single number.

LO1 – Analyzing Financial Information: Comparisons Using Analytical Methods and Ratios

Both analytical methods and ratios can be used to compare a company’s financial performance:
- Over time
- To another company
Comparisons Over Time:
- Comparing a financial statement item or ratio with the same item or ratio from a prior period helps identify trends in a company’s economic performance, financial condition, liquidity, solvency, and profitability.
Comparisons Between Companies:
- Comparing a financial statement item or ratio to another company in the same industry can provide insight into a company’s economic performance and financial condition relative to its competitors.

LO2 - Basic Analytical Methods

Users analyze a company’s financial statements using a variety of analytical methods.
Three Basic Analytical Methods:
- Horizontal Analysis
- Vertical Analysis
- Common-Sized Statements

LO2 - Basic Analytical Methods - Horizontal Analysis

The analysis of increases and decreases in the amount and percentage of comparative financial statement items is called horizontal analysis.
Each item on the most recent statement is compared with the same item on one or more earlier statements in terms of the following:
- Amount of increase or decrease
- Percent of increase or decrease
When comparing statements, the earlier statement is normally used as the base year for computing increases and decreases.

LO2- Basic Analytical Methods - Example: Horizontal Analysis

Comparative Balance Sheet
Comparative Income Statement
Comparative Retained Earnings Statement
Example with Lincoln Company:
- Comparative Income Statement for the Years Ended December 31, 20Y6 and 20Y5:
  - Sales:
    - 20Y6: $1,498,000
    - 20Y5: $1,200,000
    - Increase (Decrease): $298,000 or 24.8%
  - Cost of merchandise sold:
    - 20Y6: $1,043,000
    - 20Y5: $820,000
    - Increase (Decrease): $223,000 or 27.2%
  - Gross profit:
    - 20Y6: $455,000
    - 20Y5: $380,000
    - Increase (Decrease): $75,000 or 19.7%
  - Selling expenses:
    - 20Y6: $191,000
    - 20Y5: $147,000
    - Increase (Decrease): $44,000 or 29.9%
  - Administrative expenses:
    - 20Y6: $104,000
    - 20Y5: $97,400
    - Increase (Decrease): $6,600 or 6.8%
  - Total operating expenses:
    - 20Y6: $295,000
    - 20Y5: $244,400
    - Increase (Decrease): $50,600 or 20.7%
  - Income from operations:
    - 20Y6: $160,000
    - 20Y5: $135,600
    - Increase (Decrease): $24,400 or 18.0%
  - Other revenue and expense:
    - Other revenue:
      - 20Y6: $8,500
      - 20Y5: $11,000
      - Increase (Decrease): $(2,500) or -22.7%
    - Other expense (interest):
      - 20Y6: $(6,000)
      - 20Y5: $(12,000)
      - Increase (Decrease): $(6,000) or -50.0%
  - Income before income tax expense:
    - 20Y6: $162,500
    - 20Y5: $134,600
    - Increase (Decrease): $27,900 or 20.7%
  - Income tax expense:
    - 20Y6: $71,500
    - 20Y5: $58,100
    - Increase (Decrease): $13,400 or 23.1%
  - Net income:
    - 20Y6: $91,000
    - 20Y5: $76,500
    - Increase (Decrease): $14,500 or 19.0%
- Comparative Balance Sheet December 31, 20Y6 and 20Y5:
  - Assets:
    - Current assets:
      - 20Y6: $550,000
      - 20Y5: $533,000
      - Increase (Decrease): $17,000 or 3.2%
    - Long-term investments:
      - 20Y6: $95,000
      - 20Y5: $177,500
      - Increase (Decrease): $(82,500) or -46.5%
    - Property, plant, and equipment (net):
      - 20Y6: $585,000
      - 20Y5: $444,500
      - Increase (Decrease): $140,500 or 31.6%
    - Intangible assets:
      - 20Y6: $50,000
      - 20Y5: $75,500
      - Increase (Decrease): $(25,500) or -33.8%
    - Total assets:
      - 20Y6: $1,280,000
      - 20Y5: $1,230,500
      - Increase (Decrease): $49,500 or 4.0%
  - Liabilities:
    - Current liabilities:
      - 20Y6: $210,000
      - 20Y5: $243,000
      - Increase (Decrease): $(33,000) or -13.6%
    - Long-term liabilities:
      - 20Y6: $100,000
      - 20Y5: $200,000
      - Increase (Decrease): $(100,000) or -50.0%
    - Total liabilities:
      - 20Y6: $310,000
      - 20Y5: $443,000
      - Increase (Decrease): $(133,000) or -30.0%
  - Stockholders' Equity:
    - Preferred 6% stock, $100 par:
      - 20Y6: $150,000
      - 20Y5: $150,000
      - Increase (Decrease): $0
    - Common stock, $10 par:
      - 20Y6: $500,000
      - 20Y5: $500,000
      - Increase (Decrease): $0
    - Retained earnings:
      - 20Y6: $320,000
      - 20Y5: $137,500
      - Increase (Decrease): $182,500 or 132.7%
    - Total stockholders' equity:
      - 20Y6: $970,000
      - 20Y5: $787,500
      - Increase (Decrease): $182,500 or 23.2%
  - Total liabilities and stockholders' equity:
    - 20Y6: $1,280,000
    - 20Y5: $1,230,500
    - Increase (Decrease): $49,500 or 4.0%
- Comparative Retained Earnings Statement For the Years Ended December 31, 20Y6 and 20Y5
  - Retained earnings, January 1:
    - 20Y6: $137,500
    - 20Y5: $100,000
    - Increase (Decrease): $37,500 or 37.5%
  - Net income:
    - 20Y6: $91,000
    - 20Y5: $76,500
    - Increase (Decrease): $14,500 or 19.0%
  - Dividends:
    - Preferred stock dividends:
      - 20Y6: $(9,000)
      - 20Y5: $(9,000)
      - Increase (Decrease): $0
    - Common stock dividends:
      - 20Y6: $(40,000)
      - 20Y5: $(30,000)
      - Increase (Decrease): $10,000 or 33.3%
  - Retained earnings, December 31:
    - 20Y6: $179,500
    - 20Y5: $137,500
    - Increase (Decrease): $42,000 or 30.5%
- Comparative Schedule of Current Assets December 31, 20Y6 and 20Y5:
  - Cash:
    - 20Y6: $90,500
    - 20Y5: $64,700
    - Increase (Decrease): $25,800 or 39.9%
  - Temporary investments:
    - 20Y6: $75,000
    - 20Y5: $60,000
    - Increase (Decrease): $15,000 or 25.0%
  - Accounts receivable, net:
    - 20Y6: $115,000
    - 20Y5: $120,000
    - Increase (Decrease): $(5,000) or -4.2%
  - Inventories:
    - 20Y6: $264,000
    - 20Y5: $283,000
    - Increase (Decrease): $(19,000) or -6.7%
  - Prepaid expenses:
    - 20Y6: $5,500
    - 20Y5: $5,300
    - Increase (Decrease): $200 or 3.8%
  - Total current assets:
    - 20Y6: $550,000
    - 20Y5: $533,000
    - Increase (Decrease): $17,000 or 3.2%

LO2 - Basic Analytical Methods: Vertical Analysis

The percentage analysis of the relationship of each component in a financial statement to a total within the statement.
Balance Sheet: Each asset item is stated as a percentage of the total assets.
Balance Sheet: Each liability and stockholders’ equity item is stated as a percentage of the total liabilities and stockholders’ equity.
Income Statement: Each item is stated as a percentage of sales.

LO2 - Basic Analytical Methods: Common-Sized Statements

All items are expressed as percentages, with no dollar amounts shown.
Useful for:
- Comparing one company with another
- Comparing a company with industry averages

LO3 - Analyzing Liquidity

Liquidity analysis evaluates the ability of a company to convert current assets into cash.
Banks and other short-term creditors are interested in a company’s liquidity.
Liquidity ratios and measures focus upon a company’s current position (current assets and liabilities), accounts receivable, and inventory.
Current Position Analysis is covered in more depth; Accounts Receivable Analysis and Inventory Analysis will not be covered in this chapter.

LO3 - Analyzing Liquidity: Current Position Analysis

Current position analysis evaluates a company’s ability to pay its current liabilities.
This information helps short-term creditors determine how quickly they will be repaid.
This analysis includes:
- Working capital
- Current ratio
- Quick ratio

LO3 - Analyzing Liquidity: Current Position Analysis: Working Capital

A company’s working capital is computed as follows:
- $\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}$
For Lincoln Company:
- 20Y6: 550,000 - $210,000 = $340,000
- 20Y5: 533,000 - $243,000 = $290,000

LO3 - Analyzing Liquidity: Current Position Analysis: Working Capital (cont.)

Working capital is used to evaluate a company’s ability to pay current liabilities.
A company’s working capital is often monitored monthly, quarterly, or yearly by creditors and other debtors.
It is difficult to use working capital to compare companies of different sizes.

LO3 - Analyzing Liquidity: Current Position Analysis: Current Ratio

The current ratio is a more reliable indicator of a company’s ability to pay its current liabilities than is working capital and is much easier to compare across companies.
The current ratio, sometimes called the working capital ratio, is computed as follows:
- $\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$
For Lincoln Company:
- 20Y6: \frac{$550,000}{$210,000} = 2.6
- 20Y5: \frac{$533,000}{$243,000} = 2.2

LO3 - Analyzing Liquidity: Current Position Analysis: Quick Ratio

A ratio that measures the “instant” debt-paying ability of a company is the quick ratio, sometimes called the acid-test ratio.
The quick ratio is computed as follows:
- $\text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}}$
Quick assets are cash and other current assets that can be easily converted to cash.
Quick assets normally include cash, temporary investments, and receivables but exclude inventories and prepaid assets.

LO3 - Analyzing Liquidity: Current Position Analysis: Quick Ratio (cont.)

For Lincoln Company and Jefferson Company:
- Lincoln Company 20Y6:
  - Quick Assets = 90,500 (Cash) + $75,000 (Temp. Investments) + $115,000 (A/R) = $280,500$
  - Quick Ratio = \frac{$280,500}{$210,000} = 1.3
- Jefferson Company 20Y6:
  - Quick Assets = 30,000 (Cash) + $45,000 (Temp. Investments) + $82,000 (A/R) = $157,000$
  - Quick Ratio = \frac{$157,000}{$140,000} = 1.1

LO4 - Analyzing Solvency

Solvency analysis evaluates a company’s ability to pay its long-term debts.
Bondholders and other long-term creditors use solvency analysis to evaluate a company’s ability to:
- Repay the face amount of debt at maturity
- Make periodic interest payments
Solvency ratios are often used by prospective lenders when evaluating a company's creditworthiness as well as by potential bond investors.
An unfavorable ratio can indicate some likelihood that a company will default on its debt obligations.
For Analyzing Solvency we are reviewing the Times Interest Earned Ratio only in this Chapter.

LO4 - Analyzing Solvency: Times Interest Earned

The times interest earned, sometimes called the coverage ratio, measures the risk that interest payments will not be made if earnings decrease.
The times interest earned is computed as follows:
- $\text{Times Interest Earned} = \frac{\text{Income Before Income Tax + Interest Expense}}{\text{Interest Expense}}$
Income before taxes is used in computing the times interest earned:
- Interest expense is paid before income taxes.
- Interest expense is deducted in determining taxable income and, thus, income tax.
The higher the ratio, the more likely interest payments will be paid if earnings decrease.

LO4 - Analyzing Solvency: Times Interest Earned (cont.)

For Lincoln Company 20Y6:
- Income Before Income Tax = $162,500
- Interest Expense = $6,000
- Times Interest Earned = \frac{$162,500 + $6,000}{$6,000} = 28.1

Summary of Analytical Measures

Liquidity Measures:
- Working Capital:
  - Method of Computation: Current Assets - Current Liabilities
  - Use: Measures the company's ability to pay current liabilities
- Current Ratio:
  - Method of Computation: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$
- Quick Ratio:
  - Method of Computation: $\frac{\text{Quick Assets}}{\text{Current Liabilities}}$
  - Use: Measures the company's instant debt-paying ability.
Solvency Measures:
- Times Interest Earned:
  - Method of Computation: $\frac{\text{Income Before Income Tax + Interest Expense}}{\text{Interest Expense}}$
  - Use: Measures the risk that interest payments will not be made if earnings decrease.

LO6 Corporate Annual Reports

Public corporations issue annual reports summarizing their operating activities for the past year and plans for the future.
Corporate Annual Reports Include:
- Financial statements and accompanying notes
- Management discussion and analysis
- Report on internal control
- Report on fairness of the financial statements

LO6 Corporate Annual Reports: Management Discussion and Analysis

Management’s Discussion and Analysis (MD&A) is required in annual reports filed with the Securities and Exchange Commission.
It includes management’s analysis of current operations and its plans for the future.
Typical Items Included in MD&A:
- Management’s analysis and explanations of any significant changes between the current and prior years’ financial statements.
- Important accounting principles or policies that could affect interpretation of the financial statements, including the effect of changes in accounting principles or the adoption of new accounting principles.
- Management’s assessment of the company’s liquidity and the availability of capital to the company.
- Significant risk exposures that might affect the company.
- Any “off-balance-sheet” arrangements such as leases not included in the financial statements.

LO6 Corporate Annual Reports: Report on Internal Control

The Sarbanes-Oxley Act of 2002 requires a report on internal control by management.
The report states management’s responsibility for establishing and maintaining internal control.
In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report.
Sarbanes-Oxley also requires a public accounting firm to verify management’s conclusions on internal control.
Thus, two reports on internal control, one by management and one by a public accounting firm, are included in the annual report.

LO6 Corporate Annual Reports: Report on Fairness of the Financial Statements

All publicly held corporations are required to have an independent audit (examination) of their financial statements.
The Certified Public Accounting (CPA) firm that conducts the audit renders an opinion, called the Report of Independent Registered Public Accounting Firm, on the fairness of the statements.
An opinion stating that the financial statements present fairly the financial position, results of operations, and cash flows of the company is said to be an unmodified opinion, sometimes called a clean opinion.
Any report other than an unmodified opinion raises a red flag for financial statement users and requires further investigation as to its cause.

LO6 – Corporate Annual Reports: Links

Link to SEC Website: https://www.sec.gov/edgar.shtml
Link to AT&T Corporate Annual Report 10K: https://www.sec.gov/edgar/search/#/ciks=0000732717&entityName=AT%2526T%2520INC.%2520(T%252C%2520TBC%252C%2520T-PC%252C%2520T-PA)%2520(CIK%25200000732717)&filter_forms=10-K