Basics of Financial Statement Analysis

Analyzing financial statements involves evaluating three characteristics: a company's liquidity, profitability, and solvency. A short-term creditor, such as a bank, is primarily interested in liquidity—the ability of the borrower to pay obligations when they come due. The liquidity of the borrower is extremely important in evaluating the safety of a loan. A long-term creditor, such as a bondholder, 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. Similarly, stockholders look at the profitability and solvency of the company. They want to assess the likelihood of dividends and the growth potential of the stock.

Need for Comparative Analysis

Every item reported in a financial statement has significance. When Macy's, Inc. reports cash and cash equivalents of $3 billion on its balance sheet, we know the company had that amount of cash on the balance sheet date. But, we do not know whether the amount represents an increase over prior years, or whether it is adequate in relation to the company's need for cash. To obtain such information, we need to compare the amount of cash with other financial statement data.

Comparisons can be made on a number of different bases. Three are illustrated in this chapter.

1. Intracompany basis. Comparisons within a company are often useful to detect changes in financial relationships and significant trends. For example, a comparison of Macy's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. Likewise, a comparison of Macy's year-end cash amount with the amount of its total assets at year-end shows the proportion of total assets in the form of cash.

2. Industry averages. Comparisons with industry averages provide information about a company's relative position within the industry. For example, financial statement readers can compare Macy's financial data with the averages for its industry compiled by financial rating organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's, or with information provided on the Internet by organizations such as Yahoo! on its financial site.

3. Intercompany basis. Comparisons with other companies provide insight into a company's competitive position. For example, investors can compare Macy's total sales for the year with the total sales of its competitors in retail, such as J.C. Penney.

Tools of Analysis

We use various tools to evaluate the significance of financial statement data. Three commonly used tools are as follows:

• Horizontal analysis evaluates a series of financial statement data over a period of time.
• Vertical analysis evaluates financial statement data by expressing each item in a financial statement as a percentage of a base amount.
• Ratio analysis expresses the relationship among selected items of financial statement data.

Horizontal analysis is used primarily in intracompany comparisons. Two features in published financial statements and annual report information facilitate this type of comparison. First, each of the basic financial statements presents comparative financial data for a minimum of two years. Second, a summary of selected financial data is presented for a series of five to 10 years or more. Vertical analysis is used in both intra- and intercompany comparisons. Ratio analysis is used in all three types of comparisons. In the following sections, we explain and illustrate each of the three types of analysis.

Horizontal Analysis

Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place. This change may be expressed as either an amount or a percentage. For example, Illustration 18-1 shows recent net sales figures of Macy's, Inc.

Illustration 18-1
Macy's, Inc.'s net sales

If we assume that 2009 is the base year, we can measure all percentage increases or decreases from this base period amount as follows.

Illustration 18-2
Formula for horizontal analysis of changes since base period

For example, we can determine that net sales for Macy's increased from 2009 to 2010 approximately 6.4% [($25,003 − $23,489) ÷ $23,489]. Similarly, we can determine that net sales increased from 2009 to 2011 approximately 12.4% [($26,405 − $23,489) ÷ $23,489].

Alternatively, we can express current year sales as a percentage of the base period. We do this by dividing the current year amount by the base year amount, as shown below.

Illustration 18-3
Formula for horizontal analysis of current year in relation to base year

Illustration 18-4 presents this analysis for Macy's for a three-year period using 2009 as the base period.

Illustration 18-4
Horizontal analysis of Macy's, Inc.'s net sales in relation

Balance Sheet

To further illustrate horizontal analysis, we will use the financial statements of Quality Department Store Inc., a fictional retailer. Illustration 18-5 presents a horizontal analysis of its two-year condensed balance sheets, showing dollar and percentage changes.

Illustration 18-5
Horizontal analysis of balance sheets

The comparative balance sheets in Illustration 18-5 show that a number of significant changes have occurred in Quality Department Store's financial structure from 2010 to 2011:

• In the assets section, plant assets (net) increased $167,500, or 26.5%.
• In the liabilities section, current liabilities increased $41,500, or 13.7%.
• In the stockholders’ equity section, retained earnings increased $202,600, or 38.6%.

These 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.

Income Statement

Illustration 18-6 presents a horizontal analysis of the two-year condensed income statements of Quality Department Store Inc. for the years 2011 and 2010. Horizontal analysis of the income statements shows the following changes:

• Net sales increased $260,000, or 14.2% ($260,000 ÷ $1,837,000).
• Cost of goods sold increased $141,000, or 12.4% ($141,000 ÷ $1,140,000).
• Total operating expenses increased $37,000, or 11.6% ($37,000 ÷ $320,000).

Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality's profit trend appears favorable.

Illustration 18-6
Horizontal analysis of income statements

Helpful Hint Note that though the amount column is additive (the total is $55,300), the percentage column is not additive (26.5% is not the column total). A separate percentage has been calculated for each item.

Retained Earnings Statement

Illustration 18-7 presents a horizontal analysis of Quality Department Store's comparative retained earnings statements. Analyzed horizontally, net income increased $55,300, or 26.5%, whereas dividends on the common stock increased only $1,200, or 2%. We saw in the horizontal analysis of the balance sheet that ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities.

Illustration 18-7
Horizontal analysis of retained earnings statements

Horizontal analysis of changes from period to period is relatively straightforward and is quite useful. But, complications can occur in making the computations. If an item has no value in a base year or preceding year but does have a value in the next year, we cannot compute a percentage change. Similarly, 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.

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Vertical Analysis

Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percentage of a base amount. On a balance sheet, we might say that current assets are 22% of total assets—total assets being the base amount. Or on an income statement, we might say that selling expenses are 16% of net sales—net sales being the base amount.

Balance Sheet

Illustration 18-8 presents the vertical analysis of Quality Department Store Inc.'s comparative balance sheets. The base for the asset items is total assets. The base for the liability and stockholders’ equity items is total liabilities and stockholders’ equity.

Vertical analysis shows the relative size of each category in the balance sheet. It also can show the percentage change in the individual asset, liability, and stockholders’ equity items. For example, we can see that current assets decreased from 59.2% of total assets in 2010 to 55.6% in 2011 (even though the absolute dollar amount increased $75,000 in that time). Plant assets (net) have increased from 39.7% to 43.6% of total assets. Retained earnings have increased from 32.9% to 39.7% of total liabilities and stockholders’ equity. These results reinforce the earlier observations that Quality Department Store is choosing to finance its growth through retention of earnings rather than through issuing additional debt.

Illustration 18-8
Vertical analysis of balance sheets

Helpful Hint The formula for calculating these balance sheet percentages is:

Income Statement

Illustration 18-9 shows vertical analysis of Quality Department Store's income statements. Cost of goods sold as a percentage of net sales declined 1% (62.1% vs.61.1%), and total operating expenses declined 0.4% (17.4% vs. 17.0%). As a result, it is not surprising to see net income as a percentage of net sales increase from 11.4% to 12.6%. Quality Department Store appears to be a profitable business that is becoming even more successful.

Illustration 18-9
Vertical analysis of income statements

Helpful Hint The formula for calculating these income statement percentages is:

An associated benefit of vertical analysis is that it enables you to compare companies of different sizes. For example, Quality Department Store's main competitor is a Macy's store in a nearby town. Using vertical analysis, we can compare the condensed income statements of Quality Department Store Inc. (a small retail company) with Macy's, Inc.¹ (a giant international retailer), as shown in Illustration 18-10.

Illustration 18-10
Intercompany income statement comparison

Macy's net sales are 12,592 times greater than the net sales of relatively tiny Quality Department Store. But vertical analysis eliminates this difference in size. The percentages show that Quality's and Macy's gross profit rates were comparable at 38.9% and 40.4%, respectively. However, the percentages related to income from operations were significantly different at 21.9% and 9.1%, respectively. This disparity can be attributed to Quality's selling and administrative expense percentage (17%) which is much lower than Macy's (31.3%). Although Macy's earned net income more than 4,757 times larger than Quality's, Macy's net income as a percentage of each sales dollar (4.7%) is only 37% of Quality's (12.6%).

Ratio Analysis

Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. The relationship is expressed in terms of either a percentage, a rate, or a simple proportion. To illustrate, in 2011 Nike, Inc. had current assets of $11,297 million and current liabilities of $3,958 million. We can find the relationship between these two measures by dividing current assets by current liabilities. The alternative means of expression are:

To analyze the primary financial statements, we can use ratios to evaluate liquidity, profitability, and solvency. Illustration 18-11 describes these classifications.

Illustration 18-11
Financial ratio classifications

Ratios can provide clues to underlying conditions that may not be apparent from individual financial statement components. However, a single ratio by itself is not very meaningful. Thus, in the discussion of ratios we will use 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 Macy's, Inc. as Quality Department Store's principal competitor.

ANATOMY OF A FRAUD

Liquidity Ratios

Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. The ratios we can use to determine the company's short-term debt-paying ability are the current ratio, the acid-test ratio, accounts receivable turnover, and inventory turnover.

1. CURRENT RATIO

The current ratio is a widely used measure for evaluating a company's liquidity and short-term debt-paying ability. The ratio is computed by dividing current assets by current liabilities. Illustration 18-12 shows the 2011 and 2010 current ratios for Quality Department Store and comparative data.

Illustration 18-12
Current ratio

Helpful Hint Can any company operate successfully without working capital? Yes, if it has very predictable cash flows and solid earnings. A number of companies (e.g., Whirlpool, American Standard, and Campbell's Soup) are pursuing this goal. The rationale: Less money tied up in working capital means more money to invest in the business.

What does the ratio actually mean? The 2011 ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets. Quality's current ratio has decreased in the current year. But, compared to the industry average of 1.70:1, Quality appears to be reasonably liquid. Macy's has a current ratio of 1.40:1, which indicates it has adequate current assets relative to its current liabilities.

The current ratio is sometimes referred to as the working capital ratio. Working capital is current assets minus current liabilities. The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have significantly different current ratios.

The current ratio is only one measure of liquidity. 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. A dollar of cash would be more readily available to pay the bills than a dollar of slow-moving inventory.

2. ACID-TEST RATIO

The acid-test (quick) ratio is a measure of a company's immediate short-term liquidity. We compute this ratio by dividing the sum of cash, short-term investments, and net accounts receivable by current liabilities. Thus, it is an important complement to the current ratio. For example, assume that the current assets of Quality Department Store for 2011 and 2010 consist of the items shown in Illustration 18-13.

Illustration 18-13
Current assets of Quality Department Store

Cash, short-term investments, and accounts receivable (net) are highly liquid compared to inventory and prepaid expenses. The inventory may not be readily saleable, and the prepaid expenses may not be transferable to others. Thus, the acid-test ratio measures immediate liquidity. The 2011 and 2010 acid-test ratios for Quality Department Store and comparative data are as follows.

Illustration 18-14
Acid-test ratio

The ratio has declined in 2011. Is an acid-test ratio of 1.02:1 adequate? This depends on the industry and the economy. When compared with the industry average of 0.70:1 and Macy's of 0.51:1, Quality's acid-test ratio seems adequate.

3. ACCOUNTS RECEIVABLE TURNOVER

We can measure liquidity by how quickly a company can convert certain assets to cash. How liquid, for example, are the accounts receivable? The ratio used to assess the liquidity of the receivables is accounts receivable turnover. It measures the number of times, on average, the company collects receivables during the period. We compute accounts receivable turnover by dividing net credit sales (net sales less cash sales) by the average net accounts receivable. Unless seasonal factors are significant, average net accounts receivable can be computed from the beginning and ending balances of the net accounts receivable.²

Assume that all sales are credit sales. The balance of net accounts receivable at the beginning of 2010 is $200,000. Illustration 18-15 shows the accounts receivable turnover for Quality Department Store and comparative data. Quality's accounts receivable turnover improved in 2011. The turnover of 10.2 times is substantially lower than Macy's 74.8 times, and is also lower than the department store industry's average of 46.4 times.

Illustration 18-15
Accounts receivable turnover

AVERAGE COLLECTION PERIOD A popular variant of the accounts receivable turnover is to convert it to an average collection period in terms of days. To do so, we divide the accounts receivable turnover into 365 days. For example, the accounts receivable turnover of 10.2 times divided into 365 days gives an average collection period of approximately 36 days. This means that accounts receivable are collected on average every 36 days, or about every 5 weeks. Analysts frequently use the average collection period 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).

4. INVENTORY TURNOVER

Inventory turnover measures the number of times, on average, the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. We compute the inventory turnover by dividing cost of goods sold by the average inventory. Unless seasonal factors are significant, we can use the beginning and ending inventory balances to compute average inventory.

Assuming that the inventory balance for Quality Department Store at the beginning of 2010 was $450,000, its inventory turnover and comparative data are as shown in Illustration 18-16. Quality's inventory turnover declined slightly in 2011. The turnover of 2.3 times is low compared with the industry average of 4.3 and Macy's 3.2. Generally, the faster the inventory turnover, the less cash a company has tied up in inventory and the less the chance of inventory obsolescence.

Illustration 18-16
Inventory turnover

DAYS IN INVENTORY A variant of inventory turnover is the days in inventory. We calculate it by dividing the inventory turnover into 365. For example, Quality's 2011 inventory turnover of 2.3 times divided into 365 is approximately 159 days. An average selling time of 159 days is also high compared with the industry average of 84.9 days (365 ÷ 4.3) and Macy's 114.1 days (365 ÷ 3.2).

Inventory turnovers vary considerably among industries. For example, grocery store chains have a turnover of 17.1 times and an average selling period of 21 days. In contrast, jewelry stores have an average turnover of 0.80 times and an average selling period of 456 days.

Profitability Ratios

Profitability ratios measure the income or operating success of a company for a given period of time. Income, or the lack of it, affects the company's ability to obtain debt and equity financing. It also affects the company's liquidity position and the company's ability to grow. As a consequence, both creditors and investors are interested in evaluating earning power—profitability. Analysts frequently use profitability as the ultimate test of management's operating effectiveness.

5. PROFIT MARGIN

Profit margin is a measure of the percentage of each dollar of sales that results in net income. We can compute it by dividing net income by net sales. Illustration 18-17 shows Quality Department Store's profit margin and comparative data.

Alternative Terminology
Profit margin is also called the rate of return on sales.

Illustration 18-17
Profit margin

Quality experienced an increase in its profit margin from 2010 to 2011. Its profit margin is unusually high in comparison with the industry average of 8% and Macy's 4.8%.

High-volume (high inventory turnover) businesses, such as grocery stores (Safeway or Kroger) and discount stores (Kmart or Wal-Mart), generally experience low profit margins. In contrast, low-volume businesses, such as jewelry stores (Tiffany & Co.) or airplane manufacturers (Boeing Co.), have high profit margins.

6. ASSET TURNOVER

Asset turnover measures how efficiently a company uses its assets to generate sales. It is determined by dividing net sales by average total assets. The resulting number shows the dollars of sales produced by each dollar invested in assets. Unless seasonal factors are significant, we can use the beginning and ending balance of total assets to determine average total assets. Assuming that total assets at the beginning of 2010 were $1,446,000, the 2011 and 2010 asset turnover for Quality Department Store and comparative data are shown in Illustration 18-18.

Illustration 18-18
Asset turnover

Asset turnover shows that in 2011 Quality generated sales of $1.20 for each dollar it had invested in assets. The ratio changed very little from 2010 to 2011. Quality's asset turnover is below the industry average of 1.4 times and equal to Macy's ratio of 1.2 times.

Asset turnovers vary considerably among industries. For example, a large utility company like Consolidated Edison (New York) has a ratio of 0.4 times, and the large grocery chain Kroger Stores has a ratio of 3.4 times.

7. RETURN ON ASSETS

An overall measure of profitability is return on assets. We compute this ratio by dividing net income by average total assets. The 2011 and 2010 return on assets for Quality Department Store and comparative data are shown below.

Illustration 18-19
Return on assets

Quality's return on assets improved from 2010 to 2011. Its return of 15.4% is very high compared with the department store industry average of 8.9% and Macy's 5.9%.

8. RETURN ON COMMON STOCKHOLDERS’ EQUITY

Another widely used profitability ratio is return on common stockholders’ equity. It measures profitability from the common stockholders’ viewpoint. This ratio shows how many dollars of net income the company earned for each dollar invested by the owners. We compute it by dividing net income by average common stockholders’ equity. Assuming that common stockholders’ equity at the beginning of 2010 was $667,000, Illustration 18-20 shows the 2011 and 2010 ratios for Quality Department Store and comparative data.

Illustration 18-20
Return on common stockholders’ equity

Quality's rate of return on common stockholders’ equity is high at 29.3%, considering an industry average of 18.3% and a rate of 21.9% for Macy's.

WITH PREFERRED STOCK When a company has preferred stock, we must deduct preferred dividend requirements from net income to compute income available to common stockholders. Similarly, we deduct the par value of preferred stock (or call price, if applicable) from total stockholders’ equity to determine the amount of common stockholders’ equity used in this ratio. The ratio then appears as follows.

Illustration 18-21
Return on common stockholders’ equity with preferred stock

Note that Quality's rate of return on stockholders’ equity (29.3%) is substantially higher than its rate of return on assets (15.4%). The reason is that Quality has made effective use of leverage. Leveraging or trading on the equity at a gain means that the company has borrowed money at a lower rate of interest than it is able to earn by using the borrowed money. Leverage enables Quality Department Store to use money supplied by nonowners to increase the return to the owners. A comparison of the rate of return on total assets with the rate of interest paid for borrowed money indicates the profitability of trading on the equity. Quality Department Store earns more on its borrowed funds than it has to pay in the form of interest. Thus, the return to stockholders exceeds the return on the assets, due to benefits from the positive leveraging.

9. EARNINGS PER SHARE (EPS)

Earnings per share (EPS) is a measure of the net income earned on each share of common stock. It is computed by dividing net income by the number of weighted-average common shares outstanding during the year. A measure of net income earned on a per share basis provides a useful perspective for determining profitability. Assuming that there is no change in the number of outstanding shares during 2010 and that the 2011 increase occurred midyear, Illustration 18-22 shows the net income per share for Quality Department Store for 2011 and 2010.

Illustration 18-22
Earnings per share

Note that no industry or Macy's data are presented. Such comparisons are not meaningful because of the wide variations in the number of shares of outstanding stock among companies. The only meaningful EPS comparison is an intracompany trend comparison: Quality's earnings per share increased 20 cents per share in 2011. This represents a 26% increase over the 2010 earnings per share of 77 cents.

The terms “earnings per share” and “net income per share” refer to the amount of net income applicable to each share of common stock. Therefore, in computing EPS, if there are preferred dividends declared for the period, we must deduct them from net income to determine income available to the common stockholders.

10. PRICE-EARNINGS RATIO

The price-earnings (P-E) ratio is an oft-quoted measure of the ratio of the market price of each share of common stock to the earnings per share. The price-earnings (P-E) ratio reflects investors’ assessments of a company's future earnings. We compute it by dividing the market price per share of the stock by earnings per share. Assuming that the market price of Quality Department Store Inc. stock is $8 in 2010 and $12 in 2011, the price-earnings ratio computation is as follows.

Illustration 18-23
Price-earnings ratio

In 2011, each share of Quality's stock sold for 12.4 times the amount that the company earned on each share. Quality's price-earnings ratio is lower than the industry average of 21.3 times but higher than the ratio of 10.9 times for Macy's. The average price-earnings ratio for the stocks that constitute the Standard and Poor's 500 Index (500 largest U.S. firms) in late 2012 was approximately 15.9 times.

11. PAYOUT RATIO

The payout ratio measures the percentage of earnings distributed in the form of cash dividends. We compute it by dividing cash dividends by net income. Companies that have high growth rates generally have low payout ratios because they reinvest most of their net income into the business. The 2011 and 2010 payout ratios for Quality Department Store are computed as shown in Illustration 18-24.

Illustration 18-24
Payout ratio

Quality's payout ratio is higher the industry average payout ratio of 16.1%.

Solvency Ratios

Solvency ratios measure the ability of a company to survive over a long period of time. Long-term creditors and stockholders are particularly interested in a company's ability to pay interest as it comes due and to repay the face value of debt at maturity. Debt to assets and times interest earned are two ratios that provide information about debt-paying ability.

12. DEBT TO ASSETS RATIO

The debt to assets ratio measures the percentage of the total assets that creditors provide. We compute it by dividing debt (both current and long-term liabilities) by assets. This ratio indicates the company's degree of leverage. It also provides some indication of the company's ability to withstand losses without impairing the interests of creditors. The higher the percentage of debt to assets, the greater the risk that the company may be unable to meet its maturing obligations. The 2011 and 2010 ratios for Quality Department Store and comparative data are as follows.

Illustration 18-25
Debt to assets ratio

A ratio of 45.3% means that creditors have provided 45.3% of Quality Department Store's total assets. Quality's 45.3% is above the industry average of 34.2%. It is considerably below the high 73.1% ratio of Macy's. The lower the ratio, the more equity “buffer” there is available to the creditors. Thus, from the creditors’ point of view, a low ratio of debt to assets is usually desirable.

The adequacy of this ratio is often judged in the light of the company's earnings. Generally, companies with relatively stable earnings (such as public utilities) have higher debt to assets ratios than cyclical companies with widely fluctuating earnings (such as many high-tech companies).

13. TIMES INTEREST EARNED

Times interest earned provides an indication of the company's ability to meet interest payments as they come due. We compute it by dividing income before interest expense and income taxes by interest expense. Illustration 18-26 shows the 2011 and 2010 ratios for Quality Department Store and comparative data. Note that times interest earned uses income before income taxes and interest expense. This represents the amount available to cover interest. For Quality Department Store, the 2011 amount of $468,000 is computed by taking the income before income taxes of $432,000 and adding back the $36,000 of interest expense.

Alternative Terminology
Times interest earned is also called interest coverage.

Illustration 18-26
Times interest earned

Quality's interest expense is well covered at 13 times, compared with the industry average of 16.1 times and Macy's 5.4 times.

Summary of Ratios

Illustration 18-27 summarizes the ratios discussed in this chapter. The summary includes the formula and purpose or use of each ratio.

Illustration 18-27
Summary of liquidity, profitability, and solvency ratios

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Earning Power and Irregular Items

Users of financial statements are interested in the concept of earning power. Earning power means the normal level of income to be obtained in the future. Earning power differs from actual net income by the amount of irregular revenues, expenses, gains, and losses. Users are interested in earning power because it helps them derive an estimate of future earnings without the “noise” of irregular items.

For users of financial statements to determine earning power or regular income, the “irregular” items are separately identified on the income statement. Companies report two types of “irregular” items.

1. Discontinued operations.

2. Extraordinary items.

These “irregular” items are reported net of income taxes. That is, the income statement first reports income tax on the income before “irregular” items. Then the amount of tax for each of the listed “irregular” items is computed. The general concept is “let the tax follow income or loss.”

Discontinued Operations

Discontinued operations refers to the disposal of a significant component of a business, such as the elimination of a major class of customers, or an entire activity. For example, to downsize its operations, General Dynamics Corp. sold its missile business to Hughes Aircraft Co. for $450 million. In its income statement, General Dynamics reported the sale in a separate section entitled “Discontinued operations.”

Following the disposal of a significant component, the company should report on its income statement both income from continuing operations and income (or loss) from discontinued operations. The income (loss) from discontinued operations consists of two parts: the income (loss) from operations and the gain (loss) on disposal of the component.

To illustrate, assume that during 2014 Acro Energy Inc. has income before income taxes of $800,000. During 2014, Acro discontinued and sold its unprofitable chemical division. The loss in 2014 from chemical operations (net of $60,000 taxes) was $140,000. The loss on disposal of the chemical division (net of $30,000 taxes) was $70,000. Assuming a 30% tax rate on income, Illustration 18-28 shows Acro's income statement presentation.

Illustration 18-28
Statement presentation of discontinued operations

Helpful Hint Observe the dual disclosures. (1) The results of operations of the discontinued division must be eliminated from the results of continuing operations. (2) The company must also report the disposal of the operation.

Note that the statement uses the caption “Income from continuing operations” and adds a new section “Discontinued operations.” The new section reports both the operating loss and the loss on disposal net of applicable income taxes. This presentation clearly indicates the separate effects of continuing operations and discontinued operations on net income.

Extraordinary Items

Extraordinary items are events and transactions that meet two conditions. They are (1) unusual in nature, and (2) infrequent in occurrence. To be unusual, the item should be abnormal and only incidentally related to the company's customary activities. To be infrequent, the item should not be reasonably expected to recur in the foreseeable future.

A company must evaluate both criteria in terms of its operating environment. Thus, Weyerhaeuser Co. reported the $36 million in damages to its timberland caused by the volcanic eruption of Mount St. Helens as an extraordinary item. The eruption was both unusual and infrequent. In contrast, Florida Citrus Company does not report frost damage to its citrus crop as an extraordinary item, because frost damage is not infrequent. Illustration 18-29 shows the classification of extraordinary and ordinary items.

Illustration 18-29
Examples of extraordinary and ordinary items

Companies report extraordinary items net of taxes in a separate section of the income statement, immediately below discontinued operations. To illustrate, assume that in 2014 a foreign government expropriated property held as an investment by Acro Energy Inc. If the loss is $70,000 before applicable income taxes of $21,000, the income statement will report a deduction of $49,000, as shown in Illustration 18-30. When there is an extraordinary item to report, the company adds the caption “Income before extraordinary item” immediately before the section for the extraordinary item. This presentation clearly indicates the effect of the extraordinary item on net income.

Illustration 18-30
Statement presentation of extraordinary items

Helpful Hint If there are no discontinued operations, the third line of the income statement would be labeled “Income before extraordinary item.”

What if a transaction or event meets one (but not both) of the criteria for an extraordinary item? In that case, the company reports it under either “Other revenues and gains” or “Other expenses and losses” at its gross amount (not net of tax). This is true, for example, of gains (losses) resulting from the sale of property, plant, and equipment, as explained in Chapter 10. It is quite common for companies to use the label “Non-recurring charges” for losses that do not meet the extraordinary item criteria.

Changes in Accounting Principle

For ease of comparison, users of financial statements expect companies to prepare such statements on a basis consistent with the preceding period. A change in accounting principle occurs when the principle used in the current year is different from the one used in the preceding year. Accounting rules permit a change when management can show that the new principle is preferable to the old principle. An example is a change in inventory costing methods (such as FIFO to average cost).

Companies report most changes in accounting principle retroactively. That is, they report both the current period and previous periods using the new principle. As a result, the same principle applies in all periods. This treatment improves the ability to compare results across years.

Comprehensive Income

The income statement reports most revenues, expenses, gains, and losses recognized during the period. However, over time, specific exceptions to this general practice have developed. Certain items now bypass income and are reported directly in stockholders’ equity.

For example, in Chapter 16 you learned that companies do not include in income any unrealized gains and losses on available-for-sale securities. Instead, they report such gains and losses in the balance sheet as adjustments to stockholders’ equity. Why are these gains and losses on available-for-sale securities excluded from net income? Because disclosing them separately (1) reduces the volatility of net income due to fluctuations in fair value, yet (2) informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value.

Many analysts have expressed concern over the significant increase in the number of items that bypass the income statement. They feel that such reporting has reduced the usefulness of the income statement. To address this concern, 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. A number of alternative formats for reporting comprehensive income are allowed. These formats are discussed in advanced accounting courses.

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Quality of Earnings

In evaluating the financial performance of a company, the quality of a company's earnings is of extreme importance to analysts. 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. Here are some of the factors affecting quality of earnings.

Alternative Accounting Methods

Variations among companies in the application of generally accepted accounting principles may hamper comparability and reduce quality of earnings. For example, one company may use the FIFO method of inventory costing, while another company in the same industry may use LIFO. If inventory is a significant asset to both companies, it is unlikely that their current ratios are comparable. For example, if General Motors Corporation had used FIFO instead of LIFO for inventory valuation, its inventories in a recent year would have been 26% higher, which significantly affects the current ratio (and other ratios as well).

In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization. Although these differences in accounting methods might be detectable from reading the notes to the financial statements, adjusting the financial data to compensate for the different methods is often difficult, if not impossible.

Pro Forma Income

Companies whose stock is publicly traded are required to present their income statement following generally accepted accounting principles (GAAP). In recent years, many companies have also reported a second measure of income, called pro forma income. Pro forma income usually excludes items that the company thinks are unusual or non-recurring. For example, at one time, Cisco Systems (a high-tech company) reported a quarterly net loss under GAAP of $2.7 billion. Cisco reported pro forma income for the same quarter as a profit of $230 million. This large difference in profits between GAAP income numbers and pro forma income is not unusual these days. For example, during one 9-month period the 100 largest firms on the Nasdaq stock exchange reported a total pro forma income of $19.1 billion but a total loss as measured by GAAP of $82.3 billion—a difference of about $100 billion!

To compute pro forma income, companies generally can exclude any items they deem inappropriate for measuring their performance. Many analysts and investors are critical of the practice of using pro forma income because these numbers often make companies look better than they really are. As the financial press noted, pro forma numbers might be called EBS, which stands for “earnings before bad stuff.” Companies, on the other hand, argue that pro forma numbers more clearly indicate sustainable income because they exclude unusual and non-recurring expenses. “Cisco's technique gives readers of financial statements a clear picture of Cisco's normal business activities,” the company said in a statement issued in response to questions about its pro forma income accounting.

The SEC has provided guidance on how companies should present pro forma information. Stay tuned: Everyone seems to agree that pro forma numbers can be useful if they provide insights into determining a company's sustainable income. However, many companies have abused the flexibility that pro forma numbers allow and have used the measure as a way to put their companies in a good light.

Improper Recognition

Due to pressure from Wall Street to continually increase earnings, some managers have manipulated the earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue. One practice that companies are using is channel stuffing. Offering deep discounts on their products to customers, companies encourage their customers to buy early (stuff the channel) rather than later. This lets the company report good earnings in the current period, but it often leads to a disaster in subsequent periods because customers have no need for additional goods. To illustrate, Bristol-Myers Squibb at one time indicated that it used sales incentives to encourage wholesalers to buy more drugs than needed to meet patients’ demands. As a result, the company had to issue revised financial statements showing corrected revenues and income.

Another practice is the improper capitalization of operating expenses. The classic case is WorldCom. It capitalized over $7 billion of operating expenses so that it would report positive net income. In other situations, companies fail to report all their liabilities. Enron had promised to make payments on certain contracts if financial difficulty developed, but these guarantees were not reported as liabilities. In addition, disclosure was so lacking in transparency that it was impossible to understand what was happening at the company.

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SUMMARY OF LEARNING OBJECTIVES

1 Discuss the need for comparative analysis. There are three bases of comparison: (1) intracompany, which compares an item or financial relationship with other data within a company; (2) industry, which compares company data with industry averages; and (3) inter-company, which compares an item or financial relationship of a company with data of one or more competing companies.

2 Identify the tools of financial statement analysis. Financial statements can be analyzed horizontally, vertically, and with ratios.

3 Explain and apply horizontal analysis. Horizontal analysis is a technique for evaluating a series of data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage.

4 Describe and apply vertical analysis. Vertical analysis is a technique that expresses each item within a financial statement in terms of a percentage of a relevant total or a base amount.

5 Identify and compute ratios used in analyzing a firm's liquidity, profitability, and solvency. The formula and purpose of each ratio is presented in Illustration 18-27 (pages 858–859).

6 Understand the concept of earning power, and how irregular items are presented. Earning power refers to a company's ability to sustain its profits from operations. “Irregular items”—discontinued operations and extraordinary items—are presented net of tax below income from continuing operations to highlight their unusual nature.

7 Understand the concept of quality of earnings. A high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements. Issues related to quality of earnings are (1) alternative accounting methods, (2) pro forma income, and (3) improper recognition.

GLOSSARY

Accounts receivable turnover A measure of the liquidity of accounts receivable; computed by dividing net credit sales by average net accounts receivable. (p. 852).

Acid-test (quick) ratio A measure of a company's immediate short-term liquidity; computed by dividing the sum of cash, short-term investments, and net accounts receivable by current liabilities. (p. 850).

Asset turnover A measure of how efficiently a company uses its assets to generate sales; computed by dividing net sales by average total assets. (p. 854).

Change in accounting principle The use of a principle in the current year that is different from the one used in the preceding year. (p. 863).

Comprehensive income Includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders. (p. 864).

Current ratio A measure used to evaluate a company's liquidity and short-term debt-paying ability; computed by dividing current assets by current liabilities. (p. 850).

Debt to assets ratio Measures the percentage of assets provided by creditors; computed by dividing debt by assets. (p. 857).

Discontinued operations The disposal of a significant component of a business. (p. 861).

Earnings per share (EPS) The net income earned on each share of common stock; computed by dividing net income minus preferred dividends (if any) by the number of weighted-average common shares outstanding. (p. 856).

Extraordinary items Events and transactions that are unusual in nature and infrequent in occurrence. (p. 862).

Horizontal analysis A technique for evaluating a series of financial statement data over a period of time, to determine the increase (decrease) that has taken place, expressed as either an amount or a percentage. (p. 843).

Inventory turnover A measure of the liquidity of inventory; computed by dividing cost of goods sold by average inventory. (p. 852).

Leveraging See Trading on the equity. (p. 855).

Liquidity ratios Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. (p. 850).

Payout ratio Measures the percentage of earnings distributed in the form of cash dividends; computed by dividing cash dividends by net income. (p. 857).

Price-earnings (P-E) ratio Measures the ratio of the market price of each share of common stock to the earnings per share; computed by dividing the market price of the stock by earnings per share. (p. 856).

Profit margin Measures the percentage of each dollar of sales that results in net income; computed by dividing net income by net sales. (p. 853).

Profitability ratios Measures of the income or operating success of a company for a given period of time. (p. 853).

Pro forma income A measure of income that usually excludes items that a company thinks are unusual or non-recurring. (p. 865).

Quality of earnings Indicates the level of full and transparent information provided to users of the financial statements. (p. 865).

Ratio An expression of the mathematical relationship between one quantity and another. The relationship may be expressed either as a percentage, a rate, or a simple proportion. (p. 848).

Ratio analysis A technique for evaluating financial statements that expresses the relationship between selected financial statement data. (p. 848).

Return on assets An overall measure of profitability; computed by dividing net income by average total assets. (p. 854).

Return on common stockholders’ equity Measures the dollars of net income earned for each dollar invested by the owners; computed by dividing net income minus preferred dividends (if any) by average common stockholders’ equity. (p. 855).

Solvency ratios Measures of the ability of the company to survive over a long period of time. (p. 857).

Times interest earned Measures a company's ability to meet interest payments as they come due; computed by dividing income before interest expense and income taxes by interest expense. (p. 858).

Trading on the equity Borrowing money at a lower rate of interest than can be earned by using the borrowed money. (p. 855).

Vertical analysis A technique for evaluating financial statement data that expresses each item within a financial statement as a percentage of a base amount. (p. 846).

Self-Test, Brief Exercises, Exercises, Problem Set A, and many more components are available for practice in WileyPLUS.