Managerial Accounting ch14

14-1
Chapter 14
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.
14-2
Preview of Chapter 14
Managerial Accounting
Sixth Edition
Weygandt Kimmel Kieso
14-3
Basics of Financial Statement Analysis

Analyzing financial statements involves:
Comparison
Bases
Characteristics
Liquidity
Intracompany
Horizontal
Profitability
Vertical
Solvency
Industry
averages
Ratio
14-4
Tools of
Analysis
LO 1
LO 2
Intercompany
Discuss the need for comparative analysis.

Identify the tools of financial statement analysis.
Horizontal Analysis
Horizontal analysis, also called trend analysis:
14-5
Technique for evaluating a series of financial statement

data over a period of time.
Purpose is to determine the increase or decrease that has

taken place.
Commonly applied to the balance sheet, income statement,

and statement of retained earnings.
LO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Balance Sheet
These changes
suggest that the
company expanded its
asset base during
2009 and financed
this expansion
primarily by retaining
income rather than
assuming additional
long-term debt.
Illustration 14-5
Horizontal analysis of
balance sheets
14-6
LO 3
Horizontal Analysis
Income
Statement
Overall, gross profit
and net income were
up substantially. Gross
profit increased
17.1%, and net
income, 26.5%.
Qualitys profit trend
appears favorable.
Illustration 14-6
Income statements
14-7
LO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Retained Earnings Statement
Illustration 14-7
retained earnings statements
Ending retained earnings increased 38.6%. As indicated earlier, the company

retained a significant portion of net income to finance additional plant
facilities.
14-8
LO 3
Financial information for Rosepatch Company is as follows.
Compute the amount and percentage changes in 2014 using

horizontal analysis, assuming 2013 is the base year.
14-9
LO 3
Vertical Analysis
Vertical analysis, also called common-size analysis:
14-10
Technique that expresses each financial statement item as

a percent of a base amount.
On an income statement, we might say that selling

expenses are 16% of net sales.
Commonly applied to the balance sheet and the income

statement.
LO 4 Describe and apply vertical analysis.
Vertical Analysis
Balance
Sheet
These results
reinforce the earlier
observations that
Quality is
choosing to
finance its growth
through retention
of earnings rather
than through
issuing additional
debt.
Illustration 14-8
14-11
LO 4
Vertical Analysis
Income
Statement
Quality appears
to be a profitable
enterprise that is
becoming even
more successful.
Illustration 14-9
14-12
LO 4
Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 14-10
14-13
LO 4
Ratio Analysis
Ratio analysis expresses the relationship among selected
items of financial statement data.
Financial Ratio Classifications
14-14
Liquidity
Profitability
Solvency
Measures shortterm ability of the

company to pay its
maturing obligations
and to meet
unexpected needs
for cash.
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.
LO 5 Identify and compute ratios used in analyzing a

firms liquidity, profitability, and solvency.
Ratio Analysis
A single ratio by itself is not very meaningful.
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 J.C. Penney Company
as Quality Department Stores principal competitor.
14-15

Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for cash.
14-16
Short-term creditors such as bankers and suppliers are

particularly interested in assessing liquidity.
Ratios include the current ratio, the acid-test ratio,

receivables turnover, and inventory turnover.

Ratio Analysis
Liquidity Ratios
1. Current Ratio
Illustration 14-12
The ratio of 2.96:1 means that for every dollar of current liabilities,
Quality has $2.96 of current assets.
14-17
LO 5
Ratio Analysis
Liquidity Ratios
2. Acid-Test Ratio
Illustration 14-13
14-18
LO 5
Ratio Analysis
Liquidity Ratios
2. Acid-Test Ratio
Illustration 14-14
Measures immediate short-term liquidity.
14-19

14-20
Ratio Analysis
Liquidity Ratios
3. Receivables Turnover
Illustration 14-15
Number of times, on average, the company collects receivables.

14-21
LO 5
Ratio Analysis
Liquidity Ratios
$2,097,000
Receivables Turnover
= 10.2 times
($180,000 + $230,000) 2
A variant of the receivables turnover ratio is to convert it to an
average collection period in terms of days.
365 days 10.2 times = every 35.78 days

This means that receivables are collected on average every 36
days.
14-22

Ratio Analysis
Liquidity Ratios
4. Inventory Turnover
Illustration 14-16
Number of times, on average, the inventory is sold.

14-23
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.
365 days 2.3 times = every 159 days

Inventory turnover ratios vary considerably among industries.
14-24

Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for a
given period of time.
14-25
Income, or the lack of it, affects the companys ability to obtain

debt and equity financing, liquidity position, and the ability to
grow.
Ratios include the profit margin, asset turnover, return on

assets, return on common stockholders equity, earnings
per share, price-earnings, and payout ratio.
Ratio Analysis
5. Profit Margin
Illustration 14-17
Measures net income generated by each dollar of sales.

14-26
LO 5
Ratio Analysis
6. Asset Turnover
Illustration 14-18
Measures how efficiently assets are used to generate sales.

14-27
LO 5
Ratio Analysis
7. Return on Assets
Illustration 14-19
An overall measure of profitability.

14-28
LO 5
Ratio Analysis
8. Return on Common Stockholders Equity

Illustration 14-20
Dollars of net income earned for each dollar invested by the owners.
14-29
LO 5
Ratio Analysis
9. Earnings per Share (EPS)

Illustration 14-21
Measures net income earned on each share of common stock.

14-30
LO 5
Ratio Analysis
10. Price-Earnings Ratio

Illustration 14-22
Reflects investors assessments of a companys future earnings.

14-31
LO 5
Ratio Analysis
11. Payout Ratio

Illustration 14-23
Measures the percentage of earnings distributed in the form of cash

dividends.
14-32
* From analysis of retained earnings.
LO 5
Ratio Analysis
Solvency Ratios
Solvency ratios measure the ability of a company to survive
over a long period of time.
14-33
Debt to total assets and times interest earned are two

ratios that provide information about debt-paying ability.

Ratio Analysis
Solvency Ratios
12. Debt to Total Assets Ratio

Illustration 14-24
Measures the percentage of the total assets provided by creditors.

14-34
LO 5
Ratio Analysis
Solvency Ratios
13. Times Interest Earned

Illustration 14-25
14-35
Provides an indication of the companys ability to meet interest

payments as they come due.
LO 5
Summary of Ratios
Illustration 14-26
14-36
LO 5
Summary of Ratios
Illustration 14-26
14-37
LO 5
Summary of Ratios
Illustration 14-26
14-38
LO 5
Earning Power and Irregular Items

Earning power means the normal level of income to be
obtained in the future.
Irregular items are separately identified on the income
statement. Two types are:
1. Discontinued operations.
2. Extraordinary items.
These irregular items are reported net of income taxes.
14-39
LO 6 Understand the concept of earning power,

and how irregular items are presented.

Discontinued Operations
(a) Refers to the disposal of a significant component of a
business.
(b) Report the income (loss) from discontinued operations in
two parts:
1. income (loss) from operations (net of tax) and
2. gain (loss) on disposal (net of tax).
14-40


Illustration: 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 14-27
14-41
LO 6

Discontinued
Operations are reported
after Income from
continuing operations.
Previously labeled as
Net Income.
Moved to
14-42
Income Statement (in thousands)

Sales
Cost of goods sold
Gross profit
Interest expense
Total other
Income before taxes
Income tax expense
Income from continuing operations
Discontinued operations:
Loss from operations, net of tax
Loss on disposal, net of tax
Total loss on discontinued operations
Net income
$ 285,000
149,000
136,000
(21,000)
(4,000)
79,000
24,000
55,000
315
189
504
$ 54,496
LO 6

Extraordinary items are nonrecurring material items that differ
significantly from a companys typical business activities.
Extraordinary Item must be both of an
Unusual Nature and
Occur Infrequently
Company must consider the environment in which it operates.

Amount reported net of tax.
14-43
LO 6

Are these considered Extraordinary Items?
(a) A large portion of a tobacco manufacturers
crops are destroyed by a hail storm. Severe
damage from hail storms in the locality where
the manufacturer grows tobacco is rare.
YES
(b) A citrus grower's Florida crop is damaged by

frost.
NO
(c) Loss from sale of temporary investments.
NO
(d) Loss attributable to a labor strike.
NO
14-44
LO 6

Are these considered Extraordinary Items?
(e) Loss from flood damage. (The nearby Black
River floods every 2 to 3 years.)
(f)
An earthquake destroys one of the oil

refineries owned by a large multi-national oil
company. Earthquakes are rare in this
geographical location.
NO
YES
(g) Write-down of obsolete inventory.
NO
(h) Expropriation of a factory by a foreign

government.
YES
14-45
LO 6

Illustration: 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.
Illustration 14-29
14-46
LO 6

Extraordinary Items
are reported after
Income from continuing
operations.
Previously labeled as
Net Income.

Sales
Cost of goods sold
Gross profit
$ 285,000
149,000
136,000
Other revenue (expense):

Interest revenue
Interest expense
Total other
Income before taxes
Income tax expense
Extraordinary loss, net of tax
Net income
17,000
(21,000)
(4,000)
79,000
24,000
55,000
539
$ 54,461
Moved to
14-47
LO 6

Reporting when both
Discontinued
Operations and
Extraordinary Items
are present.
Discontinued
Operations
Extraordinary Items
14-48

Sales
Cost of goods sold
Gross profit
Income before taxes
Income tax expense
Discontinued operations:
Loss from operations, net of tax
Loss on disposal, net of tax
Total loss on discontinued operations
Income before extraordinary item
Extraordinary loss, net of tax
Net income
$ 285,000
149,000
136,000
79,000
24,000
55,000
315
189
504
54,496
539
$ 54,496
LO 6
14-49

Change in Accounting Principle
14-50
Occurs when the principle used in the current year is

different from the one used in the preceding year.
Accounting rules permit a change if justified.
Changes are reported retroactively.
Example would include a change in inventory costing

method such as FIFO to average cost.

In its proposed 2014 income statement, AIR Corporation

reports income before income taxes $400,000, extraordinary
loss due to earthquake $100,000, income taxes $120,000 (not

including irregular items), loss on operation of discontinued
flower division $50,000, and loss on disposal of discontinued
flower division $90,000. The income tax rate is 30%.

Prepare a correct income statement, beginning with Income
before income taxes.
14-51

Prepare a correct income statement
14-52
LO 6
Comprehensive Income
Sales
$ 285,000
Cost of goods sold
149,000
Gross profit
136,000
Operating expenses:
Selling expenses
10,000
Administrative expenses
43,000
Total operating expense
53,000
Income from operations
83,000
Other revenue (expense):
Interest revenue
17,000
Interest expense
(21,000)
Total other
(4,000)
Income before taxes
79,000
Income tax expense
24,000
Net income
$ 55,000
14-53
Other Comprehensive
Income
Unrealized gains and

losses on available-forsale securities.
Translation gains and

losses on foreign
currency.
Plus others
Reported in Stockholders
Equity
LO 6
Comprehensive Income
Why are 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,
2. yet informs the financial statement user of the gain or loss that
would be incurred if the securities were sold at fair value.
14-54

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.
Companies have incentives to manage income to meet or beat

Wall Street expectations, so that
14-55
the market price of stock increases and
the value of stock options increase.
LO 7 Understand the concept of quality of earnings.
Quality of Earnings
Alternative Accounting Methods
Variations among companies in the application of GAAP

may hamper comparability and reduce quality of earnings.
Pro Forma Income
14-56
Pro forma income usually excludes items that the company

thinks are unusual or nonrecurring.
Some companies have abused the flexibility that pro forma

numbers allow.
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:
14-57
Improper recognition of revenue (channel stuffing).
Improper capitalization of operating expenses (WorldCom).
Failure to report all liabilities (Enron).
Match each of the following terms with the phrase that it best
matches.
a. Comprehensive income
b. Quality of earnings
c. Solvency ratio
d. Vertical analysis
e. Pro forma income
f. Extraordinary item
c Measures the ability of the company to survive over a long

1. ___
period of time.
e Usually excludes items that a company thinks are unusual
2. ___
or non-recurring.
14-58
matches.
c. Solvency ratio
e. Pro forma income
a Includes all changes in stockholders equity during a period

3. ___
except those resulting from investments by stockholders and
distributions to stockholders.
b Indicates the level of full and transparent information

4. ___
provided to users of the financial statements.
14-59
matches.
c. Solvency ratio
e. Pro forma income
f Describes events and transactions that are unusual in

5. ___
nature and infrequent in occurrence.
d Expresses each item within a financial statement as a
6. ___
percent of a base amount.
14-60
Copyright
Copyright 2012 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser

may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.
14-61

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14-1

Basics of Financial Statement Analysis

Discuss the need for comparative analysis.

Technique for evaluating a series of financial statement

Purpose is to determine the increase or decrease that has

Commonly applied to the balance sheet, income statement,

LO 3 Explain and apply horizontal analysis.

LO 3 Explain and apply horizontal analysis.

Ending retained earnings increased 38.6%. As indicated earlier, the company

Financial information for Rosepatch Company is as follows.

Compute the amount and percentage changes in 2014 using

Technique that expresses each financial statement item as

On an income statement, we might say that selling

Commonly applied to the balance sheet and the income

LO 4 Describe and apply vertical analysis.

Financial Ratio Classifications

Measures shortterm ability of the

Measures the ability

LO 5 Identify and compute ratios used in analyzing a

LO 5 Identify and compute ratios used in analyzing a

Short-term creditors such as bankers and suppliers are

Ratios include the current ratio, the acid-test ratio,

LO 5 Identify and compute ratios used in analyzing a

Measures immediate short-term liquidity.

LO 5 Identify and compute ratios used in analyzing a

Number of times, on average, the company collects receivables.

365 days 10.2 times = every 35.78 days

LO 5 Identify and compute ratios used in analyzing a

Number of times, on average, the inventory is sold.

365 days 2.3 times = every 159 days

LO 5 Identify and compute ratios used in analyzing a

Income, or the lack of it, affects the companys ability to obtain

Ratios include the profit margin, asset turnover, return on

Measures net income generated by each dollar of sales.

Measures how efficiently assets are used to generate sales.

An overall measure of profitability.

8. Return on Common Stockholders Equity

9. Earnings per Share (EPS)

Measures net income earned on each share of common stock.

10. Price-Earnings Ratio

Reflects investors assessments of a companys future earnings.

11. Payout Ratio

Measures the percentage of earnings distributed in the form of cash

* From analysis of retained earnings.

Debt to total assets and times interest earned are two

LO 5 Identify and compute ratios used in analyzing a

12. Debt to Total Assets Ratio

Measures the percentage of the total assets provided by creditors.

13. Times Interest Earned

Provides an indication of the companys ability to meet interest

Earning Power and Irregular Items

These irregular items are reported net of income taxes.

LO 6 Understand the concept of earning power,

Earning Power and Irregular Items

LO 6 Understand the concept of earning power,

Earning Power and Irregular Items

Earning Power and Irregular Items

Income Statement (in thousands)

Earning Power and Irregular Items

Unusual Nature and

Company must consider the environment in which it operates.

Earning Power and Irregular Items

(b) A citrus grower's Florida crop is damaged by