Kế toán, kiểm toán - Financial analysis: The big picture

Financial Analysis: The Big PictureKimmel ● Weygandt ● KiesoFinancial Accounting, Eighth Edition13CHAPTER OUTLINEApply the concepts of sustainable income and quality of earnings.1Apply horizontal analysis and verticalanalysis.2LEARNING OBJECTIVESAnalyze a company’s performance using ratio analysis.3The most likely level of income to be obtained by a company in the future.Unusual ItemsSeparately identified on the income statement.Discontinued operations. Other comprehensive income.These “irregular” items are reported net of income tax.LO 1LEARNING OBJECTIVEApply the concepts of sustainable income and quality of earnings.1SUSTAINABLE INCOMESUSTAINABLE INCOMEILLUSTRATION 13-1Statement of comprehensiveincomeLO 1Discontinued OperationsDisposal of a significant component of a business.Income statement should report a gain (or loss) from discontinued operations, net of tax.SUSTAINABLE INCOMELO 1Illustration: Assume that during 2017 Acro Energy Inc. has income before income taxes of $800,000. During 2017, Acro discontinued and sold its unprofitable chemical division. The loss in 2017 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. Prepare Acro’s statement of comprehensive income for the year ended December 31, 2017.Discontinued OperationsLO 1Discontinued OperationsILLUSTRATION 13-2Statement presentation of discontinued operationsLO 1INVESTOR INSIGHTWhat Does “Non-Recurring” Really MeanMany companies incur restructuring charges as they attempt to reduce costs. They often label these items in the income statement as “non-recurring” charges, to suggest that they are isolated events, unlikely to occur in future periods. The question for analysts is, are these costs really one-time, “nonrecurring events” or do they reflect problems that the company will be facing for many periods in the future? If they are one-time events, then they can be largely ignored when trying to predict future earnings. But, some companies report “one-time” restructuring charges over and over again. For example, Procter & Gamble reported a restructuring charge in 12 consecutive quarters, and Motorola had “special” charges in 14 consecutive quarters. On the other hand, other companies have a restructuring charge only once in a 5- or 10-year period. There appears to be no substitute for careful analysis of the numbers that comprise net income.LO 1All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders.Certain gains and losses bypass net income and instead are reported as direct adjustments to stockholders’ equity.Example – Unrealized gain or loss on Available-for-sale securities.Comprehensive IncomeSUSTAINABLE INCOMELO 1ILLUSTRATION OF COMPREHENSIVE INCOMEAccounting standards require companies to adjust most investments in stocks and bonds up or down to their market value at the end of each accounting period. Illustration: During 2017 Stassi Company purchased IBM stock for $10,000 as an investment. At the end of 2017 Stassi was still holding the investment, but the stock’s market value was now $8,000. How should Stassi account for the $2,000 unrealized loss?Comprehensive IncomeLO 1How should Stassi account for the $2,000 unrealized loss?Answer: Depends on whether Stassi classifies the IBM stock as a Trading security or an Available for-sale security. Unrealized gains and losses (Income Statement)Unrealized gains and losses (Comprehensive Income - Stockholders’ Equity)ILLUSTRATION OF COMPREHENSIVE INCOMEComprehensive IncomeLO 1Format OneCombined statement of income and comprehensive income.Illustration 13-5Comprehensive IncomeILLUSTRATION 13-3Lower portion of combined statement of income and comprehensive incomeLO 1Format TwoComprehensive IncomeSeparate component of Stockholders’ Equity.ILLUSTRATION 13-4Unrealized loss in stockholders’ equity sectionLO 1ILLUSTRATION 13-5Complete statement ofcomprehensive incomePrinciple used in the current year is different from one used in the preceding year. Example - change from FIFO to average cost. Permissible when management can show new principle is preferable.Most changes are reported retroactively.Changes in Accounting PrincipleSUSTAINABLE INCOMELO 1INVESTOR INSIGHTMore Frequent Ups and DownsIn the past, U.S. companies used a method to account for their pension plans that smoothed out the gains and losses on their pension portfolios by spreading gains and losses over multiple years. Many felt that this approach was beneficial because it reduced the volatility of reported net income. However, recently some companies have opted to adopt a method that comes closer to recognizing gains and losses in the period in which they occur. Some of the companies that have adopted this approach are United Parcel Service (UPS), Honeywell International, IBM, AT&T, and Verizon Communications. The CFO at UPS said he favored the new approach because “events that occurred in prior years will no longer distort current-year results. It will result in better transparency by eliminating the noise of past plan performance.” When UPS switched, it resulted in a charge of $827 million from the change in accounting principle.Source: Bob Sechler and Doug Cameron, “UPS Alters Pension-Plan Accounting,” Wall Street Journal (January 30, 2012).United Parcel Service (UPS)LO 1A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements.Recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business.QUALITY OF EARNINGSLO 1Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings (FIFO vs. LIFO).Usually excludes items that are unusual or nonrecurring.Some companies have abused the flexibility that pro forma numbers allow to put their companies in a more favorable light.Alternative Accounting MethodsPro Forma IncomeQUALITY OF EARNINGSLO 1Some managers have felt pressure to continually increase earnings.Abuses include: Improper recognition of revenue (channel stuffing).Improper capitalization of operating expenses (WorldCom).Failure to report all liabilities (Enron).Improper RecognitionQUALITY OF EARNINGSLO 1In its proposed 2017 income statement, AIR Corporation reports income before income taxes $400,000, unrealized gain on available-for-sale securities $100,000, income taxes $120,000 (not including unusual items), loss from 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 statement of comprehensive income, beginning with “Income before income taxes.”Unusual ItemsDO IT!1LO 1Unusual ItemsDO IT!1LO 1Analyzing financial statements involves:Comparison BasesBasic ToolsIntracompanyIntercompany Industry averages Horizontal analysisVertical analysisRatio AnalysisLO 2LEARNING OBJECTIVEApply horizontal analysis and vertical analysis. 2Also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Purpose is to determine increase or decrease that has taken place.Commonly applied to the balance sheet and income statement.HORIZONTAL ANALYSISLO 2ILLUSTRATION 13-9Horizontal analysis of balance sheetsILLUSTRATION 13-10Horizontal analysis of income statementsLO 2Also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount. Vertical analysis is commonly applied to the balance sheet and the income statement.VERTICAL ANALYSISLO 2ILLUSTRATION 13-11Vertical analysis of balance sheetsILLUSTRATION 13-12Vertical analysis of income statementsLO 2ILLUSTRATION 13-13Intercompany comparison by vertical analysisLO 2Total take: Thousands of dollarsANATOMY OF A FRAUDThis final Anatomy of a Fraud box demonstrates that sometimes relationships between numbers can be used to detect fraud. Financial ratios that appear abnormal or statistical abnormalities in the numbers themselves can reveal fraud. For example, the fact that WorldCom’s line costs, as a percentage of either total expenses or revenues, differed very significantly from its competitors should have alerted people to the possibility of fraud. Or, consider the case of a bank manager, who cooperated with a group of his friends to defraud the bank’s credit card department. The manager’s friends would apply for credit cards and then run up balances of slightly less than $5,000. The bank had a policy of allowing bank personnel to write-off balances of less than $5,000 without seeking supervisor approval. The fraud was detected by applying statistical analysis based on Benford’s Law. Benford’s Law states that in a random collection of numbers, the frequency of lower digits (e.g., 1, 2, or 3) should be much higher than higher digits (e.g., 7, 8, or 9). In this case, bank auditors analyzed the first two digits of amounts written off. There was a spike at 48 and 49, which was not consistent with what would be expected if the numbers were random.LO 2(continued)The Missing ControlIndependent internal verification. While it might be efficient to allow employees to write off accounts below a certain level, it is important that these write-offs be reviewed and verified periodically. Such a review would likely call attention to an employee with large amounts of write-offs, or in this case, write-offs that were frequently very close to the approval threshold.Source: Mark J. Nigrini, “I’ve Got Your Number,” Journal of Accountancy Online (May 1999).Total take: Thousands of dollarsANATOMY OF A FRAUDLO 2Summary financial information for Rosepatch Company is as follows.Compute the amount and percentage changes in 2017 using horizontal analysis, assuming 2016 is the base year.Horizontal AnalysisDO IT!2LO 2Reflects investors’ assessment of a company’s future earnings.Will be higher if investors think that earnings will increase substantially in the future. Will be lower when there is the belief that a company has poor-quality earnings.PRICE-EARNINGS RATIOLO 3LEARNING OBJECTIVEAnalyze a company’s performance using ratio analysis.3ILLUSTRATION 13-14Formula for price-earnings (P-E) ratioILLUSTRATION 13-14Formula for price-earnings (P-E) ratioILLUSTRATION 13-15Earnings per share and P-E ratios of various companiesPRICE-EARNINGS RATIOLO 3LIQUIDITY RATIOSILLUSTRATION 13-16Summary of liquidity ratiosLO 3INVESTOR INSIGHTHow to Manage the Current RatioThe apparent simplicity of the current ratio can have real-world limitations because adding equal amounts to both the numerator and the denominator causes the ratio to decrease. Assume, for example, that a company has $2,000,000 of current assets and $1,000,000 of current liabilities. Its current ratio is 2:1. If it purchases $1,000,000 of inventory on account, it will have $3,000,000 of current assets and $2,000,000 of current liabilities. Its current ratio decreases to 1.5:1. If, instead, the company pays off $500,000 of its current liabilities, it will have $1,500,000 of current assets and $500,000 of current liabilities. Its current ratio increases to 3:1. Thus, any trend analysis should be done with care because the ratio is susceptible to quick changes and is easily influenced by management.LO 3SOLVENCY RATIOSILLUSTRATION 13-17Summary of solvency ratiosLO 3PROFITABILITY RATIOSILLUSTRATION 13-18Summary of profitability ratiosLO 3LO 3INVESTOR INSIGHTHigh Ratings Can Bring Low ReturnsMoody’s, Standard & Poor’s, and Fitch are three big firms that perform financial analysis on publicly traded companies and then publish ratings of the companies’ creditworthiness. Investors and lenders rely heavily on these ratings in making investment and lending decisions. Some people feel that the collapse of the financial markets was worsened by inadequate research reports and ratings provided by the financial rating agencies. Critics contend that the rating agencies were reluctant to give large companies low ratings because they feared that by offending them they would lose out on business opportunities. For example, the rating agencies gave many so-called mortgage-backed securities ratings that suggested that they were low risk. Later, many of these very securities became completely worthless. Steps have been taken to reduce the conflicts of interest that lead to these faulty ratings. Source: Aaron Lucchetti and Judith Burns, “Moody’s CEO Warned Profit Push Posed a Risk to Quality of Ratings,” Wall Street Journal Online (October 23, 2008).Analyzing financial statements involves:CharacteristicsComparison BasesLiquidityProfitabilitySolvencyIntracompany Industry averages Intercompany The financial information in Illustrations 13A-1 through 13A-4 will be used to calculate Chicago’s 2014 ratios.LEARNING OBJECTIVEAPPENDIX 13A: Evaluate a company comprehensively using ratio analysis.4LO 4ILLUSTRATION 13A-1Chicago Cereal Company’s balance sheetsLO 4ILLUSTRATION 13A-2Chicago Cereal Company’s income statementsLO 4LO 4ILLUSTRATION 13A-3Chicago Cereal Company’sstatements of cash flowsProfitabilityMeasures the income or operating success of a company for a given period of time.SolvencyMeasures the ability of the company to survive over a long period of time.Ratio analysis expresses the relationship among selected items of financial statement data.LiquidityMeasures short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.Financial Ratio ClassificationsRATIO ANALYSISLO 4Measure 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. Ratios include the current ratio, the current cash debt coverage, the accounts receivables turnover, the average collection period, the inventory turnover, and days in inventory.LIQUIDITY RATIOSLO 4Expresses the relationship of current assets to current liabilities. What do the measures tell us? A current ratio of .67 means that for every dollar of current liabilities, the company has $0.67 of current assets.Current RatioILLUSTRATION 13A-5Current ratioLO 4Measures the number of times, on average, a company collects receivables during the period. How does Chicago’s turnover compare to General Mills’s? The turnover of 11.9 times is higher than the industry average of 11.2 times, and slightly lower than General Mills’ turnover of 12.2 times.Accounts Receivable TurnoverILLUSTRATION 13A-6Accounts receivable turnoverLO 4Converts the receivable turnover ratio into days. How effective is Chicago’s credit and collection policies? General rule - collection period should not greatly exceed the credit term period (i.e., the time allowed for payment).Average Collection PeriodILLUSTRATION 13A-7Average collection periodLO 4Measures the number of times average inventory was sold during the period. The ratio of 7.5 times is higher than the industry average of 6.7 times and similar to that of General Mills.How does Chicago’s turnover compare to General Mills’s? ILLUSTRATION 13A-8Inventory turnoverInventory TurnoverLO 4Measures the average number of days inventory is held. An average selling time of 49 days is faster than the industry average and faster than that of General Mills.How does Chicago’s days compare to General Mills’s? Days in InventoryILLUSTRATION 13A-9Days in inventoryLO 4Measure the ability of a company to survive over a long period of time.Debt-Paying AbilityDebt to total assets ratioTimes interest earnedFree cash flowSOLVENCY RATIOSLO 4Indicates the degree of financial leveraging. Provides some indication of the company’s ability to withstand losses. Yes. The ratio of 78% says that Chicago would have to liquidate 78% of its assets at their book value in order to pay off all of its debts.Has Chicago’s solvency improved during the year? Debt to Assets RatioILLUSTRATION 13A-10Debt to assets ratioLO 4Also called interest coverage, indicates the company’s ability to meet interest payments as they come due. Yes, the ratio indicates that income before interest and taxes was 5.8 times the amount needed for interest expense.Is Chicago able to service its’ debt? Times Interest EarnedILLUSTRATION 13A-11Times interest earnedLO 4Ability to pay dividends or expand operations.Cash provided by operations was more than enough to allow Chicago to acquire additional productive assets and maintain dividend payments.Free Cash FlowILLUSTRATION 13A-12Free cash flowLO 4Measure the income or operating success of a company for a given period of time. ILLUSTRATION 13A-13Relationships amongprofitability measuresPROFITABILITY RATIOSLO 4Shows how many dollars of net income the company earned for each dollar invested by the owners. Chicago’s 2014 rate of return on common stockholders’ equity is unusually high at 48%, considering an industry average of 19% and General Mills’s return of 25%.Return on Common Stockholders’ EquityILLUSTRATION 13A-14Return on commonstockholders’ equityLO 4Measures the overall profitability of assets in terms of the income earned on each dollar invested in assets. Note that Chicago’s rate of return on common stockholders’ equity (48%) is substantially higher than its rate of return on assets (10%). Chicago has made effective use of leverage.Return on AssetsILLUSTRATION 13A-15Return on assetsLO 4Or rate of return on sales, is a measure of the percentage of each dollar of sales that results in net income. High-volume (high inventory turnover) businesses such as grocery stores and pharmacy chains generally have low profit margins.Profit MarginILLUSTRATION 13A-16Profit marginLO 4Measures how efficiently a company uses its assets to generate sales. The average asset turnover for utility companies is .45, for example, while the grocery store industry has an average asset turnover of 3.49.Asset TurnoverILLUSTRATION 13A-17Asset turnoverLO 4You can analyze the combined effects of profit margin and asset turnover on return on assets for Chicago as shown.Return on AssetsILLUSTRATION 13A-18Composition of return on assetsLO 4Indicates a company’s ability to maintain an adequate selling price above its cost of goods sold. As an industry becomes more competitive, this ratio declines.Gross Profit RateILLUSTRATION 13A-19Gross profit rateLO 4A measure of the net income earned on each share of common stock. Earnings Per Share (EPS)ILLUSTRATION 13A-20Earnings per shareLO 4Reflects investors’ assessments of a company’s future earnings. A lower P-E ratio suggests that the market is less optimistic about Chicago cereal than about General Mills. It might also signal that its stock is underpriced.Price-Earnings (P-E) RatioILLUSTRATION 13A-21Price-earnings ratioLO 4Measures the percentage of earnings distributed in the form of cash dividends. This ratio should be calculated over a longer period of time to evaluate any trends.Payout RatioILLUSTRATION 13A-22Payout ratioLO 4RELEVANT FACTSA Look at IFRSLEARNING OBJECTIVECompare financial statement analysis and income statement presentation under GAAP and IFRS.5The tools of financial statement analysis covered in this chapter are universal and therefore no significant differences exist in the analysis methods used.The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS.Both GAAP and IFRS follow the same approach in reporting comprehensive income.LO 5RELEVANT FACTSThe basic objectives of the income statement are the same under both GAAP and IFRS. A very important objective is to ensure that users of the income statement can evaluate the sustainable income of the company. Thus, both the IASB and the FASB are interested in distinguishing normal levels of income from unusual items in order to better predict a company’s future profitability.The basic accounting for discontinued operations is the same under IFRS and GAAP.A Look at IFRSLO 5 A Look at IFRSLOOKING TO THE FUTUREThe FASB and the IASB are working on a project that would rework the structure of financial statements. Recently, the IASB decided to require a statement of comprehensive income, similar to what was required under GAAP. In addition, another part of this project addresses the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, the approach draws attention away from one number—net income.LO 5IFRS PracticeThe basic tools of financial analysis are the same under both GAAP and IFRS except that:horizontal analysis cannot be done because the format of the statements is sometimes different.analysis is different because vertical analysis cannot be done under IFRS.the current ratio cannot be computed because current liabilities are often reported before current assets in IFRS statements of position.None of the above.A Look at IFRSLO 5IFRS PracticePresentation of comprehensive income must be reported under IFRS in:the statement of stockholders’ equity.the income statement ending with net income.the notes to the financial statements.a statement of comprehensive income.A Look at IFRSLO 5IFRS PracticeIn preparing its income statement for 2017, Parmalane assembles the following information.Sales revenue $500,000Cost of goods sold 300,000Operating expenses 40,000Loss on discontinued operations 20,000Ignoring income taxes, what is Parmalane’s income from continuing operations for 2017 under IFRS?$260,000. c) $240,000.$250,000. d) $160,000.A Look at IFRSLO 5“Copyright © 2016 John Wiley & Sons, Inc. 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