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, shareholders look at the profitability and solvency of the company. They want to assess the likelihood of dividends and the growth potential of their investment.

Need for Comparative Analysis

Every item reported in a financial statement has significance. When Marks and Spencer plc (M&S) (GBR) reports cash and cash equivalents of £422.9 million on its statement of financial position, we know the company had that amount of cash on the report 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 M&S's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. Likewise, a comparison of M&S'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 M&S's financial data with the averages for its industry compiled by financial rating organizations such as the U.S. companies 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 M&S's total sales for the year with the total sales of its competitors in retail, such as Carrefour (FRA).

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 14-1 shows recent net sales figures of Dubois Company.

Illustration 14-1 Dubois Company's net sales

If we assume that 2012 is the base year, we can measure all percentage increases or decreases from this base period amount as follows.

Illustration 14-2 Formula for horizontal analysis of changes since base period

For example, we can determine that net sales for Dubois increased from 2012 to 2013 approximately 6% [(€19,903 − €18,781) ÷ €18,781]. Similarly, we can determine that net sales increased from 2012 to 2014 approximately 5.7% [(€19,860 − €18,781) ÷ €18,781].

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 14-3 Formula for horizontal analysis of current year in relation to base year

Illustration 14-4 presents this analysis for Dubois for a three-year period using 2012 as the base period.

Illustration 14-4 Horizontal analysis of Dubois Company's net sales in relation to base period

Statement of Financial Position

To further illustrate horizontal analysis, we will use the financial statements of Quality Department Store, a fictional retailer. Illustration 14-5 presents a horizontal analysis of its two-year condensed statements of financial position, showing euro and percentage changes.

Illustration 14-5 Horizontal analysis of statements of financial position

The comparative statements of financial position in Illustration 14-5 show that a number of significant changes have occurred in Quality Department Store's financial structure from 2013 to 2014:

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

These changes suggest that the company expanded its asset base during 2014 and financed this expansion primarily by retaining income rather than assuming additional long-term debt.

Income Statement

Illustration 14-6 presents a horizontal analysis of the two-year condensed income statements of Quality Department Store for the years 2014 and 2013. 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 14-6 Horizontal analysis of income statements

Retained Earnings Statement

Illustration 14-7 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 share capital—ordinary increased only €1,200, or 2%. We saw in the horizontal analysis of the statement of financial position 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 14-7 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.

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 statement of financial position, 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.

Statement of Financial Position

Illustration 14-8 presents the vertical analysis of Quality Department Store's comparative statements of financial position. The base for the asset items is total assets. The base for the equity and liability items is total equity and liabilities.

Vertical analysis shows the relative size of each category in the statement of financial position. It also can show the percentage change in the individual asset, liability, and equity items. For example, we can see that current assets decreased from 59.2% of total assets in 2013 to 55.6% in 2014 (even though the absolute euro 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 equity and liabilities. 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.

Income Statement

Illustration 14-9 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 14-8 Vertical analysis of statements of financial position

Illustration 14-9 Vertical analysis of income statements

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 Park Street store in a nearby town. Using vertical analysis, we can compare the condensed income statements of Quality Department Store (a small retail company) with Park Street (a giant international retailer), as shown in Illustration 14-10 (page 694).

Illustration 14-10 Intercompany income statement comparison

Park Street's net sales are 8,372 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 Park Street's gross profit rates were comparable at 38.9% and 39.4%. However, the percentages related to income from operations were significantly different at 21.9% and 3.8%. This disparity can be attributed to Quality's selling and administrative expense percentage (17%), which is much lower than Park Street's (35.6%). Although Park Street earned net income more than 951 times larger than Quality's, Park Street's net income as a percentage of each sales euro (1.4%) is only 11% 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, Marks and Spencer plc (M&S), had current assets of £1,641.7 million and current liabilities of £2,210.2 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 14-11 describes these 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 Park Street as Quality Department Store's principal competitor.

Illustration 14-11 Financial ratio classifications

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 14-12 shows the 2014 and 2013 current ratios for Quality Department Store and comparative data.

Illustration 14-12 Current ratio

What does the ratio actually mean? The 2014 ratio of 2.96:1 means that for every euro 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. Park Street has a current ratio of 2.05:1, 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 euro of cash would be more readily available to pay the bills than a euro 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 receivables 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 2014 and 2013 consist of the items shown in Illustration 14-13.

Illustration 14-13 Current assets of Quality Department Store

Cash, short-term investments, and receivables (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 2014 and 2013 acid-test ratios for Quality Department Store and comparative data are as follows.

Illustration 14-14 Acid-test ratio

The ratio has declined in 2014. 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 Park Street's of 1.05:1, 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 receivables? The ratio used to assess the liquidity of the receivables is the accounts receivable turnover. It measures the number of times, on average, the company collects receivables during the period. We compute the 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.¹

Assume that all sales are credit sales. The balance of net accounts receivable at the beginning of 2013 is €200,000. Illustration 14-15 (page 698) shows the accounts receivable turnover for Quality Department Store and comparative data. Quality's accounts receivable turnover improved in 2014. The turnover of 10.2 times is substantially lower than Park Street's 37.2 times, and is also lower than the department store industry's average of 46.4 times.

Illustration 14-15 Accounts receivable turnover

AVERAGE COLLECTION PERIOD A popular variant of the accounts receivable turnover ratio is to convert it to an average collection period in terms of days. To do so, we divide the accounts receivable turnover ratio 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 receivables 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 2013 was €450,000, its inventory turnover and comparative data are as shown in Illustration 14-16. Quality's inventory turnover declined slightly in 2014. The turnover of 2.3 times is low compared with the industry average of 4.3 and Park Street's 3.1. 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 14-16 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 2014 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 Park Street's 117.7 days (365 ÷ 3.1).

Inventory turnover ratios 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 euro of sales that results in net income. We can compute it by dividing net income by net sales. Illustration 14-17 shows Quality Department Store's profit margin and comparative data.

Illustration 14-17 Profit margin

Quality experienced an increase in its profit margin from 2013 to 2014. Its profit margin is unusually high in comparison with the industry average of 8% and Park Street's 1.4%.

High-volume (high inventory turnover) businesses, such as grocery stores and discount stores, generally experience low profit margins. In contrast, low-volume businesses, such as jewelry stores or airplane manufacturers, 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 assets. The resulting number shows the euros of sales produced by each euro 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 2013 were €1,446,000, the 2014 and 2013 asset turnover for Quality Department Store and comparative data are shown in Illustration 14-18 (page 700).

Illustration 14-18 Asset turnover

Asset turnover shows that in 2014 Quality generated sales of approximately €1.20 for each euro it had invested in assets. The ratio changed very little from 2013 to 2014. Quality's asset turnover is below both the industry average of 1.4 times and Park Street's ratio of 1.4 times.

Asset turnover ratios vary considerably among industries. For example, a large utility company might have a ratio of 0.4 times, and a large grocery chain might have 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 assets. The 2014 and 2013 return on assets for Quality Department Store and comparative data are shown below.

Illustration 14-19 Return on assets

Quality's return on assets improved from 2013 to 2014. Its return of 15.4% is very high compared with the department store industry average of 8.9% and Park Street's 2.4%.

8. RETURN ON ORDINARY SHAREHOLDERS' EQUITY

Another widely used profitability ratio is return on ordinary shareholders' equity. It measures profitability from the ordinary shareholders' viewpoint. This ratio shows how many euros of net income the company earned for each euro invested by the owners. We compute it by dividing net income available to ordinary shareholders by average ordinary shareholders' equity. When a company has preference shares, we must deduct preference dividend requirements from net income to compute income available to ordinary shareholders. Similarly, we deduct the par value of preference shares (or call price, if applicable) from total equity to determine the amount of ordinary shareholders' equity used in this ratio. Assuming that ordinary shareholders' equity at the beginning of 2013 was €667,000, Illustration 14-20 shows the 2014 and 2013 ratios for Quality Department Store and comparative data.

Illustration 14-20 Return on ordinary shareholders' equity

Quality's rate of return on ordinary shareholders' equity is high at 29.3%, considering an industry average of 18.3% and a rate of 6.4% for Park Street.

Note also that Quality's rate of return on ordinary shareholders' 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 non-owners 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 shareholders 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 ordinary share. It is computed by dividing net income available to ordinary shareholders by the number of weighted-average ordinary 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 2013 and that the 2014 increase occurred midyear, Illustration 14-21 shows the net income per share for Quality Department Store for 2014 and 2013.

Illustration 14-21 Earnings per share

Note that no industry or Park Street data are presented. Such comparisons are not meaningful because of the wide variations in the number of shares outstanding among companies. The only meaningful EPS comparison is an intracompany trend comparison: Quality's earnings per share increased 20 cents per share in 2014. This represents a 26% increase over the 2013 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. Therefore, in computing EPS, if there are preference dividends declared for the period, we must deduct them from net income to determine income available to the ordinary shareholders.

10. PRICE-EARNINGS RATIO

The price-earnings (P-E) ratio is an oft-quoted measure of the ratio of the market price of each ordinary share 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 by earnings per share. Assuming that the market price of Quality Department Store shares is €8 in 2013 and €12 in 2014, the price-earnings ratio computation is as follows.

Illustration 14-22 Price-earnings ratio

In 2014, each Quality Department Store share 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, and also lower than the ratio of 17.2 times for Park Street.

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 2014 and 2013 payout ratios for Quality Department Store are computed as shown in Illustration 14-23.

Illustration 14-23 Payout ratio

Quality's payout ratio is higher than the industry average payout ratio of 16.1%. Park Street's ratio is very high because its net income in 2014 was quite low.

Solvency Ratios

Solvency ratios measure the ability of a company to survive over a long period of time. Long-term creditors and shareholders 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 total assets and times interest earned are two ratios that provide information about debt-paying ability.

12. DEBT TO TOTAL ASSETS RATIO

The debt to total assets ratio measures the percentage of the total assets that creditors provide. We compute it by dividing total debt (both current and non-current liabilities) by total 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 total assets, the greater the risk that the company may be unable to meet its maturing obligations. The 2014 and 2013 ratios for Quality Department Store and comparative data are as follows.

Illustration 14-24 Debt to total 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 62.0% ratio of Park Street. 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 total 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 total 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 14-25 (page 704) shows the 2014 and 2013 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 2014 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.

Illustration 14-25 Times interest earned

Quality's interest expense is well covered at 13 times, compared with the industry average of 16.1 times and Park Street's 2.9 times.

Summary of Ratios

Illustration 14-26 summarizes the ratios discussed in this chapter. The summary includes the formula and purpose or use of each ratio.

Illustration 14-26 Summary of liquidity, profitability, and solvency ratios

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, an “irregular” item is separately identified on the income statement as discontinued operations.

Discontinued operations are reported net of income taxes. That is, the income statement first reports income tax on the income before discontinued operations. Then, the amount of tax for discontinued operations 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. (USA) sold its missile business to Hughes Aircraft Co. (USA) 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 14-27 shows Acro's income statement presentation.

Illustration 14-27 Statement presentation of discontinued operations

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.

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 equity.

Companies do not include in income any unrealized gains and losses on non-trading securities. Instead, they report such gains and losses in the statement of financial position as adjustments to equity. Why are these gains and losses on non-trading 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. Similarly, in Chapter 9 you learned that companies that employ revaluation accounting do not include the revaluation surplus in income. It also is an adjustment to equity.

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 equity during a period except those resulting from investments by shareholders and distributions to shareholders.

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 IFRS may hamper comparability and reduce quality of earnings. For example, one company may use the average-cost method of inventory costing, while another company in the same industry may use FIFO. If inventory is a significant asset to both companies, it is unlikely that their current ratios are comparable.

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 shares are publicly traded are required to present their income statement following IFRS. Some companies also report a second measure of income, called pro forma income. Pro forma income usually excludes items that the company thinks are unusual or non-recurring.

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.

Accounting regulators have 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

Because some managers have felt pressure from some analysts to continually increase earnings, they 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 (USA) 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 (USA). 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 (USA) 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.

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. (3) Intercompany, 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 was presented in Illustration 14-26 (pages 704–705).

6 Understand the concept of earning power, and how discontinued operations are presented. Earning power refers to a company's ability to sustain its profits from operations. Discontinued operations 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. 697).

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 receivables by current liabilities. (p. 696).

Asset turnover A measure of how efficiently a company uses its assets to generate sales; computed by dividing net sales by average assets. (p. 699).

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. 708).

Comprehensive income Includes all changes in equity during a period except those resulting from investments by shareholders and distributions to shareholders. (p. 709).

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. 696).

Debt to total assets ratio Measures the percentage of total assets provided by creditors; computed by dividing total debt by total assets. (p. 703).

Discontinued operations The disposal of a significant component of a business. (p. 707).

Earnings per share (EPS) The net income earned on each ordinary share; computed by dividing net income minus preference dividends (if any) by the number of weighted-average ordinary shares outstanding. (p. 701).

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. 689).

Inventory turnover A measure of the liquidity of inventory; computed by dividing cost of goods sold by average inventory. (p. 698).

Leveraging See Trading on the equity. (p. 701).

Liquidity ratios Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. (p. 695).

Payout ratio Measures the percentage of earnings distributed in the form of cash dividends; computed by dividing cash dividends by net income. (p. 702).

Price-earnings (P-E) ratio Measures the ratio of the market price of each ordinary share to the earnings per share; computed by dividing the market price per share by earnings per share. (p. 702).

Profitability ratios Measures of the income or operating success of a company for a given period of time. (p. 699).

Profit margin Measures the percentage of each currency unit of sales that results in net income; computed by dividing net income by net sales. (p. 699).

Pro forma income A measure of income that usually excludes items that a company thinks are unusual or non-recurring. (p. 710).

Quality of earnings Indicates the level of full and transparent information provided to users of the financial statements. (p. 709).

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. 694).

Ratio analysis A technique for evaluating financial statements that expresses the relationship between selected financial statement data. (p. 694).

Return on assets An overall measure of profitability; computed by dividing net income by average assets. (p. 700).

Return on ordinary shareholders' equity Measures the currency units of net income earned for each currency unit invested by the owners; computed by dividing net income minus preference dividends (if any) by average ordinary shareholders' equity. (p. 700).

Solvency ratios Measures of the ability of the company to survive over a long period of time. (p. 703).

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. 703).

Trading on the equity Borrowing money at a lower rate of interest than can be earned by using the borrowed money. (p. 701).

Vertical analysis A technique for evaluating financial statement data that expresses each item within a financial statement as a percent of a base amount. (p. 692).