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CHAPTER 13 FINANCIAL ANALYSIS: THE BIG PICTURE

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

Understand the concept of sustainable income.
Indicate how irregular items are presented.
Explain the concept of comprehensive income.
Describe and apply horizontal analysis.
Describe and apply vertical analysis.
Identify and compute ratios used in analyzing a company's liquidity, solvency, and profitability.
Understand the concept of quality of earnings.

Feature Story

IT PAYS TO BE PATIENT

A recent issue of Forbes magazine listed Warren Buffett as the richest person in the world. His estimated wealth was $62 billion, give or take a few million. How much is $62 billion? If you invested $62 billion in an investment earning just 4%, you could spend $6.8 million per day—every day—forever.

So, how does Buffett spend his money? Basically, he doesn't! He still lives in the same house that he purchased in Omaha, Nebraska, in 1958 for $31,500. He still drives his own car (a Cadillac DTS). And, in case you were thinking that his kids are riding the road to Easy Street, think again. Buffett has committed to donate virtually all of his money to charity before he dies.

How did Buffett amass this wealth? Through careful investing. Buffett epitomizes a “value investor.” He applies the basic techniques he learned in the 1950s from the great value investor Benjamin Graham. He looks for companies that have good long-term potential but are currently underpriced. He invests in companies that have low exposure to debt and that reinvest their earnings for future growth. He does not get caught up in fads or the latest trends.

Buffett sat out on the dot-com mania in the 1990s. When other investors put lots of money into fledgling high-tech firms, Buffett didn't bite because he did not find dot-com companies that met his criteria. He didn't get to enjoy the stock price boom on the way up, but on the other hand, he didn't have to ride the price back down to Earth. When the dot-com bubble burst, everyone else was suffering from investment shock. Buffett swooped in and scooped up deals on companies that he had been following for years.

In 2012, the stock market had again reached near record highs. Buffett's returns had been significantly lagging the market. Only 26% of his investments at that time were in stock, and he was sitting on $38 billion in cash. One commentator noted that “if the past is any guide, just when Buffett seems to look most like a loser, the party is about to end.”

If you think you want to follow Buffett's example and transform your humble nest egg into a mountain of cash, be warned. His techniques have been widely circulated and emulated, but never practiced with the same degree of success. You should probably start by honing your financial analysis skills. A good way for you to begin your career as a successful investor is to master the fundamentals of financial analysis discussed in this chapter.

Source: Jason Zweig, “Buffett Is Out of Step,” Wall Street Journal (May 7, 2012).

INSIDE CHAPTER 13…

What Does “Non-Recurring” Really Mean? (p. 693)
More Frequent Ups and Downs (p. 694)
How to Manage the Current Ratio (p. 704)
High Ratings Can Bring Low Returns (p. 705)

PREVIEW OF CHAPTER 13

We can all learn an important lesson from Warren Buffett: Study companies carefully if you wish to invest. Do not get caught up in fads but instead find companies that are financially healthy. Using some of the basic decision tools presented in this book, you can perform a rudimentary analysis on any company and draw basic conclusions about its financial health. Although it would not be wise for you to bet your life savings on a company's stock relying solely on your current level of knowledge, we strongly encourage you to practice your new skills wherever possible. Only with practice will you improve your ability to interpret financial numbers.

Before we unleash you on the world of high finance, we present a few more important concepts and techniques as well as one more comprehensive review of corporate financial statements. We use all of the decision tools presented in this textbook to analyze a single company, with comparisons to a competitor and industry averages.

The content and organization of Chapter 13 are as follows.

Sustainable Income

LEARNING OBJECTIVE 1

Understand the concept of sustainable income.

Ultimately, the value of a company is a function of its future cash flows. When analysts use this year's net income to estimate future cash flows, they must make sure that this year's net income does not include irregular (i.e., out of the ordinary) revenues, expenses, gains, or losses. Net income adjusted for irregular items is referred to as sustainable income. Sustainable income is the most likely level of income to be obtained in the future. Sustainable income differs from actual net income by the amount of irregular revenues, expenses, gains, and losses included in this year's net income.

Users are interested in sustainable income because it helps them derive an estimate of future earnings without the “noise” of irregular items. For example, suppose Rye Corporation reports that this year's net income is $500,000 but included in that amount is a once-in-a-lifetime gain of $400,000. In estimating next year's net income for Rye Corporation, we would likely ignore this $400,000 gain and estimate that next year's net income will be in the neighborhood of $100,000. That is, based on this year's results, the company's sustainable income is roughly $100,000. Therefore, identifying irregular items is important if you are going to use reported earnings to estimate a company's value.

In earlier chapters, you learned how to prepare and use a basic multiple-step income statement. In this chapter, we will explain additional components of the income statement as well as a broader measure of performance called comprehensive income. Illustration 13-1 presents the components of the income statement and comprehensive income; new items are presented in red. When estimating future cash flows, analysts must consider the implications that each of these components has for future cash flows.

Illustration 13-1 Components of the income statement

IRREGULAR ITEMS

LEARNING OBJECTIVE 2

Indicate how irregular items are presented.

To help determine sustainable income, we identify irregular items by type on the income statement. There, companies report two types of irregular items:

Discontinued operations
Extraordinary items

Irregular items are reported net of income taxes. That is, a company first calculates income tax expense for the income before irregular items. Then, it calculates income tax expense for each individual irregular item. The general concept is, “Let the tax follow the income or loss.”

Discontinued Operations

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.” 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. When the disposal of a significant component occurs, the income statement should report the gain (or loss) from discontinued operations, net of tax.

To illustrate, assume that Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in 2014. The company has income before income taxes of $800,000. During 2014, the company discontinued and sold its unprofitable chemical division. The loss on disposal of the chemical division (net of $90,000 tax savings) was $210,000. Illustration 13-2 (page 692) shows the income statement presentation, assuming a 30% tax rate on income before income taxes. This presentation clearly indicates the separate effects of continuing operations and discontinued operations on net income.

Illustration 13-2 Statement presentation of discontinued operations

DECISION TOOLKIT

Extraordinary Items

Extraordinary items are events and transactions that meet two conditions. They are unusual in nature and infrequent in occurrence. To be considered unusual, the item should be abnormal and only incidentally related to the customary activities of the entity. To be regarded as infrequent, the event or transaction should not be reasonably expected to recur in the foreseeable future.

A company must evaluate both criteria in terms of the environment in which it operates. Thus, Weyerhaeuser Co. reported the $36 million in damages to its timberland caused by the eruption of Mount St. Helens as an extraordinary item because the event 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 viewed as infrequent.

Helpful Hint Ordinary gains and losses are reported at pretax amounts in arriving at income before income taxes.

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 revolutionary foreign government expropriated property held as an investment by Rozek Inc. If the loss is $70,000 before applicable income tax savings of $21,000, the income statement presentation will show a deduction of $49,000, as in Illustration 13-3.

Illustration 13-3 Statement presentation of extraordinary items

If a transaction or event meets one but not both of the criteria for an extraordinary item, a company should report it as a separate line item in the upper portion of the income statement, rather than in the bottom portion as an extraordinary item. Usually, companies report these items under either “Other revenues and gains” or “Other expenses and losses” at their 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 9. Illustration 13-4 shows the appropriate classification of extraordinary and ordinary items.

Illustration 13-4 Classification of extraordinary and ordinary items

In summary, in evaluating a company, it generally makes sense to eliminate all irregular items in estimating future sustainable income.

Investor Insight

What Does “Non-Recurring” Really Mean?

Many 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, “non-recurring 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.

If a company takes a large restructuring charge, what is the effect on the company's current income statement versus future ones? (See page 748.)

DECISION TOOLKIT

CHANGES IN ACCOUNTING PRINCIPLE

Ethics Note Changes in accounting principle should result in financial statements that are more informative for statement users. They should not be used to artificially improve the reported performance or financial position of the corporation.

For ease of comparison, users of financial statements expect companies to prepare their 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. An example is a change in inventory costing methods (such as FIFO to average-cost). Accounting rules permit a change when management can show that the new principle is preferable to the old principle.

Companies report most changes in accounting principle retroactively.¹ 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.

Investor Insight

More Frequent Ups and Downs

In 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 approved by international accounting standard-setters. Under this approach, gains and losses on the pension portfolio affect net income 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).

When predicting future earnings, how should analysts treat the one-time charge that results from a switch to the different approach for accounting for pension plans? (See page 748.)

DECISION TOOLKIT

COMPREHENSIVE INCOME

LEARNING OBJECTIVE 3

Explain the concept of comprehensive income.

Most revenues, expenses, gains, and losses are included in net income. However, certain gains and losses bypass net income. Instead, companies record these items as direct adjustments to stockholders’ equity. Many analysts have expressed concern about this practice because they believe it reduces the usefulness of the income statement. To address this concern, the FASB requires companies to report not only net income but also comprehensive income. Comprehensive income includes all changes in stockholders’ equity during a period except those changes resulting from investments by stockholders and distributions to stockholders.

Illustration of Comprehensive Income

Accounting standards require that companies adjust most investments in stocks and bonds up or down to their market price at the end of each accounting period. For example, assume that during 2014 Stassi Company purchased IBM stock for $10,000 as an investment. At the end of 2014, Stassi was still holding the investment, but the stock's market price was now $8,000. In this case, Stassi is required to reduce the recorded value of its IBM investment by $2,000. The $2,000 difference is an unrealized loss.

Should Stassi include this $2,000 unrealized loss in net income? It depends on whether Stassi classifies the IBM stock as a trading security or an available-for-sale security. A trading security is bought and held primarily for sale in the near term to generate income on short-term price differences. Companies report unrealized losses on trading securities in the “Other expenses and losses” section of the income statement. The rationale: It is likely that the company will realize the unrealized loss (or an unrealized gain), so the company should report the loss (gain) as part of net income.

If Stassi did not purchase the investment for trading purposes, it is classified as available-for-sale. Available-for-sale securities are held with the intent of selling them sometime in the future. Companies do not include unrealized gains or losses on available-for-sale securities in net income. Instead, they report them as part of “Other comprehensive income.” Other comprehensive income is not included in net income. It bypasses net income and is recorded as a direct adjustment to stockholders’ equity.

Format

One format for reporting comprehensive income is to report a combined statement of income and comprehensive income.² For example, assuming that Stassi Company has a net income of $300,000, the unrealized loss would be reported below net income as follows.

Illustration 13-5 Lower portion of combined statement of income and comprehensive income

Companies also report the unrealized loss on available-for-sale securities as a separate component of stockholders’ equity. To illustrate, assume Stassi Corporation has common stock of $3,000,000, retained earnings of $1,500,000, and an unrealized loss on available-for-sale securities of $2,000. Illustration 13-6 (page 696) shows the balance sheet presentation of the unrealized loss.

Illustration 13-6 Unrealized loss in stockholders’ equity section

Note that the presentation of the loss is similar to the presentation of the cost of treasury stock in the stockholders’ equity section. (An unrealized gain would be added in this section of the balance sheet.) Reporting the unrealized gain or loss in the stockholders’ equity section serves two important purposes: (1) It reduces the volatility of net income due to fluctuations in fair value, and (2) it informs the financial statement user of the gain or loss that would occur if the company sold the securities at fair value.

Complete Income Statement

The income statement for Pace Corporation in Illustration 13-7 presents the types of items found on this statement, such as net sales, cost of goods sold, operating expenses, and income taxes. In addition, it shows how companies report irregular items and comprehensive income (highlighted in red).

Illustration 13-7 Complete income statement

CONCLUDING REMARKS

We have shown that the computation of the correct net income number can be elusive. In assessing the future prospects of a company, some investors focus on income from operations and therefore ignore all irregular and other items. Others use measures such as net income, comprehensive income, or some modified version of one of these amounts.

Do it!

IRREGULAR ITEMS

In its draft 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), and loss on disposal of discontinued flower division $140,000. The income tax rate is 30%. Prepare a correct income statement, beginning with income before income taxes.

Action Plan

Recall that a loss is extraordinary if it is both unusual and infrequent.
Disclose the income tax effect of each component of income, beginning with income before any irregular items.
Show discontinued operations before extraordinary items.

Solution

Related exercise material: BE13-1, BE13-2, BE13-3, 13-1, and E13-1.

Comparative Analysis

LEARNING OBJECTIVE 4

Describe and apply horizontal analysis.

As indicated, in assessing the financial performance of a company, investors are interested in the core or sustainable earnings of a company. In addition, investors are interested in making comparisons from period to period. Throughout this textbook, we have relied on three types of comparisons to improve the decision-usefulness of financial information:

Intracompany basis. Comparisons within a company are often useful to detect changes in financial relationships and significant trends. For example, a comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. Likewise, a comparison of Kellogg'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.

International Note As more countries adopt IFRS, the ability of analysts to compare companies from different countries should improve. However, IFRSs are open to widely varying interpretations. In addition, some countries adopt IFRS “with modifications.” As a consequence, most cross-country comparisons are still not as transparent as within-country comparisons.
Intercompany basis. Comparisons with other companies provide insight into a company's competitive position. For example, investors can compare Kellogg's total sales for the year with the total sales of its competitors in the breakfast cereal area, such as General Mills.
Industry averages. Comparisons with industry averages provide information about a company's relative position within the industry. For example, financial statement readers can compare Kellogg'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.

We use three basic tools in financial statement analysis to highlight the significance of financial statement data:

Horizontal analysis
Vertical analysis
Ratio analysis

In previous chapters, we relied primarily on ratio analysis, supplemented with some basic horizontal and vertical analysis. In the remainder of this section, we introduce more formal forms of horizontal and vertical analysis. In the next section, we review ratio analysis in some detail.

HORIZONTAL ANALYSIS

Horizontal analysis, also known as 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, expressed as either an amount or a percentage. For example, here are recent net sales figures (in thousands) of Chicago Cereal Company:

If we assume that 2007 is the base year, we can measure all percentage increases or decreases relative to this base-period amount with the formula shown in Illustration 13-8.

Illustration 13-8 Horizontal analysis—computation of changes since base period

For example, we can determine that net sales for Chicago Cereal increased approximately 9.1% [($9,614 − $8,812) ÷ $8,812] from 2007 to 2008. Similarly, we can also determine that net sales increased by 33.6% [($11,776 − $8,812) ÷ $8,812] from 2007 to 2011.

Alternatively, we can express current-year sales as a percentage of the base period. To do so, we would divide the current-year amount by the base-year amount, as shown in Illustration 13-9.

Illustration 13-9 Horizontal analysis—computation of current year in relation to base year

Current-period sales expressed as a percentage of the base period for each of the five years, using 2007 as the base period, are shown in Illustration 13-10.

Illustration 13-10 Horizontal analysis of net sales

The large increase in net sales during 2008 would raise questions regarding possible reasons for such a significant change. Chicago Cereal's 2008 notes to the financial statements explain that the company completed an acquisition of Elf Foods Company during 2008. This major acquisition would help explain the increase in sales highlighted by horizontal analysis.

To further illustrate horizontal analysis, we use the financial statements of Chicago Cereal Company. Its two-year condensed balance sheets for 2011 and 2010, showing dollar and percentage changes, are presented in Illustration 13-11.

Illustration 13-11 Horizontal analysis of balance sheets

The comparative balance sheets show that a number of changes occurred in Chicago Cereal's financial position from 2010 to 2011. In the assets section, current assets increased $290,000, or 11.9% ($290 ÷ $2,427), and property assets (net) increased $174,000, or 6.2%. Other assets increased $219,000, or 4.0%. In the liabilities section, current liabilities increased $24,000, or 0.6%, while long-term liabilities increased $202,000, or 4.4%. In the stockholders’ equity section, we find that retained earnings increased $806,000, or 31.2%.

Illustration 13-12 presents two-year comparative income statements of Chicago Cereal Company for 2011 and 2010, showing dollar and percentage changes.

Illustration 13-12 Horizontal analysis of income statements

Horizontal analysis of the income statements shows the following changes. Net sales increased $869,000, or 8.0% ($869 ÷ $10,907). Cost of goods sold increased $515,000, or 8.5% ($515 ÷ $6,082). Selling and administrative expenses increased $252,000, or 8.2% ($252 ÷ $3,059). Overall, gross profit increased 7.3% and net income increased 9.9%. The increase in net income can be attributed to the increase in net sales and a decrease in income tax expense.

The measurement of changes from period to period in percentages is relatively straightforward and quite useful. However, complications can result in making the computations. If an item has no value in a base year or preceding year and a value in the next year, no percentage change can be computed. Likewise, no percentage change can be computed if a negative amount appears in the base or preceding period and a positive amount exists the following year.

DECISION TOOLKIT

Do it!

HORIZONTAL ANALYSIS

Summary 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.

Action Plan

Find the percentage change by dividing the amount of the increase by the 2013 amount (base year).

Solution

Related exercise material: BE13-4, BE13-6, BE13-7, BE13-9, 13-2, and E13-3.

VERTICAL ANALYSIS

LEARNING OBJECTIVE 5

Describe and apply vertical analysis.

Vertical analysis, also called common-size analysis, is a technique for evaluating financial statement data that expresses each item in a financial statement as a percentage of a base amount. For example, on a balance sheet we might express current assets as 22% of total assets (total assets being the base amount). Or, on an income statement we might express selling expenses as 16% of net sales (net sales being the base amount).

Presented in Illustration 13-13 are the comparative balance sheets of Chicago Cereal for 2011 and 2010, analyzed vertically. The base for the asset items is total assets, and the base for the liability and stockholders’ equity items is total liabilities and stockholders’ equity.

Illustration 13-13 Vertical analysis of balance sheets

In addition to showing the relative size of each category on the balance sheets, vertical analysis can show the percentage change in the individual asset, liability, and stockholders’ equity items. In this case, current assets increased $290,000 from 2010 to 2011, and they increased from 22.6% to 23.8% of total assets. Property assets (net) decreased from 26.3% to 26.2% of total assets. Other assets decreased from 51.1% to 50.0% of total assets. Also, retained earnings increased by $806,000 from 2010 to 2011, and total stockholders’ equity increased from 19.3% to 22.1% of total liabilities and stockholders’ equity. This switch to a higher percentage of equity financing has two causes: First, while total liabilities increased by $226,000, the percentage of liabilities declined from 80.7% to 77.9% of total liabilities and stockholders’ equity. Second, retained earnings increased by $806,000, from 24.1% to 29.7% of total liabilities and stockholders’ equity. Thus, the company shifted toward equity financing by relying less on debt and by increasing the amount of retained earnings.

Vertical analysis of the comparative income statements of Chicago Cereal, shown in Illustration 13-14 (page 702), reveals that cost of goods sold as a percentage of net sales increased from 55.8% to 56.0%, and selling and administrative expenses increased from 28.0% to 28.1%. Net income as a percentage of net sales increased from 9.1% to 9.4%. Chicago Cereal's increase in net income as a percentage of sales is due primarily to the decrease in interest expense and income tax expense as a percentage of sales.

Illustration 13-14 Vertical analysis of income statements

Vertical analysis also enables you to compare companies of different sizes. For example, one of Chicago Cereal's competitors is General Mills. General Mills’ sales are 1,000 times larger than those of Chicago Cereal. Vertical analysis enables us to meaningfully compare the condensed income statements of Chicago Cereal and General Mills, as shown in Illustration 13-15.

Illustration 13-15 Intercompany comparison by vertical analysis

Although Chicago Cereal's net sales are much less than those of General Mills, vertical analysis eliminates the impact of this size difference for our analysis. Chicago Cereal has a higher gross profit percentage 44.0%, compared to 40.0% for General Mills. But, Chicago Cereal's selling and administrative expenses are 28.1% of net sales, while those of General Mills are 21.5% of net sales. Looking at net income, we see that General Mills’ percentage is higher. Chicago Cereal's net income as a percentage of net sales is 9.4%, compared to 12.1% for General Mills.

ANATOMY OF A FRAUD

This final Anatomy of a Fraud box demonstrates that sometimes relationships between numbers can be used by companies 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.

Total take: Thousands of dollars

THE MISSING CONTROL

Independent 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).

DECISION TOOLKIT

Ratio Analysis

LEARNING OBJECTIVE 6

Identify and compute ratios used in analyzing a company's liquidity, solvency, and profitability.

In previous chapters, we presented many ratios used for evaluating the financial health and performance of a company. Here, we provide a summary listing of those ratios. (Page references to prior discussions are provided if you feel you need to review any individual ratios.) Appendix 13A provides an example of a comprehensive financial analysis employing these ratios.

LIQUIDITY RATIOS

Liquidity ratios (Illustration 13-16) 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.

Illustration 13-16 Summary of liquidity ratios

Investor Insight

How to Manage the Current Ratio

The 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.

How might management influence a company's current ratio? (See page 748.)

SOLVENCY RATIOS

Solvency ratios (Illustration 13-17) measure the ability of the company to survive over a long period of time. Long-term creditors and stockholders are interested in a company's long-run solvency, particularly its ability to pay interest as it comes due and to repay the balance of debt at its maturity.

Illustration 13-17 Summary of solvency ratios

PROFITABILITY RATIOS

Profitability ratios (Illustration 13-18) measure the income or operating success of a company for a given period of time. A company's income, or lack of it, affects its ability to obtain debt and equity financing, its liquidity position, and its ability to grow. As a consequence, creditors and investors alike are interested in evaluating profitability. Profitability is frequently used as the ultimate test of management's operating effectiveness.

Illustration 13-18 Summary of profitability ratios

Investor Insight

High Ratings Can Bring Low Returns

Moody's, Standard and 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).

Why are credit rating agencies important to the financial markets? (See page 748.)

Do it!

RATIO ANALYSIS

State whether each of the following is an indicator of a company's liquidity, solvency, or profitability.

(a) Cash debt coverage

(b) Average collection period

(d) Asset turnover

(e) Payout ratio

(f) Free cash flow

Action Plan

Liquidity is the short-term ability of the company to pay its maturing obligations; solvency is the ability to survive over a long period of time; and profitability is the operating success of the company over a period of time.

Solution

(a) Solvency

(b) Liquidity

(d) Profitability

(e) Profitability

(f) Solvency

Related exercise material: BE13-10, BE13-11, BE13-12, BE13-13, BE13-14, BE13-15, 13-3, E13-2, E13-7, E13-8, E13-9, E13-10, E13-11, E13-12, and E13-13.

Quality of Earnings

LEARNING OBJECTIVE 7

Understand the concept of quality of earnings.

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.

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, suppose one company uses the FIFO method of inventory costing, while another company in the same industry uses 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 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 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 been also reporting 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, in a recent year, 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. For example, during one 9-month period, the 100 largest companies 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 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 “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.

Recently, the SEC provided some 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 more favorable light.

IMPROPER RECOGNITION

Because some managers feel pressure from Wall Street to continually increase earnings, they manipulate earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue. One practice that some companies use is called channel stuffing. Offering deep discounts, companies encourage customers to buy early (stuff the channel) rather than later. This boosts 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 they needed. 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. WorldCom capitalized over $7 billion of operating expenses in order to report positive net income. In other situations, companies fail to report all their liabilities. Enron 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.

PRICE-EARNINGS RATIO

Earnings per share is net income available to common stockholders divided by the average number of common shares outstanding. The market price of a company's stock changes based on investors’ expectations about a company's future earnings per share. To compare market prices and earnings across firms, investors calculate the price-earnings (P-E) ratio. The P-E ratio divides the market price of a share of common stock by earnings per share.

Illustration 13-19 Formula for price-earnings (P-E) ratio

The P-E ratio reflects investors’ assessment of a company's future earnings. The ratio of price to earnings will be higher if investors think that earnings will increase substantially in the future and therefore are willing to pay more per share of stock. A low price-earnings ratio often signifies that investors think the company's future earnings will not be strong. In addition, sometimes a low P-E ratio reflects the market's belief that a company has poor-quality earnings.

To illustrate, assume that two identical companies each have earnings per share of $5. Suppose one of the companies manipulated its accounting numbers to achieve the $5 figure. If investors perceive that firm has lower-quality earnings, this perception will be reflected in a lower stock price and, consequently, a lower P-E.

Illustration 13-20 shows earnings per share and P-E ratios for five companies for a recent year. Note the difference in the P-E ratio of General Electric versus Google Inc.

Illustration 13-20 Earnings per share and P-E ratios of various companies

Do it!

QUALITY OF EARNINGS, FINANCIAL STATEMENT ANALYSIS

Match each of the following terms with the phrase that it best matches.

Comprehensive income	Vertical analysis
Quality of earnings	Pro forma income
Solvency ratio	Extraordinary items

Measures the ability of the company to survive over a long period of time.
Usually excludes items that a company thinks are unusual or non-recurring.
Includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.
Indicates the level of full and transparent information provided to users of the financial statements.
Describes events and transactions that are unusual in nature and infrequent in occurrence.
Expresses each item within a financial statement as a percentage of a base amount.

Action Plan

Develop a sound understanding of basic methods used for financial reporting.
Understand the use of fundamental analysis techniques.

Solution

Solvency ratio. Measures the ability of the company to survive over a long period of time.
Pro forma income. Usually excludes items that a company thinks are unusual or nonrecurring.
Comprehensive income. Includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.
Quality of earnings. Indicates the level of full and transparent information provided to users of the financial statements.
Extraordinary items. Describes events and transactions that are unusual in nature and infrequent in occurrence.
Vertical analysis. Expresses each item within a financial statement as a percentage of a base amount.

Related exercise material: 13-4.

USING THE DECISION TOOLKIT

Summary of Learning Objectives

Understand the concept of sustainable income. Sustainable income refers to a company's ability to sustain its profits from operations.
Indicate how irregular items are presented. Irregular items—discontinued operations and extraordinary items—are presented on the income statement net of tax below “Income before irregular items” to highlight their unusual nature. Changes in accounting principle are reported retroactively.
Explain the concept of comprehensive income. Comprehensive income includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders. “Other comprehensive income” is added to or subtracted from net income to arrive at comprehensive income.
Describe 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.
Describe and apply vertical analysis. Vertical analysis is a technique that expresses each item in a financial statement as a percentage of a relevant total or a base amount.
Identify and compute ratios used in analyzing a company's liquidity, solvency, and profitability. Financial ratios are provided in Illustration 13-16 (liquidity), Illustration 13-17 (solvency), and Illustration 13-18 (profitability).
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. The price-earnings (P-E) ratio reflects investors’ assessment of a company's future earnings potential.

DECISION TOOLKIT A SUMMARY

Appendix 13A

Comprehensive Illustration of Ratio Analysis

LEARNING OBJECTIVE 8

Evaluate a company comprehensively using ratio analysis.

In previous chapters, we presented many ratios used for evaluating the financial health and performance of a company. In this appendix, we provide a comprehensive review of those ratios and discuss some important relationships among them. Since earlier chapters demonstrated the calculation of each of these ratios, in this appendix we instead focus on their interpretation. Page references to prior discussions point you to any individual ratios you feel you need to review.

We used the financial information in Illustrations 13A-1 through 13A-4 to calculate Chicago Cereal Company's 2011 ratios. You can use these data to review the computations.

Illustration 13A-1 Chicago Cereal Company's balance sheets

Illustration 13A-2 Chicago Cereal Company's income statements

Illustration 13A-3 Chicago Cereal Company's statements of cash flows

Illustration 13A-4 Additional information for Chicago Cereal Company

As indicated in the chapter, we can classify ratios into three types for analysis of the primary financial statements:

Liquidity ratios. Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Solvency ratios. Measures of the ability of the company to survive over a long period of time.
Profitability ratios. Measures of the income or operating success of a company for a given period of time.

As a tool of analysis, ratios can provide clues to underlying conditions that may not be apparent from an inspection of the individual components of a particular ratio. But, a single ratio by itself is not very meaningful. Accordingly, in this discussion we use the following three comparisons.

Intracompany comparisons covering two years for Chicago Cereal Company (using comparative financial information from Illustrations 13A-1 through 13A-4).
Intercompany comparisons using General Mills as one of Chicago Cereal's competitors.
Industry average comparisons based on MSN.com median ratios for manufacturers of flour and other grain mill products and comparisons with other sources. For some of the ratios that we use, industry comparisons are not available. (These are denoted “na.”)