Accounting Fundamentals Dr. Yan Xiong Department of Accountancy CSU Sacramento The lecture notes are primarily based on Reimers (2003). 7/11/03 Chapter 11: Financial Statement Analysis Agenda
Purpose of a Business and Types of Businesses Ownership Structure of Businesses Business Processes The Accounting Equation Four Basic Financial Statements Analyzing Financial Statements Before we discuss financial statement analysis, lets take a closer
look at some of the elements of the income statement. Then, well talk about several ways to analyze financial statements. More About The Income Statement To make the information on the income statement clearer, there are several special items that are separated from the regular earnings of a business: Gains and losses from discontinued operations, Extraordinary items, and
Cumulative effect of a change in accounting principle Discontinued Operations If a segment or division of a business is eliminated, the gain or loss from the disposal must be shown after income from continuing operations, net of taxes. Any current gain or loss from the operations of that discontinued segment must also be shown separately.
How Discontinued Containers, Inc. Income Statement Operations Are Shown For the year ended December 31, 2003 Income before taxes Income tax expense Income from continuing operations Discontinued operations Income from discontinued operations net of taxes of $2,300 Gain on disposal of mailing packages segment net of taxes of $25,000 Net Income
$400,000 160,000 240,000 $ 10,100 35,000 45,100 $ 285,100 Extraordinary Items Events that are unusual in nature and infrequent in occurrence are called extraordinary items. The accounting rules are very strict about what types of events may be
classified as extraordinary. Any gain or loss from these events are shown, net of taxes, after income from continuing operations and after income from discontinued operations. Examples Of Actual Extraordinary Occurrences Volcano eruptions Take-over of foreign operations by the foreign government Effects of new laws or regulations that result in a one-time cost to comply
Each situation is unique and must be considered in the environment in which the business operates. How Extraordinary Items Are Shown Containers, Inc. Income Statement For the year ended December 31, 2003 Income before taxes Income tax expense Income from continuing operations Discontinued operations Income less taxes of $2,500 Gain on disposal less taxes of $20,000 Income before extraordinary item
Extraordinary item Expropriation of foreign operation net of tax savings of $35,000 Net Income $400,000 160,000 240,000 $ 10,100 35,000 45,100 $ 285,100 70,000 $215,100 Cumulative Effect
Of A Change In Accounting Principal The cumulative effect of a change in accounting principle is the amount of gain or loss from changing accounting methods. It must be shown separately on the income statement, net of taxes, after income from continuing operations, discontinued operations, and any extraordinary items. Example Suppose the company changed from depreciating equipment using the straight-line method to depreciating
the equipment using the double declining balance method. The equipment was purchased on January 1, 2001, at a cost of $10,000, has a useful life of 10 years, with no salvage value. Depreciation Schedules Method Year ended: December 31, 2001 December 31, 2002 Total for two years
Straight-line $1,000 $1,000 $2,000 Double-declining balance $2,000 $1,600 $3,600 The income for Containers, Inc. would have been lower by $1,600 if double-declining balance had been used from the beginning.
A switch now means the company will have to subtract $1,600, net of any tax effect, as a cumulative effect of a change in accounting principle. Cumulative Effect The income for Containers, Inc. would have been lower by $1,600 if double-declining balance had been used from the beginning. A switch now means the company will have to subtract $1,600, net of any tax effect, as a cumulative effect of a change in accounting principle.
How The Cumulative Effect Is Shown On The Income Statement Containers, Inc. Income Statement For the year ended December 31, 2003 Income before taxes Income tax expense Income from continuing operations Discontinued operations Income less taxes of $2,500 Gain on disposal less taxes of $20,000 Income before extraordinary item and cumulative effect of change in accounting principle Extraordinary item Expropriation of foreign operation net of tax
saving of $35,000 Cumulative effect of a change in accounting principle Effect on prior years of change in depreciation method, net of $400 tax savings Net Income $400,000 160,000 240,000 $ 10,100 35,000 45,100 $ 285,100 70,000 1,200
$213,900 Comprehensive Income The income statement shows all of the effects of revenues, expenses, gains, and losses on net income. Net income, in turn, affects owners equity. Other items, not included on the income statement, may affect owners equity. The total of all items that affect owners equity, not including contributions from owners and dividends, is called comprehensive income. Diagram Showing the Items that Affect Owners Equity Items that effect
Owners contributions Shareholders Equity Paid-in Capital (Contributed Capital) Dividends Retained Earnings Net income Comprehensive income
Other comprehensive income: A few other items including unrealized gains and losses from foreign currency translation and from available for sale securities Cumulative other comprehensive income (may be
labeled as a single item if it has only one component, e.g. foreign currency translation) Other Comprehensive Income Total comprehensive income = net income plus other comprehensive income Items included in other comprehensive income include: unrealized gains and losses from foreign currency translation unrealized gains and losses on
certain types of investments. One More New Financial Statement Item: Investments In Securities AA company company may may use use some some of of its its extra extra cash cash to to
invest invest in in the the debt debt or or equity equity securities securities of of another another company. company. These These investments investments must
must be be classified classified as as one one of of three three types: types: Securities held to maturity Securities held to maturity Trading securities Trading securities
Securities available for sale Securities available for sale Securities Held To Maturity Debt securities Intent and ability to hold to maturity Must not be sold in
response to changes in interest rates, funding sources, etc. Measured at cost on the balance sheet Trading Securities
Debt and equity securities Readily determinable fair values Bought and held to sell in the near term Actively and frequently traded (profit!) Measured at fair value and classified as a current asset Unrealized gains and losses, included in determination of net income Securities Available For Sale
Debt and equity securities Readily determinable fair values Not classified as either securities held to maturity or trading securities Measured at fair value on balance sheet May be either current or noncurrent
May have holding gains or losses, to be reported net as a separate component of owners equity, usually as part of other comprehensive income. Financial Statement Analysis In addition to the financial statements, annual reports contain the following: Notes to the financial statements, including a summary of the accounting methods used Managements discussion and analysis (MD&A) of the financial results The auditors report
Comparative financial data for a series of years Financial Statement Analysis Now that youll be able to recognize these new items weve just discussed, youre ready to do some analysis of the financial statements. First, well talk about horizontal and vertical analysis. Then, well discuss financial ratios -standard measures that enable analysts to compare companies of different sizes Horizontal Analysis Horizontal analysis compares one value across several
periods. First, a base year must be chosen as the basis for comparison. Sales 2003 $41,500 2002 $37,850 2001 2000 $36,300 $35,000 The difference between each year and the base
year is expressed as a percentage of the base year. Horizontal Analysis This shows 2000 as the base year. The base years sales are subtracted from each years sales. Then, this difference is expressed as a percentage of the base years sales. Sales 2003 $41,500 18.6% 2002 $37,850
8.1% 2001 2000 $36,300 $35,000 3.7% Base year Horizontal Analysis For example, the sales for 2003 represent an increase of 18.6% over the base year 2000. Sales 2003
$41,500 18.6% 2002 $37,850 8.1% 2001 2000 $36,300 $35,000 3.7% Base year Vertical Analysis compares each item in a financial
statement to a base number set to 100%. Every item on the financial statement is then reported as a percentage of that base. Vertical Analysis Sales Cost of goods sold Gross margin Total operating expenses Operating income Other income Income before taxes Income taxes
Net income 2002 $38,303 19,688 $18,615 13,209 $ 5,406 2,187 $ 7,593 2,827 $ 4,766 % 100.0 51.4
48.6 34.5 14.1 5.7 19.8 7.4 12.4 Ratio Analysis Ratios are standard measures that enable analysts to compare companies of different sizes.
Ratio Classification Liquidity: Can a company pay the bills as they come due? Solvency: Can the company survive over a long period of time? Profitability: Can a company earn a satisfactory rate of return? Market indicators: Is the stock a good investment? Liquidity: Measuring Ability to Pay Current Liabilities This ratio measures a companys ability to pay current liabilities
with current assets. Current ratio = Total current assets Total current liabilities Liquidity: Measuring Ability to Pay Current Liabilities The acid-test ratio shows the companys ability to pay all current liabilities if they come due immediately. Acid-test ratio = (Cash + Short-term investments + Net current receivables) Total current liabilities Liquidity: Measuring Ability to Pay Current Liabilities
Working capital is not a ratio, but it is often computed to evaluate a the companys ability to pay its current liabilities. Working capital = Total current assets Total current liabilities Liquidity: Measuring Ability to Sell Inventory This ratio measures how quickly a company is turning over its inventory. A high number indicates an ability to quickly sell inventory. Inventory turnover = Cost of goods sold
Average inventory Liquidity: Measuring Ability to Collect Receivables This ratio measures a companys ability to collect the cash from its credit customers. Accounts receivable turnover = Net credit sales Average accounts receivable Solvency: Measuring Ability to Pay Long-term Debt The debt to equity ratio compares the amount of debt a company has with the amount the owners have invested in the
company. Debt-to-equity ratio = Total liabilities Total equity Solvency: Times interest earned This ratio compares the amount of income that has been earned in an accounting period to the interest obligation for the same period. Times interest earned ratio = Net income + interest expense Interest expense Measuring Profitability: Return on assets This ratio measures a companys
success in using its assets to earn income for the persons who are financing the business. Return on assets = Net income + interest expense Average total assets Measuring Profitability: Return on Equity This ratio measures how much income is earned with the common shareholders investment in the company. Rate of return on common stockholders equity = (Net income preferred dividends) Average common stockholders equity
Measuring Profitability: Gross Margin Ratio This ratio measures percentage of sales price that is gross profit. A small shift usually indicates a big change in the profitability of the companys sales. Gross margin ratio = Gross margin Sales Measuring Profitability: Earnings Per Share This ratio gives the amount of net income per share of common stock. It is one of the most widely-used measures of a companys profitability. Earnings per share of common stock = (Net income Preferred dividends)
Number of shares of common stock outstanding Market Indicators: PE Ratio Price/earning ratio is the ratio of market price per share to earnings per share. This ratio indicates the market price for $1 of earnings. Price/Earnings Ratio = Market price per share of common stock Earnings per share Market Indicators: Dividend Yield Dividend yield gives the percentage of a stocks market value returned as dividends to stockholders each period. Dividend per share of common
(or preferred) stock Market price per share of common (or preferred) stock Making Ratios Useful A ratio by itself does not give much information. To be useful, a ratio must be compared to other ratios from previous periods, compared to ratios of other companies in the industry, or compared to industry averages.
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