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					Colorado Mountain College                                   5/21/2012




         Accounting II


               Chapter 13: Financial Analysis: The
               Big Picture




                                                        1




         Financial Statement Analysis
            Sustainable income
            Comparative analysis
            Ratio analysis
            Quality of earnings




                                                        2




         Sustainable Income
          Income that is expected to recur
           regularly in the future
              Income that has been adjusted for out-
               of-the ordinary, irregular, or
               nonrecurring items
          More useful for predicting future
           performance than net income
           including irregular items

                                                        3




Accounting II, Chapter 13                                          1
Colorado Mountain College                                        5/21/2012




        Multiple-Step
        Income
        Statement
        with
        Irregular Items
        and
        Comprehensive
        Income




                                                             4




         Irregular Items on the Income
         Statement
          Discontinued operations
          Extraordinary items




                                                             5




         Discontinued Operations
          Refers to the disposal of a significant
           component of a business
             Major class of customer
             An entire activity
          Gain or loss from discontinued operations
           should be disclosed separately on the
           income statement, net of tax
             Indicates the portion of current year net income
              that is not expected to recur in the future
              because of the disposal of the component of the
              business

                                                             6




Accounting II, Chapter 13                                               2
Colorado Mountain College                                            5/21/2012




         Discontinued Operations




                                                                 7




         Concept of “Net of Tax”: Gains
          Irregular items that result in gains are
           subject to income tax
          For example:
             An irregular gain of $300,000, when the income
              tax rate is 30%, would have the following effect
              on net income:




                                                                 8




         Concept of “Net of Tax”:
         Losses
          Irregular items that result in losses generate
           tax deductions, which result in tax savings
          For example
            An irregular loss of $300,000, when the tax rate is
             30%, will reduce income tax expense (tax savings)
             as follows:




                                                                 9




Accounting II, Chapter 13                                                   3
Colorado Mountain College                                            5/21/2012




         Extraordinary Items
          Events and transactions that are:
             Unusual in nature, and
               Abnormal and only incidentally related to the
                 customary activities of the entity
             Infrequent in occurrence
               Event or transaction should not be reasonably
                 expected to recur in the foreseeable future
             Both criteria must be evaluated in terms of the
              environment in which the entity operates
          See Illustration 13-4 on p. 689 for
           examples of extraordinary items
                                                                10




         Extraordinary Items
          Ordinary items
             Events or transactions that meet one but
              not both criteria are reported as “other
              revenues and gains” or “other expenses
              and losses” at their gross amount (not
              net of taxes)
          See Illustration 13-4 on p. 689 for
           examples of ordinary items


                                                                11




         Extraordinary Items
          Reported on the income statement:
            Net of taxes, below Discontinued Operations, if
             applicable




                                                                12




Accounting II, Chapter 13                                                   4
Colorado Mountain College                                            5/21/2012




         Irregular Items Not on the Income
         Statement: Changes in Accounting
         Principle

          Occurs when the accounting principle
           used in the current year is different
           from the one used in a previous
           period
          Such changes are permitted when:
             Management can show that the new
              principle is better than the old
             Effects of the change are clearly shown
              in the financial statements
                                                                13




         Irregular Items Not on the Income
         Statement: Changes in Accounting
         Principle
          Affect financial reporting in the following
           ways:
            The new principle should be used in
             reporting results of operations of the current
             year
            Prior period financial statements presented
             for comparative purposes should be restated
             as if new accounting principle had been in
             effect in those years
               Beginning retained earnings for the earliest
                year presented should be restated
               Comparability between periods is not impaired

                                                                14




         Comprehensive Income
          Certain gains and losses do not
           appear on the income statement, but
           instead are recorded as direct
           adjustments to stockholders’ equity
             E.g., unrealized gains and losses on
              available-for-sale securities
             These direct adjustments to
              stockholders’ equity are referred to as
              “Other Comprehensive Income”

                                                                15




Accounting II, Chapter 13                                                   5
Colorado Mountain College                               5/21/2012




         Comprehensive Income
          Includes “all changes in stockholders’
           equity during a period except those
           changes resulting from investments
           by stockholders (paid-in capital) and
           distributions (dividends) to
           stockholders”
          Includes:
            Net income, plus
            Other comprehensive income
                                                   16




         Reporting Comprehensive
         Income
          GAAP permits three methods of
           reporting:
            Combined statement of income and
             comprehensive income
            Separate statements of net income and
             comprehensive income
            Separate columns in presentation of the
             statement of stockholders’ equity


                                                   17




         Reporting Comprehensive
         Income




                                                   18




Accounting II, Chapter 13                                      6
Colorado Mountain College                                                            5/21/2012




         Reasons for Financial
         Statement Analysis
          To predict future performance
               Financial statements provide indicators
                of how a firm is likely to perform in the
                future
                   Profitability
                   Liquidity
                   Solvency
          To evaluate past performance
               Both internal and external users

                                                                                19




         Reasons for Financial
         Statement Analysis
              Financial statements are “general
               purpose”
                 Different analysis for different users
              Relationships are not obvious
                 Compute percentages and ratios
              Comparisons must be made
                 Intracompany basis: between periods
                 Intercompany basis: between companies
                 Industry averages: between company and
                  industry standards
                 Between alternative opportunities
                                                                                20




         Techniques of FS Analysis
             Horizontal analysis
               Measures changes between periods for balance sheet and
                 income statement items
               AKA “trend analysis”
                    Measurement tool: percentage change
             Vertical analysis
               Measures relationships on a single balance sheet or income
                 statement
               AKA “common-size analysis”
                    Measurement tool: percent of total assets or net sales
             Ratio analysis
               Appraisal of certain key relationships
                    Measurement tools: ratios, rates of return, turnover measures




                                                                                21




Accounting II, Chapter 13                                                                   7
Colorado Mountain College                                          5/21/2012




         Horizontal Analysis
          Used to analyze income statement:
           trend analysis
            Computes percentage change in income
             statement items from year to year
                Determines whether any particular item has
                 changed in an unusual way in relation to
                 the change in net sales from one period to
                 the next
                Percentages are determined by dividing the
                 dollar increase or decrease in an account by
                 the amount in the account during the
                 earliest year presented
                                                              22




         Horizontal Analysis
          Used to analyze balance sheet: trend
           analysis
            Computes percentage change in balance sheet
             items from year to year
              Determines whether any particular item has
                changed in an unusual way in relation to the
                change in total assets from one period to the
                next
              Percentages are determined by dividing the
                dollar increase or decrease in an account by the
                amount in the account during the earliest year

                                                              23




         Horizontal Analysis
          Comparisons must be made
              Between years
              Between companies
              Between actual and projected
              With industry averages




                                                              24




Accounting II, Chapter 13                                                 8
Colorado Mountain College                                          5/21/2012




         Vertical Analysis
          Used to analyze income statements:
           “common-size” income statement
            Each item of revenue and expense is
             expressed as a percentage of net sales
                Reveals which revenue and expense items
                 are out of line in their relationship with net
                 sales
                Provides clues as to strengths and
                 weaknesses in controlling costs and
                 improving profits

                                                              25




         Vertical Analysis
          Used to analyze balance sheets—
           common size balance sheet
            Each item of asset, liability, and
             stockholders’ equity is expressed as a
             percentage of total assets
                Reveals which items are out of line in their
                 relationship with total assets
                Provides clues as to strengths and
                 weaknesses in financial condition


                                                              26




         Vertical Analysis
          Comparisons must be made
              Between years
              Between companies
              Between actual and projected
              With industry averages




                                                              27




Accounting II, Chapter 13                                                 9
Colorado Mountain College                                 5/21/2012




          Ratio Analysis
         Liquidity ratios
           Measure the short-term ability of the
             enterprise to pay maturing obligations
             and meet unexpected demands for cash
           Primary users: short-term creditors:
             bankers, suppliers
         Solvency ratios
           Measure ability of enterprise to survive
             over a long period of time
           Primary users: long-term creditors and
             stockholders                            28




          Ratio Analysis
          Profitability ratios
              Measure income or operating
               success for a given period of time
              Profitability affects ability to obtain
               financing, liquidity, and solvency




                                                     29




          Liquidity ratios
            Working capital
            Current ratio
            Current cash debt coverage ratio
            Inventory turnover ratio
            Days in inventory
            Receivables inventory ratio
            Average collection period

                                                     30




Accounting II, Chapter 13                                       10
Colorado Mountain College                               5/21/2012




         Working Capital
          Current assets – current liabilities
          Indicates the amount of cash and
           near cash assets available for current
           expenditure
          Indicates the ability of the firm to
           meet currently maturing obligations



                                                   31




         Current Ratio
          Current assets ÷ current liabilities
          Measure of liquidity or margin of
           safety in meeting current liabilities
          AKA working capital ratio




                                                   32




         Acid Test Ratio
          Same as current ratio, except
           inventories and prepaid assets are
           excluded from numerator
          AKA quick ratio
          Measures immediate debt paying
           ability



                                                   33




Accounting II, Chapter 13                                     11
Colorado Mountain College                                 5/21/2012




         Current Cash Debt Coverage
         Ratio
          Cash provided by operating activities
           ÷ average current liabilities
          Improves on the current ratio (which
           uses end-of-year balances) by using
           annual averages




                                                     34




         Accounts Receivable Turnover
         Ratio
          Net credit sales ÷ average net accounts
           receivable for period
          Measures speed of collection of receivables
          Higher turnover means speedier collection




                                                     35




         Average Collection Period
          365 ÷ Receivables turnover ratio
          Indicates, on average, how many
           days it takes to collect receivables
          Should be compared with credit terms




                                                     36




Accounting II, Chapter 13                                       12
Colorado Mountain College                          5/21/2012




         Inventory Turnover
          Cost of goods sold ÷ average
           inventory for period
          Measures speed of sale of inventory
          Higher turnover means speedier sales




                                              37




         Days in Inventory
          365 ÷ Inventory turnover ratio
          Indicates, on average, how long
           it takes to sell inventory




                                              38




         Solvency Ratios
            Debt to total assets ratio
            Cash debt coverage ratio
            Times interest earned ratio
            Free cash flow




                                              39




Accounting II, Chapter 13                                13
Colorado Mountain College                                          5/21/2012




         Debt to Total Assets Ratio
          Total liabilities ÷ total assets
          Measures the percentage of total
           assets financed by debt
            Similar measure: debt to equity ratio
              Total liabilities/total stockholders’ equity




                                                              40




         Times Interest Earned Ratio
          Income before interest and taxes ÷
           interest expense
          Measures ability of company to pay
           interest charges
          Shows the margin of safety to
           creditors



                                                              41




         Cash Debt Coverage Ratio
          Cash provided by operations ÷
           average total liabilities
          Indicates a company’s ability to repay
           its liabilities from cash generated
           from operating activities without
           having to liquidate productive assets



                                                              42




Accounting II, Chapter 13                                                14
Colorado Mountain College                           5/21/2012




         Free Cash Flow
          Cash provided by operations – capital
           expenditures – cash dividends
          Measures solvency and ability to pay
           dividends and expand operations




                                               43




         Profitability Ratios
          Return on common stockholders’
           equity
          Return on assets ratio
          Profit margin ratio
          Asset turnover ratio
          Gross profit rate
          Earnings per share
          Price-earnings ratio
          Payout ratio                        44




         Return on Common
         Stockholders’ Equity
          (Net income-preferred dividends) ÷
           average common stockholders’ equity
          Focuses on rate of profits earned on
           the amount invested by the common
           stockholders




                                               45




Accounting II, Chapter 13                                 15
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         Return on Assets Ratio
          Net income ÷ average total assets
          Measures the profitability of total
           assets




                                                 46




         Profit Margin Ratio
          Net income ÷ net sales
          Measure of the percentage of each
           dollar of sales that results in net
           income




                                                 47




         Asset Turnover Ratio
          Net sales ÷ average total assets
          Measures how efficiently a company
           uses its assets to generate sales




                                                 48




Accounting II, Chapter 13                                   16
Colorado Mountain College                             5/21/2012




         Gross Profit Rate
          Gross profit ÷ Net sales
          Indicates a company’s ability to
           maintain an adequate selling price
           above its cost of goods sold




                                                 49




         Earnings Per Share on Common
         Stock
          (Net income-preferred dividends) ÷
           average number of shares of common
           stock outstanding during period
          Measures net income earned on each
           share of common stock




                                                 50




         Payout Ratio
          Cash dividends declared on common
           stock ÷ Net income
          Measures the percentage of earnings
           distributed as cash dividends to
           shareholders




                                                 51




Accounting II, Chapter 13                                   17
Colorado Mountain College                                  5/21/2012




         Quality of Earnings
          High quality of earnings: indicated by
           full and transparent information that
           will not confuse or mislead users of
           financial statements
          Factors affecting quality of earnings:
            Alternative accounting methods
            Pro forma income
            Improper recognition

                                                      52




         Quality of Earnings: Alternative
         Accounting Methods
          Variations among companies may
           hamper comparability and reduce
           quality of earnings
            E.g., inventory costing methods;
             methods of depreciation, amortization,
             depletion




                                                      53




         Quality of Earnings: Pro Forma
         Income
          Pro forma income: a measure that
           usually excludes unusual and
           nonrecurring items
            May be useful, but may also be
             misleading because of flexibility in
             reporting methods




                                                      54




Accounting II, Chapter 13                                        18
Colorado Mountain College                              5/21/2012




         Quality of Earnings: Improper
         Recognition
          Improper revenue recognition
            E.g., channel stuffing
          Improper expense capitalization




                                                  55




         Price-Earnings Ratio
          Market price per share ÷ earnings per
           share
          Measures price relative to earnings
            An indicator of a company’s future
             earnings prospects




                                                  56




Accounting II, Chapter 13                                    19

				
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