Prepared by

Coby Harmon
University of California, Santa Barbara
Westmont College

18-1
 18 Financial Statement
Analysis
Learning Objectives
After studying this chapter, you should be able to:
[1] Discuss the need for comparative analysis.
[2] Identify the tools of financial statement analysis.
[3] Explain and apply horizontal analysis.
[4] Describe and apply vertical analysis.
[5] Identify and compute ratios used in analyzing a firm’s liquidity,
profitability, and solvency.
[6] Understand the concept of earning power, and how irregular items are
presented.
[7] Understand the concept of quality of earnings.

18-2
 Preview of Chapter 18

Accounting Principles
Eleventh Edition
Weygandt Kimmel Kieso
18-3
 Basics of Financial Statement Analysis

Analyzing financial statements involves:

Comparison Tools of
Characteristics
Bases Analysis

 Liquidity  Intracompany  Horizontal

 Profitability  Industry  Vertical
 Solvency averages  Ratio
 Intercompany

LO 1 Discuss the need for comparative analysis.

18-4 LO 2 Identify the tools of financial statement 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.
 Purpose is to determine the increase or decrease that has
taken place.

 Commonly applied to the balance sheet, income

statement, and statement of retained earnings.

18-5 LO 3 Explain and apply horizontal analysis.

 Horizontal Analysis

Illustration 18-5
Horizontal analysis of
balance sheets

Changes suggest
that the company
expanded its asset
base during 2011
and financed this
expansion primarily
by retaining income
rather than assuming
additional long-term
debt.

18-6 LO 3 Explain and apply horizontal analysis.

 Horizontal Analysis
Illustration 18-6
Horizontal analysis of
Income statements

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.

18-7 LO 3 Explain and apply horizontal analysis.

 Horizontal Analysis

Illustration 18-7
Horizontal analysis of In the horizontal analysis of the balance sheet the ending
retained earnings
statements
retained earnings increased 38.6%. As indicated earlier, the
company retained a significant portion of net income to
finance additional plant facilities.

18-8 LO 3 Explain and apply horizontal analysis.

 Vertical Analysis

Vertical analysis, also called common-size analysis, is a

technique that expresses each financial statement item as
a percent of a base amount.

 On an income statement, we might say that selling

expenses are 16% of net sales.

 Vertical analysis is commonly applied to the balance

sheet and the income statement.

18-9 LO 4 Describe and apply vertical analysis.

 Vertical Analysis
Illustration 18-8
Vertical analysis of
balance sheets

These results reinforce

the earlier observations
that Quality is
choosing to finance
its growth through
retention of earnings
rather than through
issuing additional
debt.

18-10 LO 4 Describe and apply vertical analysis.

 Vertical Analysis
Illustration 18-9
Vertical analysis of
Income statements

Quality appears
to be a profitable
enterprise that is
becoming even more
successful.

18-11 LO 4 Describe and apply vertical analysis.

 Vertical Analysis

Enables a comparison of companies of different sizes.

Illustration 18-10
Intercompany income
statement comparison

18-12 LO 4 Describe and apply vertical analysis.

 Ratio Analysis

Ratio analysis expresses the relationship among selected

items of financial statement data.

Financial Ratio Classifications

Liquidity Profitability Solvency

Measures short- Measures the Measures the

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

18-13
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 Ratio Analysis

A single ratio by itself is not very meaningful.

The discussion of ratios will include 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 Macy’s, Inc. as Quality

Department Store’s principal competitor.

18-14
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 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. The numeric relationships that can reveal
fraud can be such things as financial ratios that appear abnormal, or statistical abnormalities in
the numbers themselves. 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 CONTROLS
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.

18-15 Advance slide in presentation mode to reveal answer. LO 5

 Ratio Analysis

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.

 Ratios include the current ratio, the acid-test ratio,

accounts receivable turnover, and inventory turnover.

18-16
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-17 Advance slide in presentation mode to reveal solution. LO 5

 Ratio Analysis Liquidity Ratios

Current Ratio Illustration 18-12

Ratio of 2.96:1 means that for every dollar of current liabilities, Quality
has $2.96 of current assets.

18-18
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Liquidity Ratios

Acid-Test Ratio
Illustration 18-13

18-19
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Balance Sheet (partial)
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-20 LO 5
 Ratio Analysis Liquidity Ratios

Acid-Test Ratio
Illustration 18-14

Acid-test ratio measures immediate liquidity.

18-21
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
18-22
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial) Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

18-23 LO 5
 Ratio Analysis Liquidity Ratios

Accounts Receivable Turnover

Illustration 18-15

Measures the number of times, on average, the company collects

receivables during the period.
18-24 LO 5
 Ratio Analysis Liquidity Ratios

Accounts Receivable Turnover

$2,097,000
= 10.2 times
($180,000 + $230,000) / 2

A variant of the accounts receivable turnover ratio is to convert it

to an average collection period in terms of days.

365 days / 10.2 times = every 35.78 days

Accounts receivable are collected on average every 36 days.

18-25
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial) Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-26 LO 5
 Ratio Analysis Liquidity Ratios

Inventory Turnover
Illustration 18-16

Measures the number of times, on average, the inventory is sold

during the period.
18-27 LO 5
 Ratio Analysis Liquidity Ratios

Inventory Turnover
$1,281,000
= 2.3 times
($500,000 + $620,000) / 2

A variant of inventory turnover is the days in inventory.

365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among industries.

18-28
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 Ratio Analysis

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, liquidity position, and the ability to
grow.

 Ratios include the profit margin, asset turnover, return on

assets, return on common stockholders’ equity, earnings
per share, price-earnings, and payout ratio.

18-29
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

18-30 LO 5
 Ratio Analysis Profitability Ratios

Profit Margin
Illustration 18-17

Measures the percentage of each dollar of sales that results in

net income.

18-31
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-32 LO 5
 Ratio Analysis Profitability Ratios

Asset Turnover
Illustration 18-18

Measures how efficiently a company uses its assets to generate

sales.
18-33
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-34 LO 5
 Ratio Analysis Profitability Ratios

Return on Asset
Illustration 18-19

An overall measure of profitability.

18-35
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-36 LO 5
 Ratio Analysis Profitability Ratios

Return on Common Stockholders’ Equity

Illustration 18-20

Shows how many dollars of net income the company earned for each
dollar invested by the owners.
18-37 LO 5
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-38 LO 5
 Ratio Analysis Profitability Ratios

Earnings Per Share (EPS)

Illustration 18-22

A measure of the net income earned on each share of common stock.

18-39 LO 5
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-40 LO 5
 Ratio Analysis Profitability Ratios

Price-Earnings Ratio
Illustration 18-23

Measures the net income earned on each share of common stock.

18-41 LO 5
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-42 LO 5
 Ratio Analysis Profitability Ratios

Payout Ratio
Illustration 18-24

Measures the percentage of earnings distributed in the form of cash

dividends.

18-43 LO 5
 Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a company to survive

over a long period of time.
 Debt to Assets and

 Times Interest Earned

are two ratios that provide information about debt-

paying ability.

18-44
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-45 LO 5
 Ratio Analysis Solvency Ratios

Debt to Total Assets Ratio

Illustration 18-25

Measures the percentage of the total assets that creditors provide.

18-46 LO 5
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-47 LO 5
 Ratio Analysis Solvency Ratios

Times Interest Earned

Illustration 18-25

Provides an indication of the company’s ability to meet interest

payments as they come due.

18-48 LO 5
 Ratio Analysis

Summary of Ratios
Illustration 18-27

18-49 LO 5
 Summary of Ratios
Illustration 18-27

18-50 LO 5
 Earning Power and Irregular Items

Earning power means the normal level of income to be

obtained in the future.

“Irregular” items are separately identified on the income

statement. Two types are:

1. Discontinued operations.

2. Extraordinary items.

“Irregular” items are reported net of income taxes.

18-51
LO 6 Understand the concept of earning power,
and how irregular items are presented.
 Earning Power and Irregular Items

Discontinued Operations
(a) Disposal of a significant component of a business.

(b) Report the income (loss) from discontinued operations in

two parts:

1. income (loss) from operations (net of tax) and

2. gain (loss) on disposal (net of tax).

18-52
LO 6 Understand the concept of earning power,
and how irregular items are presented.
 Earning Power and Irregular Items

Illustration: During 2014 BD Inc. has income before income

taxes of $79,000,000. During 2014, BD discontinued and sold
its unprofitable chemical division. The loss in 2014 from
chemical operations (net of $135,000 taxes) was $315,000. The
loss on disposal of the chemical division (net of $81,000 taxes)
was $189,000. Assuming a 30% tax rate on income.

18-53 LO 6
 Earning Power and Irregular Items
Income Statement (in thousands)
Discontinued Sales $ 285,000
Operations are reported Cost of goods sold 149,000
after “Income from
continuing operations.” Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Previously labeled as
Income from continuing operations 55,000
“Net Income”.
Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Moved to
Net income $ 54,496

18-54
LO 6
 Earning Power and Irregular Items

Extraordinary Items
Nonrecurring material items that differ significantly from a
company’s typical business activities.
 Must be both of an
► Unusual Nature and
► Occur Infrequently.
 Must consider the environment in which it operates.
 Amounts reported “net of tax.”

18-55 LO 6 Understand the concept of earning power,

and how irregular items are presented.
 Earning Power and Irregular Items

Are these considered Extraordinary Items?

(a) A large portion of a tobacco manufacturer’s crops

are destroyed by a hail storm. Severe damage
YES
from hail storms in the locality where the
manufacturer grows tobacco is rare.

(b) A citrus grower's Florida crop is damaged by NO

frost.

(c) Loss from sale of temporary investments. NO

(d) Loss attributable to a labor strike. NO

18-56 LO 6 Understand the concept of earning power,

and how irregular items are presented.
 Earning Power and Irregular Items

Are these considered Extraordinary Items?

(e) Loss from flood damage. (The nearby Black River

NO
floods every 2 to 3 years.)

(f) An earthquake destroys one of the oil refineries

owned by a large multi-national oil company. YES
Earthquakes are rare in this geographical location.

(g) Write-down of obsolete inventory. NO

(h) Expropriation of a factory by a foreign YES

government.

18-57 LO 6 Understand the concept of earning power,

and how irregular items are presented.
 Earning Power and Irregular Items

Illustration: In 2014 a foreign government expropriated property

held as an investment by DB Inc. If the loss is $770,000 before
applicable income taxes of $231,000, the income statement will
report a deduction of $539,000.

18-58 LO 6 Understand the concept of earning power,

and how irregular items are presented.
 Earning Power and Irregular Items
Income Statement (in thousands)
Extraordinary Items are Sales $ 285,000
reported after “Income Cost of goods sold 149,000
from continuing
operations.” Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Previously labeled as
Income from continuing operations 55,000
“Net Income”.
Extraordinary loss, net of tax 539
Net income $ 54,461
Moved to

18-59 LO 6 Understand the concept of earning power,

and how irregular items are presented.
 Earning Power and Irregular Items
Income Statement (in thousands)
Reporting when both Sales $ 285,000
Discontinued Cost of goods sold 149,000
Operations and
Extraordinary Items Interest expense (21,000)
Total other (4,000)
are present.
Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations 55,000
Discontinued operations:
Discontinued Loss from operations, net of tax 315
Operations Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Income before extraordinary item 54,496
Extraordinary Item Extraordinary loss, net of tax 539
Net income $ 53,957

18-60 LO 6 Understand the concept of earning power,

and how irregular items are presented.
18-61
 Earning Power and Irregular Items

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 if justified.

 Changes are reported retroactively.

 Example would include a change in inventory costing

method such as FIFO to average cost.

18-62 LO 6 Understand the concept of earning power,

and how irregular items are presented.
 Earning Power and Irregular Items

Comprehensive Income All changes in stockholders’

equity except those resulting
Income Statement (in thousands)
from investments by
Sales $ 285,000
Cost of goods sold 149,000
stockholders and distributions
Gross profit 136,000 to stockholders.
Operating expenses:
Advertising expense 10,000
Depreciation expense 43,000 Reported in Stockholders’
Total operating expense 53,000 Equity
Income from operations 83,000
Other revenue: Unrealized gains and
Interest revenue 17,000 + losses on available-for-
Total other 17,000 sale securities.
Income before taxes 100,000
Income tax expense 24,000
Plus other items
Net income $ 76,000

18-63 LO 6 Understand the concept of earning power,

and how irregular items are presented.
 Earning Power and Irregular Items

Comprehensive Income
Why are gains and losses on available-for-sale securities
excluded from net income?

Because disclosing them separately

1) reduces the volatility of net income due to fluctuations in fair

value,

2) yet informs the financial statement user of the gain or loss

that would be incurred if the securities were sold at fair
value.

18-64 LO 6 Understand the concept of earning power,

and how irregular items are presented.
 Quality of Earnings

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.

18-65 LO 7 Understand the concept of quality of earnings.

 Quality of Earnings

Alternative Accounting Methods

 Variations among companies in the application of GAAP
may hamper comparability and reduce quality of earnings.

Pro Forma Income

 Pro forma income usually excludes items that the company
thinks are unusual or nonrecurring.
 Some companies have abused the flexibility that pro forma
numbers allow.

18-66 LO 7 Understand the concept of quality of earnings.

 Quality of Earnings

Improper Recognition
Some managers have felt pressure to continually increase
earnings and have manipulated the earnings numbers to meet
these expectations.
Abuses include:
 Improper recognition of revenue (channel stuffing).
 Improper capitalization of operating expenses (WorldCom).
 Failure to report all liabilities (Enron).

18-67 LO 7 Understand the concept of quality of earnings.

 A Look at IFRS

Key Points
 The tools of financial statement analysis covered in this chapter are
universal and therefore no significant differences exist in the analysis
methods used.
 The basic objectives of the income statement are the same under both
GAAP and IFRS. Thus, both the IASB and the FASB are interested in
distinguishing normal levels of income from irregular items in order to
better predict a company’s future profitability.
 The basic accounting for discontinued operations is the same under
IFRS and GAAP.

LO 8 Compare financial statement analysis and income

18-68 statement presentation under GAAP and IFRS..
 A Look at IFRS

Key Points
 Under IFRS, there is no classification for extraordinary items. In other
words, extraordinary item treatment is prohibited under IFRS. All
revenue and expense items are considered ordinary in nature.
 The accounting for changes in accounting principles and changes in
accounting estimates are the same for both GAAP and IFRS.
 Both GAAP and IFRS follow the same approach in reporting
comprehensive income. The statement of comprehensive income can be
prepared under the one-statement approach or the two-statement
approach.

LO 8 Compare financial statement analysis and income

18-69 statement presentation under GAAP and IFRS..
 A Look at IFRS

Key Points
 The issues related to quality of earnings are the same under both GAAP
and IFRS. It is hoped that by adopting a more principles-based
approach, as found in IFRS, many of the earnings’ quality issues will
disappear.

LO 8 Compare financial statement analysis and income

18-70 statement presentation under GAAP and IFRS..
 A Look at IFRS

Looking to the Future

The FASB and the IASB are working on a project that would rework the
structure of financial statements. Recently, the IASB decided to require a
statement of comprehensive income, similar to what was required under
GAAP. In addition, another part of this project addresses the issue of how to
classify various items in the income statement. A main goal of this new
approach is to provide information that better represents how businesses
are run. In addition, the approach draws attention away from one number—
net income.

LO 8 Compare financial statement analysis and income

18-71 statement presentation under GAAP and IFRS..
 A Look at IFRS

IFRS Self-Test Questions

The basic tools of financial analysis are the same under both GAAP and
IFRS except that:
a) horizontal analysis cannot be done because the format of the
statements is sometimes different.
b) analysis is different because vertical analysis cannot be done
under IFRS.
c) the current ratio cannot be computed because current liabilities
are often reported before current assets in IFRS statements of
position.
d) None of the above.
LO 8 Compare financial statement analysis and income
18-72 statement presentation under GAAP and IFRS..
 A Look at IFRS

IFRS Self-Test Questions

Under IFRS:

a) the reporting of discontinued items is different than GAAP.

b) the reporting of extraordinary items is prohibited.

c) the reporting of changes in accounting principles is different than

under GAAP.

d) None of the above.

LO 8 Compare financial statement analysis and income

18-73 statement presentation under GAAP and IFRS..
 A Look at IFRS

IFRS Self-Test Questions

Presentation of comprehensive income must be reported under IFRS in:

a) the statement of stockholders’ equity.

b) the income statement ending with net income.

c) the notes to the financial statements.

d) a statement of comprehensive income.

LO 8 Compare financial statement analysis and income

18-74 statement presentation under GAAP and IFRS..
 Copyright

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18-75