Basics of Financial Statement Analysis

Discuss the need for comparative analysis.

Analyzing financial statements involves evaluating three characteristics: a company’s liquidity, profitability, and solvency. A short-term creditor, such as a bank, is primarily interested in liquidity—the ability of the borrower to pay obligations when they come due. The liquidity of the borrower is extremely important in evaluating the safety of a loan. A long-term creditor, such as a bondholder, looks to profitability and solvency measures that indicate the company’s ability to survive over a long period of time. Long-term creditors consider such measures as the amount of debt in the company’s capital structure and its ability to meet interest payments. Similarly, shareholders look at the profitability and solvency of the company. They want to assess the likelihood of dividends and the growth potential of their investment.

 

 

Need for Comparative Analysis

Every item reported in a financial statement has significance. When Marks and Spencer plc (M&S) (GBR) reports cash and cash equivalents of £422.9 million on its statement of financial position, we know the company had that amount of cash on the report date. But, we do not know whether the amount represents an increase over prior years, or whether it is adequate in relation to the company’s need for cash. To obtain such information, we need to compare the amount of cash with other financial statement data.

Comparisons can be made on a number of different bases. Three are illustrated in this chapter.

• Intracompany basis. Comparisons within a company are often useful to detect changes in financial relationships and significant trends. For example, a comparison of M&S‘s current year’s cash amount with the prior year’s cash amount shows either an increase or a decrease. Likewise, a comparison of M&S’s year-end cash amount with the amount of its total assets at year-end shows the proportion of total assets in the form of cash.
• Industry averages. Comparisons with industry averages provide information about a company’s relative position within the industry. For example, financial statement readers can compare M&S’s financial data with the averages for its industry compiled by financial rating organizations such as the U.S. companies Dun & Bradstreet, Moody’s, and Standard & Poor’s, or with information provided on the Internet by organizations such as Yahoo! on its financial site.
• Intercompany basis. Comparisons with other companies provide insight into a company’s competitive position. For example, investors can compare M&S’s total sales for the year with the total sales of its competitors in retail, such as Carrefour (FRA).

 

Tools of Analysis

Learning Objective 2

Identify the tools of financial statement analysis.

We use various tools to evaluate the significance of financial statement data. Three commonly used tools are as follows.

• Horizontal analysis evaluates a series of financial statement data over a period of time.
• Vertical analysis evaluates financial statement data by expressing each item in a financial statement as a percentage of a base amount.
• Ratio analysis expresses the relationship among selected items of financial statement data.

Horizontal analysis is used primarily in intracompany comparisons. Two features in published financial statements and annual report information facilitate this type of comparison. First, each of the basic financial statements presents comparative financial data for a minimum of two years. Second, a summary of selected financial data is presented for a series of five to 10 years or more. Vertical analysis is used in both intra- and intercompany comparisons. Ratio analysis is used in all three types of comparisons. In the following sections, we explain and illustrate each of the three types of analysis.

 

  Horizontal Analysis

Learning Objective 3

Explain and apply horizontal analysis.

Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place. This change may be expressed as either an amount or a percentage. For example, Illustration 14-1 shows recent net sales figures of Dubois SA.

DUBOIS SA Net Sales (in thousands)
2017	2016	2015
€19,860	€19,903	€18,781

Illustration 14-1    Dubois SA’s net sales

If we assume that 2015 is the base year, we can measure all percentage increases or decreases from this base period amount as follows.

Change Since Base Period

=

Current Year Amount −Base Year AmountBase Year Amount

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

For example, we can determine that net sales for Dubois increased from 2015 to 2016 approximately 6% [(€19,903−€18,781)÷€18,781]. Similarly, we can determine that net sales increased from 2015 to 2017 approximately 5.7% [(€19,860−€18,781)÷€18,781].

Alternatively, we can express current year sales as a percentage of the base period. We do this by dividing the current year amount by the base year amount, as shown below.

Current Results in Relation to Base Period

=

Current Year AmountBase Year Amount

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

Illustration 14-4 presents this analysis for Dubois for a three-year period using 2015 as the base period.

DUBOIS SA Net Sales (in thousands) in Relation to Base Period 2015
2017	2016	2015
€19,860	€19,903	€18,781
105.7%	106.0%	100%

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

Statement of Financial Position

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

QUALITY DEPARTMENT STORE Condensed Statements of Financial Position December 31
			Increase or (Decrease) during 2017
	2017	2016	Amount	Percent
Assets
Intangible assets	€   15,000	€   17,500	€ (2,500)	(14.3%)
Plant assets (net)	800,000	632,500	167,500	26.5%
Current assets	1,020,000	945,000	75,000	7.9%
Total assets	€1,835,000	€1,595,000	€240,000	15.0%
Equity
Share capital—ordinary, €1 par	€  275,400	€  270,000	€  5,400	2.0%
Retained earnings	727,600	525,000	202,600	38.6%
Total equity	1,003,000	795,000	208,000	26.2%
Liabilities
Non-current liabilities	€  487,500	€  497,000	€ (9,500)	(1.9%)
Current liabilities	344,500	303,000	41,500	13.7%
Total liabilities	832,000	800,000	32,000	4.0%
Total equity and liabilities	€1,835,000	€1,595,000	€240,000	15.0%

Illustration 14-5    Horizontal analysis of statements of financial positionThe comparative statements of financial position in Illustration 14-5 show that a number of significant changes have occurred in Quality Department Store’s financial structure from 2016 to 2017:

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

These changes suggest that the company expanded its asset base during 2017 and financed this expansion primarily by retaining incomerather than assuming additional long-term debt.

Income Statement

Illustration 14-6 presents a horizontal analysis of the two-year condensed income statements of Quality Department Store for the years 2017 and 2016. Horizontal analysis of the income statements shows the following changes:

• •Net sales increased €260,000, or 14.2% (€260,000÷€1,837,000).
• •Cost of goods sold increased €141,000, or 12.4% (€141,000÷€1,140,000).
• •Total operating expenses increased €37,000, or 11.6% (€37,000÷€320,000).

Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality’s profit trend appears favorable.

QUALITY DEPARTMENT STORE Condensed Income Statements For the Years Ended December 31
			Increase or (Decrease) during 2017
	2017	2016	Amount	Percent
Sales revenue	€2,195,000	€1,960,000	€235,000	12.0%
Sales returns and allowances	98,000	123,000	(25,000)	(20.3%)
Net sales	2,097,000	1,837,000	260,000	14.2%
Cost of goods sold	1,281,000	1,140,000	141,000	12.4%
Gross profit	816,000	697,000	119,000	17.1%
Selling expenses	253,000	211,500	41,500	19.6%
Administrative expenses	104,000	108,500	(4,500)	(4.1%)
Total operating expenses	357,000	320,000	37,000	11.6%
Income from operations	459,000	377,000	82,000	21.8%
Other income and expense
Interest and dividends	9,000	11,000	(2,000)	(18.2%)
Interest expense	36,000	40,500	(4,500)	(11.1%)
Income before income taxes	432,000	347,500	84,500	24.3%
Income tax expense	168,200	139,000	29,200	21.0%
Net income	€  263,800	€  208,500	€ 55,300	26.5%

Illustration 14-6    Horizontal analysis of income statements

HELPFUL HINT

Note that though the amount column is additive (the total is €55,300), the percentage column is not additive (26.5% is not the column total). A separate percentage has been calculated for each item.

Retained Earnings Statement

Illustration 14-7 presents a horizontal analysis of Quality Department Store’s comparative retained earnings statements. Analyzed horizontally, net income increased €55,300, or 26.5%, whereas dividends on the share capital—ordinary increased only €1,200, or 2%. We saw in the horizontal analysis of the statement of financial position that ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities.

QUALITY DEPARTMENT STORE Retained Earnings Statements For the Years Ended December 31
			Increase or (Decrease) during 2017
	2017	2016	Amount	Percent
Retained earnings, Jan. 1	€525,000	€376,500	€148,500	39.4%
Add: Net income	263,800	208,500	55,300	26.5%
	788,800	585,000	203,800
Deduct: Dividends	61,200	60,000	1,200	2.0%
Retained earnings, Dec. 31	€727,600	€525,000	€202,600	38.6%

Illustration 14-7    Horizontal analysis of retained earnings statements

Horizontal analysis of changes from period to period is relatively straightforward and is quite useful. But, complications can occur in making the computations. If an item has no value in a base year or preceding year but does have a value in the next year, we cannot compute a percentage change. Similarly, if a negative amount appears in the base or preceding period and a positive amount exists the following year (or vice versa), no percentage change can be computed.

  Vertical Analysis

Learning Objective 4

Describe and apply vertical analysis.

Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percentage of a base amount. On a statement of financial position, we might say that current assets are 22% of total assets—total assets being the base amount. Or on an income statement, we might say that selling expenses are 16% of net sales—net sales being the base amount.

Statement of Financial Position

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

QUALITY DEPARTMENT STORE Condensed Statements of Financial Position December 31
	2017		2016
	Amount	Percent	Amount	Percent
Assets
Intangible assets	€   15,000	0.8%	€   17,500	1.1%
Plant assets (net)	800,000	43.6%	632,500	39.7%
Current assets	1,020,000	55.6%	945,000	59.2%
Total assets	€1,835,000	100.0%	€1,595,000	100.0%
Equity
Share capital—ordinary, €1 par	€  275,400	15.0%	€  270,000	16.9%
Retained earnings	727,600	39.7%	525,000	32.9%
Total equity	1,003,000	54.7%	795,000	49.8%
Liabilities
Non-current liabilities	€  487,500	26.5%	€  497,000	31.2%
Current liabilities	344,500	18.8%	303,000	19.0%
Total liabilities	832,000	45.3%	800,000	50.2%
Total equity and liabilities	€1,835,000	100.0%	€1,595,000	100.0%

Illustration 14-8    Vertical analysis of statements of financial position

HELPFUL HINT

The formula for calculating these statement of financial position percentages is: Each itemTotal assets=%

Vertical analysis shows the relative size of each category in the statement of financial position. It also can show the percentage change in the individual asset, liability, and equity items. For example, we can see that current assets decreased from 59.2% of total assets in 2016 to 55.6% in 2017 (even though the absolute euro amount increased €75,000 in that time). Plant assets (net) have increased from 39.7% to 43.6% of total assets. Retained earnings have increased from 32.9% to 39.7% of total equity and liabilities. These results reinforce the earlier observations that Quality Department Store is choosing to finance its growth through retention of earnings rather than through issuing additional debt.

Income Statement

Illustration 14-9 shows vertical analysis of Quality Department Store’s income statements. Cost of goods sold as a percentage of net sales declined 1% (62.1% vs. 61.1%), and total operating expenses declined 0.4% (17.4% vs. 17.0%). As a result, it is not surprising to see net income as a percentage of net sales increase from 11.4% to 12.6%. Quality Department Store appears to be a profitable business that is becoming even more successful.

QUALITY DEPARTMENT STORE Condensed Income Statements For the Years Ended December 31
	2017		2016
	Amount	Percent	Amount	Percent
Sales revenue	€2,195,000	104.7%	€1,960,000	106.7%
Sales returns and allowances	98,000	4.7%	123,000	6.7%
Net sales	2,097,000	100.0%	1,837,000	100.0%
Cost of goods sold	1,281,000	61.1%	1,140,000	62.1%
Gross profit	816,000	38.9%	697,000	37.9%
Selling expenses	253,000	12.0%	211,500	11.5%
Administrative expenses	104,000	5.0%	108,500	5.9%
Total operating expenses	357,000	17.0%	320,000	17.4%
Income from operations	459,000	21.9%	377,000	20.5%
Other income and expense
Interest and dividends	9,000	0.4%	11,000	0.6%
Interest expense	36,000	1.7%	40,500	2.2%
Income before income taxes	432,000	20.6%	347,500	18.9%
Income tax expense	168,200	8.0%	139,000	7.5%
Net income	€  263,800	12.6%	€  208,500	11.4%

Illustration 14-9    Vertical analysis of income statements

HELPFUL HINT

The formula for calculating these income statement percentages is: Each item on I/SNet sales=%

An associated benefit of vertical analysis is that it enables you to compare companies of different sizes. For example, Quality Department Store’s main competitor is a Park Street store in a nearby town. Using vertical analysis, we can compare the condensed income statements of Quality Department Store (a small retail company) with Park Street (a giant global retailer), as shown in Illustration 14-10.

CONDENSED INCOME STATEMENTS For the Year Ended December 31, 2017 (in thousands)
	Quality Department Store		Park Street
	Amount	Percent	Amount	Percent
Net sales	€2,097	100.0%	€17,556,000	100.0%
Cost of goods sold	1,281	61.1%	10,646,000	60.6%
Gross profit	816	38.9%	6,910,000	39.4%
Selling and administrative expenses	357	17.0%	6,247,000	35.6%
Income from operations	459	21.9%	663,000	3.8%
Other income and expense (including income taxes)	195	9.3%	412,000	2.4%
Net income	€  264	12.6%	€   251,000	1.4%

Illustration 14-10    Intercompany income statement comparison

Park Street’s net sales are 8,372 times greater than the net sales of relatively tiny Quality Department Store. But vertical analysis eliminates this difference in size. The percentages show that Quality’s and Park Street’s gross profit rates were comparable at 38.9% and 39.4%. However, the percentages related to income from operations were significantly different at 21.9% and 3.8%. This disparity can be attributed to Quality’s selling and administrative expense percentage (17%), which is much lower than Park Street’s (35.6%). Although Park Street earned net income more than 951 times larger than Quality’s, Park Street’s net income as a percentage of each sales euro (1.4%) is only 11% of Quality’s (12.6%).

 

Ratio Analysis

Learning Objective 5

Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. The relationship is expressed in terms of either a percentage, a rate, or a simple proportion. To illustrate, in 2013, Marks and Spencer plc (M&S) had current assets of £1,267.9 million and current liabilities of £2,238.3 million. We can find the relationship between these two measures by dividing current assets by current liabilities. The alternative means of expression are:

 

Percentage:	Current assets are 57% of current liabilities.
Rate:	Current assets are .57 times current liabilities.
Proportion:	The relationship of current assets to liabilities is .57:1.

To analyze the primary financial statements, we can use ratios to evaluate liquidity, profitability, and solvency. Illustration 14-11 describes these classifications.

Illustration 14-11    Financial ratio classifications

Ratios can provide clues to underlying conditions that may not be apparent from individual financial statement components. However, a single ratio by itself is not very meaningful. Thus, in the discussion of ratios we will use the following types of comparisons.

• Intracompany comparisons for two years for Quality Department Store.
• Industry average comparisons based on median ratios for department stores.
• Intercompany comparisons based on Park Street as Quality Department Store’s principal competitor.

ANATOMY OF A FRAUD

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 (USA) 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).

 

Liquidity Ratios

Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. The ratios we can use to determine the company’s short-term debt-paying ability are the current ratio, the acid-test ratio, accounts receivable turnover, and inventory turnover.

 

1. CURRENT RATIO

The current ratio is a widely used measure for evaluating a company’s liquidity and short-term debt-paying ability. The ratio is computed by dividing current assets by current liabilities. Illustration 14-12 shows the 2017 and 2016 current ratios for Quality Department Store and comparative data.

 

Current ratio = Current Assets Current Liabilities
Quality Department Store
2017		2016
€ 1,020,000 € 344,500 = 2.96:1		€ 945,000 € 303,000 = 3.12:1
Industry average 1.70:1		Park Street 2.05:1

Illustration 14-12    Current ratio

What does the ratio actually mean? The 2017 ratio of 2.96:1 means that for every euro of current liabilities, Quality has €2.96 of current assets. Quality’s current ratio has decreased in the current year. But, compared to the industry average of 1.70:1, Quality appears to be very liquid. Park Street has a current ratio of 2.05:1, which indicates it has adequate current assets relative to its current liabilities.

HELPFUL HINT

Any company can operate successfully without working capital if it has very predictable cash flows and solid earnings. A number of U.S. companies (e.g., Whirlpool, American Standard, and Campbell’s Soup) are pursuing this goal as less money tied up in working capital means more money to invest in the business.

 

The current ratio is sometimes referred to as the working capital ratio. Working capital is current assets minus current liabilities. The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have significantly different current ratios.

The current ratio is only one measure of liquidity. It does not take into account the composition of the current assets. For example, a satisfactory current ratio does not disclose the fact that a portion of the current assets may be tied up in slow-moving inventory. A euro of cash would be more readily available to pay the bills than a euro of slow-moving inventory.

Investor InsightHow 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.

QHow might management influence a company’s current ratio?

 

2. ACID-TEST RATIO

The acid-test (quick) ratio is a measure of a company’s immediate short-term liquidity. We compute this ratio by dividing the sum of cash, short-term investments, and net accounts receivable by current liabilities. Thus, it is an important complement to the current ratio. For example, assume that the current assets of Quality Department Store for 2017 and 2016 consist of the items shown in Illustration 14-13.

 

QUALITY DEPARTMENT STORE Statement of Financial Position (partial)
			2017	2016
Current assets
Prepaid expenses			€   50,000	€   40,000
Inventory			620,000	500,000
Accounts receivable (neta)			230,000	180,000
Short-term investments			20,000	70,000
Cash			100,000	155,000
Total current assets			€1,020,000	€ 945,000

Illustration 14-13    Current assets of Quality Department Store

Cash, short-term investments, and accounts receivable (net) are highly liquid compared to inventory and prepaid expenses. The inventory may not be readily saleable, and the prepaid expenses may not be transferable to others. Thus, the acid-test ratio measures immediate liquidity. The 2017 and 2016 acid-test ratios for Quality Department Store and comparative data are as follows.

 

Acid-Test Ratio = Cash + Short-Term Investments + Accounts Receivable ( Net ) Current Liabilities
Quality Department Store
2017		2016
€ 100,000 + € 20,000 + € 230,000 € 344,500 = 1.02:1		€ 155,000 + € 70,000 + € 180,000 € 303,000 = 1.34:1
Industry average 0.70:1		Park Street 1.05:1

Illustration 14-14    Acid-test ratio

The ratio has declined in 2017. Is an acid-test ratio of 1.02:1 adequate? This depends on the industry and the economy. When compared with the industry average of 0.70:1 and Park Street’s of 1.05:1, Quality’s acid-test ratio seems adequate.

 

3. ACCOUNTS RECEIVABLE TURNOVER

We can measure liquidity by how quickly a company can convert certain assets to cash. How liquid, for example, are the accounts receivable? The ratio used to assess the liquidity of the receivables is the accounts receivable turnover. It measures the number of times, on average, the company collects receivables during the period. We compute the accounts receivable turnover by dividing net credit sales (net sales less cash sales) by the average net accounts receivable. Unless seasonal factors are significant, average net accounts receivable can be computed from the beginning and ending balances of the net accounts receivable.¹

Assume that all sales are credit sales. The balance of net accounts receivable at the beginning of 2016 is €200,000. Illustration 14-15 shows the accounts receivable turnover for Quality Department Store and comparative data. Quality’s accounts receivable turnover improved in 2017. The turnover of 10.2 times is substantially lower than Park Street’s 37.2 times, and is also lower than the department store industry’s average of 46.4 times.

 

Accounts Receivable Turnover = Net Credit Sales Average Net Accounts Receivable
Quality Department Store
2017		2016
€ 2,097,000 [ € 180,000 + € 230,000 2 ] = 10.2   times		€ 1,837,000 [ € 200,000 + € 180,000 2 ] = 9.7   times
Industry average 46.4   times		Park Street 37.2   times

Illustration 14-15    Accounts receivable turnover

 

AVERAGE COLLECTION PERIOD

A popular variant of the accounts receivable turnover is to convert it to an average collection period in terms of days. To do so, we divide the accounts receivable turnover into 365 days. For example, the accounts receivable turnover of 10.2 times divided into 365 days gives an average collection period of approximately 36 days. This means that accounts receivable are collected on average every 36 days, or about every 5 weeks. Analysts frequently use the average collection period to assess the effectiveness of a company’s credit and collection policies. The general rule is that the collection period should not greatly exceed the credit term period (the time allowed for payment).

 

4. INVENTORY TURNOVER

Inventory turnover measures the number of times, on average, the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. We compute the inventory turnover by dividing cost of goods sold by the average inventory. Unless seasonal factors are significant, we can use the beginning and ending inventory balances to compute average inventory.

Assuming that the inventory balance for Quality Department Store at the beginning of 2016 was €450,000, its inventory turnover and comparative data are as shown in Illustration 14-16. Quality’s inventory turnover declined slightly in 2017. The turnover of 2.3 times is low compared with the industry average of 4.3 and Park Street’s 3.1. Generally, the faster the inventory turnover, the less cash a company has tied up in inventory and the less chance a company has of inventory obsolescence.

 

Inventory Turnover = Cost of Goods Sold Average Inventory
Quality Department Store
2017		2016
€ 1,281,000 [ € 500,000 + € 620,000 2 ] = 2.3   times		€ 1,140,000 [ € 450,000 + € 500,000 2 ] = 2.4   times
Industry average 4.3   times		Park Street 3.1   times

Illustration 14-16    Inventory turnover

 

DAYS IN INVENTORY

A variant of inventory turnover is the days in inventory. We calculate it by dividing the inventory turnover into 365. For example, Quality’s 2017 inventory turnover of 2.3 times divided into 365 is approximately 159 days. An average selling time of 159 days is also high compared with the industry average of 84.9 days

(

365

÷

4.3

)

and Park Street’s 117.7 days

(

365

÷

3.1

)

.

Inventory turnovers vary considerably among industries. For example, grocery store chains have a turnover of 17.1 times and an average selling period of 21 days. In contrast, jewelry stores have an average turnover of 0.80 times and an average selling period of 456 days.

 

Profitability Ratios

Profitability ratios measure the income or operating success of a company for a given period of time. Income, or the lack of it, affects the company’s ability to obtain debt and equity financing. It also affects the company’s liquidity position and the company’s ability to grow. As a consequence, both creditors and investors are interested in evaluating earning power—profitability. Analysts frequently use profitability as the ultimate test of management’s operating effectiveness.

 

Alternative Terminology

Profit margin is also called the rate of return on sales.

 

 

5. PROFIT MARGIN

Profit margin is a measure of the percentage of each euro of sales that results in net income. We can compute it by dividing net income by net sales. Illustration 14-17 shows Quality Department Store’s profit margin and comparative data.

 

Profit Margin = Net Income Net Sales
Quality Department Store
2017		2016
€ 263,800 € 2,097,000 = 12.6 %		€ 208,500 € 1,837,000 = 11.4 %
Industry average 8.0 %		Park Street 1.4 %

Illustration 14-17    Profit margin

Quality experienced an increase in its profit margin from 2016 to 2017. Its profit margin is unusually high in comparison with the industry average of 8% and Park Street’s 1.4%.

High-volume (high inventory turnover) businesses, such as grocery stores and discount stores, generally experience low profit margins. In contrast, low-volume businesses, such as jewelry stores or airplane manufacturers, have high profit margins.

 

6. ASSET TURNOVER

Asset turnover measures how efficiently a company uses its assets to generate sales. It is determined by dividing net sales by average total assets. The resulting number shows the euros of sales produced by each euro invested in assets. Unless seasonal factors are significant, we can use the beginning and ending balance of total assets to determine average total assets. Assuming that total assets at the beginning of 2016 were €1,446,000, the 2017 and 2016 asset turnover for Quality Department Store and comparative data are shown in Illustration 14-18.

 

Asset Turnover = Net Sales Average Total Assets
Quality Department Store
2017		2016
€ 2,097,000 [ € 1,595,000 + € 1,835,000 2 ] = 1.2   times		€ 1,837,000 [ € 1,446,000 + € 1,595,000 2 ] = 1.2   times
Industry average 1.4   times		Park Street 1.4   times

Illustration 14-18    Asset turnover

Asset turnover shows that in 2017 Quality generated sales of approximately €1.20 for each euro it had invested in assets. The ratio changed very little from 2016 to 2017. Quality’s asset turnover is below both the industry average of 1.4 times and Park Street’s ratio of 1.4 times.

Asset turnovers vary considerably among industries. For example, a large utility company might have a ratio of 0.4 times, and a large grocery chain might have a ratio of 3.4 times.

 

7. RETURN ON ASSETS

An overall measure of profitability is return on assets. We compute this ratio by dividing net income by average total assets. The 2017 and 2016 return on assets for Quality Department Store and comparative data are shown below.

 

Return on Assets = Net Income Average Total Assets
Quality Department Store
2017		2016
€ 263,800 [ € 1,595,000 + € 1,835,000 2 ] = 15.4 %		€ 208,500 [ € 1,446,000 + € 1,595,000 2 ] = 13.7 %
Industry average 8.9 %		Park Street 2.4 %

Illustration 14-19    Return on assets

Quality’s return on assets improved from 2016 to 2017. Its return of 15.4% is very high compared with the department store industry average of 8.9% and Park Street’s 2.4%.

 

8. RETURN ON ORDINARY SHAREHOLDERS’ EQUITY

Another widely used profitability ratio is return on ordinary shareholders’ equity. It measures profitability from the ordinary shareholders’ viewpoint. This ratio shows how many euros of net income the company earned for each euro invested by the owners. We compute it by dividing net income available to ordinary shareholders by average ordinary shareholders’ equity. When a company has preference shares, we must deduct preference dividend requirements from net income to compute income available to ordinary shareholders. Similarly, we deduct the par value of preference shares (or call price, if applicable) from total equity to determine the amount of ordinary shareholders’ equity used in this ratio. Assuming that ordinary shareholders’ equity at the beginning of 2016 was €667,000, Illustration 14-20 shows the 2017 and 2016 ratios for Quality Department Store and comparative data.

 

Return on Ordinary Shareholders’ Equity = Net Income − Preference Dividends Average Ordinary Shareholders’ Equity
Quality Department Store
2017		2016
€ 263,800 − € 0 [ € 795,000 + € 1,003,000 2 ] = 29.3 %		€ 208,500 − € 0 [ € 667,000 + € 795,000 2 ] = 28.5 %
Industry average 18.3 %		Park Street 6.4 %

Illustration 14-20    Return on ordinary shareholders’ equity

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

Note also that Quality’s rate of return on ordinary shareholders’ equity (29.3%) is substantially higher than its rate of return on assets (15.4%). The reason is that Quality has made effective use of leverage. Leveraging or trading on the equity at a gain means that the company has borrowed money at a lower rate of interest than it is able to earn by using the borrowed money. Leverage enables Quality Department Store to use money supplied by non-owners to increase the return to the owners. A comparison of the rate of return on total assets with the rate of interest paid for borrowed money indicates the profitability of trading on the equity. Quality Department Store earns more on its borrowed funds than it has to pay in the form of interest. Thus, the return to shareholders exceeds the return on the assets, due to benefits from the positive leveraging.

 

9. EARNINGS PER SHARE (EPS)

Earnings per share (EPS) is a measure of the net income earned on each ordinary share. It is computed by dividing net income available to ordinary shareholders by the number of weighted-average ordinary shares outstanding during the year. A measure of net income earned on a per share basis provides a useful perspective for determining profitability. Assuming that there is no change in the number of outstanding shares during 2016 and that the 2017 increase occurred midyear, Illustration 14-21 shows the net income per share for Quality Department Store for 2017 and 2016.

 

Earnings per Share = Net Income − Preference Dividends Weighted-Average Ordinary Shares Outstanding
Quality Department Store
2017		2016
€ 263,800 − € 0 [ 270,000 + 275,400 2 ] = € 0.97		€ 208,500 − € 0 270,000 = € 0.77

Illustration 14-21    Earnings per share

Note that no industry or specific competitive data are presented. Such comparisons are not meaningful because of the wide variations in the number of shares outstanding among companies. The only meaningful EPS comparison is an intracompany trend comparison. Here, Quality’s earnings per share increased 20 cents per share in 2017. This represents a 26% increase over the 2016 earnings per share of 77 cents.

The terms “earnings per share” and “net income per share” refer to the amount of net income applicable to each ordinary share. Therefore, in computing EPS, if there are preference dividends declared for the period, we must deduct them from net income to determine income available to the ordinary shareholders.

 

10. PRICE-EARNINGS RATIO

The price-earnings (P-E) ratio is a widely used measure of the ratio of the market price of each ordinary share to the earnings per share. The price-earnings (P-E) ratio reflects investors’ assessments of a company’s future earnings. We compute it by dividing the market price per share by earnings per share. Assuming that the market price of Quality Department Store shares is €8 in 2016 and €12 in 2017, the price-earnings ratio computation is as follows.

 

Price-Earnings Ratio = Market Price per Share Earnings per Share
Quality Department Store
2017		2016
€ 12.00 € 0.97 = 12.4   times		€ 8.00 € 0.77 = 10.4   times
Industry average 21.3   times		Park Street 17.2   times

Illustration 14-22    Price-earnings ratio

In 2017, each Quality Department Store share sold for 12.4 times the amount that the company earned on each share. Quality’s price-earnings ratio is lower than the industry average of 21.3 times, and also lower than the ratio of 17.2 times for Park Street.

 

11. PAYOUT RATIO

The payout ratio measures the percentage of earnings distributed in the form of cash dividends. We compute it by dividing cash dividends declared on ordinary shares by net income. Companies that have high growth rates generally have low payout ratios because they reinvest most of their net income into the business. The 2017 and 2016 payout ratios for Quality Department Store are computed as shown in Illustration 14-23.

 

Payout Ratio = Cash Dividends Declared on Ordinary Shares Net Income
Quality Department Store
2017		2016
€ 61,200 € 263,800 = 23.2 %		€ 60,000 € 208,500 = 28.8 %
Industry average 16.1 %		Park Street 63.0 %

Illustration 14-23    Payout ratio

Quality’s payout ratio is higher than the industry average payout ratio of 16.1%. Park Street’s ratio is very high because its net income in 2017 was quite low.

 

Solvency Ratios

Solvency ratios measure the ability of a company to survive over a long period of time. Long-term creditors and shareholders are particularly interested in a company’s ability to pay interest as it comes due and to repay the face value of debt at maturity. Debt to assets and times interest earned are two ratios that provide information about debt-paying ability.

 

12. DEBT TO ASSETS RATIO

The debt to assets ratio measures the percentage of the total assets that creditors provide. We compute it by dividing total liabilities (both current and non-current liabilities) by total assets. This ratio indicates the company’s degree of leverage. It also provides some indication of the company’s ability to withstand losses without impairing the interests of creditors. The higher the percentage of total liabilities to total assets, the greater the risk that the company may be unable to meet its maturing obligations. The 2017 and 2016 ratios for Quality Department Store and comparative data are as follows.

 

Debt to Assets Ratio = Total Liabilities Total Assets
Quality Department Store
2017		2016
€ 832,000 € 1,835,000 = 45.3 %		€ 800,000 € 1,595,000 = 50.2 %
Industry average 34.2 %		Park Street 62.0 %

Illustration 14-24    Debt to assets ratio

A ratio of 45.3% means that creditors have provided 45.3% of Quality Department Store’s total assets. Quality’s 45.3% is above the industry average of 34.2%. It is considerably below the high 62.0% ratio of Park Street. The lower the ratio, the more equity “buffer” there is available to the creditors. Thus, from the creditors’ point of view, a low ratio of debt to assets is usually desirable.

The adequacy of this ratio is often judged in the light of the company’s earnings. Generally, companies with relatively stable earnings (such as public utilities) have higher debt to assets ratios than cyclical companies with widely fluctuating earnings (such as many high-tech companies).

 

13. TIMES INTEREST EARNED

Times interest earned provides an indication of the company’s ability to meet interest payments as they come due. We compute it by dividing the sum of net income, interest expense, and income tax expense by interest expense. Illustration 14-25 shows the 2017 and 2016 ratios for Quality Department Store and comparative data. Note that times interest earned uses net income before interest expense and income tax expense. This represents the amount available to cover interest. For Quality Department Store, the 2017 amount of €468,000 is computed by taking net income of €263,800 and adding back the €36,000 of interest expense and the €168,200 of income tax expense.

 

Times Interest Earned = Net Income + Interest Expense + Income Tax Expense Interest Expense
Quality Department Store
2017		2016
€ 263,800 + € 36,000 + € 168,200 € 36,000 = 13   times		€ 208,500 + € 40,500 + € 139,000 € 40,500 = 9.6   times
Industry average 16.1   times		Park Street 2.9   times

Illustration 14-25    Times interest earned

Quality’s interest expense is well covered at 13 times. It is less than the industry average of 16.1 times but significantly exceeds Park Street’s 2.9 times.

Alternative Terminology

Times interest earned is also called interest coverage.

 

 

Summary of Ratios

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

 

Ratio	Formula	Purpose or Use
Liquidity Ratios
1. Current ratio	Current assets Current liabilities	Measures short-term debt-paying ability.
2. Acid-test (quick) ratio	Cash + Short-term investments + Accounts receivable (net) Current liabilities	Measures immediate short-term liquidity.
3. Accounts receivable turnover	Net credit sales Average net accounts receivable	Measures liquidity of accounts receivable.
4. Inventory turnover	Cost of goods sold Average inventory	Measures liquidity of inventory.
Profitability Ratios
5. Profit margin	Net income Net sales	Measures net income generated by each currency unit of sales.
6. Asset turnover	Net sales Average total assets	Measures how efficiently assets are used to generate sales.
7. Return on assets	Net income Average total assets	Measures overall profitability of assets.
8. Return on ordinary shareholders’ equity	Net Income − Preference dividends Average ordinary shareholders’ equity	Measures profitability of owners’ investment.
9. Earnings per share (EPS)	Net Income − Preference dividends Weighted-average ordinary shares outstanding	Measures net income earned on each ordinary share.
10. Price-earnings (P-E) ratio	Market price per share Earnings per share	Measures the ratio of the market price per share to earnings per share.
11. Payout ratio	Cash dividends declared on ordinary shares Net income	Measures percentage of earnings distributed in the form of cash dividends.
Solvency Ratios
12. Debt to assets ratio	Total liabilities Total assets	Measures the percentage of total assets provided by creditors.
13. Times interest earned	Net Income + Interest Expense + Income Tax Expense Interest Expense	Measures ability to meet interest payments as they come due.

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

 

  Earning Power and Unusual Items

 

Learning Objective 6

Understand the concept of earning power, and how discontinued operations are presented.

Users of financial statements are interested in the concept of earning power. Earning power means the normal level of income to be obtained in the future. Earning power differs from actual net income by the amount of unusual revenues, expenses, gains, and losses. Users are interested in earning power because it helps them derive an estimate of future earnings without the “noise” of unusual items.

 

For users of financial statements to determine earning power or regular income, discontinued operations are separately identified on the income statement. Discontinued operations are reported net of income taxes. That is, the income statement first reports income tax on the income before discontinued operations. Then, the amount of tax for discontinued operations is computed. The general concept is “let the tax follow income or loss.”

 

Discontinued Operations

Discontinued operations refers to the disposal of a significant component of a business, such as the elimination of a major class of customers or an entire activity. For example, to downsize its operations, General Dynamics Corp. (USA) sold its missile business to Hughes Aircraft Co. (USA) for $450 million. In its income statement, General Dynamics reported the sale in a separate section entitled “Discontinued operations.”

Following the disposal of a significant component, the company should report on its income statement both income from continuing operations and income (or loss) from discontinued operations. The income (loss) from discontinued operations consists of two parts: the income (loss) from operations and the gain (loss) on disposal of the component.

To illustrate, assume that during 2017 Acro Energy Ltd. has income before income taxes of NT$800,000. During 2017, Acro discontinued and sold its unprofitable chemical division. The loss in 2017 from chemical operations (net of NT$60,000 taxes) was NT$140,000. The loss on disposal of the chemical division (net of NT$30,000 taxes) was NT$70,000. Assuming a 30% tax rate on income, Illustration 14-27 shows Acro’s income statement presentation.

 

ACRO ENERGY LTD. Income Statement (partial) For the Year Ended December 31, 2017
Income before income taxes				NT$800,000
Income tax expense				240,000
Income from continuing operations				560,000
Discontinued operations
Loss from operations of chemical division, net of NT$60,000 income tax savings			NT$140,000
Loss from disposal of chemical division, net of NT$30,000 income tax savings			70,000	210,000
Net income				NT$350,000

Illustration 14-27    Statement presentation of discontinued operations

 

HELPFUL HINT

Observe the dual disclosures: (1) the results of operations of the discontinued division must be eliminated from the results of continuing operations, and (2) the company must also report the disposal of the operation.

 

Note that the statement uses the caption “Income from continuing operations” and adds a new section “Discontinued operations.” The new section reports both the operating loss and the loss on disposal net of applicable income taxes. This presentation clearly indicates the separate effects of continuing operations and discontinued operations on net income.

Investor InsightWhat Does “Non-Recurring” Really Mean?

Procter & Gamble Co. (USA)

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 which are 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, 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, toothpaste and other consumer-goods giant Procter & Gamble Co. (USA) reported a restructuring charge in 12 consecutive quarters. Motorola (USA) had “special” charges in 14 consecutive quarters. On the other hand, other companies have a restructuring charge only once in a five- or ten-year period. There appears to be no substitute for careful analysis of the numbers that comprise net income.

QIf a company takes a large restructuring charge, what is the effect on the company’s current income statement versus future ones?

 

Changes in Accounting Principle

For ease of comparison, users of financial statements expect companies to prepare such statements on a basis consistent with the preceding period. A change in accounting principle occurs when the principle used in the current year is different from the one used in the preceding year. Accounting rules permit a change when management can show that the new principle is preferable to the old principle. An example is a change in inventory costing methods (such as FIFO to average-cost).

Companies report most changes in accounting principle retroactively. That is, they report both the current period and previous periods using the new principle. As a result the same principle applies in all periods. This treatment improves the ability to compare results across years.

 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.

 

 

Comprehensive Income

The income statement reports most revenues, expenses, gains, and losses recognized during the period. However, over time, specific exceptions to this general practice have developed. Certain items now bypass income and are reported directly in equity.

Companies do not include in income any unrealized gains and losses on non-trading securities. Instead, they report such gains and losses in the statement of financial position as adjustments to equity, called accumulated other comprehensive income. Why are these gains and losses on non-trading securities excluded from net income? Because disclosing them separately (1) reduces the volatility of net income due to fluctuations in fair value, yet (2) informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value. Similarly, in Chapter 9 you learned that companies that employ revaluation accounting do not include the revaluation surplus in income. It also is closed out to accumulated other comprehensive income.

Many analysts have expressed concern over the significant increase in the number of items that bypass the income statement. They feel that such reporting has reduced the usefulness of the income statement. To address this concern, in addition to reporting net income, a company must also report comprehensive income. Comprehensive income is therefore the sum of net income plus other comprehensive income items. In other words, it includes all changes in equity during a period except those resulting from investments by shareholders and distributions to shareholders.

To illustrate, assume Stassi AG has ordinary shares of €3,000,000, retained earnings of €1,500,000, and accumulated other comprehensive loss of €2,000. Illustration 14-28 shows the statement of financial position presentation of the unrealized loss.

 

STASSI AG Statement of Financial Position (partial)
Equity
Share capital—ordinary		€3,000,000
Retained earnings		1,500,000
Accumulated other comprehensive loss		2,000
Total equity		€4,498,000

Illustration 14-28    Unrealized loss in equity section

Note that the presentation of the accumulated other comprehensive loss is similar to the presentation of the cost of treasury shares in the equity section. (An unrealized gain would be added in this section of the statement of financial position.) Reporting the unrealized gain or loss in the 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 STATEMENT OF COMPREHENSIVE INCOME

In earlier chapters, we presented other comprehensive income items in a separate comprehensive income statement. Alternatively, companies can present other comprehensive income items and net income in a combined statement of comprehensive income. The statement of comprehensive income for Pace AG in Illustration 14-29 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 discontinued operations and other comprehensive income (highlighted in red).

 

PACE AG Statement of Comprehensive Income For the Year Ended December 31, 2017
Net sales		€440,000
Cost of goods sold		260,000
Gross profit		180,000
Operating expenses		110,000
Income from operations		70,000
Other revenues and gains		5,600
Other expenses and losses		9,600
Income before income taxes		66,000
Income tax expense ( € 66,000 × 30 % )		19,800
Income from continuing operations		46,200
Discontinued operations: Gain on disposal of plastics division, net of €15,000 income taxes (€50,000 × 30%)		35,000
Loss from operation of plastics division, net of income tax savings €18,000 (€60,000 × 30%)		42,000
Net income		39,200
Other comprehensive income
Unrealized gain on non-trading securities, net of income taxes (€15,000 × 30%)		10,500
Comprehensive income		€ 49,700

Illustration 14-29    Complete statement of comprehensive income

 

Quality of Earnings

Learning Objective 7

Understand the concept of quality of earnings.

In evaluating the financial performance of a company, the quality of a company’s earnings is of extreme importance to analysts. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements.

The issue of quality of earnings has taken on increasing importance because recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business. Here are some of the factors affecting quality of earnings.

Alternative Accounting Methods

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

In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization. Although these differences in accounting methods might be detectable from reading the notes to the financial statements, adjusting the financial data to compensate for the different methods is often difficult, if not impossible.

Pro Forma Income

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

To compute pro forma income, companies generally can exclude any items they deem inappropriate for measuring their performance. Many analysts and investors are critical of the practice of using pro forma income because these numbers often make companies look better than they really are. As the financial press noted, pro forma numbers might be called EBBS, which stands for “earnings before bad stuff.” Companies, on the other hand, argue that pro forma numbers more clearly indicate sustainable income because they exclude unusual and non-recurring expenses.

Accounting regulators have provided guidance on how companies should present pro forma information. Stay tuned: Everyone seems to agree that pro forma numbers can be useful if they provide insights into determining a company’s sustainable income. However, many companies have abused the flexibility that pro forma numbers allow and have used the measure as a way to put their companies in a good light.

Improper Recognition

Because some managers have felt pressure from some analysts to continually increase earnings, they have manipulated the earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue. One practice that companies are using is channel stuffing: Offering deep discounts on their products to customers, companies encourage their customers to buy early (stuff the channel) rather than later. This lets the company report good earnings in the current period, but it often leads to a disaster in subsequent periods because customers have no need for additional goods. To illustrate, Bristol-Myers Squibb (USA) at one time indicated that it used sales incentives to encourage wholesalers to buy more drugs than needed to meet patients’ demands. As a result, the company had to issue revised financial statements showing corrected revenues and income.

Another practice is the improper capitalization of operating expenses. The classic case is WorldCom (USA). It capitalized over $7 billion of operating expenses so that it would report positive net income. In other situations, companies fail to report all their liabilities. Enron (USA) had promised to make payments on certain contracts if financial difficulty developed, but these guarantees were not reported as liabilities. In addition, disclosure was so lacking in transparency that it was impossible to understand what was happening at the company.