Attachments
1114237 – Wiley US ©
CHAPTER 13
Financial Analysis: The Big Picture
Chapter Preview
We can all learn an important lesson from Warren Buffett: Study companies carefully if
you wish to invest. Do not get caught up in fads but instead find companies that are
financially healthy. Using some of the basic decision tools presented in this text, you can
perform a rudimentary analysis on any company and draw basic conclusions about its
financial health. Although it would not be wise for you to bet your life savings on a
company’s stock relying solely on your current level of knowledge, we strongly encourage
you to practice your new skills wherever possible. Only with practice will you improve your
ability to interpret financial numbers.
Before we unleash you on the world of high finance, we present a few more important
concepts and techniques as well as one more comprehensive review of corporate financial
statements. We use all of the decision tools presented in this text to analyze a single
company, with comparisons to a competitor and industry averages.
1114237 – Wiley US ©
Feature Story
It Pays to Be Patient
A recent issue of Forbes magazine listed Warren Buffett as the second richest person
in the world. His estimated wealth was $69 billion, give or take a few million. How
much is $69 billion? If you invested $69 billion in an investment earning just 4%, you
could spend $7.6 million per day—every day—forever.
So, how does Buffett spend his money? Basically, he doesn’t! He still lives in the same
house that he purchased in Omaha, Nebraska, in 1958 for $31,500. He still drives his
own car (a Cadillac DTS). And, in case you were thinking that his kids are riding the
road to Easy Street, think again. Buffett has committed to donate virtually all of his
money to charity before he dies.
How did Buffett amass this wealth? Through careful investing. Buffett epitomizes a
“value investor.” He applies the basic techniques he learned in the 1950s from the
great value investor Benjamin Graham. He looks for companies that have good long-
term potential but are currently underpriced. He invests in companies that have low
exposure to debt and that reinvest their earnings for future growth. He does not get
caught up in fads or the latest trends.
For example, Buffett sat out on the dot-com mania in the 1990s. When other investors
put lots of money into fledgling high-tech firms, Buffett didn’t bite because he did not
find dot-com companies that met his criteria. He didn’t get to enjoy the stock price
boom on the way up, but on the other hand, he didn’t have to ride the price back down
to Earth. When the dot-com bubble burst, everyone else was suffering from
investment shock. Buffett swooped in and scooped up deals on companies that he
had been following for years.
In 2012, the stock market had again reached near record highs. Buffett’s returns had
been significantly lagging the market. Only 26% of his investments at that time were
in stock, and he was sitting on $38 billion in cash. One commentator noted that “if the
past is any guide, just when Buffett seems to look most like a loser, the party is about
to end.”
If you think you want to follow Buffett’s example and transform your humble nest egg
into a mountain of cash, be warned. His techniques have been widely circulated and
emulated, but never practiced with the same degree of success. You should probably
start by honing your financial analysis skills. A good way for you to begin your career
as a successful investor is to master the fundamentals of financial analysis
discussed in this chapter.
Source: Jason Zweig, “Buffett Is Out of Step,” Wall Street Journal (May 7, 2012).
1114237 – Wiley US ©
Chapter Outline
LEARNING OBJECTIVES
LO 1 Apply the concepts of sustainable
income and quality of earnings.
Sustainable
income
Quality of
earnings
DO IT! 1
Unusual Items
LO 2 Apply horizontal analysis and
vertical analysis.
Horizontal
analysis
Vertical analysis
DO IT! 2
Horizontal
Analysis
LO 3 Analyze a company’s performance
using ratio analysis.
Liquidity ratios
Solvency ratios
Profitability ratios
Financial analysis
and data analytics
Comprehensive
example
DO IT! 3 Ratio
Analysis
Go to the Review and Practice section at the end of the chapter for a targeted
summary and practice applications with solutions.
Visit WileyPLUS for additional tutorials and practice opportunities.
Sustainable Income and Quality of Earnings
LEARNING OBJECTIVE 1
Apply the concepts of sustainable income and quality of earnings.
Sustainable Income
The value of a company like Google is a function of the amount, timing, and uncertainty
of its future cash flows. Google’s current and past income statements are particularly
useful in helping analysts predict these future cash flows. In using this approach, analysts
must make sure that Google’s past income numbers reflect its sustainable income, that is,
do not include unusual (out-of-the-ordinary) revenues, expenses, gains, and losses.
Sustainable income is, therefore, the most likely level of income to be obtained by a
company in the future. Sustainable income differs from actual net income by the amount
of unusual revenues, expenses, gains, and losses included in the current year’s income.
Analysts are interested in sustainable income because it helps them derive an estimate of
future earnings without the “noise” of unusual items.
Fortunately, an income statement provides information on sustainable income by
separating operating transactions from nonoperating transactions. This statement also
highlights intermediate components of income such as income from operations, income
before income taxes, and income from continuing operations. In addition, information on
unusual items such as gains or losses on discontinued items and components of other
comprehensive income are disclosed.
1114237 – Wiley US ©
Illustration 13.1 presents a statement of comprehensive income for Cruz Company for the
year 2022. A statement of comprehensive income includes not only net income but a
broader measure of income called comprehensive income. The two major unusual items
in this statement are discontinued operations and other comprehensive income
(highlighted in red). When estimating future cash flows, analysts must consider the
implications of each of these components.
ILLUSTRATION 13.1 Statement of comprehensive income
Cruz Company
Statement of Comprehensive Income
For the Year Ended 2022
Sales revenue $900,000
Cost of goods sold 650,000
Gross profit 250,000
Operating expenses 100,000
Income from operations 150,000
Other revenues (expenses) and gains (losses) 20,000
Income before income taxes 170,000
Income tax expense 24,000
Income from continuing operations 146,000
Discontinued operations (net of tax) 30,000
Net income 176,000
Other comprehensive income items (net of tax) 10,000
Comprehensive income $186,000
In looking at Illustration 13.1, note that Cruz Company’s two major types of unusual items,
discontinued operations and other comprehensive income, are reported net of tax. That is,
Cruz first calculates income tax expense before income from continuing operations. Then,
it calculates income tax expense related to the discontinued operations and other
comprehensive income, and displays each item separately, net of tax. The general concept
is, “Let the tax follow the income or loss.” We discuss discontinued operations and other
comprehensive income in more detail next.
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 (see Decision
Tools). For example, to downsize its operations, General Dynamics Corp. sold its missile
business to Hughes Aircraft Co. for $450 million. In the net income section of its
statement of comprehensive income, General Dynamics reported the sale in a separate
section entitled “Discontinued operations.”
Decision Tools
The discontinued operations section alerts users to the sale of any of a company’s
major components of its business.
Following the disposal of a significant component, the company should report on its
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 2022 Acro Energy Inc. has income before income taxes of
$800,000. During 2022, Acro discontinued and sold its unprofitable chemical division. The
1114237 – Wiley US ©
loss in 2022 from chemical operations (net of $60,000 taxes) was $140,000. The loss on
disposal of the chemical division (net of $30,000 taxes) was $70,000. Assuming a 30%
tax rate on income, Illustration 13.2 shows Acro’s statement of comprehensive income
presentation (see Helpful Hint).
ILLUSTRATION 13.2 Statement presentation of discontinued operations
Acro Energy Inc.
Statement of Comprehensive Income (partial)
For the Year Ended December 31, 2022
Income before income taxes $800,000
Income tax expense 240,000
Income from continuing operations 560,000
Discontinued operations
Loss from operation of chemical division, net of
$60,000 income tax savings
$140,000
Loss from disposal of chemical division, net of
$30,000 income tax savings
70,000 210,000
Net income $350,000
HELPFUL HINT
Observe the dual disclosures: (1) the results of operation of the discontinued
division must be separated from the results of continuing operations, and (2) the
company must also report the gain or loss on disposal of the division.
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.
1114237 – Wiley US ©
Investor Insight
What Does “Non-Recurring” Really Mean?
Many companies incur restructuring charges as they attempt to reduce costs. They
often label these items in the income statement as “non-recurring” charges, to
suggest that they are isolated events, unlikely to occur in future periods. The question
for analysts is, are these costs really one-time, “non-recurring events” or do they reflect
problems that the company will be facing for many periods in the future? If they are
one-time events, then they can be largely ignored when trying to predict future
earnings.
But, some companies report “one-time” restructuring charges over and over again. For
example, Procter & Gamble reported a restructuring charge in 12 consecutive
quarters, and Motorola had “special” charges in 14 consecutive quarters. On the other
hand, other companies have a restructuring charge only once in a 5- or 10-year period.
There appears to be no substitute for careful analysis of the numbers that comprise
net income.
If a company takes a large restructuring charge, what is the effect on the
company’s current income statement versus future ones? (Go to WileyPLUS for this
answer and additional questions.)
Comprehensive Income
Most revenues, expenses, gains, and losses are included in net income. However, as
discussed in earlier chapters, certain gains and losses that bypass net income are reported
as part of a more inclusive earnings measure called comprehensive income.
Comprehensive income is the sum of net income and other comprehensive income
items.1
Illustration of Comprehensive Income
Accounting standards require that companies adjust most investments in stocks and
bonds up or down to their market price at the end of each accounting period. For example,
assume that during 2022, its first year of operations, Stassi Corporation purchased IBM
bonds for $10,500 as an investment, which it intends to sell sometime in the future. At the
end of 2022, Stassi was still holding the investment, but the bonds’ market price was now
$8,000. In this case, Stassi is required to reduce the recorded value of its IBM investment
by $2,500. The $2,500 difference is an “unrealized” loss. A gain or loss is referred to as
unrealized when as asset has experienced a change in value but the owner has not sold
the asset. The sale of the asset results in “realization” of the gain or loss.
1114237 – Wiley US ©
Should Stassi include this $2,500 unrealized loss in net income? It depends on whether
Stassi classifies the IBM bonds as a trading security or an available-for-sale security. A
trading security is bought and held primarily for sale in the near term to generate income
on short-term price differences. Companies report unrealized losses on trading securities
in the “Other expenses and losses” section of the income statement. The rationale: It is
likely that the company will realize the unrealized loss (or an unrealized gain), so the
company should report the loss (gain) as part of net income.
If Stassi did not purchase the investment for trading purposes, it is classified as available-
for-sale. Available-for-sale securities are held with the intent of selling them sometime in
the future. Companies do not include unrealized gains or losses on available-for-sale
securities in net income. Instead, they report them as part of “Other comprehensive
income.” Other comprehensive income is not included in net income.
Format
One format for reporting other comprehensive income is to report a separate
comprehensive income statement. For example, assuming that Stassi Corporation has a
net income of $300,000 and a 20% tax rate, the unrealized loss would be reported below
net income, net of tax, as shown in Illustration 13.3.
ILLUSTRATION 13.3 Lower portion of combined statement of income and
comprehensive income
Stassi Corporation
Comprehensive Income Statement
For the Year Ended December 31, 2022
Net income $300,000
Other comprehensive income
Unrealized loss on available-for-sale securities, net of $500 income
tax savings
2,000
Comprehensive income $298,000
Companies report the cumulative amount of other comprehensive income from all years
as a separate component of stockholders’ equity. To illustrate, assume Stassi has
common stock of $3,000,000, retained earnings of $300,000, and accumulated other
comprehensive loss of $2,000. (To simplify, we are assuming that this is Stassi’s first year
of operations. Since it has only operated for one year, the cumulative amount of other
comprehensive income is this year’s loss of $2,000.) Illustration 13.4 shows the balance
sheet presentation of the accumulated other comprehensive loss.
ILLUSTRATION 13.4 Unrealized loss in stockholders’ equity section
Stassi Corporation
Balance Sheet (partial)
Stockholders’ equity
Common stock $3,000,000
Retained earnings 300,000
Total paid-in capital and retained earnings 3,300,000
Accumulated other comprehensive loss (2,000)
Total stockholders’ equity $3,298,000
Note that the presentation of the accumulated other comprehensive loss is similar to the
presentation of the cost of treasury stock in the stockholders’ equity section. (An
unrealized gain would be added in this section of the balance sheet.)
Complete Statement of Comprehensive Income
1114237 – Wiley US ©
As seen in Illustration 13.1, as an alternative to preparing a separate comprehensive
income statement, many companies report net income and other comprehensive income
in a combined statement of comprehensive income. (For your homework in this chapter,
use this combined format.) The statement of comprehensive income for Pace Corporation
in Illustration 13.5 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).
ILLUSTRATION 13.5 Complete statement of comprehensive income
Pace Corporation
Statement of Comprehensive Income
For the Year Ended December 31, 2022
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
Loss from operation of plastics division, net of
income tax savings $18,000 ($ 60,000 × 30%)
$42,000
Gain on disposal of plastics division, net of
$15,000 income taxes ($ 50,000 × 30%)
35,000 7,000
Net income 39,200
Other comprehensive income Unrealized gain on
available-for-sale securities, net of income taxes ($
15,000 × 30%)
10,500
Comprehensive income $ 49,700
Changes in Accounting Principle
For ease of comparison, users of financial statements expect companies to prepare their
statements on a basis consistent with the preceding period. A change in accounting
principle occurs when the principle used in the current year is different from the one used
in the preceding year (see Decision Tools). An example is a change in inventory costing
methods (such as FIFO to average-cost). Accounting rules permit a change when
management can show that the new principle is preferable to the old principle.
Decision Tools
Informing users of a change in accounting principle helps them determine the effect
of this change on current and prior periods.
Companies report most changes in accounting principle retroactively.2 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.
1114237 – Wiley US ©
Investor Insight United Parcel Service (UPS)
More Frequent Ups and Downs
In the past, U.S. companies used a method to account for their pension plans that
smoothed out the gains and losses on their pension portfolios by spreading gains
and losses over multiple years. Many felt that this approach was beneficial because it
reduced the volatility of reported net income. However, recently some companies have
opted to adopt a method that comes closer to recognizing gains and losses in the
period in which they occur. Some of the companies that have adopted this approach
are United Parcel Service (UPS), Honeywell International, IBM, AT&T, and Verizon
Communications. The CFO at UPS said he favored the new approach because “events
that occurred in prior years will no longer distort current-year results. It will result in
better transparency by eliminating the noise of past plan performance.” When UPS
switched, it resulted in a charge of $827 million from the change in accounting
principle.
Source: Bob Sechler and Doug Cameron, “UPS Alters Pension-Plan Accounting,” Wall Street
Journal (January 30, 2012).
When predicting future earnings, how should analysts treat the one-time charge
that results from a switch to the different approach for accounting for pension
plans? (Go to WileyPLUS for this answer and additional questions.)
Quality of Earnings
The quality of a company’s earnings is of extreme importance to analysts. A company
that has a high quality of earnings provides full and transparent information that will not
confuse or mislead users of the financial statements.
Recent accounting scandals suggest that some companies are spending too much time
managing their income and not enough time managing their business. Here are some of
the factors affecting quality of earnings.
Alternative Accounting Methods
Variations among companies in the application of generally accepted accounting
principles may hamper comparability and reduce quality of earnings. For example,
suppose one company uses the FIFO method of inventory costing, while another company
in the same industry uses LIFO. If inventory is a significant asset to both companies, it is
unlikely that their current ratios are comparable. For example, if General Motors
Corporation used FIFO instead of LIFO for inventory valuation, its inventories in a recent
1114237 – Wiley US ©
year would have been 26% higher, which significantly affects the current ratio (and other
ratios as well).
In addition to differences in inventory costing methods, differences also exist in reporting
such items as depreciation and amortization. Although these differences in accounting
methods might be detectable from reading the notes to the financial statements, adjusting
the financial data to compensate for the different methods is often difficult, if not
impossible.
Pro Forma Income
Companies whose stock is publicly traded are required to present their income statement
following generally accepted accounting principles (GAAP). In recent years, many
companies have been also reporting a second measure of income, called pro forma
income. Pro forma income usually excludes items that the company thinks are unusual or
non-recurring. For example, in a recent year, Cisco Systems (a high-tech company)
reported a quarterly net loss under GAAP of $2.7 billion. Cisco reported pro forma income
for the same quarter as a profit of $230 million. This large difference in profits between
GAAP income numbers and pro forma income is not unusual. For example, during one
nine-month period, the 100 largest companies on the Nasdaq stock exchange reported a
total pro forma income of $19.1 billion but a total loss as measured by GAAP of $82.3
billion—a difference of about $100 billion!
To compute pro forma income, companies generally exclude any items they deem
inappropriate for measuring their performance. Many analysts and investors are critical of
the practice of using pro forma income because these numbers often make companies
look better than they really are. As the financial press noted, pro forma numbers might be
called “earnings before bad stuff.” Companies, on the other hand, argue that pro forma
numbers more clearly indicate sustainable income because they exclude unusual and non-
recurring expenses. “Cisco’s technique gives readers of financial statements a clear picture
of Cisco’s normal business activities,” the company said in a statement issued in response
to questions about its pro forma income accounting.
Recently, the SEC provided some guidance on how companies should present pro forma
information. Stay tuned: Everyone seems to agree that pro forma numbers can be useful if
they provide insights into determining a company’s sustainable income. However, many
companies have abused the flexibility that pro forma numbers allow and have used the
measure as a way to put their companies in a more favorable light.
Improper Recognition
Because some managers feel pressure from Wall Street to continually increase earnings,
they manipulate earnings numbers to meet these expectations. The most common abuse
is the improper recognition of revenue. One practice that some companies use is called
channel stuffing. Offering deep discounts, companies encourage customers to buy early
(stuff the channel) rather than later. This boosts the seller’s earnings in the current period,
but it often leads to a disaster in subsequent periods because customers have no need for
additional goods. To illustrate, Bristol-Myers Squibb at one time indicated that it used
sales incentives to encourage wholesalers to buy more drugs than they needed. As a
result, the company had to issue revised financial statements showing corrected revenues
and income.
Another practice is the improper capitalization of operating expenses. WorldCom
capitalized over $7 billion of operating expenses in order to report positive net income. In
other situations, companies fail to report all their liabilities. Enron promised to make
payments on certain contracts if financial difficulty developed, but these guarantees were
not reported as liabilities. In addition, disclosure was so lacking in transparency that it was
impossible to understand what was happening at the company.
1114237 – Wiley US ©
DO IT! 1 | Unusual Items
In its proposed 2022 income statement, AIR Corporation reports income before
income taxes $400,000, unrealized gain on available-for-sale securities $100,000,
income taxes $120,000 (not including unusual items), loss from operation of
discontinued flower division $50,000, and loss on disposal of discontinued flower
division $90,000. The income tax rate is 30%. Prepare a correct statement of
comprehensive income, beginning with “Income before income taxes.”
ACTION PLAN
Show discontinued operations and other comprehensive income net of tax.
Solution
AIR Corporation
Statement of Comprehensive Income (partial)
For the Year Ended December 31, 2022
Income before income taxes $400,000
Income tax expense 120,000
Income from continuing operations 280,000
Discontinued operations
Loss from operation of flower division, net of
$15,000 income tax savings
$35,000
Loss on disposal of flower division, net of
$27,000 income tax savings
63,000 98,000
Net income 182,000
Other comprehensive income
Unrealized gain on available-for-sale securities,
net of $30,000 income taxes
70,000
Comprehensive income $252,000
Related exercise material: BE13.1, BE13.2, DO IT! 13.1, E13.1, and E13.2.
Horizontal Analysis and Vertical Analysis
LEARNING OBJECTIVE 2
Apply horizontal analysis and vertical analysis.
As indicated, in assessing the financial performance of a company, investors are
interested in the core or sustainable earnings of a company. In addition, investors are
interested in making comparisons from period to period. Throughout this text, we have
relied on three types of comparisons to improve the decision-usefulness of financial
information:
1. Intracompany basis. Comparisons within a company are often useful to detect
changes in financial relationships and significant trends. For example, a comparison of
1114237 – Wiley US ©
Kellogg’s current year’s cash amount with the prior year’s cash amount shows either an
increase or a decrease. Likewise, a comparison of Kellogg’s year-end cash amount with
the amount of its total assets at year-end shows the proportion of total assets in the
form of cash.
2. Intercompany basis. Comparisons with other companies provide insight into a
company’s competitive position. For example, investors can compare Kellogg’s total
sales for the year with the total sales of its competitors in the breakfast cereal area,
such as General Mills.
3. Industry averages. Comparisons with industry averages provide information about
a company’s relative position within the industry. For example, financial statement
readers can compare Kellogg’s financial data with the averages for its industry
compiled by financial rating organizations such as Dun & Bradstreet, Moody’s, and
Standard & Poor’s, or with information provided on the Internet by organizations such
as Yahoo! on its financial site.
We use three basic tools in financial statement analysis to highlight the significance of
financial statement data:
1. Horizontal analysis.
2. Vertical analysis.
3. Ratio analysis.
In previous chapters, we relied primarily on ratio analysis, supplemented with some basic
horizontal and vertical analysis. In the remainder of this section, we introduce more formal
forms of horizontal and vertical analysis. In the next section, we review ratio analysis in
some detail.
Horizontal Analysis
Horizontal analysis, also known as trend analysis, is a technique for evaluating a series of
financial statement data over a period of time (see Decision Tools). Its purpose is to
determine the increase or decrease that has taken place, expressed as either an amount or
a percentage. For example, here are recent net sales figures (in thousands) of Chicago
Cereal Company:
2022 2021 2020 2019 2018
$11,776 $10,907 $10,177 $9,614 $8,812
Decision Tools
Horizontal analysis helps users compare a company’s financial position and
operating results with those of the previous period.
If we assume that 2018 is the base year, we can measure all percentage increases or
decreases relative to this base-period amount with the formula shown in Illustration 13.6.
ILLUSTRATION 13.6 Horizontal analysis—computation of changes since base period
For example, we can determine that net sales for Chicago Cereal increased approximately
9.1% [($ 9,614 − $ 8,812) ÷ $ 8,812] from 2018 to 2019. Similarly, we can also determine
that net sales increased by 33.6% [($ 11,776 − $ 8,812) ÷ $ 8,812] from 2018 to 2022.
Alternatively, we can express current-year sales as a percentage of the base period. To do
so, we would divide the current-year amount by the base-year amount, as shown in
Illustration 13.7.
1114237 – Wiley US ©
ILLUSTRATION 13.7 Horizontal analysis—computation of …