Income statements for burch company for 2018 and 2019 follow

Financial Statement Analysis

LEARNING OBJECTIVES After you have mastered the material in this chapter, you will be able to:

LO 13-1 Differentiate between horizontal and vertical analysis.

LO 13-2 Calculate ratios for assessing a company’s liquidity.

LO 13-3 Calculate ratios for assessing a company’s solvency.

LO 13-4 Calculate ratios for assessing a company’s managerial effectiveness.

LO 13-5 Calculate ratios for assessing a company’s position in the stock market.

Video lectures and accompanying self-assessment quizzes are available in Connect® for all learning objectives.

CHAPTER 13

CHAPTER OPENING

Expressing financial statement information in the form of ratios enhances its usefulness.

Ratios permit comparisons over time and among companies, highlighting similarities, differ-

ences, and trends. Proficiency with common financial statement analysis techniques bene-

fits both internal and external users. Before beginning detailed explanations of numerous

ratios and percentages, however, we consider factors relevant to communicating useful

information.

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The Curious Accountant

Precision Castings Corp. manufactures metal components and products, and provides castings, forgings, fastener systems, and other structures for customers in the aerospace and power industries. On August 10, 2015, Berkshire Hathaway, Inc., which is run by Warren Buffett, purchased Precision Castings Corp. for $235 per share, or $32.4 billion in total. This price of $235 per share was 21 percent higher than the stock was currently trading on the New York Stock Exchange.

On September 2, 2013, Microsoft Corp. announced that it had purchased the cell phone business of Nokia Corp. for $7 billion. As a part of the acquisition, 32,000 employees of Nokia would now work for Microsoft. At least one observer on CNBC noted that Microsoft probably could have purchased Nokia for 25 percent less a year or so earlier.

How do companies such as Berkshire Hathaway and Microsoft determine that a business they want to own is worth more than the current market price? What types of analysis would they use to make such decisions? Do you think the highly educated, experienced, and well-paid individuals involved in making these high-dollar acquisitions made the right decisions? (Answer on page 595.)

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FACTORS IN COMMUNICATING USEFUL INFORMATION

The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the intended users, the types of decisions users make with financial statement information, and available means of analyzing the information.

The Users Users of financial statement information include managers, creditors, stockholders, potential investors, and regulatory agencies. These individuals and organizations use financial statements for different purposes and bring varying levels of sophistication to understanding business activities. For example, investors range from private individuals who know little about financial statements to large investment brokers and institutional investors capable of using complex statistical analysis techniques. At what level of user knowledge should financial statements be aimed? Condensing and reporting complex business transactions at a level easily understood by nonprofessional investors is increas- ingly difficult. Current reporting standards target users that have a reasonably informed knowledge of business, though that level of sophistication is difficult to define.

The Types of Decisions Just as the knowledge level of potential users varies, the information needs of users varies, depending on the decision at hand. A supplier considering whether or not to sell goods on account to a particular company wants to evaluate the likelihood of getting paid; a potential investor in that company wants to predict the likelihood of increases in the market value of the company’s common stock. Financial statements, however, are designed for general pur- poses; they are not aimed at any specific user group. Some disclosed information, therefore, may be irrelevant to some users but vital to others. Users must employ different forms of analysis to identify information most relevant to a particular decision.

Financial statements can provide only highly summarized economic information. The costs to a company of providing excessively detailed information would be prohibitive. In addition, too much detail leads to information overload, the problem of having so much data that important information becomes obscured by trivial information. Users faced with reams of data may become so frustrated attempting to use it that they lose the value of key information that is provided.

Information Analysis Because of the diversity of users, their different levels of knowledge, the varying informa- tion needs for particular decisions, and the general nature of financial statements, a variety of analysis techniques has been developed. In the following sections, we explain several common methods of analysis. The choice of method depends on which technique appears to provide the most relevant information in a given situation.

METHODS OF ANALYSIS

Financial statement analysis should focus primarily on isolating information useful for making a particular decision. The information required can take many forms but usually involves comparisons, such as comparing changes in the same item for the same company over a number of years, comparing key relationships within the same year, or comparing the operations of several different companies in the same industry. This chapter discusses three categories of analysis methods: horizontal, vertical, and ratio. Exhibits 13.1 and 13.2 present comparative financial statements for Milavec Company. We refer to these statements in the examples of analysis techniques.

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Differentiate between horizontal and vertical analysis.

LO 13-1

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EXHIBIT 13.1

MILAVEC COMPANY Income Statements and Statements of

Retained Earnings For the Years Ending December 31

2018 2017

Sales $900,000 $800,000 Cost of goods sold Beginning inventory 43,000 40,000 Purchases 637,000 483,000 Goods available for sale 680,000 523,000 Ending inventory 70,000 43,000 Cost of goods sold 610,000 480,000 Gross margin 290,000 320,000 Operating expenses 248,000 280,000 Income before taxes 42,000 40,000 Income taxes 17,000 18,000 Net income 25,000 22,000 Plus: Retained earnings, beginning balance 137,000 130,000 Less: Dividends 0 15,000 Retained earnings, ending balance $162,000 $137,000

EXHIBIT 13.2

MILAVEC COMPANY Balance Sheet

As of December 31

2018 2017

Assets Cash $ 20,000 $ 17,000 Marketable securities 20,000 22,000 Notes receivable 4,000 3,000 Accounts receivable 50,000 56,000 Merchandise inventory 70,000 43,000 Prepaid expenses 4,000 4,000 Property, plant, and equipment (net) 340,000 310,000 Total assets $508,000 $455,000

Liabilities and Stockholders’ Equity Accounts payable $ 40,000 $ 38,000 Salaries payable 2,000 3,000 Taxes payable 4,000 2,000 Bonds payable, 8% 100,000 100,000 Preferred stock, 6%, $100 par, cumulative 50,000 50,000 Common stock, $10 par 150,000 125,000 Retained earnings 162,000 137,000 Total liabilities and stockholders’ equity $508,000 $455,000

Horizontal Analysis Horizontal analysis, also called trend analysis, refers to studying the behavior of indi- vidual financial statement items over several accounting periods. These periods may be several quarters within the same fiscal year or they may be several different years. The analysis of a given item may focus on trends in the absolute dollar amount of the item or trends in percentages. For example, a user may observe that revenue increased from one period to the next by $42 million (an absolute dollar amount) or that it increased by a per- centage such as 15 percent.

Absolute Amounts The absolute amounts of particular financial statement items have many uses. Various national economic statistics, such as gross domestic product and the amount spent to replace productive capacity, are derived by combining absolute amounts reported by businesses. Financial statement users with expertise in particular industries might evaluate amounts reported for research and development costs to judge whether a company is spending exces- sively or conservatively. Users are particularly concerned with how amounts change over time. For example, a user might compare a pharmaceutical company’s revenue before and after the patent expired on one of its drugs.

Comparing only absolute amounts has drawbacks, however, because materiality levels differ from company to company or even from year to year for a given company. The materiality of information refers to its relative importance. An item is considered material if knowledge of it would influence the decision of a reasonably informed user. Generally accepted accounting principles permit companies to account for immaterial items in the most convenient way, regardless of technical accounting rules. For example, companies may expense, rather than capitalize and depreciate, relatively inexpensive long-term assets like pencil sharpeners or wastebaskets even if the assets have useful lives of many years. The

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concept of materiality, which has both quantitative and qualitative aspects, underlies all accounting principles.

It is difficult to judge the materiality of an absolute financial statement amount without considering the size of the company reporting it. For reporting purposes, Exxon Corporation’s financial statements are rounded to the nearest million dollars. For Exxon, a $400,000 increase in sales is not material. For a small company, however, $400,000 could represent total sales, a highly material amount. Meaningful comparisons between the two companies’ operating performance are impossible using only absolute amounts. Users can surmount these difficulties with percentage analysis.

Percentage Analysis Percentage analysis involves computing the percentage relationship between two amounts. In horizontal percentage analysis, a financial statement item is expressed as a

percentage of the previous balance for the same item. Percentage analysis sidesteps the materiality problems of comparing different size companies by measuring changes in per- centages rather than absolute amounts. Each change is converted to a percentage of the base year. Exhibit 13.3 presents a condensed version of Milavec’s income statement with horizontal percentages for each item.

The percentage changes disclose that, even though Milavec’s net income increased slightly more than sales, products may be underpriced. Cost of goods sold increased much more than sales, resulting in a lower gross margin. Users would also want to investigate why operating expenses decreased substantially despite the increase in sales.

Whether basing their analyses on absolute amounts, percentages, or ratios, users must

avoid drawing overly simplistic conclusions about the reasons for the results. Numerical relationships flag conditions requiring further study. Recall that a change that appears favorable on the surface may not necessarily be a good sign. Users must evaluate the under- lying reasons for the change.

EXHIBIT 13.3

MILAVEC COMPANY Comparative Income Statements

For the Years Ending December 31

Percentage 2018 2017 Difference

Sales $900,000 $800,000 +12.5%* Cost of goods sold 610,000 480,000 +27.1 Gross margin 290,000 320,000 −9.4 Operating expenses 248,000 280,000 −11.4 Income before taxes 42,000 40,000 +5.0 Income taxes 17,000 18,000 −5.6 Net income $ 25,000 $ 22,000 +13.6

*($900,000 − $800,000) ÷ $800,000; all changes expressed as percentages of previous totals.

CHECK YOURSELF 13.1

The following information was drawn from the annual reports of two retail companies (amounts are shown in millions). One company is an upscale department store; the other is a discount store. Based on this limited information, identify which company is the upscale department store.

Jenkins Co. Horn’s, Inc.

Sales $325 $680 Cost of goods sold 130 408 Gross margin $195 $272

Answer Jenkins’ gross margin represents 60 percent ($195 ÷ $325) of sales. Horn’s gross margin represents 40 percent ($272 ÷ $680) of sales. Since an upscale department store would have higher margins than a discount store, the data suggest that Jenkins is the upscale department store.

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When comparing more than two periods, analysts use either of two basic approaches: (1) choosing one base year from which to calculate all increases or decreases or (2) calculating each period’s percentage change from the preceding figure. To illustrate, assume Milavec’s sales for 2015 through 2018 are as follows:

2018 2017 2016 2015

Sales $900,000 $800,000 $750,000 $600,000 Increase over 2015 sales 50.0% 33.3% 25.0% — Increase over preceding year 12.5% 6.7% 25.0% —

Analysis discloses that Milavec’s 2018 sales represented a 50 percent increase over 2015 sales, and a large increase (25 percent) occurred in 2016. From 2016 to 2017, sales increased only 6.7 percent but in the following year, sales increased much more (12.5 percent).

Obviously Berkshire Hathaway’s and

Microsoft’s acquisitions were based on

a desire to make a profit on their investments. Even though Berkshire’s $235 was higher than Precision Castparts’ cur-

rent market price, in the past couple of years the stock had traded for as much as $275 per share. One of the company’s

major customer bases is the gas and oil industry. Gas and oil prices were depressed in August 2015, which made the

stock market cautious about Precision Castparts’ stock. However, Mr. Buffett, Berkshire’s CEO, believed the company

was a good long-term investment and that the current low price presented a good buying opportunity.

Microsoft wanted to acquire Nokia’s cell phone business to try to increase the use of Microsoft’s Windows operating

system for mobile phones, a segment where Apple and Android dominated. By owning both the hardware and software

aspect of the phone, Microsoft predicted its profit would increase from less than $10 per phone to $40.

How do companies decide what another company is worth? Valuing a potential investment is the result of extensive

financial analysis, as discussed in this chapter, along with capital budgeting techniques, which were discussed in

Chapter 10. As you have seen in these chapters, such decision making is based on estimates about future events.

Predicting the future is imperfect, no matter how well trained the forecaster might be.

How good were the decisions of Berkshire Hathaway and Microsoft? It is too early to say for the purchase of

Precision Castparts, but since Mr. Buffett bought Berkshire Hathaway in 1965, the company’s return has been double

that of the S&P 500 index. As for Microsoft’s purchase of Nokia, things did not turn out well. In July 2015, just two

years after its acquisition, Microsoft announced it was writing down $7.6 billion of its Nokia investment, and eliminat-

ing 7,800 jobs.

Does this mean that financial analysis is useless? No. Assume you were planning to drive across the United States.

Would you prefer to take the trip with a map or without? Obviously you would prefer to have a map or GPS, even though

you know neither device is perfect. Financial analysis can be of great benefit when making business decisions, but there

are always uncertainties about future events that mathematics cannot eliminate.

Sources: Companies’ documents, The Wall Street Journal, and Reuters.

Answers to The Curious Accountant

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Vertical Analysis Vertical analysis uses percentages to compare individual components of financial state- ments to a key statement figure. Horizontal analysis compares items over many time peri- ods; vertical analysis compares many items within the same time period.

Vertical Analysis of the Income Statement Vertical analysis of an income statement (also called a common size income statement) in- volves converting each income statement component to a percentage of sales. Although vertical analysis suggests examining only one period, it is useful to compare common size income statements for several years. Exhibit 13.4 presents Milavec’s income statements, along with vertical percentages, for 2018 and 2017. This analysis discloses that cost of goods sold increased significantly as a percentage of sales. Operating expenses and income taxes, however, decreased in relation to sales. Each of these observations indicates a need for more analysis regarding possible trends for future profits.

EXHIBIT 13.4

MILAVEC COMPANY Vertical Analysis of Comparative Income Statements

2018 2017

Percentage* Percentage* Amount of Sales Amount of Sales

Sales $900,000 100.0% $800,000 100.0% Cost of goods sold 610,000 67.8 480,000 60.0 Gross margin 290,000 32.2 320,000 40.0 Operating expenses 248,000 27.6 280,000 35.0 Income before taxes 42,000 4.7 40,000 5.0 Income taxes 17,000 1.9 18,000 2.3 Net income $ 25,000 2.8% $ 22,000 2.8%

*Percentages may not add exactly due to rounding.

Vertical Analysis of the Balance Sheet Vertical analysis of the balance sheet involves converting each balance sheet component to a percentage of total assets. The vertical analysis of Milavec’s balance sheets in Exhibit 13.5 discloses few large percentage changes from the preceding year. Even small individual percentage changes, however, may represent substantial dollar increases. For example, in- ventory constituted 9.5 percent of total assets in 2017 and 13.8 percent in 2018. While this appears to be a small increase, it actually represents a 62.8 percent increase in the inventory account balance [($70,000 − $43,000) ÷ $43,000] from 2017 to 2018. Careful analysis re- quires considering changes in both percentages and absolute amounts.

RATIO ANALYSIS

Ratio analysis involves studying various relationships between different items reported in a set of financial statements. For example, net earnings (net income) reported on the income statement may be compared to total assets reported on the balance sheet. Analysts calculate many different ratios for a wide variety of purposes. The remainder of this chapter is devoted to discussing some of the more commonly used ratios.

Objectives of Ratio Analysis As suggested earlier, various users approach financial statement analysis with many different objectives. Creditors are interested in whether a company will be able to repay its

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debts on time. Both creditors and stockholders are concerned with how the company is financed, whether through debt, equity, or earnings. Stockholders and potential investors analyze past earnings performance and dividend policy for clues to the future value of their investments. In addition to using internally generated data to analyze operations, company managers find much information prepared for external purposes useful for examining past operations and planning future policies. Although many of these objec- tives are interrelated, it is convenient to group ratios into categories such as measures of debt-paying ability and measures of profitability.

MEASURES OF DEBT-PAYING ABILITY

Liquidity Ratios Liquidity ratios indicate a company’s ability to pay short-term debts. They focus on current assets and current liabilities. The examples in the following section use the financial state- ment information reported by Milavec Company.

Working Capital Working capital is current assets minus current liabilities. Current assets include assets most likely to be converted into cash in the current operating period. Current liabilities represent debts that must be satisfied in the current period. Working capital therefore

EXHIBIT 13.5

MILAVEC COMPANY Vertical Analysis of Comparative Balance Sheets

Percentage* Percentage* 2018 of Total 2017 of Total

Assets Cash $ 20,000 3.9% $ 17,000 3.7% Marketable securities 20,000 3.9 22,000 4.8 Notes receivable 4,000 0.8 3,000 0.7 Accounts receivable 50,000 9.8 56,000 12.3 Merchandise inventory 70,000 13.8 43,000 9.5 Prepaid expenses 4,000 0.8 4,000 0.9 Total current assets 168,000 33.1 145,000 31.9 Property, plant, and equipment 340,000 66.9 310,000 68.1 Total assets $508,000 100.0% $455,000 100.0% Liabilities and Stockholders’ Equity Accounts payable $ 40,000 7.9% $ 38,000 8.3% Salaries payable 2,000 0.4 3,000 0.7 Taxes payable 4,000 0.8 2,000 0.4 Total current liabilities 46,000 9.1 43,000 9.4 Bonds payable, 8% 100,000 19.7 100,000 22.0 Total liabilities 146,000 28.8 143,000 31.4 Preferred stock 6%, $100 par 50,000 9.8 50,000 11.0 Common stock, $10 par 150,000 29.5 125,000 27.5 Retained earnings 162,000 31.9 137,000 30.1 Total stockholders’ equity 362,000 71.2 312,000 68.6 Total liabilities and stockholders’ equity $508,000 100.0% $455,000 100.0%

*Percentages may not add exactly due to rounding.

Calculate ratios for assessing a company’s liquidity.

LO 13-2

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measures the excess funds the company will have available for operations, excluding any new funds it generates during the year. Think of working capital as the cushion against short-term debt-paying problems. Working capital at the end of 2018 and 2017 for Milavec Company was as follows:

2018 2017

Current assets $168,000 $145,000 − Current liabilities 46,000 43,000 Working capital $122,000 $102,000

Milavec Laroque

Current assets (a) $168,000 $500,000 − Current liabilities (b) 46,000 378,000 Working capital $122,000 $122,000 Current ratio (a ÷ b) 3.65:1 1.32:1

Milavec’s working capital increased from 2017 to 2018, but the numbers themselves say little. Whether $122,000 is sufficient or not depends on such factors as the industry in which Milavec operates, its size, and the maturity dates of its current obligations. We can see, however, that the increase in working capital is primarily due to the increase in inventories.

Current Ratio Working capital is an absolute amount. Its usefulness is limited by the materiality difficul- ties discussed earlier. It is hard to draw meaningful conclusions from comparing Milavec’s working capital of $122,000 with another company that also has working capital of $122,000. By expressing the relationship between current assets and current liabilities as a ratio, however, we have a more useful measure of the company’s debt-paying ability relative to other companies. The current ratio, also called the working capital ratio, is calculated as follows:

Current ratio = Current assets Current liabilities

To illustrate using the current ratio for comparisons, consider Milavec’s current position relative to that of Laroque’s, a larger firm with current assets of $500,000 and current liabil- ities of $378,000.

The current ratio is expressed as the number of dollars of current assets for each dollar of current liabilities. In the above example, both companies have the same amount of work- ing capital. Milavec, however, appears to have a much stronger working capital position. Any conclusions from this analysis must take into account the circumstances of the particu- lar companies; there is no single ideal current ratio that suits all companies. In recent years, the average current ratio of the nonfinancial companies that constitute the Dow Jones Indus- trial Average (DJIA) was around 1.54:1. The individual company ratios, however, ranged from 0.77:1 to 3.39:1. A current ratio can be too high. Money invested in factories and developing new products is usually more profitable than money held as large cash balances or invested in inventory.

Quick Ratio The quick ratio, also known as the acid-test ratio, is a conservative variation of the cur- rent ratio. The quick ratio measures a company’s immediate debt-paying ability. Only

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cash, receivables, and current marketable securities (quick assets) are included in the numerator. Less liquid current assets, such as inventories and prepaid expenses, are omitted. Inventories may take several months to sell; prepaid expenses reduce otherwise necessary expenditures but do not lead eventually to cash receipts. The quick ratio is computed as follows:

Quick ratio = Quick assets Current liabilities

Milavec Company’s current ratios and quick ratios for 2018 and 2017 follow:

2018 2017

Current ratio 168,000 ÷ 46,000 145,000 ÷ 43,000 3.65:1 3.37:1 Quick ratio 94,000 ÷ 46,000 98,000 ÷ 43,000 2.04:1 2.28:1

The decrease in the quick ratio from 2017 to 2018 reflects both a decrease in quick as- sets and an increase in current liabilities. The result indicates that the company is less liquid (has less ability to pay its short-term debt) in 2018 than it was in 2017.

Accounts Receivable Ratios Offering customers credit plays an enormous role in generating revenue, but it also increases expenses and delays cash receipts. To minimize bad debts expense and collect cash for use in current operations, companies want to collect receivables as quickly as possible without losing customers. Two relationships are often examined to assess a company’s collection record: accounts receivable turnover and average days to collect receivables (average collection period).

Accounts receivable turnover is calculated as follows:

Accounts receivable turnover = Net credit sales Average accounts receivable

Net credit sales refers to total sales on account less sales discounts and returns. When most sales are credit sales or when a breakdown of total sales between cash sales and credit sales is not available, the analyst must use total sales in the numerator. The denominator is based on net accounts receivable (receivables after subtracting the allowance for doubtful accounts). Since the numerator represents a whole period, it is preferable to use average receivables in the denominator if possible. When comparative statements are available, the average can be based on the beginning and ending balances. Milavec Company’s accounts receivable turnover is computed as follows:

*The 2017 beginning receivables balance was drawn from the 2016 financial statements, which are not included in the illustration.

2018 2017

Net sales (assume all on account) (a) $900,000 $800,000 Beginning receivables (b) $ 56,000 $ 55,000* Ending receivables (c) 50,000 56,000 Average receivables (d) = (b + c) ÷ 2 $ 53,000 $ 55,500 Accounts receivable turnover (a ÷ d) 16.98 14.41

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The 2018 accounts receivable turnover of 16.98 indicates Milavec collected its average receivables almost 17 times that year. The higher the turnover, the faster the collections. A company can have cash flow problems and lose substantial purchasing power if resources are tied up in receivables for long periods.

Average days to collect receivables, or the average collection period, is calculated as follows:

Average days to collect receivables = 365 days Accounts receivable turnover

This ratio offers another way to look at turnover by showing the number of days, on average, it takes to collect a receivable. If receivables were collected 16.98 times in 2018, the average collection period was 21 days, 365 ÷ 16.98 (the number of days in the year divided by accounts receivable turnover). For 2017, it took an average of 25 days (365 ÷ 14.41) to collect a receivable.

Although the collection period improved, no other conclusions can be reached without considering the industry, Milavec’s past performance, and the general economic environment. In recent years, the average time to collect accounts receivable for the 26 nonfinancial companies that make up the DJIA was around 37 days. (Financial firms are excluded because, by the nature of their business, they have very long collec- tion periods.)

Inventory Ratios A fine line exists between having too much and too little inventory in stock. Too little inven- tory can result in lost sales and costly production delays. Too much inventory can use needed space, increase financing and insurance costs, and become obsolete. To help analyze how efficiently a company manages inventory, we use two ratios similar to those used in analyz- ing accounts receivable.

Inventory turnover indicates the number of times, on average, that inventory is totally replaced during the year. The relationship is computed as follows.