I need problem E14-11 solved on page 714 of the document attached.

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 674 14 Financial Statement Analysis Chapter STUDY OBJECTIVES After studying this chapter, you should be able to: 1 Discuss the need for comparative analysis. 2 Identify the tools of financial statement analysis. 3 Explain and apply horizontal analysis. 4 Describe and apply vertical analysis. 5 Identify and compute ratios used in analyzing a firm's liquidity, profitability, and solvency. 6 Understand the concept of earning power, and how irregular items are presented. 7 Understand the concept of quality of earnings. The Navigator The Navigator Scan Study Objectives Read Feature Story Read Preview Read text and answer p. 681 p. 694 Work Comprehensive Do it! p. 699 Do it! p. 701 p. 703 Review Summary of Study Objectives Answer Self-Study Questions Complete Assignments Feature Story IT PAYS TO BE PATIENT In 2008 Forbes magazine listed Warren Buffett as the richest person in the world. His estimated wealth was $62 billion, give or take a few million. How much is $62 billion? If you invested $62 billion in an investment earning just 4%, you could spend $6.8 million per dayevery dayforever. How did Mr. Buffett amass this wealth? Through careful investing. You think you might want to follow Buffett's example and transform your humble nest-egg into a mountain of cash. His techniques have been widely circulated and emulated, but never practiced with the same degree of success. Buffett epitomizes a \"value investor.\" To this day he applies the same basic techniques he learned in the 1950s from the great value investor 674 JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 675 Benjamin Graham. That means he spends his time looking 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 trend. Instead, he looks for companies in industries with sound economics and ones that have high returns on stockholders' equity. He looks for steady earnings trends and high margins. Buffett sat out on the dot-com mania in the 1990s, when investors put lots of money into fledgling hightech firms, 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. Instead, when the dot-com bubble burst, and nearly everyone else was suffering from investment shock, he swooped in and scooped up deals on companies that he had been following for years. So, how does Mr. 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 giving virtually all of his money to charity before he dies. So, given that neither you nor anyone else will be inheriting Mr. Buffett's riches, you should start honing your financial analysis skills as soon as possible. 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. The Navigator Inside Chapter 14... How to Manage the Current Ratio Keeping Up to Date as an Investor (p. 685) (p. 693) What Does \"Non-Recurring\" Really Mean? (p. 698) All About You: Should I Play the Market Yet? (p. 702) 675 JWCL165_c14_674-725.qxd 8/20/09 11:11 AM Page 676 Preview of Chapter 14 We can learn an important lesson from Warren Buffett. The lesson: 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 book, you can perform a rudimentary analysis on any U.S. 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 unleashing you on the world of high finance, we will present a few more important concepts and techniques, as well as provide you with one more comprehensive review of corporate financial statements. We use all of the decision tools presented in this text to analyze a single companyJ.C. Penney Company, one of the country's oldest and largest retail store chains. The content and organization of Chapter 14 are as follows. Financial Statement Analysis Basics of Financial Statement Analysis Need for comparative analysis Tools of analysis Horizontal and Vertical Analysis Balance sheet Income statement Retained earnings statement Ratio Analysis Liquidity Profitability Solvency Summary Earning Power and Irregular Items Discontinued operations Extraordinary items Changes in accounting principle Comprehensive income Quality of Earnings Alternative accounting methods Pro forma income Improper recognition The Navigator BASICS OF FINANCIAL STATEMENT 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 liquiditythe 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, stockholders look at the profitability and solvency of the company. They want to assess the likelihood of dividends and the growth potential of the stock. Need for Comparative Analysis STUDY OBJECTIVE 1 Discuss the need for comparative analysis. 676 Every item reported in a financial statement has significance. When J.C. Penney Company, Inc. reports cash of $2,471 million on its balance sheet, we know the company had that amount of cash on the balance sheet date. But, we do not know whether the amount represents an increase JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 677 677 Horizontal Analysis 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: 1. Intracompany basis. This basis compares an item or financial relationship within a company in the current year with the same item or relationship in one or more prior years. For example, J.C. Penney can compare its cash balance at the end of the current year with last year's balance to find the amount of the increase or decrease. Likewise, J.C. Penney can compare the percentage of cash to current assets at the end of the current year with the percentage in one or more prior years. Intracompany comparisons are useful in detecting changes in financial relationships and significant trends. 2. Industry averages. This basis compares an item or financial relationship of a company with industry averages (or norms) published by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's. For example, J.C. Penney's net income can be compared with the average net income of all companies in the retail chain-store industry. Comparisons with industry averages provide information as to a company's relative performance within the industry. 3. Intercompany basis. This basis compares an item or financial relationship of one company with the same item or relationship in one or more competing companies. Analysts make these comparisons on the basis of the published financial statements of the individual companies. For example, we can compare J.C. Penney's total sales for the year with the total sales of a major competitor such as Kmart. Intercompany comparisons are useful in determining a company's competitive position. Intracompany XYZ Co. 2011 2012 Industry averages XYZ Co. A Co. B Co. C Co. A+B+C 3 Intercompany XYZ Co. A Co. Tools of Analysis We use various tools to evaluate the significance of financial statement data. Three commonly used tools are these: STUDY OBJECTIVE 2 Identify the tools of financial statement analysis. 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 percent 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 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 ten 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 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 STUDY OBJECTIVE 3 Explain and apply horizontal analysis. JWCL165_c14_674-725.qxd 678 8/16/09 7:46 AM Page 678 Chapter 14 Financial Statement Analysis may be expressed as either an amount or a percentage. For example, the recent net sales figures of J.C. Penney Company are as follows. Illustration 14-1 J.C. Penney Company's net sales J.C. PENNEY COMPANY Net Sales (in millions) 2007 2006 2005 $19,860 $19,903 $18,781 If we assume that 2005 is the base year, we can measure all percentage increases or decreases from this base period amount as follows. Illustration 14-2 Formula for horizontal analysis of changes since base period Change Since Current Year Amount Base Year Amount Base Period Base Year Amount For example, we can determine that net sales for J.C. Penney increased from 2005 to 2006 approximately 6% [($19,903 $18,781) $18,781]. Similarly, we can determine that net sales increased from 2005 to 2007 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. Illustration 14-3 Formula for horizontal analysis of current year in relation to base year Current Results in Current Year Amount Relation to Base Period Base Year Amount Illustration 14-4 presents this analysis for J.C. Penney for a three-year period using 2005 as the base period. Illustration 14-4 Horizontal analysis of J.C. Penney Company's net sales in relation to base period J.C. PENNEY COMPANY Net Sales (in millions) in relation to base period 2005 2007 2006 2005 $19,860 105.7% $19,903 106.0% $18,781 100.0% Balance Sheet To further illustrate horizontal analysis, we will use the financial statements of Quality Department Store Inc., a fictional retailer. Illustration 14-5 (page 679) presents a horizontal analysis of its two-year condensed balance sheets, showing dollar and percentage changes. JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 679 Horizontal Analysis Illustration 14-5 Horizontal analysis of balance sheets QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets December 31 Increase or (Decrease) during 2007 2007 2006 Amount Percent Current assets Plant assets (net) Intangible assets $1,020,000 800,000 15,000 $ 945,000 632,500 17,500 $ 75,000 167,500 (2,500) 7.9% 26.5% (14.3%) Total assets $1,835,000 $1,595,000 $240,000 15.0% $ 344,500 487,500 $ 303,000 497,000 $ 41,500 (9,500) 13.7% (1.9%) 832,000 800,000 32,000 4.0% 275,400 727,600 270,000 525,000 5,400 202,600 2.0% 38.6% 1,003,000 795,000 208,000 26.2% $1,835,000 $1,595,000 $240,000 15.0% Assets Liabilities Current liabilities Long-term liabilities Total liabilities Stockholders' Equity Common stock, $1 par Retained earnings Total stockholders' equity Total liabilities and stockholders' equity The comparative balance sheets in Illustration 14-5 show that a number of significant changes have occurred in Quality Department Store's financial structure from 2006 to 2007: In the assets section, plant assets (net) increased $167,500, or 26.5% ($167,500 $632,500). In the liabilities section, current liabilities increased $41,500, or 13.7% ($41,500 $303,000). In the stockholders' equity section, retained earnings increased $202,600, or 38.6% ($202,600 $525,000). These changes suggest that the company expanded its asset base during 2007 and financed this expansion primarily by retaining income rather than assuming additional long-term debt. Income Statement Illustration 14-6 (page 680) presents a horizontal analysis of the two-year condensed income statements of Quality Department Store Inc. for the years 2007 and 2006. 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. 679 JWCL165_c14_674-725.qxd 680 8/16/09 7:46 AM Page 680 Chapter 14 Financial Statement Analysis Illustration 14-6 Horizontal analysis of income statements QUALITY DEPARTMENT STORE INC. Condensed Income Statements For the Years Ended December 31 Increase or (Decrease) during 2007 2007 2006 Amount Percent $2,195,000 98,000 $1,960,000 123,000 $235,000 (25,000) 12.0% (20.3%) 2,097,000 1,281,000 1,837,000 1,140,000 260,000 141,000 14.2% 12.4% Gross profit 816,000 697,000 119,000 17.1% Selling expenses Administrative expenses 253,000 104,000 211,500 108,500 41,500 (4,500) 19.6% (4.1%) Total operating expenses 357,000 320,000 37,000 11.6% Income from operations Other revenues and gains Interest and dividends Other expenses and losses Interest expense 459,000 377,000 82,000 21.8% 9,000 11,000 (2,000) (18.2%) 36,000 40,500 (4,500) (11.1%) Income before income taxes Income tax expense 432,000 168,200 347,500 139,000 84,500 29,200 24.3% 21.0% $ 263,800 $ 208,500 $ 55,300 26.5% Sales Sales returns and allowances Net sales Cost of goods sold 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 total). A separate percentage has been calculated for each item. Net income 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 common stock increased only $1,200, or 2%. We saw in the horizontal analysis of the balance sheet that ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities. Illustration 14-7 Horizontal analysis of retained earnings statements QUALITY DEPARTMENT STORE INC. Retained Earnings Statements For the Years Ended December 31 Increase or (Decrease) during 2007 2007 Retained earnings, Jan. 1 Add: Net income Deduct: Dividends Retained earnings, Dec. 31 2006 Amount Percent $525,000 263,800 $376,500 208,500 $148,500 55,300 39.4% 26.5% 788,800 61,200 585,000 60,000 203,800 1,200 2.0% $727,600 $525,000 $202,600 38.6% 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 JWCL165_c14_674-725.qxd 8/20/09 11:11 AM Page 681 Vertical Analysis 681 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. before you go on... Do it! Summary financial information for Rosepatch Company is as follows. December 31, 2011 December 31, 2010 Current assets Plant assets (net) $234,000 756,000 $180,000 420,000 Total assets $990,000 Horizontal Analysis $600,000 Compute the amount and percentage changes in 2011 using horizontal analysis, assuming 2010 is the base year. Solution Increase in 2011 Amount Percent Current assets Plant assets (net) $ 54,000 336,000 30% [($234,000 $180,000) $180,000] 80% [($756,000 $420,000) $420,000] Total assets $390,000 Action Plan Find the percentage change by dividing the amount of the increase by the 2010 amount (base year). 65% [($990,000 $600,000) $600,000] Related exercise material: BE14-2, BE14-3, BE14-5, BE14-6, BE14-7, E14-1, E14-3, E14-4, and Do it! 14-1. The Navigator VERTICAL ANALYSIS Vertical analysis, also called common-size analysis, is a technique that STUDY OBJECTIVE 4 expresses each financial statement item as a percent of a base amount. On Describe and apply vertical a balance sheet we might say that current assets are 22% of total assets analysis. total assets being the base amount. Or on an income statement, we might say that selling expenses are 16% of net salesnet sales being the base amount. Balance Sheet Illustration 14-8 (page 682) presents the vertical analysis of Quality Department Store Inc.'s comparative balance sheets. The base for the asset items is total assets. The base for the liability and stockholders' equity items is total liabilities and stockholders' equity. Vertical analysis shows the relative size of each category in the balance sheet. It also can show how the percentage in the individual asset, liability, and stockholders' equity items changes from year to year. For example, we can see that current assets decreased from 59.2% of total assets in 2006 to 55.6% in 2007 (even though the absolute dollar 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 liabilities and stockholders' equity. These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt. Income Statement Illustration 14-9 (page 682) shows vertical analysis of Quality'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 JWCL165_c14_674-725.qxd 682 8/16/09 7:46 AM Page 682 Chapter 14 Financial Statement Analysis Illustration 14-8 Vertical analysis of balance sheets QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets December 31 2007 2006 Amount Percent Amount Percent Current assets Plant assets (net) Intangible assets $1,020,000 800,000 15,000 55.6% 43.6% 0.8% $ 945,000 632,500 17,500 59.2% 39.7% 1.1% Total assets $1,835,000 100.0% $1,595,000 100.0% $ 344,500 487,500 18.8% 26.5% $ 303,000 497,000 19.0% 31.2% 832,000 45.3% 800,000 50.2% 275,400 727,600 15.0% 39.7% 270,000 525,000 16.9% 32.9% 1,003,000 54.7% 795,000 49.8% $1,835,000 100.0% $1,595,000 100.0% Assets Liabilities Current liabilities Long-term liabilities Total liabilities Stockholders' Equity HELPFUL HINT The formula for calculating these balance sheet percentages is: Each item on B/S = % Total assets Common stock, $1 par Retained earnings Total stockholders' equity Total liabilities and stockholders' equity Illustration 14-9 Vertical analysis of income statements QUALITY DEPARTMENT STORE INC. Condensed Income Statements For the Years Ended December 31 2007 2006 Amount Percent Amount Percent $2,195,000 98,000 104.7% 4.7% $1,960,000 123,000 106.7% 6.7% 2,097,000 1,281,000 100.0% 61.1% 1,837,000 1,140,000 100.0% 62.1% Gross profit 816,000 38.9% 697,000 37.9% Selling expenses Administrative expenses 253,000 104,000 12.0% 5.0% 211,500 108,500 11.5% 5.9% Total operating expenses 357,000 17.0% 320,000 17.4% Income from operations Other revenues and gains Interest and dividends 459,000 21.9% 377,000 20.5% 9,000 0.4% 11,000 0.6% 36,000 1.7% 40,500 2.2% 432,000 168,200 20.6% 8.0% 347,500 139,000 18.9% 7.5% $ 263,800 12.6% $ 208,500 11.4% Sales Sales returns and allowances Net sales Cost of goods sold HELPFUL HINT The formula for calculating these income statement percentages is: Each item on I/S =% Net sales Other expenses and losses Interest expense Income before income taxes Income tax expense Net income to see net income as a percent of net sales increase from 11.4% to 12.6%. Quality appears to be a profitable enterprise that is becoming even more successful. An associated benefit of vertical analysis is that it enables you to compare companies of different sizes. For example, Quality's main competitor is a J.C. Penney store in a nearby town. Using vertical analysis, we can compare the condensed JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 683 Ratio Analysis 683 income statements of Quality Department Store Inc. (a small retail company) with J.C. Penney Company, Inc. (a giant international retailer), as shown in Illustration 14-10. Illustration 14-10 Intercompany income statement comparison CONDENSED INCOME STATEMENTS (in thousands) Quality Department Store Inc. J.C. Penney Company1 Dollars Percent Dollars Percent $2,097 1,281 100.0% 61.1% $19,860,000 12,189,000 100.0% 61.4% Gross profit Selling and administrative expenses 816 357 38.9% 17.0% 7,671,000 5,357,000 38.6% 27.0% Income from operations Other expenses and revenues (including income taxes) 459 21.9% 2,314,000 11.6% 195 9.3% 1,203,000 6.0% $ 264 12.6% $ 1,111,000 5.6% Net sales Cost of goods sold Net income J.C. Penney's net sales are 9,471 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 J.C. Penney's gross profit rates were comparable at 38.9% and 38.6%. However, the percentages related to income from operations were significantly different at 21.9% and 11.6%. This disparity can be attributed to Quality's selling and administrative expense percentage (17%) which is much lower than J.C. Penney's (27.0%).Although J.C. Penney earned net income more than 4,208 times larger than Quality's, J.C. Penney's net income as a percent of each sales dollar (5.6%) is only 44% of Quality's (12.6%). RATIO ANALYSIS Ratio analysis expresses the relationship among selected items of financial STUDY OBJECTIVE 5 statement data. A ratio expresses the mathematical relationship between Identify and compute ratios used one quantity and another. The relationship is expressed in terms of either in analyzing a firm's liquidity, a percentage, a rate, or a simple proportion.To illustrate, in 2007 Nike, Inc., profitability, and solvency. had current assets of $8,839.3 million and current liabilities of $3,321.5 million. We can find the relationship between these two measures by dividing current assets by current liabilities. The alternative means of expression are: Percentage: Rate: Proportion: Current assets are 266% of current liabilities. Current assets are 2.66 times current liabilities. The relationship of current assets to current liabilities is 2.66:1. To analyze the primary financial statements, we can use ratios to evaluate liquidity, profitability, and solvency. Illustration 14-11 (page 684) describes these classifications. 1 2007 Annual Report J.C. Penney Company, Inc. (Dallas, Texas). JWCL165_c14_674-725.qxd 684 8/20/09 11:11 AM Page 684 Chapter 14 Financial Statement Analysis Illustration 14-11 Financial ratio classifications Liquidity Ratios Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash Profitability Ratios Revenues - Expenses = Net income Solvency Ratios Founded in 1892 Measure the ability of the company to survive over a long period of time XYZ Co. INTERNATIONAL NOTE As more countries adopt international accounting standards, the ability of analysts to compare companies from different countries should improve. However, international standards are open to widely varying interpretations. In addition, some countries adopt international standards \"with modifications.\" As a consequence, most cross-country comparisons are still not as transparent as within-country comparisons. ETHICS NOTE Companies can affect the current ratio by speeding up or withholding payments on accounts payable just before the balance sheet date. Management can alter the cash balance by increasing or decreasing long-term assets or long-term debt, or by issuing or purchasing equity shares. Measure the income or operating success of a company for a given period of time 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. 1. 2. 3. Intracompany comparisons for two years for Quality Department Store. Industry average comparisons based on median ratios for department stores. Intercompany comparisons based on J.C. Penney Company as Quality Department Store's principal competitor. 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 enterprise's short-term debt-paying ability are the current ratio, the acid-test ratio, receivables 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 2007 and 2006 current ratios for Quality Department Store and comparative data. Illustration 14-12 Current ratio Current Ratio Current Assets Current Liabilities Quality Department Store 2007 2006 $1,020,000 2.961 $344,500 $945,000 3.121 $303,000 Industry average 1.061 J.C. Penney Company 2.021 JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 685 Ratio Analysis What does the ratio actually mean? The 2007 ratio of 2.96:1 means that for every dollar 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 1.06:1, Quality appears to be reasonably liquid. J.C. Penney has a current ratio of 2.02 which indicates it has adequate current assets relative to its current liabilities. 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 slowmoving inventory. A dollar of cash would be more readily available to pay the bills than a dollar of slow-moving inventory. 685 HELPFUL HINT Can any company operate successfully without working capital? Yes, if it has very predictable cash flows and solid earnings. A number of companies (e.g., Whirlpool, American Standard, and Campbell's Soup) are pursuing this goal. The rationale: Less money tied up in working capital means more money to invest in the business. ACCOUNTING ACROSS THE ORGANIZATION How to Manage the Current Ratio The apparent simplicity of the current ratio can have real-world limitations. An addition of equal amounts to both the numerator and the denominator causes the ratio to change. 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 will decrease 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, and its current ratio will increase 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. How might management influence the 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 receivables 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 2007 and 2006 consist of the items shown in Illustration 14-13. QUALITY DEPARTMENT STORE INC. Balance Sheet (partial) 2007 Current assets Cash Short-term investments Receivables (net*) Inventory Prepaid expenses Total current assets 2006 $ 100,000 20,000 230,000 620,000 50,000 $155,000 70,000 180,000 500,000 40,000 $1,020,000 $945,000 *Allowance for doubtful accounts is $10,000 at the end of each year. Illustration 14-13 Current assets of Quality Department Store JWCL165_c14_674-725.qxd 686 8/16/09 7:46 AM Page 686 Chapter 14 Financial Statement Analysis Cash, short-term investments, and receivables (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 2007 and 2006 acid-test ratios for Quality Department Store and comparative data are as follows. Illustration 14-14 Acid-test ratio Acid-Test Ratio Cash Short-Term Investments Receivables (Net) Current Liabilities Quality Department Store 2007 2006 $100,000 $20,000 $230,000 $155,000 $70,000 $180,000 1.021 1.341 $344,500 $303,000 Industry average 0.291 J.C. Penney Company 0.871 The ratio has declined in 2007. 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 0.29:1 and Penney's of 0.87:1, Quality's acid-test ratio seems adequate. 3. RECEIVABLES TURNOVER We can measure liquidity by how quickly a company can convert certain assets to cash. How liquid, for example, are the receivables? The ratio used to assess the liquidity of the receivables is receivables turnover. It measures the number of times, on average, the company collects receivables during the period.We compute receivables turnover by dividing net credit sales (net sales less cash sales) by the average net receivables. Unless seasonal factors are significant, average net receivables can be computed from the beginning and ending balances of the net receivables.2 Assume that all sales are credit sales.The balance of net receivables at the beginning of 2006 is $200,000. Illustration 14-15 shows the receivables turnover for Quality Department Store and comparative data. Quality's receivables turnover improved in 2007. The turnover of 10.2 times is substantially lower than J.C. Penney's 57 times, and is also lower than the department store industry's average of 28.2 times. Illustration 14-15 Receivables turnover Receivables Turnover Net Credit Sales Average Net Receivables Quality Department Store 2007 2006 $2,097,000 10.2 times $180,000 $230,000 2 $1,837,000 9.7 times $200,000 $180,000 2 [ Industry average 28.2 times 2 [ [ [ J.C. Penney Company 57 times If seasonal factors are significant, the average receivables balance might be determined by using monthly amounts. JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 687 Ratio Analysis Average Collection Period. A popular variant of the receivables turnover ratio is to convert it to an average collection period in terms of days. To do so, we divide the receivables turnover ratio into 365 days. For example, the receivables turnover of 10.2 times divided into 365 days gives an average collection period of approximately 36 days. This means that receivables 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 2006 was $450,000, its inventory turnover and comparative data are as shown in Illustration 14-16. Quality's inventory turnover declined slightly in 2007. The turnover of 2.3 times is relatively low compared with the industry average of 7.0 and J.C. Penney's 3.5. Generally, the faster the inventory turnover, the less cash a company has tied up in inventory and the less the chance of inventory obsolescence. Illustration 14-16 Inventory turnover Cost of Goods Sold Inventory Turnover Average Inventory Quality Department Store 2007 $1,281,000 2.3 times $500,000 $620,000 2 $1,140,000 2.4 times $450,000 $500,000 2 [ Industry average 7.0 times [ [ [ 2006 J.C. Penney Company 3.5 times 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 2007 inventory turnover of 2.3 times divided into 365 is approximately 159 days. An average selling time of 159 days is also relatively high compared with the industry average of 52.1 days (365 7.0) and J.C. Penney's 104.3 days (365 3.5). Inventory turnover ratios vary considerably among industries. For example, grocery store chains have a turnover of 10 times and an average selling period of 37 days. In contrast, jewelry stores have an average turnover of 1.3 times and an average selling period of 281 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 powerprofitability.Analysts frequently use profitability as the ultimate test of management's operating effectiveness. 687 JWCL165_c14_674-725.qxd 688 8/16/09 7:46 AM Page 688 Chapter 14 Financial Statement Analysis A LT E R N AT I V E 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 dollar 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. Illustration 14-17 Profit margin Net Income Net Sales Profit Margin Quality Department Store 2007 2006 $263,800 12.6% $2,097,000 $208,500 11.4% $1,837,000 Industry average 3.7% J.C. Penney Company 5.6% Quality experienced an increase in its profit margin from 2006 to 2007. Its profit margin is unusually high in comparison with the industry average of 3.7% and J.C. Penney's 5.6%. High-volume (high inventory turnover) enterprises such as grocery stores (Safeway or Kroger) and discount stores (Kmart or Wal-Mart) generally experience low profit margins. In contrast, low-volume enterprises such as jewelry stores (Tiffany & Co.) or airplane manufacturers (Boeing Co.) 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 assets. The resulting number shows the dollars of sales produced by each dollar 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 2006 were $1,446,000, the 2007 and 2006 asset turnover for Quality Department Store and comparative data are shown in Illustration 14-18. Illustration 14-18 Asset turnover Asset Turnover Net Sales Average Assets Quality Department Store 2007 $2,097,000 1.22 times $1,595,000 $1,835,000 2 $1,837,000 1.21 times $1,446,000 $1,595,000 2 [ Industry average 2.14 times [ [ [ 2006 J.C. Penney Company 1.47 times Asset turnover shows that in 2007 Quality generated sales of $1.22 for each dollar it had invested in assets.The ratio changed little from 2006 to 2007. Quality's asset turnover is below the industry average of 2.14 times and J.C. Penney's ratio of 1.47 times. Asset turnover ratios vary considerably among industries. For example, a large utility company like Consolidated Edison (New York) has a ratio of 0.49 times, and the large grocery chain Kroger Stores has a ratio of 4.34 times. JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 689 Ratio Analysis 7. RETURN ON ASSETS An overall measure of profitability is return on assets. We compute this ratio by dividing net income by average assets. The 2007 and 2006 return on assets for Quality Department Store and comparative data are shown below. Return on Assets Illustration 14-19 Return on assets Net Income Average Assets Quality Department Store 2007 $263,800 15.4% $1,595,000 $1,835,000 2 $208,500 13.7% $1,446,000 $1,595,000 2 [ [ [ [ 2006 Industry average 7.9% J.C. Penney Company 8.2% Quality's return on assets improved from 2006 to 2007. Its return of 15.4% is very high compared with the department store industry average of 7.9% and J.C. Penney's 8.2%. 8. RETURN ON COMMON STOCKHOLDERS' EQUITY Another widely used profitability ratio is return on common stockholders' equity. It measures profitability from the common stockholders' viewpoint. This ratio shows how many dollars of net income the company earned for each dollar invested by the owners. We compute it by dividing net income by average common stockholders' equity. Assuming that common stockholders' equity at the beginning of 2006 was $667,000, Illustration 14-20 shows the 2007 and 2006 ratios for Quality Department Store and comparative data. Return on Common Net Income Stockholders' Equity Average Common Stockholders' Equity Quality Department Store 2007 $263,800 29.3% $795,000 $1,003,000 2 $208,500 28.5% $667,000 $795,000 2 [ Industry average 19.2% [ [ [ 2006 J.C. Penney Company 23.1% Quality's rate of return on common stockholders' equity is high at 29.3%, considering an industry average of 19.2% and a rate of 23.1% for J.C. Penney. With Preferred Stock. When a company has preferred stock, we must deduct preferred dividend requirements from net income to compute income available to common stockholders. Similarly, we deduct the par value of preferred stock (or call price, if applicable) from total stockholders' equity to determine the amount of common stockholders' equity used in this ratio. The ratio then appears as follows. Illustration 14-20 Return on common stockholders' equity 689 JWCL165_c14_674-725.qxd 690 8/16/09 7:46 AM Page 690 Chapter 14 Financial Statement Analysis Illustration 14-21 Return on common stockholders' equity with preferred stock Return on Common Net Income Preferred Dividends Stockholders' Equity Average Common Stockholders' Equity Note that Quality's rate of return on stockholders' 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 nonowners 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 stockholders 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 share of common stock. It is computed by dividing net income by the number of weightedaverage common 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 2006 and that the 2007 increase occurred midyear, Illustration 14-22 shows the net income per share for Quality Department Store for 2007 and 2006. Illustration 14-22 Earnings per share Earnings Net Income per Share Weighted-Average Common Shares Outstanding Quality Department Store 2007 $263,800 $0.97 270,000 275,400 2 $208,500 $0.77 270,000 [ [ 2006 Note that no industry or J.C. Penney data are presented. Such comparisons are not meaningful because of the wide variations in the number of shares of outstanding stock among companies. The only meaningful EPS comparison is an intracompany trend comparison: Quality's earnings per share increased 20 cents per share in 2007. This represents a 26% increase over the 2006 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 share of common stock. Therefore, in computing EPS, if there are preferred dividends declared for the period, we must deduct them from net income to determine income available to the common stockholders. 10. PRICE-EARNINGS RATIO The price-earnings (P-E) ratio is an oft-quoted measure of the ratio of the market price of each share of common stock 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 of the stock by earnings per share. Assuming that the market price of Quality Department Store Inc. stock is $8 in 2006 and $12 in 2007, the price-earnings ratio computation is as follows. JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 691 Ratio Analysis Price-Earnings Ratio Market Price per Share of Stock Earnings per Share Illustration 14-23 Price-earnings ratio Quality Department Store 2007 2006 $12.00 12.4 times $0.97 $8.00 10.4 times $0.77 Industry average 17.1 times J.C. Penney Company 9.7 times In 2007 each share of Quality's stock 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 17.1 times, but 28% higher than the ratio of 9.7 times for J.C. Penney. The average price-earnings ratio for the stocks that constitute the Standard and Poor's 500 Index (500 largest U.S. firms) in early 2007 was approximately 19.1 times. 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 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 2007 and 2006 payout ratios for Quality Department Store are computed as shown in Illustration 14-24. Cash Dividends Payout Ratio Net Income Quality Department Store 2007 2006 $61,200 23.2% $263,800 $60,000 28.8% $208,500 Industry average 16.1% J.C. Penney Company 15.7% Quality's payout ratio is higher than J.C. Penney's payout ratio of 15.7%. As indicated earlier (page 681), Quality funded its purchase of plant assets through retention of earnings but still is able to pay dividends. Solvency Ratios Solvency ratios measure the ability of a company to survive over a long period of time. Long-term creditors and stockholders 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 total assets and times interest earned are two ratios that provide information about debt-paying ability. 12. DEBT TO TOTAL ASSETS RATIO The debt to total assets ratio measures the percentage of the total assets that creditors provide. We compute it by dividing total debt (both current and long-term Illustration 14-24 Payout ratio 691 JWCL165_c14_674-725.qxd 692 8/16/09 7:46 AM Page 692 Chapter 14 Financial Statement Analysis 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 debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations. The 2007 and 2006 ratios for Quality Department Store and comparative data are as follows. Illustration 14-25 Debt to total assets ratio Debt to Total Assets Ratio Total Debt Total Assets Quality Department Store 2007 2006 $832,000 45.3% $1,835,000 $800,000 50.2% $1,595,000 Industry average 40.1% J.C. Penney Company 62.9% 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 40.1%. It is considerably below the high 62.9% ratio of J.C. Penney. 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 total 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 total assets ratios than cyclical companies with widely fluctuating earnings (such as many high-tech companies). A LT E R N AT I V E TERMINOLOGY Times interest earned is also called interest coverage. Illustration 14-26 Times interest earned 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 income before interest expense and income taxes by interest expense. Illustration 14-26 shows the 2007 and 2006 ratios for Quality Department Store and comparative data. Note that times interest earned uses income before income taxes and interest expense. This represents the amount available to cover interest. For Quality Department Store the 2007 amount of $468,000 is computed by taking the income before income taxes of $432,000 and adding back the $36,000 of interest expense. Times Interest Income before Income Taxes and Interest Expense Earned Interest Expense Quality Department Store 2007 2006 $468,000 13 times $36,000 $388,000 9.6 times $40,500 Industry average 10.7 times J.C. Penney Company 12.3 times Quality's interest expense is well covered at 13 times, compared with the industry average of 10.7 times and J.C. Penney's 12.3 times. JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 693 Ratio Analysis I N V E S T O R I N S I G H T Keeping Up to Date as an Investor Today, investors have access to information provided by corporate managers that used to be available only to professional analysts. Corporate managers have always made themselves available to security analysts for questions at the end of every quarter. Now, because of a combination of new corporate disclosure requirements by the Securities and Exchange Commission and technologies that make communication to large numbers of people possible at a very low price, the average investor can listen in on these discussions. For example, one individual investor, Matthew Johnson, a Nortel Networks local area network engineer in Belfast, Northern Ireland, \"stayed up past midnight to listen to Apple Computer's Internet conference call. Hearing the company's news 'from the dog's mouth,' he says 'gave me better information' than hunting through chat-rooms.\" Source: Jeff D. Opdyke, \"Individuals Pick Up on Conference Calls,\" Wall Street Journal, November 20, 2000. If you want to keep current with the financial and operating developments of a company in which you own shares, what are some ways you can do so? Summary of Ratios Illustration 14-27 summarizes the ratios discussed in this chapter. The summary includes the formula and purpose or use of each ratio. Illustration 14-27 Summary of liquidity, profitability, and solvency ratios Ratio Formula Purpose or Use Liquidity Ratios Current assets Current liabilities Measures short-term debt-paying ability. 2. Acid-test (quick) ratio Cash Short-term investments Receivables (net) Current liabilities Measures immediate short-term liquidity. 3. Receivables turnover Net credit sales Average net receivables 1. Current ratio 4. Inventory turnover Cost of goods sold Average inventory Measures liquidity of receivables. Measures liquidity of inventory. Profitability Ratios 5. Profit margin 6. Asset turnover 7. Return on assets 8. Return on common stockholders' equity Net income Net sales Measures net income generated by each dollar of sales. Net sales Average assets Measures how efficiently assets are used to generate sales. Net income Average assets Measures overall profitability of assets. Net income Preferred dividends Average common stockholders' equity Measures profitability of owners' investment. 693 JWCL165_c14_674-725.qxd 694 8/20/09 11:11 AM Page 694 Chapter 14 Financial Statement Analysis Illustration 14-27 (continued) Ratio Formula 9. Earnings per share (EPS) Net income Preferred dividends Weighted-average common shares outstanding 10. Price-earnings (P-E) ratio Market price per share of stock Earnings per share Measures the ratio of the market price per share to earnings per share. Cash dividends Net income Measures percentage of earnings distributed in the form of cash dividends. 11. Payout ratio Purpose or Use Measures net income earned on each share of common stock. Solvency Ratios 12. Debt to total assets ratio 13. Times interest earned Total debt Total assets Measures the percentage of total assets provided by creditors. Income before income taxes and interest expense Interest expense Measures ability to meet interest payments as they come due. before you go on... Ratio Analysis Do it! The condensed financial statements of John Cully Company, for the years ended June 30, 2011 and 2010, are presented below. JOHN CULLY COMPANY Balance Sheets June 30 Assets Current assets Cash and cash equivalents Accounts receivable (net) Inventories Prepaid expenses and other current assets Total current assets Property, plant, and equipment (net) Investments Intangibles and other assets Total assets (in thousands) 2011 2010 $ 553.3 776.6 768.3 204.4 $ 611.6 664.9 653.5 269.2 2,302.6 694.2 12.3 876.7 2,199.2 647.0 12.6 849.3 $3,885.8 $3,708.1 $1,497.7 679.5 1,708.6 $1,322.0 637.1 1,749.0 $3,885.8 $3,708.1 Liabilities and Stockholders' Equity Current liabilities Long-term liabilities Stockholders' equitycommon Total liabilities and stockholders' equity JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 695 Ratio Analysis 695 JOHN CULLY COMPANY Income Statements For the Years Ended June 30 Revenues Costs and expenses Cost of goods sold Selling and administrative expenses Interest expense Total costs and expenses Income before income taxes Income tax expense Net income (in thousands) 2011 2010 $6,336.3 $5,790.4 1,617.4 4,007.6 13.9 5,638.9 697.4 291.3 $ 406.1 1,476.3 3,679.0 27.1 5,182.4 608.0 232.6 $ 375.4 Compute the following ratios for 2011 and 2010. (a) (b) (c) (d) (e) (f) (g) Current ratio. Inventory turnover. (Inventory on 6/30/09 was $599.0.) Profit margin. Return on assets. (Assets on 6/30/09 were $3,349.9.) Return on common stockholders' equity. (Stockholders' equity on 6/30/09 was $1,795.9.) Debt to total assets ratio. Times interest earned. Solution 2011 (a) Current ratio: $2,302.6 $1,497.7 $2,199.2 $1,322.0 (b) Inventory turnover: $1,617.4 [($768.3 $653.5) 2] $1,476.3 [($653.5 $599.0) 2] (c) Profit margin: $406.1 $6,336.3 $375.4 $5,790.4 (d) Return on assets: $406.1 [($3,885.8 $3,708.1) 2] $375.4 [($3,708.1 $3,349.9) 2] (e) Return on common stockholders' equity: $406.1 [($1,708.6 $1,749.0) 2] $375.4 [($1,749.0 $1,795.9) 2] (f) Debt to total assets ratio: ($1,497.7 $679.5) $3,885.8 ($1,322.0 $637.1) $3,708.1 (g) Times interest earned: ($406.1 $291.3 $13.9) $13.9 ($375.4 $232.6 $27.1) $27.1 2010 1.51 1.71 Action Plan Remember that the current ratio includes all current assets. The acid-test ratio uses only cash, short-term investments, and net receivables. Use average balances for turnover ratios like inventory, receivables, and assets. 2.3 times 2.4 times 6.4% 6.5% 10.7% 10.6% 23.5% 21.2% 56.0% 52.8% 51.2 times 23.4 times Related exercise material: BE14-9, BE14-10, BE14-11, BE14-12, BE14-13, E14-5, E14-6, E14-7, E14-8, E14-9, E14-10, E14-11, and Do it! 14-2. The Navigator JWCL165_c14_674-725.qxd 696 8/16/09 7:46 AM Page 696 Chapter 14 Financial Statement Analysis EARNING POWER AND IRREGULAR ITEMS Users of financial statements are interested in the concept of earning power. Earning power means the normal level of income to be obtained in Understand the concept of the future. Earning power differs from actual net income by the amount of earning power, and how irregular irregular revenues, expenses, gains, and losses. Users are interested in items are presented. earning power because it helps them derive an estimate of future earnings without the \"noise\" of irregular items. For users of financial statements to determine earning power or regular income, the \"irregular\" items are separately identified on the income statement. Companies report two types of \"irregular\" items. STUDY OBJECTIVE 6 1. Discontinued operations. 2. Extraordinary items. These \"irregular\" items are reported net of income taxes. That is, the income statement first reports income tax on the income before \"irregular\" items. Then the amount of tax for each of the listed \"irregular\" items 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. Examples involve stopping an entire activity or eliminating a major class of customers. For example, Kmart reported as discontinued operations its decision to terminate its interest in four business activities, including PACE Membership Warehouse and PayLess Drug Stores Northwest. 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 segment. To illustrate, assume that during 2011 Acro Energy Inc. has income before income taxes of $800,000. During 2011 Acro discontinued and sold its unprofitable chemical division. The loss in 2011 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 14-28 shows Acro's income statement presentation. Illustration 14-28 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. (2) The company must also report the disposal of the operation. ACRO ENERGY INC. Income Statement (partial) For the Year Ended December 31, 2011 Income before income taxes Income tax expense Income from continuing operations Discontinued operations Loss from operations of chemical division, net of $60,000 income tax saving Loss from disposal of chemical division, net of $30,000 income tax saving Net income $800,000 240,000 560,000 $140,000 70,000 210,000 $350,000 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 JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 697 697 Earning Power and Irregular Items presentation clearly indicates the separate effects of continuing operations and discontinued operations on net income. Extraordinary Items Extraordinary items are events and transactions that meet two conditions:They are (1) unusual in nature, and (2) infrequent in occurrence. To be unusual, the item should be abnormal and only incidentally related to the company's customary activities.To be infrequent, the item should not be reasonably expected to recur in the foreseeable future. A company must evaluate both criteria in terms of its operating environment.Thus, Weyerhaeuser Co. reported the $36 million in damages to its timberland caused by the volcanic eruption of Mount St. Helens as an extraordinary item.The eruption was both unusual and infrequent. In contrast, Florida Citrus Company does not report frost damage to its citrus crop as an extraordinary item, because frost damage is not infrequent. Illustration 14-29 shows the classification of extraordinary and ordinary items. Extraordinary items Illustration 14-29 Examples of extraordinary and ordinary items Ordinary items 1. Effects of major natural casualties, if rare in the area. 1. Effects of major natural casualties, not uncommon in the area. 2. Expropriation (takeover) of property by a foreign government. 2. Write-down of inventories or write-off of receivables. XYZ e tibl ollec c unIN VOIC E 3. Effects of a newly enacted law or regulation, such as a property condemnation action. 3. Losses attributable to labor strikes. 4. Gains or losses from sales of property, plant, or equipment. Companies report extraordinary items net of taxes in a separate section of the income statement, immediately below discontinued operations. To illustrate, assume that in 2011 a foreign government expropriated property held as an investment by Acro Energy Inc. If the loss is $70,000 before applicable income taxes of $21,000, the income statement will report a deduction of $49,000, as shown in Illustration 14-30 (page 698). When there is an extraordinary item to report, the company adds the caption \"Income before extraordinary item\" immediately before the section for the extraordinary item. This presentation clearly indicates the effect of the extraordinary item on net income. What if a transaction or event meets one (but not both) of the criteria for an extraordinary item? In that case the company reports it under either \"Other revenues and gains\" or \"Other expenses and losses\" at its gross amount (not net of tax). This is true, for example, of gains (losses) resulting from the sale of property, plant, and equipment, as explained in Chapter 9. It is quite common for companies to use the label \"Non-recurring charges\" for losses that do not meet the extraordinary item criteria. JWCL165_c14_674-725.qxd 698 8/20/09 11:11 AM Page 698 Chapter 14 Financial Statement Analysis Illustration 14-30 Statement presentation of extraordinary items ACRO ENERGY INC. Income Statement (partial) For the Year Ended December 31, 2011 Income before income taxes Income tax expense HELPFUL HINT If there are no discontinued operations, the third line of the income statement would be labeled \"Income before extraordinary item.\" $800,000 240,000 Income from continuing operations Discontinued operations Loss from operations of chemical division, net of $60,000 income tax saving Loss from disposal of chemical division, net of $30,000 income tax saving 560,000 $140,000 70,000 Income before extraordinary item Extraordinary item Expropriation of investment, net of $21,000 income tax saving Net income I N V E S T O R 210,000 350,000 49,000 $301,000 I N S I G H T 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 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. reported a restructuring charge in 12 consecutive quarters. Motorola had \"special\" charges in 14-consecutive quarters. On the other hand, other companies have a restructuring charge only once in a fiveor ten-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? 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 Changes in accounting change in accounting principle occurs when the principle used in the current principle should result in financial year is different from the one used in the preceding year. Accounting rules statements that are more permit a change when management can show that the new principle is informative for statement users. They should not be used to preferable to the old principle. An example is a change in inventory costing artificially improve the reported methods (such as FIFO to average-cost). performance or financial position Companies report most changes in accounting principle retroactively. of the corporation. 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 JWCL165_c14_674-725.qxd 8/20/09 11:11 AM Page 699 Quality of Earnings 699 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 stockholders' equity. For example, in Chapter 12 you learned that companies do not include in income any unrealized gains and losses on available-for-sale securities. Instead, they report such gains and losses in the balance sheet as adjustments to stockholders' equity. Why are these gains and losses on available-for-sale securities excluded from net income? Because disclosing them separately (1) reduces the volatility of net income due to fluctuations in fair value, yet (2) informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value. 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 includes all changes in stockholders' equity during a period except those resulting from investments by stockholders and distributions to stockholders. A number of alternative formats for reporting comprehensive income are allowed. These formats are discussed in advanced accounting courses. before you go on... Do it! In its proposed 2011 income statement, AIR Corporation reports income before income taxes $400,000, extraordinary loss due to ea