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Chapter 2 Accounting Information, Regression Analysis By Cheng Few Lee Joseph Finnerty John Lee Alice C Lee Donald Wort Chapter Outline • • 2.1 Introduction 2.2 Financial Statement: A Brief Review • • • • • • • 2.3 Critique of Accounting Information • • • • • • 2 2.4.1 Static Determination of Financial Ratios 2.4.2 Dynamic Analysis of Financial Ratios 2.4.3 Statistical Distribution of Financial Ratios 2.5 Cost-Volume-Profit Analysis and its Applications • • 2.3.1 Criticism 2.3.2 Methods for Improvement 2.4 Static ratio analysis and its extension • • 2.2.1 Balance Sheet 2.2.2 Statement of Earnings 2.2.3 Statement of Equity 2.2.4 Statement of Cash Flows 2.2.5 Interrelationship Among Four Financial Statements 2.2.6 Annual vs. Quarterly Financial Data 2.5.1 Deterministic Analysis 2.5.2 Stochastic Analysis 2.6 Accounting Income vs. Economic Income 2.2 Financial statement: A brief review • • • • • 3 Balance sheet Income statement Cash flow statement Equity statement Annual vs. quarterly financial data 2.2.1 Balance Sheet Table 2-1 Consolidated Balance Sheets of Johnson & Johnson Inc & Consolidated Subsidiaries (2004–2009) (Dollars in Millions) 2004 2005 2006 2007 Assets Current Assets Cash and Cash Equivalent ($) Marketable Securities Account Receivable Inventory Deferred Taxes on Income Prepaid Expenses and Other Receivable Total Current Assets 9,203 3,681 6,831 3,744 1,737 2,124 27,320 16,055 83 7,010 3,959 1,845 2,442 31,394 4,083 1 8,712 4,889 2,094 3,196 22,975 7,770 1,545 9,444 5,110 2,609 3,467 29,945 10,768 2,041 9,719 5,052 3,430 3,367 34,377 15,810 3,615 9,646 5,180 2,793 2,497 39,541 Marketable Securities — Non-current Property, Plant and Equipment, Net Intangible Assets, Net Deferred Taxes on Income Other Assets Total Assets 46 10,436 11,842 551 3,122 53,317 20 10,830 12,175 385 3,221 58,025 16 13,044 28,688 3,210 2,623 70,556 2 14,185 28,763 4,889 3,170 80,954 14,365 27,695 5,841 2,634 84,912 14,759 31,185 5,507 3,690 94,682 Liabilities and Shareholder’s Equity Current Liabilities Loans and Notes Payable Account Payable Accrued Liabilities Accrued Rebates, Returns, and Promotion Accrued Salaries, Wages, and Commissions Taxes on Income Total Current Liabilities 280 5,227 3,523 2,297 1,094 1,506 13,927 668 4,315 3,529 2,017 1,166 940 12,635 4,579 5,691 4,587 2,189 1,391 724 19,161 2,463 6,909 6,412 2,318 1,512 223 19,837 3,732 7,503 5,531 2,237 1,432 417 20,852 6,318 5,541 5,796 2,028 1,606 442 21,731 2,565 403 2,631 1,978 2,017 211 3,065 2,226 2,014 1,319 5,584 3,160 7,074 1,493 5,402 3,829 8,120 1,432 7,791 4,206 8,223 1,424 6,769 5,947 Long-term Debt Deferred Tax liability Employee Related Obligations Other Liabilities 4 2008 2009 2.2.1 Balance Sheet Table 2-1 Consolidated Balance Sheets of Johnson & Johnson Inc & Consolidated Subsidiaries (2004–2009) (continued) 5 Shareowners’ Equity Preferred Stock-without Par Value Common Stock-Par Value $1.00 Net Receivable from Employee Stock Plan Accumulated Other Comprehensive Income Retained Earnings Less: Common Stock Held in Treasury Total Shareowners’ Equity — — — — — — 3,120 −11 −515 35,223 6,004 31,813 3,120 — −755 41,471 5,965 37,871 3,120 — −2,118 49,290 10,974 39,318 3,120 — −693 55,280 14,388 43,319 3,120 — −4,955 63,379 19,033 42,511 3,120 — −3,058 70,306 19,780 50,588 Total Liabilities and Shareholders’ Equity 53,317 58,025 70556 80954 84912 94682 2.2.2 Income Statement Table 2-2 Consolidated Statements of Earnings of JNJ Inc. & Subsidiaries (2004-09) (dollars in millions) (Dollars in Millions Except Per Share 2004 2005 2006 2007 2008 2009 Figures) Sales to Customers ($) 47,348 50,514 53,324 61,095 63,747 61,897 Cost of Products Sold Gross Profit Selling, Marketing and administrative expenses Research Expense Purchased in-process research and development Interest Income Interest Expense, net of portion capitalized Other (income) expense, Net Earnings before Provision for Taxes on Income Provision for Taxes on Income Net Earnings Basic Net Earnings per Share ($) Diluted Net Earnings per Share ($) 6 13,422 33,926 13,954 36,560 15,057 38,267 17,751 43,344 18,511 45,236 18,447 43,450 15,860 16,877 17,433 20,451 21,490 19,801 5,203 6,312 7,125 7,680 7,577 6,986 18 362 559 807 181 — −195 −487 −829 −452 −361 90 187 54 63 296 435 451 15 −214 −671 1,279 −1,015 547 21,088 22,904 23,680 30,061 26,307 27,695 12,838 13,656 14,587 13,283 16,929 15,755 4,329 3,245 3,534 2,707 3,980 3,489 8,509 10,411 11,053 10,576 12,949 12,266 2.87 3.5 3.76 3.67 4.62 4.45 2.84 3.46 3.73 3.63 4.57 4.4 2.2.3 Statement of Equity 7 2.2.3 Statement of Equity 8 2.2.3 Statement of Equity 9 2.2.4 Statement of Cash Flows 10 2.2.4 Statement of Cash Flows 11 2.3 Critique of accounting information • Criticism • 12 Methods for improvement a) Use of Alternative Information b) Statistical Adjustments c) Application of Finance and Economic Theories 2.4 Static ratio analysis and its extension • Static determination of financial ratios Dynamic analysis of financial ratios Statistical distribution of financial ratios • • 13 Static determination of financial ratios Table 2.5: Company ratios period 2003-2004 Ratio Classification Formula J&J Industry 2008 2009 2008 2009 Liquidity Ratio Current Ratio Current asset Current liabilities 1.65 1.82 2.18 2.06 Quick Ratio CA inventory other CA Current liabilities 0.61 0.89 1.61 1.51 0.48 0.45 0.48 0.49 0.96 0.84 1.02 1.04 2.00 1.87 2.10 2.12 27.78 30.39 26.49 27.16 Leverage Ratio Debt-to-Asset Debt-to-Equity Equity Multiplier Times Interest Paid 14 Total debt Total asset Total debt Total equity Total asset Total equity EBIT Interest expenses Static determination of financial ratios Table 2.5: Company ratios period 2003-2004 (Continued) Ratio Classification Formula J&J Industry 2008 2009 2008 2009 54.11 56.32 72.73 73.14 6.65 6.39 5.81 5.88 3.09 3.04 2.40 2.38 1.26 1.12 3.82 3.82 0.75 0.65 0.67 0.71 20.30% 19.80% 19.47% 19.43% 15.25% 12.95% 12.41% 12.38% 30.20% 26.40% 25.07% 24.51% 12.95 14.47 17.32 20.99 3.90 3.51 3.63 4.27 Activity Ratios Average collection period Accounts receivable Turnover Inventory Turnover Fixed Asset Turnover Total Asset Turnover Profitability Ratios Profit margin Return on assets Return on equity Account Re ceivable Sales / 365 Sales AcountsRe ceivable Cost of Good Sold Inventory Sales Fixed assets Sales Total assets Net income Sales Net incom e Total assets Net Incom e Total equity Market value Price/earnings Price-to-book-value 15 Market price per share Earning per share Market price per share Book value per share Dynamic Analysis of Financial Ratios Basic Model Yj,t=Yj,t-1+δj(Yj,t*-Yj,t-1) where 0≤δj≤1, and δj = A partial adjustment coefficient; Yj,t = Firm’s jth financial ratio period t; Yj,t-1 = Firm’s jth financial ratio period t-1; and Y*j,t = Firm’s jth financial ratio target in period t, 16 (2.1) Dynamic Analysis of Financial Ratios Basic Model Y*j,t = CXj,t-1 + τj,t, (2.2) Yj,t -Yj,t-1 =δj[Xj,t-1-Yj,t-1] (2.3) Zj,t =Aj+BjWj,t-1+εj,t (2.4) where Zj,t = Yj,t - Yj,t-1; Wj,t-1 = Xj,t-1 - Yj,t-1; Aj and Bj = Regression parameters, and εjj,t = The error term. 17 Dynamic Analysis of Financial Ratios Extensions of Basic Model Z′j,t = A′j + B′jW′j,t-1 + εj′j,t, where Z′j,t = log (Yj,t) - log (Yj,t-1); W′j,t-1 = log (Xj,t-1) - log (Yj,t-1); and εj′j,t = The Error term. 18 (2.5) Dynamic Analysis of Financial Ratios Extension of Basic Model log(Y j ,t / Y j ,t 1 ) Bj log( X j ,t 1 / Y j ,t 1 ) % change in [Yj,t / Y j ,t 1 ] % change in [X j,t-1 / Y j ,t 1 ] Yj,t* CX j ,t 1 (2.7) Yj ,t Aˆ Bˆ1 X j ,t 1 Bˆ2Yj ,t 1 j ,t 19 (2.6) (2.8) Dynamic Analysis of Financial Ratios Empirical Data Table 2.6: Dynamic adjustment ratio regression results Variable Current Ratio Leverage Ratio Mean Z 0.0075 -0.03083 Mean W -0.14583 0.361666667 Var(Z) 0.013039 0.006099 Cov(Z,W) 0.074 0.009 Bj` 0.810* 0.259 t-Statistics [3.53] [1.06] Aj` 0.032 -0.042 * Partial adjustment coefficient significant at 95% level 20 Dynamic Analysis of Financial Ratios Empirical Data Table 2.7: Ratio correlation coefficient matrix CR CR AT GPM LR 21 AT GPM LR 1.0 -0.443841 1.0 0.363273 0.381393 1.0 -0.51175 0.21961 -0.05028 1.0 Dynamic Analysis of Financial Ratios Empirical Data Z1,t = A0 +A1Z2,t + A2W1 + εj1,t, (2.9a) Z2,t = B0 + B1Z1,t + B2W2 + εj2,t. (2.9b) where Ai, Bi (i = 0, 1, 2) are coefficients, εj1 and εj2 are error terms, and Z1,t = Individual firm’s current ratio in period t individual firm’s current ratio in period t-1; Z2,t = Individual firm’s leverage ratio in period t individual firm’s leverage ratio period t-1; W1,t = Industry average current ratio in period t-1 individual firm’s current ratio period t-1; W2,t = Industry average leverage ratio in period t-1 individual firm’s leverage ratio in period t-1. 22 Dynamic Analysis of Financial Ratios Empirical Data Table 2.8: Johnson & Johnson empirical results for the simultaneous equation system 23 A0(B0) A1(B1) A2(B2) (2.9a) -0.071 [-1.80] -0.378 [-5.52] 0.080 [1.20] (2.9b) -0.0577 [-1.59] -0.842 [-6.07] 0.074 [0.91] Statistical Distribution of Financial Ratios 1 ( X )2 / 2 2 F[ X ] e 2 ( X ), (2.10) where μ and σ2 are the population mean and variance, respectively, and e and π are given constants; that is, π= 3.14159 and e = 2.71828. 24 Statistical Distribution of Financial Ratios There is a direct relationship between the normal distribution and the log-normal distribution. If Y is log-normally distributed, then X = log Y is normally distributed. Following this definition, the mean and the variance of Y can be defined as: 1 2 Y exp(x x ), 2 Y2 exp(2x x2 )(exp( x2 ) 1), (2.11a) (2.11b) where exp represents an exponential with base e. 25 Deterministic Analysis 26 2.5 COST-VOLUME-PROFIT ANALYSIS AND ITS APPLICATIONS • • 27 Deterministic analysis Stochastic analysis Deterministic Analysis Operating Profit = EBIT = Q(P－V)－F, where Q = Quantity of goods sold; P = Price per unit sold; V = Variable cost per unit sold; F = Total amount of fixed costs; and P - V = Contribution margin. 28 (2.12) Deterministic Analysis F Q (P V ) * (2.13) % Change in profits Q( P V ) Fixed Costs DOL =1 % Change in sales Q( P V ) F Profits DOL 1 . * [1 (Q / Q)] (2.15) Operating profit = EBIT = Qπ(Pπ － Vπ) －F. 29 (2.16) (2.14) Deterministic Analysis 30 2.6 ACCOUNTING INCOME VS. ECONOMIC INCOME Et = At + Pt, where Et = Economic income, At = Accounting earnings, and Pt = Proxy errors. 31 (2.17) 2.7 SUMMARY In this chapter, the usefulness of accounting information in financial analysis is conceptually and analytically evaluated. Both statistical methods and regression analysis techniques are used to show how accounting information can be used to perform active financial analysis for the pharmaceutical industry. In these analyses, static ratio analysis is generalized to dynamic ratio analysis. The necessity of using simultaneous-equation technique in conducting dynamic financial ratio analysis is also demonstrated in detail. In addition, both deterministic and stochastic CVP analyses are examined. The potential applications of CVP analysis in financial analysis and planning are discussed in some detail. Overall, this chapter gives readers a good understanding of basic accounting information and econometric methods, which are needed for financial analysis and planning. 32