Comparative Financial Statement Analysis

Comparability Issues

Financial statements are furnished using four qualitative characteristics that serve as both a guide and a basis. These features are relevance, reliability, understandability, and comparability (Franco, Kothhari & Verdi 2009). They are embedded in the framework of the generally accepted accounting practice (GAAP). The GAAP is used to make it possible to compare data from one accounting period of a company to another accounting period and to compare the financial statements of different companies. Furthermore, a comparison of financial statements of two different companies must be maintained within the same line of business if they are prepared in accordance with the GAAP standards (Franco, Kothhari & Verdi 2009). This helps a general user to analyze the performance and position of one company as compared to another company as well as to the industry standards. This section analyzes the comparison of the financial statements of Goodyear and Michelin. The comparability study will be conducted using the financial statements of 2012 published in the companies` annual reports.

Financial statements of companies include the following elements: assets, liabilities, equity, income, and expenses. The first three elements demonstrate the financial position of the company, and the two others exhibit the company’s operations and financial results. A financial statement that presents information on assets, liability and equity is called a balance sheet. A financial statement that presents information on income and expenses is called an income statement. A comparison of Goodyear and Michelin financial statements is conducted using the entries and data of the companies’ balance sheets and income statements.

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A balance sheet of a company contains information about assets, equity, and liabilities (Utah State University, n.d). Assets are the companyВ’s resources, equity is the companyВ’s obligation to its owners, and liability is the companyВ’s obligation to the third parties. Assets of a company are classified as current and non-current assets. The GAAP framework recommends the following sub-classification of current and non-current assets.

Current assets:

• Cash and cash equivalents
• Account receivable
• Inventory
• Prepaid expenses and other current assets

Noncurrent assets:

• Intangible assets
• Fixed assets
• Investments
• Other long-term assets

The assets sections of the balance sheet reveal that both companies used the same format and structure. Both companies are using deferred income tax assets, which are used to reduce any subsequent period`s income tax expense. At the same time, the restriction is applied to the use of deferred tax assets in the balance sheet unless there are 50% probabilities that the company will generate positive accounting income in the next fiscal year (Utah State University, n.d). MichelinВ’s deferred assets are substantially higher than that of Goodyear. This is an important issue that affects the comparability of assets. However, in this study, it has been ignored.

The liabilities of a company are classified as current and non-current liabilities. The GAAP framework recommends the following sub-classification of current and non-current liabilities. All payable events relate to current liabilities and all long-term debt relates to non-current liabilities. For financial statement comparability, structure, and format of the document play an important role. The goal is to make the document simple and readable to general users. The following table illustrates the liability section of the balance sheets presented in the companiesВ’ annual reports.

The structure of the above document shows that Goodyear used entries that could have been consolidated into a single entry to make the document readable to a wide range of people. The table presented below is developed using consolidated entries. Accounts payable and compensation and benefits of Goodyear are entered under accounts payable; overdraft and debt of Goodyear within one year are entered under “short term debt.” Michelin’s current financial liability is entered under “short-term debt.” This is how comparability is achieved for this section of the document.

The basic accounting equation is Asset = Liability + Equity. This equation implies that the ownerВ’s equity is assets minus liabilities. Both Michelin and Goodyear are corporations; the owner’s equity of these companies is Stockholders’ Equity. In the balance sheet, the equity section includes common stocks, preferred stocks, paid-in capital in excess of par value, paid-in capital from treasury stock, retained earnings, and other values. The annual reports of Michelin and Goodyear use the following entries in the equity section of the balance sheet

In order to make entries of two companies comparable the following steps are applied:

Capital surplus = Share premium

Common stock = Share capital

Reserves = Retained earnings

Other stockholdersВ’ equity = Non controlling interest

Asset = Liability + equity

$16,973 = $15,814 + $1,159 (in millions) – Goodyear

$29,783 = $18,052+ $11,731 (in millions) В– Michelin

A balance sheet contains information about assets, liability, and equity. Two other elements of a companyВ’s financial activity are income and expenses, which are the constituent parts of an income statement. A typical income statement informs the user about the gross profit, operating expenses, operating income, and net income of a company. The income statement illustrates the income and expenses of the company. Goodyear income statement first reports tasks associated with the operation of the company and net income is derived using a classical accounting approach. Goodyear adds or subtracts income and losses caused by different activities, such as foreign currency translation, amortization of prior service cost and unrecognized gains (losses) included in total benefit-cost, increase in net actuarial losses, immediate recognition of prior service cost and unrecognized gains (losses) due to curtailments, settlements, and divestitures, prior service credit (cost) from plan amendments, deferred derivative gains (losses), and reclassification adjustments for amounts recognized in the income to the value of the net income. This arithmetical operation reveals the company’s comprehensive income or loss. The table provided below illustrates the above-described methodology.

The format and structure of the above table do not allow presenting a comparable statement. Numerous issues related to subtasks affect the comparability. It requires developing a better format and structure to describe the principal operations of different categories of the activities. For Michelin, the following assumption is accepted: Total other income (loss) = Net-recurring income + Share of profit -Other financial income & expenses. For Goodyear, comprehensive income and losses are not included in the income statement since such a document is supposed to display activities associated with operating income. This is achieved in the following table.

Financial Analysis: Question A

The acronyms of the given formula

(EBIT / SALES) x (PBT/EBIT) x (PAT / PBT) x (SALES / Assets) x (Assets / Equity) represent the following:

EBIT = Earnings before interest and taxes;

PBT = Profit before income taxes;

PAT = Profit after taxes.

After algebraic manipulation, the formula turns into PAT / Equity or Net income / Stockholders’ equity. The ratio, Net income/Equity, expresses the profitability of a company; return on equity. The decomposition of the ROE illustrates operating profit margin, interest burden, tax efficiency, asset turnover, and financial leverage (Damodhara n.d). The numerical values of variables are available in the balance sheet and the income statement. The following table illustrates the results of the calculation using the decomposed formula.

Financial Analysis: Question B

Return on equity or ROE ratio portrays a company’s profitability. The ratio shows the value of net income generated from one unit of stockholders’ equity. The ratio ROE is decomposed into two parts: return on assets (ROA) and financial leverage (FL). The ROA is then decomposed into net profit margin (NPM) and total asset turnover (TA Turnover). The NPM is then decomposed into tax burden (TB), interest burden (IB), and EBIT / Sales (James Madison University n.d.). The EBIT/Sales ratio expresses operating return on assets. All financing costs and taxes are excluded from this analysis. The ratio describes the percentage of revenue that is left in the company after operating expenses are paid.

EBIT / Sales 2012 2011

Goodyear 3.80% 4.16%

Michelin 11.28% 9.39%

The calculation shows that Michelin was able to obtain a higher amount of revenue from sales both in 2011 and 2012. Michelin was able to increase it in 2012 as compared to 2011. On the contrary, Goodyear did just the opposite.

The ratio PBT / EBIT demonstrates income tax burden (James Madison University n.d.). It shows the amount of interest that is paid from operating earnings and the balance that is left in the company.

PBT / EBIT 2012 2011

Goodyear 55.21% 65.19%

Michelin 85.27% 83.03%

The above calculation shows that after interest payment is made, Michelin was able to keep more money in the company than Goodyear from the operating income EBIT. Moreover, the value increased in 2012 as compared to 2011. It implies that Michelin was able to reduce interest payments in 2012 as compared to 2011. However, Goodyear paid more interest on $1 EBIT in 2012 than in 2011.

The ratio PAT / PBT expresses the relationship between profit after taxes and before taxes (James Madison University n.d.). PBT is derived from EBIT after interest is paid; it indicates that, from the sales, the cost of goods, and other expenses that include operating expenses and interest are paid. The income tax is paid from PBT. Once the income tax is paid, the value becomes PAT. The ratio PAT / PBT shows a companyВ’s tax burden.

PAT / PBT 2012 2011

Goodyear 53.86% 67.48%

Michelin 92.50% 87.24%

The above numbers imply that Michelin’s operations both of the fiscal year 2011 and 2012 were more tax-efficient than Goodyear’s operations. Furthermore, Michelin increased the efficiency in 2012 as compared to 2011. Goodyear, on the contrary, became less tax efficient in 2012 as compared to 2011.

In operating activities, it is important to know how efficiently a company is deploying its assets. The ratio Sales /Assets expresses asset turnover, or so to say revenue per one dollar of assets. A low asset turnover ratio may be associated with poor inventory management or excess production capacity. An increase in asset turnover per year indicates that the company is growing while a decrease implies the opposite.

Sales / Assets 2012 2011

Goodyear 1.24 1.29

Michelin 1.0 1.0

In terms of asset turnover, Goodyear performed slightly better than Michelin. Asset turnover of both companies remained constant during the period of observation.

The accounting formula “assets = liability + equity” describes that assets consist of liability and equity. This concept is further used and the ratio “assets/equity” indicates what part of a company`s assets belongs to the stockholders (Utah State University, n.d). This ratio also indicates the companyВ’s debt ratio. The ratio illustrates that the perfect value of “asset/equity” will be 1.0; it indicates that the entire amount of assets belongs to equity. However, the ratio starts increasing as the company accumulates assets through liability. A high ratio may indicate either that the company is taking debt just to survive or is trading on equity very efficiently. In the second case, a return may be higher through borrowed capital than using equity.

Assets / Equity 2012 2011

Goodyear 27.16 17.33

Michelin 2.54 2.58

The above calculation indicates that Michelin uses equity than debt to run the business; the company is also stable as compared to using debt. However, Goodyear operates on debt financing; moreover, debt financing in 2012 increased by 58% as compared to 2011.

The overall assessment of the above ratios established that Michelin made about 2.5 times higher earnings than Goodyear after paying the cost of goods and operating expenses. In the course of running the business, it pays 20% – 35% less interest and 35% fewer taxes than Goodyear. The latter uses 7%-10% higher debt financing than Michelin. However, Goodyear made 2.4 times and 1.7 times higher return on equity (ROE) than Michelin in 2011 and 2012 respectively. The table provided below illustrates the results of the ROE decomposed formula.