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Chapter 16Chapter 16

How to Read, Analyze, How to Read, Analyze, and Interpret and Interpret

Financial ReportsFinancial Reports

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

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• Explain the purpose and the key items on the balance sheet

• Explain and complete vertical and horizontal analysis

How to Read, Analyze, and Interpret Financial Reports#16#16Learning Unit ObjectivesBalance Sheet -- Report as of a Particular Date

LU16.1LU16.1

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• Explain the purpose and the key items on the income statement

• Explain and complete vertical and horizontal analysis

How to Read, Analyze, and Interpret Financial Reports#16#16Learning Unit ObjectivesIncome Statement -- Report for a Specific Period of Time

LU16.2LU16.2

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• Explain and complete a trend analysis

• List, explain, and calculate key financial ratios

How to Read, Analyze, and Interpret Financial Reports#16#16Learning Unit ObjectivesTrend and Ratio AnalysisLU16.3LU16.3

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Accounting Equation

Accounting Equation: Assets = Liabilities + Owner’s Equity

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Balance SheetGives a financial picture of what a company is worth as of particular date.

Assets

Liabilities+

Owner’s Equity= How

much the company

owns

How much the owner is

worth

How much the company

owes

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Figure 16.1 - Elements of the Balance Sheet

MOOL COMPANYBalance Sheet

December 31, 2007Assets Liabilities

a. Current assets: a. Current liabilities:

b. Cash $ 7,000 b. Accounts payable $ 80,000

c. Accounts receivable 9,000 c. Salaries payable 12,000

d. Merchandise inventory 30,000 d. Total current liabilities $ 92,000

e. Prepaid expenses 15,000 e. Long-term liabilities:

f. Total current assets $61,000 f. Mortgage note payable 58,000

g. Plant and equipment: g. Total liabilities $150,000

h. Building (net) $60,000

i. Land 84,000 Stockholders Equity

j. Total plant and equipment 144,000 a. Common stock $ 20,000

b. Retained earnings 35,000

c. Total stockholders equity 55,000

k. Total assets $205,000 d. Total liab. and stkhlds equity $205,000

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Preparing a Vertical Analysis of a Balance Sheet

Step 1. Divide each asset (the portion) as a percent of total assets (the base). Round as indicated.

Step 2. Round each liability and stockholders’ equity (the portions) as a percent of total liabilities and stockholders’ equity (the base). Round as indicated.

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Figure 16.2 - Comparative Balance Sheet: Vertical Analysis

ROGER COMPANY

Comparative Balance Sheet

December 31, 2006 and 2007

2007 2006Amount Percent Amount Percent

AssetsCurrent Assets:

Cash $22,000 25.88 $18,000 22.22

Accounts Receivable 8,000 9.41 9,000 11.11

Merchandise inventory 9,000 10.59 7,000 8.64

Prepaid rent 4,000 4.71 5,000 6.71

Total current assets $43,000 50.59 $39,000 48.15*

Plant and equipment:

Building (net) $18,000 21.19 $18,000 22.22

Land 24,000 28.24 24,000 29.63

Total plant and equipment $42,000 49.41* $42,000 51.85

Total assets $85,000 100.00 $81,000 100.00

* Due to rounding

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Preparing a Horizontal Analysis of a Comparative Balance Sheet

Step 1. Calculate the increase or decrease (portion) in each item from the base year.

Step 2. Divide the increase or decrease in Step 1 by the old or base year.

Step 3. Round as indicated.

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Figure 16.3 - Comparative Balance Sheet: Horizontal Analysis

ABBY ELLEN COMPANY

Comparative Balance Sheet

December 31, 2006 and 2007

Increase(decrease) 2007 2006 Amount Percent

AssetsCurrent Assets:

Cash $ 6,000 $ 4,000 $ 2,000 50.00

Accounts Receivable 5,000 6,000 (1,000) -16.67

Merchandise inventory 9,000 4,000 5,000 125.00

Prepaid rent 5,000 7,000 (2,000) -28.57

Total current assets $25,000 $21,000 $ 4,000 19.05

Plant and equipment:

Building (net) $12,000 $12,000 0 0

Land 18,000 18,000 0 0

Total plant and equipment $30,000 $30,000 0 0

Total assets $55,000 $51,000 $4,000 7.84

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Income Statement

A financial report that tells how well a company is performing (its profitability or net profit) during a specific period of time.

Service Business

Revenues

-Operating Expenses

=Net Income

Retail Business

Revenues (Sales)

- Cost of merchandise sold

= Gross profit from sales

- Operating Expenses

= Net Income (Profit)

Income

Statement

$

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MOOL COMPANYIncome Statement

For Month Ended December 31, 2007 Revenuesa. Gross Sales $22,080b. Less: Sales returns and allowances $ 1,082c. Sales discounts 432 1,514d. Net Sales Cost of merchandise (goods) sold: $20,566a. Merchandise Inventory 12/1/2004 $ 1,248b. Purchases $10,512c. Less: Purchases returns and allowances $336d. Less: Purchase discounts 204 540e. Cost of net purchases 9,972f. Cost of merchandise (goods available for sale) $11,220g. Less: Merchandise inventory 12/31/2004 1,600h. Cost of merchandise (goods sold) 9,620 Gross profit from sales $10,946 Operating expenses: a. Salary $ 2,200b. Insurance 1.300c. Utilities 400d. Plumbing 120e. Rent 410c. Depreciation 200

Total operating expenses 4,630 Net income $ 6,316

Figure 16.4 - Income Statement

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Key Calculations on Income Statement

Net sales = Gross sales - Sales returns and - Sales discounts Allowances

Net income = Gross profit - Operating expenses

Gross profit = Net sales - Cost of merchandise from sales (goods) sold

Cost of Net purchasesmerchandise = Beginning + (purchase less - Ending(goods) sold inventory returns & discounts) inventory

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Figure 16.5 - Income Statement Vertical Analysis

ROYAL COMPANYComparative Income Statement

For Years Ended December 31, 2006 and 2007

2007 Percent 2006 Percent of net of net

Net Sales $45,000 100.00 $29,000 100.00Cost of merchandise sold 19,000 42.22 12,000 41.38Gross profit from sales $26,000 57.78 $17,000 58.62Operating expenses: Depreciation $1,000 2.22 $ 500 1.72 Selling and Advertising 4,200 9.33 1,600 5.52 Research 2,900 6.44 2,000 6.90 Miscellaneous 500 1.11 200 .69 Total operating expenses $8,600 19.11* $ 4,300 14.83Income before interest and taxes $17,400 38.67 $12,700 43.79Interest expense 6,000 13.33 3,000 10.34Income before taxes $11,400 25.33* $ 9,700 33.45Provision for taxes 5,500 12.22 3,000 10.34Net income $ 5,900 13.11 $ 6,700 23.10*

* Due to rounding

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FLINT COMPANYComparative Income Statement

For Years Ended December 31, 2006 and 2007

2007 2006 Increase (decrease) Amount Percent

Sales $ 90,000 $80,000 $10,000Sales returns and allowances 2,000 2,000 0Net Sales $88,000 $78,000 $10,000 + 12.82Cost of merchandise sold 45,000 40,000 5,000 + 12.50Gross profit from sales $43,000 $38,000 $ 5,000 + 13.16Operating expenses: Depreciation $ 6,000 $ 5,000 $ 1,000 + 20.00 Selling and Advertising 16,000 12,000 4,000 + 33.33 Research 600 1,000 (400) - 40.00 Miscellaneous 1,200 500 700 + 140.00 Total operating expenses $23,800 $18,500 $ 5,300 + 28.65Income before interest and taxes $19,200 $19,500 $ (300) - 1.54Interest expense 4,000 4,000 0 Income before taxes $15,200 $15,500 $ (300) - 1.94Provision for taxes 3,800 4,000 (200) - 5.00Net income $11,400 $11,500 $ (100) - .87

Figure 16.6 - Horizontal Analysis Income Statement

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Completing a Trend AnalysisAnalyzes the changes that occur by expressing

each number as a percent of the base year

Each ItemBase Amount

Step 1. Select the base year (100%)

Step 2. Express each amount as a

percent of the base year amount

(rounded to the nearest whole

percent)

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Trend Analysis

Given (base year 2005)

2008 2007 2006 2005

Sales $750,000 $650,000 $625,000 $650,000

Gross Profit 200,000 150,000 135,000 140,000

Net Income 75,000 50,000 35,000 40,000

Trend Analysis

2008 2007 2006 2005

Sales* 115% 100% 96% 100%

Gross Profit 143 107 96 100

Net Income 188 125 88 100

$625,000$650,000

* Round to nearest whole percent

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Ratio AnalysisA relationship of one number to another. Usedto make comparisons versus previous performanceor other companies

Asset Management ratios

How well the company manages its assets

Debt Management ratios

The company’s debt situation

Profitability ratios

The company’s profitability picture

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Summary of Key RatiosCurrent ratio = Current assets

Current liabilitiesIndustry average, 2 to 1

Acid test (quick ratio) = Current assets - inventory-prepaid expenses Current liabilities

Industry average, 1 to 1

Average day’s collection = Accounts receivableNet sales 360

Industry average, 90-120 days

Total debt to total assets = Total liabilities Total assets

Industry average, 50% - 70%

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Summary of Key Ratios

Return on equity = Net Income Stockholders equity

Industry average, 15% - 20%

Asset turnover = Net sales Total assets

Industry average, $.03 to $.08

Profit margin on net sales = Net income Net sales

Industry average, 25% - 40%