Analyzing Financial Statements

12.3 in textbook

Types of Financial Statements That we have learned about: Income Statement- Summarizes the items

of revenue and expense and shows the net income (revenue > expense) or net loss (expense > revenue) of a business, for a given FISCAL PERIOD

Balance Sheet- statement showing the financial position (assets, liabilities and capital) of an individual, company, or other organization on a CERTAIN DATE.

1. Owners- use to evaluate the performance of the people who run the company for them and learn about company activities in general

2. Managers- Use them the most, study them in order to improve results and efficiency, and to eliminate weaknesses. Statements help managers make key business decisions

3. Investors- Shares of public corporations are traded by stockbrokers through stock exchange. Stay informed about the affairs of corporations by reading their financial reports

Used By:

Used By: Cont.4. Creditors- particularly bankers, ask for financial

statements regularly. Stay inform about a company’s progress and its ability to meet its loan obligations. (Banks must protect their loans)

5. Shareholders – law requires that corporations provide shareholders with financial statements regularly. Must be aware of its progress

◦ All use financial statements to evaluate the stability and growth of a business

To make it easier to understand meaningful information, comparative, common size and trend analysis may be used

Management will attempt to find reason for change

The longer the period compared, the better for observing trends

Why do we need to Analysis Financial Statements?

3 Ways to Analysis Data1. Comparative Analysis

2. Common-size Analysis

3. Trend Analysis

When comparing financial statements for two consecutive years

Find the: ◦ A) dollar amount of the increase/decrease from

year 1 to year 2

1. Comparative Analysis is…

Year 1 Year 2 Increase/ decrease

Company A 270 000 290 000 20 000Company B 10 000 30 000 20 000

Increasing

Can indicate the direction of the business; if all numbers are increasing, then there should be an overall increase in company performance

However, it is not as useful as percentage change %

What does the chart tell us?

B) percentage amount of the increase/decrease from year 1 to year 2

Calculate:Percentage Change = Difference/Base Year

x100

Comparative Analysis cont.

Year 1 Year 2 Increase/ decrease

Percentage Change

Company A 270 000 290 000 20 000 20 000/270000 = 7.4%

Company B 10 000 30 000 20 000 20 000/ 10 000 = 200%

Both companies A & B increase by $20 000, however, Company A’s percentage increase is only 7.4% compared to Company B’s percentage increase of 200%

What can we conclude?

◦Useful for year to year comparisons showing owner/manager areas to investigate

◦Indicates whether amounts are within proper range

◦Percentages can depend on many different factors (ie. Size of market, competition, product etc.)

Benefits of Comparative Analysis:

Let’s Try It! Exercise #1 p. 584 (t), p. 471 (w)

Common-size financial statements are based on a common percentage framework.

a) Income Statement- Net Sales (revenue) will represent 100% and all other account balances will be compared to this figure and analyzed

2. Common-Size Analysis

Company A Company BRevenue Sales $150 000 $450 000Expenses Automotive Expense $ 25 000 $ 54 000 Bank Interest Expense

18 000

Rent Expense 24 000 45 000 Wages Expense 60 000 270 000 Other Expenses 4 500 3 500 Total Expenses $114 000 $400 000Net Income $ 36 000 $ 49 500

Income StatementYear Ended December 31, 2011

Common-size Income Statements

Company A Company B

Revenue Sales $150 000 100 % $450 000 100 %

Expenses Automotive Expense $ 25 000 17% $ 54 000 12% Bank Interest Expense 18 000 4% Rent Expense 24 000 16% 45 000 10% Wages Expense 60 000 40% 270 000 60% Other Expenses 4 500 3% 13 500 3% Total Expenses $ 114 000 76% $ 400 000 89%Net Income $36 000 24% $ 49 500 11%

b) Balance Sheet- ◦ Total Assets will represent 100% and the % of

each asset will be compared to this figure

◦ Total Liabilities and Owner’s Equity will represent 100% and liability and owner’s equity figures will be compared to this figure

Common-size Analysis Cont.

**Please Note: Data in common-size form can be easily analyzed, not only within one company, but by comparing percentages relative between two companies

Trend Analysis Trend analysis shows financial data (as

figures and percentages) over a number of consecutive periods

Lets consider the following sales figures for a company:

What can you tell me about these figures?

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Sales $55 000 $60 000 $75 000 $45 000 $105 000 $112 000

Percentages Not easy to interpret these figures just by

looking at them, but if we change these figures into percentages or a graph, we can easily analyze it

Calculate the percentage change◦ Comparison Year/Base Year * 100 = Percentage

ChangeYear 1 Year 2 Year 3 Year 4 Year 5 Year 6

Sales $55 000 $60 000 $75 000 $45 000 $105 000 $112 000

Percentage

100 % 109.1 % 136.4 % 81.8 % 190.9 % 203.6 %

What Can We Conclude? There was a significant decrease in sales %

in year 4, however, by year 6 the company doubled their sales

3 New GAAPs1. The Consistency Principle:

Requires that a business must use the same accounting methods and procedures from period to period

If there is a change the financial statements must clearly indicate the change

Example: a company records revenue when payments are received, not when invoices are issued. If the company had a bad year, it would be wrong to make the results look better by including some revenue for invoices issued but for which payment has not been received

2. The Materiality Principle: Requires accountants to follow

generally accepted accounting principles except when to do so would be expensive or difficult, and where it makes no real difference if the rules are ignored

◦ Example: invoice error for $50 discovered by company with a net income of approximately $350 000, no effort would be made to correct the error because the $50 is not significant in relation to the net income figure.

3. Full Disclosure Principle: States that all information needed for

a full understanding of the company’s financial affairs must be included in the financial statement◦ Example: Company being sued for millions, have

an impact on the financial standing of the company if they lost the lawsuit. Other examples that might require an accompanying note are tax disputes and company takeovers.

Read p. 567-573 (t) and answer review questions #1-5 p. 583 (t), p. 470 (w)

Ex. 1 & 2 p. 584 (t), p. 471-473 (w) Ex. 1-3 on the handout