College Accounting, by Heintz and Parry

Chapter 25:

Analysis of Financial Statements

“Another thing Rick Swagger’s accountant wants to do, Eddie, is complete a horizontal analysis and a vertical analysis of the company’s books. I don’t know about you, man, but I think his analysis will come out the same whether he’s lying down or standing up!”

Eddie wasn’t positive that Nick was kidding, so he kept a straight face as he answered. “Actually, a horizontal analysis and a vertical analysis can tell you a lot about a company. Would you like me to demonstrate how?”

“Okay, but no lying down on the job!”

“No problem. A horizontal analysis is just a comparison of this year’s numbers to last year’s numbers where we calculate whether the financial statement amounts went up or down, and also convert the increase or decrease into a percentage.”

Eddie grabbed the financial statements for 2000 and added to them. He made the single-step income statement into a horizontal analysis, projecting numbers for the full year of 2001.

The CD Side of Town Income Statement For Years Ended Dec. 31, 2000 and 2001 2000 2001 increase percent (decrease) Revenues: Sales $365,876 440,925 75,049 21% Rent Revenue 500 3,000 2,500 500% Interest Revenue 368 1,436 1,068 290% Total Revenues 366,744 445,361 78,617 21%Expenses: Cost of Goods Sold $213,675 263,984 50,309 24% Wage Expense 74,160 85,922 11,762 16% Depn. Exp.-Bldg. 6,490 8,653 2,163 33% Supply Exp. 835 792 (43) (5%)

Advertising Expense 7,230 7,843 613 8% Insurance Exp. 920 1,100 180 20% Bank Credit Card Exp. 4,369 6,223 1,854 42% Utilities Expense 1,853 2,242 389 21% Miscellaneous Exp. 1,238 1,385 147 12% Interest Expense 2,386 2,629 243 10% Total Expenses 313,156 380,773 67,617 22%Net Income $53,588 $64,588 $11,000 21%

“If we combine some of the categories, we can draw some conclusions: Our cost of goods sold has risen more than our sales (because we have lowered our markups to keep sales strong), and most of our expenses are creeping up with the exception of wages (wages aren’t up as much because our more experienced employees are better able to run the store by themselves at off-peak sales times).

The CD Side of Town Income Statement For Years Ended Dec. 31, 2000 and 2001 2000 2001 increase percent (decrease) Revenues: Sales $365,876 440,925 75,049 21% Other Revenue 868 4,436 3,568 411% Total Revenues 366,744 445,361 78,617 21%Expenses: Cost of Goods Sold $213,675 263,984 50,309 24% Wage Expense 74,160 85,922 11,762 16% Other Op. Exp. 25,321 30,867 5,546 22% Total Expenses 313,156 380,773 67,617 22%Net Income $53,588 $64,588 $11,000 21%

Eddie also prepared a balance sheet using horizontal analysis. The assets looked like this: The CD Side of Town Balance Sheet Dec. 31, 2000 and 2001

Assets 2000 2001 Inc.(Dec.) PercentCurrent Assets: Cash $8,383 $12,342 3,959 47% Accounts Receivable 1,329 1,886 557 42% Merchandise Inventory 10,218 13,231 3,013 29% Supplies 225 232 7 3% Prepaid Insurance 320 350 30 9% Total Current Assets $20,475 $28,041 7,566 37%Prop., Plant, & Equip.: Land $24,000 $24,000 0 0% Building, net of depr’n. 107,890 99,237 (8,653) (8%) Equipment, net 0 4,992 4,992 n/a Total P P & E 131,890 128,229 (3,661) (3%) Total Assets $152,365 $156,270 3,905 3%

Eddie saw little that was significant here. Current assets crept higher, but plant assets were down due to depreciation. The overall change was small. The CD Side of Town Balance Sheet Dec. 31, 2000 and 2001

Assets 2000 2001 Inc.(Dec.) PercentCurrent Assets: Cash $8,383 $12,342 3,959 47% Accounts Receivable 1,329 1,886 557 42% Merchandise Inventory 10,218 13,231 3,013 29% Supplies 225 232 7 3% Prepaid Insurance 320 350 30 9% Total Current Assets $20,475 $28,041 7,566 37%Prop., Plant, & Equip.: Land $24,000 $24,000 0 0% Building, net of depr’n. 107,890 99,237 (8,653) (8%) Equipment, net 0 4,992 4,992 n/a Total P P & E 131,890 128,229 (3,661) (3%) Total Assets $152,365 $156,270 3,905 3%

Eddie included liabilities and owners’ equity in his horizontal analysis, as well. Current liabilities crept up as the business grew, while long-term liabilities went down as they continued to pay on their mortgage. The CD Side of Town

Balance Sheet Dec. 31, 2000 and 2001 Liabilities 2000 2001 Inc.(Dec.) PercentCurrent Liabilities: Accts. Payable $4,360 6,234 1,874 43% Wages Payable 867 429 (438) (51%) Deferred Rent Rev. 1,000 250 (750) (75%) Mortgage Pay. (curr. portion) 1,723 1,915 192 11% Tot. Curr. Liabilities $7,950 8,828 878 11% Long-term Liabilities Mortgage Payable 32,827 31,182 (1,645) (5%)Total liabilities $40,777 40,010 (767) (2%) Owner’s EquityNick Flannery, Capital 111,588 116,260 4,672 4% Tot. Liab. & Own. Equity $152,365 $156,270 3,905 3%

“A vertical analysis, by contrast, computes every line on a financial statement as a percentage of the same total. On an income statement, for example, each number is calculated as a percentage of sales.”

The CD Side of Town Income Statement For Years Ended Dec. 31, 2000 and 2001 2000 percent 2001 percent Revenues: Sales $365,876 100% 440,925 100% Rent Revenue 500 0% 3,000 1% Interest Revenue 368 0% 1,436 0% Total Revenues 366,744 100% 445,361 101%Expenses: Cost of Goods Sold $213,675 58% 263,984 60% Wage Expense 74,160 20% 85,922 19% Depn. Exp.-Bldg. 6,490 2% 8,653 2% Supply Exp. 835 0% 792 0% Advertising Expense 7,230 2% 7,843 2% Insurance Exp. 920 0% 1,100 0% Bank Credit Card Exp. 4,369 1% 6,223 1% Utilities Expense 1,853 1% 2,242 1% Miscellaneous Exp. 1,238 0% 1,385 0% Interest Expense 2,386 1% 2,629 1% Total Expenses 313,156 86% 380,773 86%Net Income $53,588 15% $64,588 15%

“Although a vertical analysis doesn’t compare numbers between years on an absolute basis (like a horizontal analysis does), it shows significant statistics like cost of goods sold as a percent of sales and net income as a percent of sales. The CD Side of Town Income Statement For Years Ended Dec. 31, 2000 and 2001 2000 percent 2001 percent Revenues: Sales $365,876 100% 440,925 100% Rent Revenue 500 0% 3,000 1% Interest Revenue 368 0% 1,436 0% Total Revenues 366,744 100% 445,361 101%Expenses: Cost of Goods Sold $213,675 58% 263,984 60% Wage Expense 74,160 20% 85,922 19% Depn. Exp.-Bldg. 6,490 2% 8,653 2% Supply Exp. 835 0% 792 0% Advertising Expense 7,230 2% 7,843 2% Insurance Exp. 920 0% 1,100 0% Bank Credit Card Exp. 4,369 1% 6,223 1% Utilities Expense 1,853 1% 2,242 1% Miscellaneous Exp. 1,238 0% 1,385 0% Interest Expense 2,386 1% 2,629 1% Total Expenses 313,156 86% 380,773 86%Net Income $53,588 15% $64,588 15%

When Eddie prepared a balance sheet using vertical analysis, each number was divided by total assets. The asset section looked like this: The CD Side of Town Balance Sheet Dec. 31, 2000 and 2001

Assets 2000 Percent 2001 PercentCurrent Assets: Cash $8,383 6% $12,342 8% Accounts Receivable 1,329 1% 1,886 1% Merchandise Inventory 10,218 7% 13,231 8% Supplies 225 0% 232 0% Prepaid Insurance 320 0% 350 0% Total Current Assets $20,475 13% $28,041 18%Prop., Plant, & Equip.: Land $24,000 16% $24,000 15% Building, net of depr’n. 107,890 71% 99,237 64% Equipment, net 0 0% 4,992 3% Total P P & E 131,890 87% 128,229 82% Total Assets $152,365 100% $156,270 100%

In Eddie’s vertical analysis of liabilities and owners’ equity, he divided each number by total liabilities and owners’ equity (which is, of course, the same number as total assets). In this case, the vertical analysis of the balance sheet showed the same trends noted in the horizontal analysis. The CD Side of Town

Balance Sheet Dec. 31, 2000 and 2001 Liabilities 2000 Percent 2001 PercentCurrent Liabilities: Accts. Payable $4,360 3% 6,234 4% Wages Payable 867 1% 429 0% Deferred Rent Rev. 1,000 1% 250 0% Mortgage Pay. (curr. portion) 1,723 1% 1,915 1% Tot. Curr. Liabilities $7,950 5% 8,828 6% Long-term Liabilities Mortgage Payable 32,827 22% 31,182 20%Total liabilities $40,777 27% 40,010 26% Owner’s EquityNick Flannery, Capital 111,588 73% 116,260 74% Tot. Liab. & Own. Equity $152,365 100% $156,270 100%

“The last thing Rick’s accountant is doing is analyzing our liquidity, profitability, and leverage. I think he can see our profitability right there on the bottom line, and I’m not sure what the other two things mean.”

“Don’t worry, Nick, all he’s talking about is the financial statement analysis we talked about a month or so ago.”

“Oh, you mean ‘working hospitals’ and ‘currents raging’ and all that stuff?”

“Yes, ‘working capital’ and ‘current ratio’ and all that stuff. I’ll be glad to go through all of the key ratios again, and I’ll include some different ones in all three categories you mentioned, but only if you take notes this time, Mr. Memory!”

“Okay, okay, I’ll get out some paper and a pen to supplement my usually brilliant memory, uh, Teddy.”

Liquidity measures are an attempt to predict whether the company can pay it’s current debts. The first one we will calculate is the store’s working capital. The calculation is:

Current Assets - Current Liabilities = Working Capital

2000: 20,475 - 7,950 = 12,525

2001: 28,041 - 8,828 = 19,213 This amount tells us the company can still comfortably pay its current liabilities today.

As you may remember, it can be useful to compare the working capital of companies that are very different in size, so we calculate current ratio, a number that takes out size as a factor by computing the relative size of a company’s current assets and current liabilities. The calculation is:

Current Assets / Current Liabilities = Current Ratio

2000: 20,475 / 7,950 = 2.58 to 1

2001: 28,041 / 8,828 = 3.18 to 1

This means that The CD Side of Town now has $3.18 in current assets for every $1.00 of current liabilities.

Question: Do you remember what most companies try to maintain as a current ratio?

Answer: ”Most companies want a current ratio of at least two to one.Now let’s recalculate the store’s quick ratio (or acid-test ratio) using our projected numbers for 2001. This compares the company’s quick assets, the assets normally convertible into cash in 30 days, with the current liabilities (usually due within 30 days). The quick assets are: 1) cash, 2) temporary investments, and 3) accounts receivable. Our quick ratio is: Quick Assets / Curr. Liabilities = Quick Ratio

2000: 9,712 / 7,950 = 1.22 to 1

2001: 14,228 / 8,828 = 1.61 to 1This means that The CD Side of Town has $1.61 in quick assets for every $1.00 of current liabilities.”

Question: Do you remember what most companies try to maintain as a quick ratio?

Answer: ”Most companies want a quick ratio of at least one to one. Another leverage measure we’ve already discussed is accounts receivable turnover. The formula is: Net Credit Sales for the Period Average Accounts Receivable = Accts. Rec. TurnoverAn easy way to estimate average accounts receivable is to take an average of beginning accounts receivable and ending accounts receivable: 2000: ($105 beg. A/R + $1,329 ending A/R) / 2 = $7172001: ($1,329 + $1,886) / 2 = $1,607.50Eddie calculated that the net credit sales (sales on account minus related returns and allowances) and came up with $12,457.

Question: What is the accounts receivable turnover for 2001, and is it a “good” number?

Answer: The store’s accounts receivable turnover is:

$12,457 / $1,607.50 = 7.75 timesTo determine whether this is a good number, it helps to calculate the average collection period using this formula:

365 (days) / accounts receivable turnover

or 365 / 7.75 = 47 daysThis means that the typical credit customer is paying 47 days after the sale was made. Since the store offers payment terms of net 30 days, this represents a poor record of collections. Because the store has few credit customers (mostly disc jockeys), this could mean that there are one or two customers who need to be written off, turned over to a collection agency, and/or set up on a payment plan.

“The final leverage ratio that I’m sure will get calculated is inventory turnover. It’s the ratio that measures how long it takes a business to sell inventory after it buys it. The formula for this ratio is:

Cost of Goods Sold for the Year Average Inventory = Inventory TurnoverAgain, we will estimate average inventory by averaging the beginning inventory and ending inventory.2000: ($7,683 beg. inv. + $10,218 end. inv.) / 2 = $8,950.52001: ($10,218 + $13,231) / 2 = $11,724.5

The average inventory is $11,724.50. We can use our projected cost of goods sold of $263,984 to estimate our inventory turnover.”

Question: What is the estimated inventory turnover for 2001, and is it a “good” number?

Answer: The store’s inventory turnover is:

$263,984 / $11,724.50 = 22.5 timesTo determine whether this is a good number, it helps to calculate the average days to sell inventory using this formula:

365 (days) / inventory turnover

or 365 / 22.5 = 16.2 daysThis means that the typical CD is being sold 16 days after it is purchased by the store. This number is 1 day slower than last year’s, which mainly reflects that there are no “grand opening” sales included in the 2001 figures. However, that’s still a very impressive number for this type of inventory.

“That brings us to the profitability measures, of which there are more than you might think. For example, the ratio of net sales to assets is just that: a measure of how well the company uses its assets to generate sales. The formula for this ratio is: Net Sales Average Assets

We will estimate average assets by averaging the beginning assets and ending assets.2001: ($152,365 + $156,270) / 2 = $154,317.50 Therefore, the ratio is:

Net Sales / Average Assets $440,925 / 154,317.50 = 2.86 We would need to look at prior years or industry averages to decide if this is a good number or not.”

“The next profitability measure is pretty similar to the last one. The return on total assets is a measure of how well the company uses its assets to generate net income. The formula for this ratio is: Net Income Average Assets

Since we already calculated average assets, we can quickly calculate this ratio:

Net Income / Average Assets $64,588 / 154,317.50 = 41.9% Again, a look at prior years or industry averages is normally used to decide if this is a good number or not, but a 41.9% return on total assets is clearly an impressive number.”

“Another profitability measure is called return on common stockholders’ equity. This is the corporate equivalent of the return on owners’ equity that we discussed before. The formula is: Net Income Available to Common Stockholders Average Common Stockholders’ Equity The formula means that dividends to preferred stockholders should be subtracted from net income to get the top number, and preferred stock should be subtracted from owners’ equity to get the bottom number. If your capital was in the form of common stock (no preferred stock), the calculation would be:

Net Income/((Jan. 1 Owners’ Equity + Dec. 31 Owners’ Equity)/2)$64,588 / ((111,588 + 116,260)/2) = 56.7% Comparison with prior years or industry averages is often helpful, but a 56.7% return on common stockholders’ equity is very high.”

“The next profitability measure is called earnings per share of common stock. This is a major determining factor in the selling price of publicly traded stocks. The formula is: Net Income Available to Common Stockholders Average Number of Common Shares Outstanding Again, dividends to preferred stockholders should be subtracted from net income to get the top number. If your capital was in the form of 500 shares of common stock for the entire year (no preferred stock), the calculation would be:

Net Income / # of Common Shares $64,588 / 500 = $129.18 earnings per share Whether this seems like a good number probably depends upon how much you paid for the share of stock!”

“The next profitability measure is called book value per share of common stock. This sometimes acts as an approximate floor for the selling price of publicly traded stocks. The formula is: Common Stockholders’ Equity Number of Common Shares Outstanding at Year End Assume once more that your capital was in the form of 500 shares of common stock for the entire year (no preferred stock), the calculation would be: Common Stockholders’ Equity / # of Common Shares $116,260 / 500 = $232.52 This means that, according to your books, each share is worth $232.52. This probably isn’t an accurate value, even if the corporation liquidated, because assets (and even liabilities) can undergo fluctuations in their current market value. However, in combination with other measures, it gives useful information about a stock’s value.”

“The last two measures I will show you are called leverage measures. Their used to measure how much your business is financed by debt and whether you are able to meet your debt obligations. The first one is called ratio of liabilities to stockholders’ equity. The name tells you the calculation (based on our 2001 projections):

Total Liabilities 40,010 Total Stockholders’ Equity = 116,260 = 0.34 to 1 This number is best evaluated by comparison to industry averages. Companies and industries that have consistently good revenues and profitability can afford to maintain a high ratio of liabilities to stockholders’ equity. Other companies probably shouldn’t try it.”

“The last leverage measure we’ll calculate is the times interest earned ratio. The calculation is:

Earnings Before Taxes and Interest Interest Expense The top number is calculated like this:

Net Income $64,588 + Income Tax 0 (because we are not a corporation) + Interest Expense 2,629 $67,217

Therefore, our projected 2001 calculation would be:

$67,217 2,629 = 25.6 timesGenerally, 2 or 3 times is an adequate ratio, so ours is very safe.

“Okay, let’s see if you can answer any of these without referring to the beautiful notes I see you’ve been taking:

Questions: 1) What is the formula for quick ratio?

2) What is the formula for earnings per share of common stock?

3) What is the formula for merchandise inventory turnover?

4) What is the formula for times interest earned ratio?

“Answers: 1) The formula for quick ratio is:

Quick Assets / Current Liabilities 2) The formula for earnings per share of common stock is:

Net Income Available to Common Stockholders Average Number of Common Shares Outstanding 3) The formula for merchandise inventory turnover is:

Cost of Goods Sold for the Year Average Inventory 4) The formula for times interest earned ratio is:

Earnings Before Taxes and Interest Interest Expense”“Hey, I got all but the last one. That means my ‘brilliance to ignorance ratio’ is 3 to 1, right, Eddie?”