Analyzing Financial Statements

1. Analyzing Financial Statements Chapter 23

2. Preparing comparative balance sheets. Learning Objective 1

3. Comparative Balance Sheets Assets 20x8 20x7 Change % Current Assets: Cash $ 3,040 $ 4,080 $(1,040) (25.5) Accounts Receivable Net 20,000 16,000 4,000 25.0 Merchandise Inventory 24,160 26,120 (1,960) (7.5) Prepaid Expenses 80,000 60,000 200 33.3 Total Current Assets $ 48,000 $ 46,800 $ 1,200 2.6 Plant and Equipment Office Equipment, Net $125,200 $116,800 $ 8,400 7.2 Total Assets $173,200 $163,600 $ 9,600 5.9

4. Comparative Balance Sheets Liabilities 20x8 20x7 Change % Current Liabilities: Notes Payable $20,960 $17,320 $3,640 21.0 Accounts Payable 240 280 (40)(14.3) Total Current Liabilities $21,200 $17,600 $3,600 20.5 Long-Term Liabilities: Mortgage Payable $60,000 $60,000 -0- -0- Total Liabilities $81,200 $77,600 $3,600 4.6

5. Comparative Balance Sheets Stockholders’ Equity 20x8 20x7 Change % Common Stock, $10 par $ 60,000 $ 60,000 -0- -0- Retained Earnings 32,000 26,000$6,00023.1 Total Stockholders’ Equity $ 92,000 $ 86,000 $6,000 7.0 Total Liabilities and Stockholders’ Equity $173,200$163,600$9,600 5.9

6. Using horizontal and vertical analysis techniques. Learning Objective 2

7. Learning Unit 23-1 What is horizontal analysis? • Comparative balance sheets are analyzed for percentages of change – increases or (decreases). • Compute the dollar change from the base period to the later period. • Divide the dollar change by the base period amount.

8. Learning Unit 23-1 20x8 20x7 Difference Cash $3,040 $4,080 $(1,040) $1,040 ÷ $4,080 = .2549, or 25.5%

9. Learning Unit 23-1 • Vertical analysis compares each item on a report to a base number set to 100%. • The base will be either total assets or total liabilities and stockholders’ equity on a balance sheet.

10. Learning Unit 23-1 Assets 20x8 % Current Assets: Cash $ 3,040 1.8 Accounts Receivable Net 20,000 11.5 Merchandise Inventory 24,160 13.9 Prepaid Expenses 800 .5 Total Current Assets $ 48,000 27.7 Plant and Equipment Office Equipment, Net $125,200 72.3 Total Assets $173,200 100.0

11. Learning Unit 23-2 • Comparative income statement changes are shown also as percentage increases or decreases. • In the case of the income statement, each item is shown as a percentage of net sales.

12. Learning Unit 23-2 20x8 % Net Sales $317,600 100.0 Cost of Goods Sold 198,000 62.3 Gross Profit from Sales $119,600 37.7 Total Operating Expenses 83,600 26.3 Operating Income $ 36,000 11.3 Less Interest Expense 4,200 1.3 Income Before Taxes $ 31,800 10.0 Income Taxes 15,900 5.0 Net Income $ 15,900 5.0

13. Learning Unit 23-2 • What is trend analysis? • It is a special type of horizontal analysis that deals with the percentage of changes in certain key items over several years. Trend % = Any year $ ÷ Base year $

14. Year 20x8 20x7 20x5 Sales $317,600 $302,000 $270,000 Cost of Goods Sold 198,000 194,000 142,000 Gross Profit $119,600 $108,000 $128,000 20x5 is the base year. Learning Unit 23-2 What are the trend percentages?

15. Year 20x8 20x7 20x5 Sales 118% 112% 100% Cost of Goods Sold 139% 137% 100% Gross Profit 93% 84% 100% Learning Unit 23-2

16. Calculating the four different types of ratios: liquidity ratios, asset management ratios, debt management ratios, and profitability ratios. Learning Objective 3

17. Learning Unit 23-3 • A ratio is the relationship of two quantities or numbers, one divided by the other. • Ratios can be compared over time for one business. • They also can be compared to readily available industry ratios.

18. Learning Unit 23-3 Liquidity Ratios Current ratio = Total current assets ÷ Total current liabilities Acid test ratio = (Current assets – Merchandise inventory – Prepaid expenses) ÷ Current liabilities

19. Learning Unit 23-3 • The current ratio indicates ability to pay short-term obligations. • The acid test, or quick, ratio shows availability of assets that can easily be converted to cash to pay current liabilities.

20. Learning Unit 23-3 Asset Management Ratios Accounts receivable turnover = Net credit sales ÷ Average accounts receivable Average collection period = 365 days ÷ Accounts receivable turnover

21. Learning Unit 23-3 Accounts receivable turnover shows how many times accounts receivable is converted to cash in one year.

22. Learning Unit 23-3 Inventory turnover = Cost of goods sold ÷ Average inventory Asset turnover = Net sales ÷ Total assets

23. Learning Unit 23-3 • The inventory turnover calculates the number of times inventory turns over in one period. • The asset turnover indicates whether or not assets have been used efficiently to generate sales.

24. Learning Unit 23-3 Debt Management Ratios Debt to total assets = Total liabilities ÷ Total assets Debt to stockholders’ equity = Total liabilities ÷ Stockholders’ equity

25. Learning Unit 23-3 • The debt-to-total-assets ratio indicates the amount of assets that are financed by creditors. • The debt-to-stockholders’-equity ratio shows stockholders’ risk compared to creditors’ risk.

26. Learning Unit 23-3 Times interest earned = Income before taxes and interest expense ÷ Interest expense It reveals ability to meet interest payment due dates.

27. Learning Unit 23-3 Profitability Ratios Gross profit rate = Gross profit ÷ Net sales Return on sales = Net income before taxes ÷ Net sales

28. Learning Unit 23-3 • The gross profit ratio indicates how much of the sales income is available to pay expenses and generate a net income. • A high return on sales ratio usually means that inventory consists of high priced items such as autos and furniture.

29. Learning Unit 23-3 Rate of return on total assets = Net income before interest and taxes ÷ Total assets Rate of return on common stockholders’ equity = (Net income before taxes – preferred dividends) ÷ Common stockholders’ equity

30. Learning Unit 23-3 • The rate of return on total assets indicates earning power. • The rate of return on common stockholders’ equity shows the amount of the net income share that remains for the common stockholders (after preferred dividends are deducted).

31. End of Chapter 23