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Chapter 16
How to Read, Analyze, How to Read, Analyze, and Interpret and Interpret
Financial ReportsFinancial Reports
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
16-2
1. Explain the purpose and the key items on the balance sheet
2. 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
16-3
1. Explain the purpose and the key items on the income statement
2. 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
16-4
1. Explain and complete a trend analysis
2. List, explain, and calculate key financial ratios
How to Read, Analyze, and Interpret Financial Reports#16#16Learning Unit ObjectivesTrend and Ratio AnalysisLU16.3LU16.3
16-5
Accounting Equation
Accounting Equation: Assets = Liabilities + Owner’s Equity
16-6
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
16-7
Figure 16.1 - Elements of the Balance Sheet
MOOL COMPANYBalance Sheet
December 31, 2011Assets 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
Assets broken down into current assets and plant and equipment.
Liabilities broken down into current and long-term
Total of current assets and plant and equipment.
(Total is double- ruled)
Total of all liabilities and stockholders’ equity.
16-8
Preparing a Vertical Analysis of a Balance Sheet
Step 2. Round each liability and stockholders’ equity (the portions) as a percent of total liabilities and stockholders’ equity (the base). Round as indicated.
Step 1. Divide each asset (the portion) as a percent of total assets (the base). Round as indicated.
16-9
Figure 16.2 - Comparative Balance Sheet: Vertical Analysis
ROGER COMPANY
Comparative Balance Sheet
December 31, 2010 and 2011
2011 2010Amount 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
16-10
Figure 16.2 - Comparative Balance Sheet: Vertical Analysis
ROGER COMPANY
Comparative Balance Sheet
December 31, 2010 and 2011
2011 2010Amount Percent Amount Percent
LiabilitiesCurrent liabilities:
Accounts payable $14,000 16.47 $8,000 9.88
Salaries payable 18,000 21.18 17,000 20.99
Total current liabilities $32,,000 37.65 $25,000 30.86*
Long-term liabilities:
Mortgage note payable $12,000 14.12 $20,000 24.69
Total liabilities $44,000 51.76* $25,000 30.86*
Stockholders’ EquityCommon stock $20,000 23.53 $20,000 24.69
Retained earnings 21,000 24.71 16,000 19.75
Total Stockholders’ equity $41,000 48.24 $36,000 44.44
Total Liabilities and Stockholders’ Equity $85,000 100.00 $81,000 100.00
* Due to rounding
16-11
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.
16-12
Figure 16.3 - Comparative Balance Sheet: Horizontal Analysis
ABBY ELLEN COMPANY
Comparative Balance Sheet
December 31, 2010 and 2011
Increase(decrease) 2011 2010 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
16-13
Figure 16.3 - Comparative Balance Sheet: Horizontal Analysis
ABBY ELLEN COMPANY
Comparative Balance Sheet
December 31, 2010 and 2011
Increase(decrease) 2010 2011 Amount Percent
LiabilitiesCurrent liabilities:
Accounts payable $ 3,200 $ 1,800 $ 1,400 77.78
Salaries payable 2,900 3,200 (300) -9.38
Total current liabilities $ 6,100 5,000 1,100 22.00
Long-term liabilities:
Mortgage note payable 17,000 15,000 2,000 13.33
Total Liabilities $ 23,100 20,000 3,100 15.50
Owner’s EquityAbby Ellen, capital $31,900 31,000 $ 900 2.90
Total liabilities and owner’s equity $55,000 51,000 $4,000 7.84
16-14
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
$
16-15
MOOL COMPANYIncome Statement
For Month Ended December 31, 2011 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 410f. Depreciation 200g. Total operating expenses 4,630 Net income $ 6,316
Figure 16.4 - Income Statement
16-16
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
16-17
Figure 16.5 - Income Statement Vertical Analysis
ROYAL COMPANYComparative Income Statement
For Years Ended December 31, 2010 and 2011
2011 Percent 2010 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
16-18
FLINT COMPANYComparative Income Statement
For Years Ended December 31, 2010 and 2011
2011 2010 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
16-19
Completing a Trend AnalysisAnalyzes the changes that occur by expressing
each number as a percent of the base year
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)
Each ItemBase Amount
16-20
Trend Analysis
Given (base year 2009)
2012 2011 2010 2009
Sales $621,000 $460,000 $340,000 $420,000
Gross Profit 182,000 141,000 112,000 124,000
Net Income 48,000 41,000 22,000 38,000
Trend Analysis
2012 2011 2010 2009
Sales* 148% 110% 81% 100%
Gross Profit 147 114 90 100
Net Income 126 108 58 100
$340,000$420,000
* Round to nearest whole percent
16-21
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
16-22
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%
16-23
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%
16-24
Problem 16-15:
Return on equity: X
$15.2
X = 0.10 ($15.2)
X = $1.52 million
= 10%
16-25
Problem 16-17:
a. Total liabilities $1,768 Total assets $2,015 = 87.74%
b. Net income $147 Stockholders' equity $427 = 34.43%
c. Net sales $265 Total assets $2015 = 13¢
d. Net income $147 Net sales $265 = 55.47%
16-26
Problem 16-18:
2009 2008 2007 2006 2005
Sales 98% 106% 100% 98% 100%
$3,154 $3,414 $3,208 $3,152 $3,216
$3,216 $3,216 $3,216 $3,216 $3,216
= 98.072139 = 106.15671 = 99.751243 = 98.00995 =100%
= 98% =106% = 100% = 98%
