# How to Read, Analyze, and Interpret Financial Reports

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How to Read, Analyze, and Interpret Financial Reports

How to Read, Analyze, and Interpret Financial Reports
#16 How to Read, Analyze, and Interpret Financial Reports Learning Unit Objectives Balance Sheet -- Report as of a Particular Date LU16.1 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 How to Read, Analyze, and Interpret Financial Reports Learning Unit Objectives Income Statement -- Report for a Specific Period of Time LU16.2 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 How to Read, Analyze, and Interpret Financial Reports Learning Unit Objectives LU16.3 Trend and Ratio Analysis Explain and complete a trend analysis List, explain, and calculate key financial ratios

Accounting Equation Accounting Equation: Assets = Liabilities + Owner’s Equity

Balance Sheet Gives a financial picture of what a company is worth as of particular date. How much the company owes Liabilities + Owner’s Equity = Assets How much the company owns How much the owner is worth

Figure 16.1 - Elements of the Balance Sheet
MOOL COMPANY Balance Sheet December 31, 2007 Assets Liabilities a. Current assets: a. Current liabilities: b. Cash \$ 7, b. Accounts payable \$ 80,000 c. Accounts receivable ,000 c. Salaries payable ,000 d. Merchandise inventory ,000 d Total current liabilities \$ 92,000 e. Prepaid expenses , e. Long-term liabilities: f Total current assets \$61, f Mortgage note payable ,000 g. Plant and equipment: g Total liabilities \$150,000 h. Building (net) \$60,000 i Land , Stockholders Equity j Total plant and equipment ,000 a. Common stock \$ 20,000 b. Retained earnings ,000 c Total stockholders equity ,000 k. Total assets \$205, d. Total liab. and stkhlds equity \$205,000

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.

Figure 16.2 - Comparative Balance Sheet: Vertical Analysis
ROGER COMPANY Comparative Balance Sheet December 31, 2006 and 2007 Amount Percent Amount Percent Assets Current Assets: Cash \$22, \$18, Accounts Receivable 8, , Merchandise inventory 9, , Prepaid rent , , Total current assets \$43, \$39, * Plant and equipment: Building (net) \$18, \$18, Land , , Total plant and equipment \$42, * \$42, Total assets \$85, \$81, * Due to rounding

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.

Figure 16.3 - Comparative Balance Sheet: Horizontal Analysis
ABBY ELLEN COMPANY Comparative Balance Sheet December 31, 2006 and 2007 Increase(decrease) Amount Percent Assets Current Assets: Cash \$ 6,000 \$ 4,000 \$ 2, Accounts Receivable , , (1,000) Merchandise inventory , , , Prepaid rent , , (2,000) Total current assets \$25,000 \$21,000 \$ 4, Plant and equipment: Building (net) \$12,000 \$12, Land , , Total plant and equipment \$30,000 \$30, Total assets \$55,000 \$51,000 \$4,

Income Statement Income Statement\$ A financial report that tells how well a company is performing (its profitability or net profit) during a specific period of time. Retail Business Revenues (Sales) - Cost of merchandise sold = Gross profit from sales - Operating Expenses = Net Income (Profit) Service Business Revenues -Operating Expenses =Net Income

Figure 16.4 - Income Statement
MOOL COMPANY Income Statement For Month Ended December 31, 2007 Revenues a. Gross Sales \$22,080 b. Less: Sales returns and allowances \$ 1,082 c Sales discounts ,514 d. Net Sales Cost of merchandise (goods) sold: \$20,566 a. Merchandise Inventory 12/1/ \$ 1,248 b. Purchases \$10,512 c. Less: Purchases returns and allowances \$336 d. Less: Purchase discounts e. Cost of net purchases ,972 f. Cost of merchandise (goods available for sale) \$11,220 g. Less: Merchandise inventory 12/31/ ,600 h. Cost of merchandise (goods sold) ,620 Gross profit from sales \$10,946 Operating expenses: a Salary \$ 2,200 b Insurance c Utilities d Plumbing e Rent c Depreciation Total operating expenses ,630 Net income \$ 6,316

Key Calculations on Income Statement
Net sales = Gross sales - Sales returns and - Sales discounts Allowances Cost of Net purchases merchandise = Beginning (purchase less Ending (goods) sold inventory returns & discounts) inventory Gross profit = Net sales - Cost of merchandise from sales (goods) sold Net income = Gross profit - Operating expenses

Figure 16.5 - Income Statement Vertical Analysis
ROYAL COMPANY Comparative Income Statement For Years Ended December 31, 2006 and 2007 Percent Percent of net of net Net Sales \$45, \$29, Cost of merchandise sold 19, , Gross profit from sales \$26, \$17, Operating expenses: Depreciation \$1, \$ Selling and Advertising , , Research , , Miscellaneous Total operating expenses \$8, * \$ 4, Income before interest and taxes \$17, \$12, Interest expense , , Income before taxes \$11, * \$ 9, Provision for taxes , , Net income \$ 5, \$ 6, * * Due to rounding

Figure 16.6 - Horizontal Analysis Income Statement
FLINT COMPANY Comparative Income Statement For Years Ended December 31, 2006 and 2007 Increase (decrease) Amount Percent Sales \$ 90, \$80,000 \$10,000 Sales returns and allowances , , Net Sales \$88, \$78,000 \$10, Cost of merchandise sold 45, , , Gross profit from sales \$43,000 \$38,000 \$ 5, Operating expenses: Depreciation \$ 6,000 \$ 5,000 \$ 1, Selling and Advertising 16, , , Research , (400) Miscellaneous , Total operating expenses \$23,800 \$18,500 \$ 5, Income before interest and taxes \$19,200 \$19,500 \$ (300) Interest expense , , Income before taxes \$15,200 \$15,500 \$ (300) Provision for taxes , , (200) Net income \$11,400 \$11,500 \$ (100)

Completing a Trend Analysis
Analyzes the changes that occur by expressing each number as a percent of the base year Each Item Base 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)

Trend Analysis Given (base year 2005) 2008 2007 2006 2005
Sales \$750,000 \$650,000 \$625,000 \$650,000 Gross Profit 200, , , ,000 Net Income , , , ,000 Trend Analysis Sales* 115% 100% 96% 100% Gross Profit Net Income \$625,000 \$650,000 * Round to nearest whole percent

Ratio Analysis A relationship of one number to another. Used
to make comparisons versus previous performance or other companies Asset Management ratios How well the company manages its assets Profitability ratios The company’s profitability picture Debt Management ratios The company’s debt situation

Summary of Key Ratios Industry average, 50% - 70%
Current ratio = Current assets Current liabilities Industry average, 2 to 1 Acid test (quick ratio) = Current assets - inventory-prepaid expenses Industry average, 1 to 1 Average day’s collection = Accounts receivable Net sales 360 Industry average, days Total debt to total assets = Total liabilities Total assets Industry average, 50% - 70%

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%