Chapter 12 Financial Statement Analysis ©2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Introduction Financial statement analysis is a useful tool for both external and internal users as they make decisions about a company or for a company. Management uses financial statements to assess the adequacy of cash flow to pay operating expenses, the efficient use of company resources, and how to improve the overall performance of the company.

Financial Statement Analysis Limitations GAAP Ratios Inflation Historical cost is reported. Increasing price effects are not included. Allows a variety of methods, estimates and assumptions to be used. No single ratio can be emphasized, but must be compared to others.

Horizontal Analysis Analyzing financial statements over time is called horizontal analysis. The idea behind horizontal analysis is to analyze changes in accounts occurring between years. To facilitate this analysis, dollar and percentage changes are calculated on each item.

Balance Sheet – Horizontal Analysis 2012 2011 $ increase/ decrease % increase/ Cash $130,000 $110,000 $20,000 18.2% Accounts Receivable 130,000 120,000 10,000 8.3 Inventory 225,000 215,000 4.7 Prepaid Insurance 25,000 30,000 (5,000) (16.7) Total Current Assets $510,000 475,000 $35,000 7.4 Long-term Investments 110,000 75,000 35,000 46.7 Land 200,000 175,000 14.3 Property and Equipment 95,000 126.3 Accumulated Depreciation (105,000) (80,000) (25,000) (31.3) Total Assets $930,000 $740,000 $190,000 25.7 Accounts Payable 60,000 50,000 20.0 Payroll Payable 8,000 2,000 25.0 Taxes Payable 9,000 1,000 11.1 Total Current Liabilities $80,000 $67,000 $13,000 19.4 Notes Payable 100,000 80,000 20,000 Capital Stock 500,000 400,000 Retained Earnings 250,000 193,000 57,000 29.5 Total Liabilities and Stockholders’ Equity $ Current Year - $ Base Year = $130,000 – 110,000 = $ Base Year $110,000 18.2% 5

Income Statement – Horizontal Analysis 2012 2011 $ increase/ decrease % increase/ Sales Revenue $700,000 $650,000 $50,000 7.7% Cost of Goods Sold 500,000 455,000 45,000 9.9 Gross Profit $200,000 $195,000 $5,000 2.6 Payroll Expense $42,250 $7,750 18.3 Insurance Expense 30,000 29,000 1,000 3.4 Rent Expense 18,000 -- Depreciation 35,000 15,000 20,000 133.3 Total Expenses $133,000 $104,250 $28,750 27.6 Operating Income $67,000 $90,750 ($23,750) (26.2) Interest Expense ($7,000) ($5,000) ($2,000) 40.0 Gain on Vehicle Sale 25,000 Loss on Sale of Securities (25,000) Interest Revenue 75,000 50,000 50.0 Net income before Interest and Taxes $135,000 $135,750 ($750) (0.06) Tax (40,000) (40,250) 250 Net Income $95,000 $95,500 ($500) (0.05) Dividends (38,000) To Retained Earnings $57,000 $57,500 Although sales increased, expenses appear to be rising much faster than sales (reflected in the larger percentage changes in Cost of Goods Sold and Total Expenses). 6

Horizontal Analysis Horizontal analysis of financial statements can and should include more than just 2 years of data. Many annual reports include, as supplemental information, up to 10 years of financial data. Using these supplemental reports, readers of financial statements can perform trend analysis. Trend analysis can be used to identify problems of abnormal account changes.

Vertical Analysis Vertical analysis compares financial statements of different companies and financial statements of the same company across time after controlling for differences in size. When comparing companies of different sizes, it is useful to standardize the statements.

Common-Size Statements All items have been restated as a percentage of a selected item on the statements. Remove size as a relevant variable in ratio analysis. Used to compare companies that make similar products. Used to compare the same company across years.

Balance Sheet - Vertical 2012 % 2011 Cash $130,000 14.0% $110,000 14.9% Accounts Receivable 130,000 14.0 120,000 16.2 Inventory 225,000 24.2 215,000 29.1 Prepaid Insurance 25,000 2.7 30,000 4.1 Total Current Assets $510,000 54.8% 475,000 64.2% Long-term Investments 110,000 11.8 75,000 10.1 Land 200,000 21.5 175,000 23.6 Property and Equipment 23.1 95,000 12.8 Accumulated Depreciation (105,000) (11.3) (80,000) (10.8) Total Assets $930,000 100% $740,000 Accounts Payable 60,000 6.5% 50,000 6.8% Payroll Payable 10,000 1.1 8,000 Taxes Payable 9,000 1.2 Total Current Liabilities $80,000 8.7% $67,000 9.1% Notes Payable 100,000 10.8 80,000 Capital Stock 500,000 53.8 400,000 54.1 Retained Earnings 250,000 26.9 193,000 26.1 Total Liabilities and Stockholders’ Equity All asset accounts are stated as a percentage of total assets.

Working Capital Working capital is defined as the excess of current assets over current liabilities and is a measure of an entity’s liquidity, or its ability to meet its immediate financial obligations. 2012 2011 Current Assets $510,000 $475,000 Current Liabilities (80,000) (67,000) Working Capital $430,000 $408,000

Income Statement – Vertical Analysis 2012 % 2011 Sales Revenue $700,000 100.0 $650,000 Cost of Goods Sold 500,000 71.4 455,000 70.0 Gross Profit $200,000 28.6 $195,000 30.0 Payroll Expense $50,000 7.1 $42,250 6.0 Insurance Expense 30,000 4.3 29,000 4.5 Rent Expense 18,000 2.6 2.8 Depreciation 35,000 5.0 15,000 2.3 Total Expenses $133,000 19.0 $104,250 16.0 Operating Income $67,000 9.6% $90,750 14.0 Interest Expense ($7,000) (1.0) ($5,000) (0.8) Gain on Vehicle Sale 25,000 3.6 -- — Loss on Sale of Securities (25,000) (3.6) Interest Revenue 75,000 10.7 50,000 7.7 Net income before Interest and Taxes $135,000 19.3 $135,750 20.9 Tax (40,000) (5.7) (40,250) (6.2) Net Income $95,000 13.6 $95,500 14.7 All expense and other income accounts are stated as a percentage of sales revenue. 12

Liquidity Ratios Liquidity ratios assess the ability of a company to meet its immediate or short-term financial obligations. Current Ratio Acid-Test Ratio Inventory Turnover Ratio Accounts Receivable Turnover

Information being used for? Solvency Ratios Solvency focuses on capital structure and assesses the extent of borrowing needed. Solvency refers to a company’s ability to remain in business over the long term. Information being used for? Capital Structure Focus Long-term Financial Health Assesses Borrowing Needs -

Solvency Ratios continued Debt-to-Equity ratio Times-Interest-Earned ratio Debt Service Coverage ratio Cash Flow from Operations to Capital Expenditures ratio 15

Profitability Ratios Managers Creditors Stockholders Indicates potential for bonuses and incentive plans linked to performance. Indicates the ability to make required principal and interest payments. Indicates related stock price increases or dividends paid.

Profitability Ratios continued Return on Assets Return on Sales Asset Turnover Return on Common Stockholders’ Equity Earnings Per Share Price Earnings ratio 17

End of Chapter 12