HOW TO READ, ANALYZE, AND INTERPRET FINANCIAL REPORTS Chapter Sixteen McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning unit objectives LU16-1: Balance Sheet -- Report as of a Particular Date Explain the purpose and the key items on the balance sheet. Explain and complete vertical and horizontal analysis. LU 16-1: Income Statement -- Report for a Specific Period of Time Explain the purpose and the key items on the income statement. Explain and complete vertical and horizontal analysis. LU 16-3: Trend and Ratio Analysis Explain and complete a trend analysis. List, explain, and calculate key financial ratios. 16-

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

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

Elements of the Balance Sheet (Figure 16.1) Assets broken down into current assets and plant and equipment Liabilities broken down into current and long-term MOOL COMPANY Balance Sheet December 31, 2014 Assets 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 Total of current assets and plant and equipment. (Total is double-ruled) Total of all liabilities and stockholders’ equity.

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.

Comparative Balance Sheet: Vertical Analysis (Figure 16.2) ROGER COMPANY Comparative Balance Sheet December 31, 2013 and 2014 2013 2014 Amount Percent Amount Percent Assets Current 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

Comparative Balance Sheet: Vertical Analysis (Figure 16.2) ROGER COMPANY Comparative Balance Sheet December 31, 2013 and 2014 2013 2014 Amount Percent Amount Percent Liabilities Current 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’ Equity Common 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

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.

Comparative Balance Sheet: Horizontal Analysis (Figure 16.3) ABBY ELLEN COMPANY Comparative Balance Sheet December 31, 2013 and 2014 Increase (decrease) 2013 2014 Amount Percent Assets Current 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

Comparative Balance Sheet: Horizontal Analysis (Figure 16.3) ABBY ELLEN COMPANY Comparative Balance Sheet December 31, 2013 and 2014 Increase (decrease) 2013 2014 Amount Percent Liabilities Current 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 Equity Abby Ellen, capital $31,900 31,000 $ 900 2.90 Total liabilities and owner’s equity $55,000 51,000 $4,000 7.84

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. Income Statement$ 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 (Figure 16.4) MOOL COMPANY Income Statement For Month Ended December 31, 2014 Revenues a. Gross Sales $22,080 b. Less: Sales returns and allowances $ 1,082 c. Sales discounts 432 1,514 d. Net Sales Cost of merchandise (goods) sold: $20,566 a. Merchandise Inventory 12/1/2014 1,248 b. Purchases 10,512 c. Less: Purchases returns and allowances $336 d. Less: Purchase discounts 204 540 e. Cost of net purchases 9,972 f. Cost of merchandise (goods available for sale) 11,220 g. Less: Merchandise inventory 12/31/2014 1,600 h. Cost of merchandise (goods sold) 9,620 Gross profit from sales 10,946 Operating expenses: a. Salary 2,200 b. Insurance 1.300 c. Utilities 400 d. Plumbing 120 e. Rent 410 f. Depreciation 200 g. Total operating expenses 4,630 Net income $ 6,316

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

Income Statement Vertical Analysis (Figure 16.5) ROYAL COMPANY Comparative Income Statement For Years Ended December 31, 2013 and 2014 2014 Percent 2013 Percent of net of net Net Sales $45,000 100.00 $29,000 100.00 Cost of merchandise sold 19,000 42.22 12,000 41.38 Gross profit from sales $26,000 57.78 $17,000 58.62 Operating 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 14.83 Income before interest and taxes $17,400 38.67 $12,700 43.79 Interest expense 6,000 13.33 3,000 10.34 Income before taxes $11,400 25.33* $ 9,700 33.45 Provision for taxes 5,500 12.22 3,000 10.34 Net income $ 5,900 13.11 $ 6,700 23.10* * Due to rounding

Horizontal Analysis Income Statement (Figure 16.6) FLINT COMPANY Comparative Income Statement For Years Ended December 31, 2013 and 2014 2014 2013 Increase (decrease) Amount Percent Sale $ 90,000 $80,000 $10,000 Sales returns and allowances 2,000 2,000 0 Net Sales $88,000 $78,000 $10,000 + 12.82 Cost of merchandise sold 45,000 40,000 5,000 + 12.50 Gross profit from sales $43,000 $38,000 $ 5,000 + 13.16 Operating 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 + 28.65 Income before interest and taxes $19,200 $19,500 $ (300) - 1.54 Interest expense 4,000 4,000 0 Income before taxes $15,200 $15,500 $ (300) - 1.94 Provision for taxes 3,800 4,000 (200) - 5.00 Net income $11,400 $11,500 $ (100) - .87

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 2012) 2015 2014 2013 2012 2015 2014 2013 2012 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 2015 2014 2013 2012 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