1. Analyzing Financial Statements
Chapter 3
Analyzing Financial
Statements
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

2. Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved
Chapter Overview
Readers of Financial Statements
Types of Financial Analysis
Management Decision Making
Financial Tricks
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

3. Readers of Financial Analysis
Owners
Track and evaluate management’s performance
Lenders
Determine the risk of the business defaulting on its loan
Managers
Compare actual and budgeted results
Government
Ensure that taxes have been paid
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

4. Readers of Financial Analysis cont.
Suppliers
Evaluate the company’s ability to pay its obligations
Investment Analysts
Evaluate the company’s performance
Mergers and Acquisitions
Highlight financial strengths, upside potential, and future value
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

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Types of Analysis
Vertical Analysis
Used to analyze variable expenses
All accounts are sized using either:
Total revenue or
Departmental revenue
Variable expenses should increase or decrease with the level of sales
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

6. Sample Vertical Analysis
Shae's
Income Statement
For the month ended June 30, 2008
Revenues:
Amount
Percent
Food
$ ,000
78.20
Beverage
220,000
19.33
Others
28,100
2.47
Total Revenues
$ 1,138,100
100.00
Cost of Sales:
$ ,400
36.00
48,400
22.00
15,455
55.00
Total Cost of Sales
$ ,255
33.76
Gross Profit:
$ ,600
50.05
171,600
15.08
12,645
1.11
Total Gross Profit
$ ,845
66.24
Accounts are divided by total revenues
$1,138,100
Cost of Sales is divided by its respective revenue amount
EX: Food
$320,400 / $890,000 = 36%
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

7. Sample Vertical Analysis cont.
Operating (Controllable) Expenses:
Amount
Percent
Salaries and Wages
$ ,811
31.00
Employee Benefits
105,843
9.30
Total Labor Cost
458,654
40.30
Direct Operating Expenses
68,286
6.00
Marketing
39,834
3.50
Utilities
44,386
3.90
Administration & General
28,453
2.50
Repairs and Maintenance
25,038
2.20
Music and Entertainment
31,867
2.80
Total Operating Expenses
$ ,517
61.20
Operating Income
$ ,328
5.04
Other (Non-controllable) Expenses:
Rent
$ ,000
0.70
Depreciation
20,470
1.80
Interest
4,500
0.40
Total Non-controllable Expenses
$ ,970
2.90
Income Before Income Taxes
$ ,358
2.14
Accounts are divided by total revenues
$1,138,100
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

8. Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved
Types of Analysis
Horizontal Analysis
Tracks and Analyzes:
Income Statement
Balance Sheet
Focuses on both $$ and % changes
Analyzes changes over time
Month to Month
Year to Year
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

9. Sample Horizontal Analysis
Danforth Hotels
Horizontal Analysis for the Balance Sheets
As of December 31
(in millions)
2007
2008
$ change
% change
Cash $ $ $
263.4
Accounts Receivable
288
269
(19)
-6.6
Marketable Securities
100
112 12
12.0
Inventory
193
158
(35)
-18.1
Other current assets 64 90 26
40.6
Total Current Assets
727
927
200
27.5
Furniture, Fixture & Equipment, net
3,641
3,520
(121)
-3.0
Management and Franchise Contracts, net
383
347
(36)
-9.4
Goodwill
1,230 -
0.0
Long term Investments
568
599 31
5.5
Other long term assets
260
328 68
26.2
Long Term Assets
6,082
6,024
(58)
-1.0
Total Assets
$ ,809
$ ,951 $
2.1
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

10. Sample Horizontal Analysis cont.
2007
2008
$ change
% change
Accounts Payable and Accrued Expenses $ $ $
11.3
Current maturities of long-term debt
329
118
(211)
-64.1
Accrued Taxes 4 -
0.0
Total Current Liabilities
873
723
(150)
-17.2
Long Term Debt
3,709
3,560
(149)
-4.0
Total Liabilities
4,582
4,283
(299)
-6.5
Owner's Equity
1,807
1,998
191
10.6
Retained Earnings
420
670
250
59.5
Total Owner's Equity
2,227
2,668
441
19.8
Total Liabilities and Owner's Equity
$ ,809
$ ,951 $
2.1
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

11. Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved
Types of Analysis
Trend Analysis
Calculations and data points
Over a specified period of time
Presented on line graphs and bar charts
Examples
RevPAR
Food Cost
Payroll Cost
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

12. Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved
Types of Analysis
Published Industry Averages
Management can compare operating results
Examples
Smith Travel Research HOST Report
Operating results
Smith Travel Research STAR Report
Occupancy, ADR, and RevPAR
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

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Types of Analysis
Ratio Analysis
Used to asses financial health
Five categories:
Liquidity
Solvency
Activity
Operating
Profitability
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Liquidity Ratios
Measures ability to meet short-term obligations
Current Ratio
Accounts Receivable Turnover
Average Collection Period
Operating Cash to Current Liabilities
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Solvency Ratios
Measure ability to meet long-term obligations
Operating Cash Flow to Long-term Debt
Long-term Debt to Total Capitalization
Debt-to-equity Ratio
Times Interest Earned (TIE)
Fixed Charge Coverage
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Activity Ratios
Gauge effectiveness of how assets are managed
Food Inventory Turnover
Beverage Inventory Turnover
Fixed Asset Turnover
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Operating Ratios
Determine how efficient the operation is
Food Cost Percentage
Beverage Cost Percentage
Labor Cost Percentage
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Profitability Ratios
Effectiveness of achieving profit margins and ROI goals
Profit Margin
Return on Assets
Return on Investment
Return on Equity
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19. Management Decision Making
Employee Scheduling
Based on:
Accurate revenue forecasts
Productivity goals
Customer service goals
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20. Management Decision Making
Food and Beverage Pricing
Track sales of each menu item
Calculate each items gross profitability
Set menu prices
Remove unprofitable items from the menu
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21. Management Decision Making
Revenue Management
Goal is to maximize RevPAR
Strategies
Close lower levels of pricing during high demand
Open all pricing levels during times of low demand
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22. Management Decision Making
Profit Flexing
Utilized when revenues fall behind budget
Adjust pricing and reduce expenses
Without impacting customer service
Maximize remaining revenue opportunities
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

23. Management Decision Making
Cost-volume-profit Modeling
Also known as Breakeven Analysis
Target the amount of revenue required to reach the owner’s goal
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24. Cost-volume-profit Equations
Breakeven Volume of Sales =
Fixed costs
(sale price – variable cost)
Desired Occupancy % =
Rooms sold
Rooms available for sale
Desired Volume =
Fixed Costs + Desired Profits
Sale Price – Variable Cost
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

25. Breakeven Volume Example
Sale price = $250 a night
Fixed costs = $40,000 per month
Variable cost = $35 per room
Breakeven Volume of Sales =
Fixed costs
(sale price – variable cost) =
40,000
( )
215
186 rooms
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

26. Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved
Financial Tricks
Window Dressing
Making a company’s financial statements look more favorable
Example
Company does not pay invoices
Makes year-end balance sheet look better
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

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Financial Tricks
Off-balance-sheet Financing
Company does not show debt associated with real estate joint ventures
As long as it owns a “relatively” minor percentage of the joint venture
Legal under GAAP
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Financial Tricks
Capitalize Current Operating Expenses
Reduces current expenses
Increases profits
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29. Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved
Financial Tricks
Improper Revenue Recognition
Revenues are recorded before they are actually earned
Violates matching principle
Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved