2. How to Read, Analyze, and Interpret Financial Reports
Chapter 16
How to Read, Analyze, and Interpret Financial Reports
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

3. 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

4. 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

5. 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

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

7. 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

8. 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

9. 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.

10. 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

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.

12. 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,

13. 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

14. 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

15. 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

16. 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

17. 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)

18. 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)

19. 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

20. 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

21. 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%

22. 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%