Chapter 16How to Read, Analyze, and Interpret Financial ReportsMcGraw-Hill/IrwinCopyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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Explain the purpose and the key items on the balance sheetExplain and complete vertical and horizontal analysisHow to Read, Analyze, and Interpret Financial Reports#16Learning Unit ObjectivesBalance Sheet -- Report as of a Particular DateLU16.1

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Explain the purpose and the key items on the income statementExplain and complete vertical and horizontal analysisHow to Read, Analyze, and Interpret Financial Reports#16Learning Unit ObjectivesIncome Statement -- Report for a Specific Period of TimeLU16.2

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Explain and complete a trend analysisList, explain, and calculate key financial ratiosHow to Read, Analyze, and Interpret Financial Reports#16Learning Unit ObjectivesTrend and Ratio AnalysisLU16.3

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Accounting EquationAccounting Equation: Assets = Liabilities + Owners Equity

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Balance SheetGives a financial picture of what a company is worth as of particular date.AssetsLiabilities+Owners Equity= How much the company owns How much the owner is worthHow much the company owes

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Figure 16.1 - Elements of the Balance SheetMOOL COMPANYBalance SheetDecember 31, 2011Assets Liabilitiesa. Current assets: a. Current liabilities:b. Cash $ 7,000 b. Accounts payable $ 80,000c. Accounts receivable 9,000c. Salaries payable 12,000d. Merchandise inventory 30,000d. Total current liabilities $ 92,000e. Prepaid expenses 15,000 e. Long-term liabilities:f. Total current assets $61,000 f. Mortgage note payable 58,000g. Plant and equipment:g. Total liabilities $150,000h. Building (net) $60,000i. Land 84,000 Stockholders Equityj. Total plant and equipment 144,000 a. Common stock $ 20,000b. Retained earnings 35,000c. Total stockholders equity 55,000k. Total assets $205,000 d. Total liab. and stkhlds equity $205,000

Assets broken down into current assets and plant and equipment.Liabilities broken down into current and long-termTotal of current assets and plant and equipment.(Total is double- ruled)Total of all liabilities and stockholders equity.

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Preparing a Vertical Analysis of a Balance SheetStep 2. Round each liability and stockholders equity (the portions) as a percent of total liabilities and stockholders equity (the base). Round as indicated.Step 1. Divide each asset (the portion) as a percent of total assets (the base). Round as indicated.

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Figure 16.2 - Comparative Balance Sheet: Vertical AnalysisROGER COMPANYComparative Balance SheetDecember 31, 2010 and 2011 2011 2010AmountPercentAmountPercentAssetsCurrent 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 6.71Total 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 29.63Total plant and equipment$42,000 49.41*$42,000 51.85Total assets$85,000 100.00$81,000 100.00

* Due to rounding

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Figure 16.2 - Comparative Balance Sheet: Vertical AnalysisROGER COMPANYComparative Balance SheetDecember 31, 2010 and 2011 2011 2010AmountPercentAmountPercentLiabilitiesCurrent 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 EquityCommon stock $20,000 23.53$20,000 24.69Retained earnings 21,000 24.71 16,000 19.75 Total Stockholders equity $41,000 48.24$36,000 44.44Total Liabilities and Stockholders Equity $85,000 100.00 $81,000 100.00

* Due to rounding

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Preparing a Horizontal Analysis of a Comparative Balance SheetStep 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.

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Figure 16.3 - Comparative Balance Sheet: Horizontal AnalysisABBY ELLEN COMPANYComparative Balance SheetDecember 31, 2010 and 2011 Increase(decrease) 2011 2010AmountPercentAssetsCurrent 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) -28.57Total current assets$25,000$21,000 $ 4,000 19.05Plant and equipment: Building (net)$12,000 $12,000 0 0 Land 18,000 18,000 0 0Total plant and equipment$30,000 $30,000 0 0Total assets$55,000 $51,000$4,000 7.84

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Figure 16.3 - Comparative Balance Sheet: Horizontal AnalysisABBY ELLEN COMPANYComparative Balance SheetDecember 31, 2010 and 2011 Increase(decrease) 2010 2011AmountPercentLiabilitiesCurrent 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 22.00Long-term liabilities: Mortgage note payable 17,000 15,000 2,000 13.33 Total Liabilities $ 23,100 20,000 3,100 15.50 Owners EquityAbby Ellen, capital$31,900 31,000 $ 900 2.90 Total liabilities and owners equity$55,000 51,000 $4,000 7.84

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

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MOOL COMPANYIncome StatementFor Month Ended December 31, 2011 Revenuesa. Gross Sales $22,080b. Less: Sales returns and allowances $ 1,082c. Sales discounts 432 1,514d. Net Sales Cost of merchandise (goods) sold:$20,566a. Merchandise Inventory 12/1/2004$ 1,248b. Purchases $10,512c. Less: Purchases returns and allowances $336d. Less: Purchase discounts 204 540e. Cost of net purchases 9,972f. Cost of merchandise (goods available for sale) $11,220g. Less: Merchandise inventory 12/31/2004 1,600h. Cost of merchandise (goods sold) 9,620 Gross profit from sales$10,946 Operating expenses: a. Salary $ 2,200b. Insurance 1.300c. Utilities 400d. Plumbing 120e. Rent 410f. Depreciation 200g.Total operating expenses 4,630 Net income$ 6,316Figure 16.4 - Income Statement

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Key Calculations on Income StatementNet sales = Gross sales - Sales returns and - Sales discounts AllowancesNet income = Gross profit - Operating expenses Gross profit = Net sales - Cost of merchandise from sales (goods) soldCost ofNet purchasesmerchandise = Beginning + (purchase less - Ending(goods) sold inventory returns & discounts) inventory

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Figure 16.5 - Income Statement Vertical AnalysisROYAL COMPANYComparative Income StatementFor Years Ended December 31, 2010 and 2011 2011 Percent 2010Percent of net of netNet Sales$45,000 100.00$29,000 100.00Cost of merchandise sold 19,000 42.22 12,000 41.38Gross profit from sales$26,000 57.78$17,000 58.62Operating 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 14.83Income before interest and taxes$17,400 38.67$12,700 43.79Interest expense 6,000 13.33 3,000 10.34Income before taxes$11,400 25.33* $ 9,700 33.45Provision for taxes 5,500 12.22 3,000 10.34Net income $ 5,900 13.11 $ 6,700 23.10** Due to rounding

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FLINT COMPANYComparative Income StatementFor Years Ended December 31, 2010 and 2011 2011 2010 Increase (decrease) Amount PercentSales $ 90,000 $80,000$10,000Sales returns and allowances 2,000 2,000 0Net Sales$88,000 $78,000 $10,000 + 12.82Cost of merchandise sold 45,000 40,000 5,000 + 12.50Gross profit from sales$43,000 $38,000 $ 5,000 + 13.16Operating 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 + 28.65Income before interest and taxes$19,200 $19,500$ (300) - 1.54Interest expense 4,000 4,000 0 Income before taxes$15,200$15,500 $ (300) - 1.94Provision for taxes 3,800 4,000 (200) - 5.00Net income$11,400 $11,500 $ (100) - .87Figure 16.6 - Horizontal Analysis Income Statement

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Completing a Trend AnalysisAnalyzes the changes that occur by expressing each number as a percent of the base year 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)Each ItemBase Amount

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Trend AnalysisGiven (base year 2009)2012201120102009Sales$621,000$460,000$340,000$420,000Gross Profit 182,000 141,000 112,000 124,000Net Income 48,000 41,000 22,000 38,000Trend Analysis2012201120102009Sales*148%110%81%100%Gross Profit14711490100Net Income12610858100$340,000$420,000* Round to nearest whole percent

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Ratio AnalysisA relationship of one number to another. Usedto make comparisons versus previous performanceor other companiesAsset Management ratiosHow well the company manages its assetsDebt Management ratiosThe companys debt situationProfitability ratiosThe companys profitability picture

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Summary of Key RatiosCurrent ratio = Current assetsCurrent liabilitiesIndustry average, 2 to 1

Acid test (quick ratio) = Current assets - inventory-prepaid expenses Current liabilitiesIndustry average, 1 to 1

Average days collection = Accounts receivableNet sales 360Industry average, 90-120 days

Total debt to total assets = Total liabilities Total assetsIndustry average, 50% - 70%

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Summary of Key RatiosReturn on equity = Net Income Stockholders equityIndustry average, 15% - 20%

Asset turnover = Net sales Total assetsIndustry average, $.03 to $.08

Profit margin on net sales = Net income Net salesIndustry average, 25% - 40%

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Problem 16-15:

Return on equity: X $15.2X = 0.10 ($15.2)

X = $1.52 million= 10%

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Problem 16-17:a. Total liabilities $1,768 Total assets $2,015 = 87.74%

b. Net income $147 Stockholders' equity $427 = 34.43%

c. Net sales $265 Total assets $2015 = 13

d. Net income $147 Net sales $265 = 55.47%

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Problem 16-18: 2009 2008 2007 2006 2005 Sales 98% 106% 100% 98% 100% $3,154 $3,414 $3,208 $3,152 $3,216$3,216 $3,216 $3,216 $3,216 $3,216

= 98.072139 = 106.15671 = 99.751243 = 98.00995 =100% = 98% =106% = 100% = 98%

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