How to Read, Analyze, and Interpret Financial Reports Chapter 16 How to Read, Analyze, and Interpret Financial Reports

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

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

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

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

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

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 $ 7,000 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

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.

Figure 16.2 - Comparative Balance Sheet: Vertical Analysis ROGER COMPANY Comparative Balance Sheet December 31, 2006 and 2007 2007 2006 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 $22000/85000 = .2588 or 25.88% * 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.

Figure 16.3 - Comparative Balance Sheet: Horizontal Analysis ABBY ELLEN COMPANY Comparative Balance Sheet December 31, 2006 and 2007 Increase(decrease) 2007 2006 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 6000-4000=2000/4000= .5 or 50%

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

Figure 16.4 - Income Statement MOOL RETAIL CLOTHING 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 432 1,514 d. Net Sales Cost of merchandise (goods) sold: $20,566 a. Merchandise Inventory 12/1/2004 $ 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 12/31/2004 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 c. Depreciation 200 Total operating expenses 4,630 Net income $ 6,316

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

Figure 16.5 - Income Statement Vertical Analysis ROYAL COMPANY Comparative Income Statement For Years Ended December 31, 2006 and 2007 2007 Percent 2006 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 $12000/$29000=.4138 OR 41.38%

Figure 16.6 - Horizontal Analysis Income Statement FLINT COMPANY Comparative Income Statement For Years Ended December 31, 2006 and 2007 2007 2006 Increase (decrease) Amount Percent Sales $ 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 Administration 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 2005) 2008 2007 2006 2005 2008 2007 2006 2005 Sales $750,000 $650,000 $625,000 $650,000 Gross Profit 200,000 150,000 135,000 140,000 Net Income 75,000 50,000 35,000 40,000 Trend Analysis 2008 2007 2006 2005 Sales* 115% 100% 96% 100% Gross Profit 143 107 96 100 Net Income 188 125 88 100 $625,000 $650,000 * Round to nearest whole percent

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

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, 90-120 days Total debt to total assets = Total liabilities Total assets Industry average, 50% - 70%

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%