Chapter 16 How to Read, Analyze, and Interpret Financial Reports McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Explain the purpose and the key items on the balance sheet 2. Explain and complete vertical and horizontal analysis How to Read, Analyze, and Interpret Financial Reports #16 Learning Unit Objectives Balance Sheet -- Report as of a Particular Date LU16.1

Explain the purpose and the key items on the income statement 2. Explain and complete vertical and horizontal analysis How to Read, Analyze, and Interpret Financial Reports #16 Learning Unit Objectives Income Statement -- Report for a Specific Period of Time LU16.2

Explain and complete a trend analysis 2. List, explain, and calculate key financial ratios How to Read, Analyze, and Interpret Financial Reports #16 Learning Unit Objectives Trend and Ratio Analysis LU16.3

16-5 Accounting Equation Accounting Equation: Assets = Liabilities + Owner’s Equity

16-6 Balance Sheet Gives a financial picture of what a company is worth as of particular date. Assets Liabilities + Owner’s Equity = How much the company owns How much the owner is worth How much the company owes

16-7 Figure Elements of the Balance Sheet MOOL COMPANY Balance Sheet December 31, 2011 Assets Liabilities a. Current assets: a. Current liabilities: b. Cash $ 7,000 b. Accounts payable $ 80,000 c. Accounts receivable 9,000c. Salaries payable 12,000 d. Merchandise inventory 30,000d. 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 Assets broken down into current assets and plant and equipment. Liabilities broken down into current and long-term Total of current assets and plant and equipment. (Total is double- ruled) Total of all liabilities and stockholders’ equity.

16-8 Preparing a Vertical Analysis of a Balance Sheet Step 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.

16-9 Figure Comparative Balance Sheet: Vertical Analysis ROGER COMPANY Comparative Balance Sheet December 31, 2010 and AmountPercentAmountPercent Assets Current Assets: Cash$22, $18, Accounts Receivable 8, , Merchandise inventory 9, , Prepaid rent 4, , Total current assets$43, $39, * Plant and equipment: Building (net)$18, $18, Land 24, , Total plant and equipment$42, *$42, Total assets$85, $81, * Due to rounding

16-10 Figure Comparative Balance Sheet: Vertical Analysis ROGER COMPANY Comparative Balance Sheet December 31, 2010 and AmountPercentAmountPercent Liabilities Current liabilities: Accounts payable $14, $8, Salaries payable 18, , Total current liabilities $32,, $25, * Long-term liabilities: Mortgage note payable $12, $20, Total liabilities $44, * $25, * Stockholders’ Equity Common stock $20, $20, Retained earnings 21, , Total Stockholders’ equity $41, $36, Total Liabilities and Stockholders’ Equity $85, $81, * Due to rounding

16-11 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.

16-12 Figure Comparative Balance Sheet: Horizontal Analysis ABBY ELLEN COMPANY Comparative Balance Sheet December 31, 2010 and 2011 Increase(decrease) AmountPercent Assets Current Assets: Cash$ 6,000$ 4,000$ 2, Accounts Receivable 5,000 6,000 (1,000) Merchandise inventory 9,000 4,000 5, Prepaid rent 5,000 7,000 (2,000) Total current assets$25,000$21,000 $ 4, Plant and equipment: Building (net)$12,000 $12, Land 18,000 18, Total plant and equipment$30,000 $30, Total assets$55,000 $51,000$4,

16-13 Figure Comparative Balance Sheet: Horizontal Analysis ABBY ELLEN COMPANY Comparative Balance Sheet December 31, 2010 and 2011 Increase(decrease) AmountPercent Liabilities Current liabilities: Accounts payable$ 3,200$ 1,800$ 1, Salaries payable 2,900 3,200 (300) Total current liabilities$ 6,100 5,000 1, Long-term liabilities: Mortgage note payable 17,000 15,000 2, Total Liabilities $ 23,100 20,000 3, Owner’s Equity Abby Ellen, capital$31,900 31,000 $ Total liabilities and owner’s equity$55,000 51,000 $4,

16-14 Income Statement A financial report that tells how well a company is performing (its profitability or net profit) during a specific period of time. 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 $

16-15 MOOL COMPANY Income Statement For Month Ended December 31, 2011 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 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 c. Utilities 400 d. Plumbing 120 e. Rent 410 f. Depreciation 200 g.Total operating expenses 4,630 Net income$ 6,316 Figure Income Statement

16-16 Key Calculations on Income Statement Net sales = Gross sales - Sales returns and - Sales discounts Allowances Net income = Gross profit - Operating expenses Gross profit = Net sales - Cost of merchandise from sales (goods) sold Cost ofNet purchases merchandise = Beginning + (purchase less - Ending (goods) sold inventory returns & discounts) inventory

16-17 Figure Income Statement Vertical Analysis ROYAL COMPANY Comparative Income Statement For Years Ended December 31, 2010 and Percent 2010Percent 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 4, , Research 2, , Miscellaneous Total operating expenses $8, * $ 4, Income before interest and taxes$17, $12, Interest expense 6, , Income before taxes$11, * $ 9, Provision for taxes 5, , Net income $ 5, $ 6, * * Due to rounding

16-18 FLINT COMPANY Comparative Income Statement For Years Ended December 31, 2010 and 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, Cost of merchandise sold 45,000 40,000 5, Gross profit from sales$43,000 $38,000 $ 5, Operating expenses: Depreciation$ 6,000 $ 5,000 $ 1, Selling and Advertising 16,000 12,000 4, Research 600 1,000 (400) Miscellaneous 1, Total operating expenses$23,800 $18,500 $ 5, Income before interest and taxes$19,200 $19,500$ (300) Interest expense 4,000 4,000 0 Income before taxes$15,200$15,500 $ (300) Provision for taxes 3,800 4,000 (200) Net income$11,400 $11,500 $ (100) -.87 Figure Horizontal Analysis Income Statement

16-19 Completing a Trend Analysis Analyzes 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 Item Base Amount

16-20 Trend Analysis Given (base year 2009) Sales$621,000$460,000$340,000$420,000 Gross Profit 182, , , ,000 Net Income 48,000 41,000 22,000 38,000 Trend Analysis Sales*148%110%81%100% Gross Profit Net Income $340,000 $420,000 * Round to nearest whole percent

16-21 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 Debt Management ratios The company’s debt situation Profitability ratios The company’s profitability picture

16-22 Summary of Key Ratios Current ratio = Current assets Current liabilities Industry average, 2 to 1 Acid test (quick ratio) = Current assets - inventory-prepaid expenses Current liabilities 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%

16-23 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%

16-24 Problem 16-15: Return on equity: X $15.2 X = 0.10 ($15.2) X = $1.52 million = 10%

16-25 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%

16-26 Problem 16-18: 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 = = = = =100% = 98% =106% = 100% = 98%