Analyzing Financial Statements Chapter 23

Preparing comparative balance sheets. Learning Objective 1

Assets 20x8 20x7 Change % Current Assets: Cash$ 3,040$ 4,080$(1,040)(25.5) Accounts Receivable Net 20,000 16,000 4, Merchandise Inventory 24,160 26,120 (1,960) (7.5) Prepaid Expenses 80,000 60, Total Current Assets$ 48,000$ 46,800$ 1, Plant and Equipment Office Equipment, Net$125,200$116,800$ 8, Total Assets$173,200$163,600$ 9, Comparative Balance Sheets

Liabilities 20x8 20x7 Change % Current Liabilities: Notes Payable$20,960$17,320$3, Accounts Payable (40)(14.3) Total Current Liabilities$21,200$17,600$3, Long-Term Liabilities: Mortgage Payable$60,000$60, Total Liabilities$81,200$77,600$3, Comparative Balance Sheets

Stockholders’ Equity 20x8 20x7 Change % Common Stock, $10 par$ 60,000$ 60, Retained Earnings 32,000 26,000$6, Total Stockholders’ Equity$ 92,000$ 86,000$6, Total Liabilities and Stockholders’ Equity$173,200$163,600$9, Comparative Balance Sheets

Using horizontal and vertical analysis techniques. Learning Objective 2

Learning Unit 23-1 What is horizontal analysis? n Comparative balance sheets are analyzed for percentages of change – increases or (decreases). n Compute the dollar change from the base period to the later period. n Divide the dollar change by the base period amount.

x8 20x7 Difference Cash$3,040$4,080 $(1,040) 20x8 20x7 Difference Cash$3,040$4,080 $(1,040) $1,040 ÷ $4,080 =.2549, or 25.5% Learning Unit 23-1

Learning Unit 23-1 n Vertical analysis compares each item on a report to a base number set to 100%. n The base will be either total assets or total liabilities and stockholders’ equity on a balance sheet.

Learning Unit 23-1 Assets20x8 % Current Assets: Cash$ 3, Accounts Receivable Net 20, Merchandise Inventory 24, Prepaid Expenses Total Current Assets$ 48, Plant and Equipment Office Equipment, Net$125, Total Assets$173,

Learning Unit 23-2 n Comparative income statement changes are shown also as percentage increases or decreases. n In the case of the income statement, each item is shown as a percentage of net sales.

Learning Unit x8 % Net Sales$317, Cost of Goods Sold 198, Gross Profit from Sales$119, Total Operating Expenses 83, Operating Income$ 36, Less Interest Expense 4, Income Before Taxes$ 31, Income Taxes 15, Net Income$ 15,

Trend % = Any year $ ÷ Base year $ Learning Unit 23-2 n What is trend analysis? n It is a special type of horizontal analysis that deals with the percentage of changes in certain key items over several years.

Year 20x8 20x7 20x5 Sales$317,600$302,000$270,000 Cost of Goods Sold 198, , ,000 Gross Profit$119,600$108,000$128,000 20x5 is the base year. Year 20x8 20x7 20x5 Sales$317,600$302,000$270,000 Cost of Goods Sold 198, , ,000 Gross Profit$119,600$108,000$128,000 20x5 is the base year. What are the trend percentages? Learning Unit 23-2

Year 20x8 20x7 20x5 Sales 118% 112% 100% Cost of Goods Sold 139% 137% 100% Gross Profit 93% 84% 100% Year 20x8 20x7 20x5 Sales 118% 112% 100% Cost of Goods Sold 139% 137% 100% Gross Profit 93% 84% 100% Learning Unit 23-2

Calculating the four different types of ratios: liquidity ratios, asset management ratios, debt management ratios, and profitability ratios. Learning Objective 3

Learning Unit 23-3 n A ratio is the relationship of two quantities or numbers, one divided by the other. n Ratios can be compared over time for one business. n They also can be compared to readily available industry ratios.

Acid test ratio = (Current assets – Merchandise inventory – Prepaid expenses) ÷ Current liabilities Acid test ratio = (Current assets – Merchandise inventory – Prepaid expenses) ÷ Current liabilities Current ratio = Total current assets ÷ Total current liabilities Current ratio = Total current assets ÷ Total current liabilities Liquidity Ratios Learning Unit 23-3

Learning Unit 23-3 n The current ratio indicates ability to pay short-term obligations. n The acid test, or quick, ratio shows availability of assets that can easily be converted to cash to pay current liabilities.

Average collection period = 365 days ÷ Accounts receivable turnover Average collection period = 365 days ÷ Accounts receivable turnover Accounts receivable turnover = Net credit sales ÷ Average accounts receivable Accounts receivable turnover = Net credit sales ÷ Average accounts receivable Asset Management Ratios Learning Unit 23-3

Accounts receivable turnover shows how many times accounts receivable is converted to cash in one year. Accounts receivable turnover shows how many times accounts receivable is converted to cash in one year. Learning Unit 23-3

Asset turnover = Net sales ÷ Total assets Inventory turnover = Cost of goods sold ÷ Average inventory Inventory turnover = Cost of goods sold ÷ Average inventory Learning Unit 23-3

Learning Unit 23-3 n The inventory turnover calculates the number of times inventory turns over in one period. n The asset turnover indicates whether or not assets have been used efficiently to generate sales.

Debt to stockholders’ equity = Total liabilities ÷ Stockholders’ equity Debt to stockholders’ equity = Total liabilities ÷ Stockholders’ equity Debt to total assets = Total liabilities ÷ Total assets Debt to total assets = Total liabilities ÷ Total assets Debt Management Ratios Learning Unit 23-3

Learning Unit 23-3 n The debt-to-total-assets ratio indicates the amount of assets that are financed by creditors. n The debt-to-stockholders’-equity ratio shows stockholders’ risk compared to creditors’ risk.

Times interest earned = Income before taxes and interest expense ÷ Interest expense Times interest earned = Income before taxes and interest expense ÷ Interest expense It reveals ability to meet interest payment due dates. It reveals ability to meet interest payment due dates. Learning Unit 23-3

Return on sales = Net income before taxes ÷ Net sales Return on sales = Net income before taxes ÷ Net sales Gross profit rate = Gross profit ÷ Net sales Profitability Ratios Learning Unit 23-3

Learning Unit 23-3 n The gross profit ratio indicates how much of the sales income is available to pay expenses and generate a net income. n A high return on sales ratio usually means that inventory consists of high priced items such as autos and furniture.

Learning Unit 23-3 Rate of return on common stockholders’ equity = (Net income before taxes – preferred dividends) ÷ Common stockholders’ equity Rate of return on common stockholders’ equity = (Net income before taxes – preferred dividends) ÷ Common stockholders’ equity Rate of return on total assets = Net income before interest and taxes ÷ Total assets Rate of return on total assets = Net income before interest and taxes ÷ Total assets

Learning Unit 23-3 n The rate of return on total assets indicates earning power. n The rate of return on common stockholders’ equity shows the amount of the net income share that remains for the common stockholders (after preferred dividends are deducted).

End of Chapter 23