Analyzing Financial Statements 12.3 in textbook

 Income Statement- Summarizes the items of revenue and expense and shows the net income (revenue > expense) or net loss (expense > revenue) of a business, for a given FISCAL PERIOD  Balance Sheet- statement showing the financial position (assets, liabilities and capital) of an individual, company, or other organization on a CERTAIN DATE.

1. Owners- use to evaluate the performance of the people who run the company for them and learn about company activities in general 2. Managers- Use them the most, study them in order to improve results and efficiency, and to eliminate weaknesses. Statements help managers make key business decisions 3. Investors- Shares of public corporations are traded by stockbrokers through stock exchange. Stay informed about the affairs of corporations by reading their financial reports Used By:

4. Creditors- particularly bankers, ask for financial statements regularly. Stay inform about a company’s progress and its ability to meet its loan obligations. (Banks must protect their loans) 5. Shareholders – law requires that corporations provide shareholders with financial statements regularly. Must be aware of its progress ◦ All use financial statements to evaluate the stability and growth of a business

 To make it easier to understand meaningful information, comparative, common size and trend analysis may be used  Management will attempt to find reason for change  The longer the period compared, the better for observing trends Why do we need to Analysis Financial Statements?

1. Comparative Analysis 2. Common-size Analysis 3. Trend Analysis

 When comparing financial statements for two consecutive years  Find the: ◦ A) dollar amount of the increase/decrease from year 1 to year 2 1. Comparative Analysis is… Year 1Year 2Increase/ decrease Company A Company B Increasing

 Can indicate the direction of the business; if all numbers are increasing, then there should be an overall increase in company performance  However, it is not as useful as percentage change % What does the chart tell us?

 B) percentage amount of the increase/decrease from year 1 to year 2 Calculate: Percentage Change = Difference/Base Year x100 Comparative Analysis cont. Year 1Year 2Increase/ decrease Percentage Change Company A / = 7.4% Company B / = 200%

 Both companies A & B increase by $20 000, however, Company A’s percentage increase is only 7.4% compared to Company B’s percentage increase of 200% What can we conclude?

◦ Useful for year to year comparisons showing owner/manager areas to investigate ◦ Indicates whether amounts are within proper range ◦ Percentages can depend on many different factors (ie. Size of market, competition, product etc.) Benefits of Comparative Analysis:

 Exercise #1 p. 584 (t), p. 471 (w)

 Common-size financial statements are based on a common percentage framework. a) Income Statement- Net Sales (revenue) will represent 100% and all other account balances will be compared to this figure and analyzed 2. Common-Size Analysis

Company ACompany B Revenue Sales$ $ Expenses Automotive Expense$ $ Bank Interest Expense Rent Expense Wages Expense Other Expenses Total Expenses$ $ Net Income$ $ Income Statement Year Ended December 31, 2011

Common-size Income Statements Company ACompany B Revenue Sales$ %$ % Expenses Automotive Expense$ %$ % Bank Interest Expense % Rent Expense % % Wages Expense % % Other Expenses % % Total Expenses$ %$ % Net Income$ %$ %

 b) Balance Sheet- ◦ Total Assets will represent 100% and the % of each asset will be compared to this figure ◦ Total Liabilities and Owner’s Equity will represent 100% and liability and owner’s equity figures will be compared to this figure Common-size Analysis Cont.

**Please Note: Data in common- size form can be easily analyzed, not only within one company, but by comparing percentages relative between two companies

 Trend analysis shows financial data (as figures and percentages) over a number of consecutive periods

 Lets consider the following sales figures for a company:  What can you tell me about these figures? Year 1Year 2Year 3Year 4Year 5Year 6 Sales $55 000$60 000$75 000$45 000$ $

 Not easy to interpret these figures just by looking at them, but if we change these figures into percentages or a graph, we can easily analyze it

 Calculate the percentage change ◦ Comparison Year/Base Year * 100 = Percentage Change Year 1Year 2Year 3Year 4Year 5Year 6 Sales $55 000$60 000$75 000$45 000$ $ Percentage 100 %109.1 %136.4 %81.8 %190.9 %203.6 %

 There was a significant decrease in sales % in year 4, however, by year 6 the company doubled their sales

1. The Consistency Principle:  Requires that a business must use the same accounting methods and procedures from period to period  If there is a change the financial statements must clearly indicate the change  Example: a company records revenue when payments are received, not when invoices are issued. If the company had a bad year, it would be wrong to make the results look better by including some revenue for invoices issued but for which payment has not been received

2. The Materiality Principle:  Requires accountants to follow generally accepted accounting principles except when to do so would be expensive or difficult, and where it makes no real difference if the rules are ignored ◦ Example: invoice error for $50 discovered by company with a net income of approximately $ , no effort would be made to correct the error because the $50 is not significant in relation to the net income figure.

3. Full Disclosure Principle:  States that all information needed for a full understanding of the company’s financial affairs must be included in the financial statement ◦ Example: Company being sued for millions, have an impact on the financial standing of the company if they lost the lawsuit. Other examples that might require an accompanying note are tax disputes and company takeovers.

 Read p (t) and answer review questions #1-5 p. 583 (t), p. 470 (w)  Ex. 1 & 2 p. 584 (t), p (w)  Ex. 1-3 on the handout