1. Chapter 12 Financial Statement Analysis
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2. Introduction
Financial statement analysis is a useful tool for both external and internal users as they make decisions about a company or for a company.
Management uses financial statements to assess the adequacy of cash flow to pay operating expenses, the efficient use of company resources, and how to improve the overall performance of the company.

3. Financial Statement Analysis Limitations
GAAP
Ratios
Inflation
Historical cost is reported. Increasing price effects are not included.
Allows a variety of methods, estimates and assumptions to be used.
No single ratio can be emphasized, but must be compared to others.

4. Horizontal Analysis
Analyzing financial statements over time is called horizontal analysis.
The idea behind horizontal analysis is to analyze changes in accounts occurring between years.
To facilitate this analysis, dollar and percentage changes are calculated on each item.

5. Balance Sheet – Horizontal Analysis
2012
2011
$ increase/
decrease
% increase/
Cash
$130,000
$110,000
$20,000
18.2%
Accounts Receivable
130,000
120,000
10,000
8.3
Inventory
225,000
215,000
4.7
Prepaid Insurance
25,000
30,000
(5,000)
(16.7)
Total Current Assets
$510,000
475,000
$35,000
7.4
Long-term Investments
110,000
75,000
35,000
46.7
Land
200,000
175,000
14.3
Property and Equipment
95,000
126.3
Accumulated Depreciation
(105,000)
(80,000)
(25,000)
(31.3)
Total Assets
$930,000
$740,000
$190,000
25.7
Accounts Payable
60,000
50,000
20.0
Payroll Payable
8,000
2,000
25.0
Taxes Payable
9,000
1,000
11.1
Total Current Liabilities
$80,000
$67,000
$13,000
19.4
Notes Payable
100,000
80,000
20,000
Capital Stock
500,000
400,000
Retained Earnings
250,000
193,000
57,000
29.5
Total Liabilities and Stockholders’ Equity
$ Current Year - $ Base Year = $130,000 – 110,000 =
$ Base Year $110,000
18.2% 5

6. Income Statement – Horizontal Analysis
2012
2011
$ increase/
decrease
% increase/
Sales Revenue
$700,000
$650,000
$50,000
7.7%
Cost of Goods Sold
500,000
455,000
45,000
9.9
Gross Profit
$200,000
$195,000
$5,000
2.6
Payroll Expense
$42,250
$7,750
18.3
Insurance Expense
30,000
29,000
1,000
3.4
Rent Expense
18,000 --
Depreciation
35,000
15,000
20,000
133.3
Total Expenses
$133,000
$104,250
$28,750
27.6
Operating Income
$67,000
$90,750
($23,750)
(26.2)
Interest Expense
($7,000)
($5,000)
($2,000)
40.0
Gain on Vehicle Sale
25,000
Loss on Sale of Securities
(25,000)
Interest Revenue
75,000
50,000
50.0
Net income before Interest and Taxes
$135,000
$135,750
($750)
(0.06)
Tax
(40,000)
(40,250)
250
Net Income
$95,000
$95,500
($500)
(0.05)
Dividends
(38,000)
To Retained Earnings
$57,000
$57,500
Although sales increased, expenses appear to be rising much faster than sales (reflected in the larger percentage changes in Cost of Goods Sold and Total Expenses). 6

7. Horizontal Analysis
Horizontal analysis of financial statements can and should include more than just 2 years of data.
Many annual reports include, as supplemental information, up
to 10 years of financial data.
Using these supplemental reports, readers of financial statements can perform trend analysis.
Trend analysis can be used to identify problems of abnormal account changes.

8. Vertical Analysis
Vertical analysis compares financial statements of different companies and financial statements of the same company across time after controlling for differences in size.
When comparing companies of different sizes, it is useful to standardize the
statements.

9. Common-Size Statements
All items have been restated as a percentage of a selected item on the statements.
Remove size as a relevant variable in ratio analysis.
Used to compare companies that make similar products.
Used to compare the same company across years.

10. Balance Sheet - Vertical
2012 %
2011
Cash
$130,000
14.0%
$110,000
14.9%
Accounts Receivable
130,000
14.0
120,000
16.2
Inventory
225,000
24.2
215,000
29.1
Prepaid Insurance
25,000
2.7
30,000
4.1
Total Current Assets
$510,000
54.8%
475,000
64.2%
Long-term Investments
110,000
11.8
75,000
10.1
Land
200,000
21.5
175,000
23.6
Property and Equipment
23.1
95,000
12.8
Accumulated Depreciation
(105,000)
(11.3)
(80,000)
(10.8)
Total Assets
$930,000
100%
$740,000
Accounts Payable
60,000
6.5%
50,000
6.8%
Payroll Payable
10,000
1.1
8,000
Taxes Payable
9,000
1.2
Total Current Liabilities
$80,000
8.7%
$67,000
9.1%
Notes Payable
100,000
10.8
80,000
Capital Stock
500,000
53.8
400,000
54.1
Retained Earnings
250,000
26.9
193,000
26.1
Total Liabilities and Stockholders’ Equity
All asset accounts are stated as a percentage of total assets.

11. Working Capital
Working capital is defined as the excess of current assets over current liabilities and is a measure of an entity’s liquidity, or its ability to meet its immediate financial obligations.
2012
2011
Current Assets
$510,000
$475,000
Current Liabilities
(80,000)
(67,000)
Working Capital
$430,000
$408,000

12. Income Statement – Vertical Analysis
2012 %
2011
Sales Revenue
$700,000
100.0
$650,000
Cost of Goods Sold
500,000
71.4
455,000
70.0
Gross Profit
$200,000
28.6
$195,000
30.0
Payroll Expense
$50,000
7.1
$42,250
6.0
Insurance Expense
30,000
4.3
29,000
4.5
Rent Expense
18,000
2.6
2.8
Depreciation
35,000
5.0
15,000
2.3
Total Expenses
$133,000
19.0
$104,250
16.0
Operating Income
$67,000
9.6%
$90,750
14.0
Interest Expense
($7,000)
(1.0)
($5,000)
(0.8)
Gain on Vehicle Sale
25,000
3.6 -- —
Loss on Sale of Securities
(25,000)
(3.6)
Interest Revenue
75,000
10.7
50,000
7.7
Net income before Interest and Taxes
$135,000
19.3
$135,750
20.9
Tax
(40,000)
(5.7)
(40,250)
(6.2)
Net Income
$95,000
13.6
$95,500
14.7
All expense and other income accounts are stated as a percentage of sales revenue. 12

13. Liquidity Ratios Liquidity ratios assess the ability of a company
to meet its immediate or short-term financial obligations.
Current Ratio
Acid-Test Ratio
Inventory Turnover Ratio
Accounts Receivable Turnover

14. Information being used for?
Solvency Ratios
Solvency focuses on capital structure and assesses the extent of borrowing needed.
Solvency refers to a company’s ability to remain in business over the long term.
Information being used for?
Capital Structure Focus
Long-term Financial Health
Assesses Borrowing Needs -

15. Solvency Ratios continued
Debt-to-Equity ratio
Times-Interest-Earned ratio
Debt Service Coverage ratio
Cash Flow from Operations to Capital Expenditures ratio 15

16. Profitability Ratios Managers Creditors Stockholders
Indicates potential for bonuses and incentive plans linked to performance.
Indicates the ability to make required principal and interest payments.
Indicates related stock price increases or dividends paid.

17. Profitability Ratios continued
Return on Assets
Return on Sales
Asset Turnover
Return on Common Stockholders’ Equity
Earnings Per Share
Price Earnings ratio 17

18. End of Chapter 12