financial statement analysis chapter 15 ©2014 pearson education, inc. publishing as prentice...

Financial Statement Analysis

Chapter 15

©2014 Pearson Education, Inc. Publishing as Prentice Hall 15-1

Learning Objectives

1. Explain how financial statements are used to analyze a business.

2. Perform a horizontal analysis of financial statements.

3. Perform a vertical analysis of financial statements.


Learning Objectives

4. Compute and evaluate the standard financial ratios.

5. Complete a corporate income statement including earnings per share (Appendix 15A).


Learning Objective 1

Explain how Explain how financial financial

statements are statements are used to analyze a used to analyze a

business.business.


Different Comparisons

Financial performance analysis allows us to make several comparisons•Year-to-Year.

– Use Horizontal AnalysisUse Horizontal Analysis

•vs. a Competing Company.– Use Vertical AnalysisUse Vertical Analysis

•with the industry or other companies in the industry.

– Use Ratio AnalysisUse Ratio Analysis


Sources for Information

• Annual Reports• Management

Discussion and Analysis

• Report of the Independent Auditors

• Financial Statements• Notes to Financial

Statements©2014 Pearson Education, Inc. Publishing as Prentice Hall 15-6


• Annual ReportsAnnual Reports• Management




Statements

A report required A report required by the Securities by the Securities

and Exchange and Exchange Commission that Commission that

provides provides information about a information about a company’s financial company’s financial

condition.condition.



• Annual Reports• Management Management

Discussion and Discussion and AnalysisAnalysis



Statements

The section of the The section of the annual report that annual report that is intended to help is intended to help

investors investors understand the understand the

result of operations result of operations and the financial and the financial condition of the condition of the

company.company.




Discussion and Analysis• Report of the Report of the

Independent AuditorsIndependent Auditors• Financial Statements• Notes to Financial

Statements

The report that The report that gives reasonable gives reasonable

assurance that the assurance that the financial financial

statements are statements are presented fairly in presented fairly in accordance with accordance with

generally accepted generally accepted accounting accounting principles.principles.






• Financial StatementsFinancial Statements• Notes to Financial

Statements

Includes:Includes:

•Income StatementIncome Statement•Statement of Statement of Stockholders’ Stockholders’ EquityEquity•Balance SheetBalance Sheet•Statement of Cash Statement of Cash Flows.Flows.






• Financial Statements• Notes to Financial Notes to Financial

StatementsStatements

Required Required disclosures disclosures

included with the included with the financial financial

statements that statements that provide additional provide additional information about information about

the statement the statement amounts.amounts.


Includes the income statement, balance sheet, statement of stockholders' equity, and statement of cash flows.

a. Notes to the Financial Statements

Attests to the fairness of the presentation of the financial statements.

b. Report of the independent registered public accounting firm.

Includes a summary of significant accounting policies and explanations of specific items on the financial statements.

c. Management's Discussion and Analysis (MD&A)

Is written by the company to help investors understand the results of operations and the financial condition of the company.

d. Financial Statements

Match the different parts of the annual report with the appropriate description:









c. Management's Discussion and Analysis (MD&A)




Perform a Perform a horizontal analysis horizontal analysis

of financial of financial statements.statements.


Horizontal Analysis

• Defined: Defined: The study of percentage The study of percentage changes in comparative financial changes in comparative financial statements.statements.

• Requires two steps:Requires two steps:1.1. Compute the $-amount of the change Compute the $-amount of the change

from the earlier period to the later period.from the earlier period to the later period.

2.2. Divide the $-amount of change by the Divide the $-amount of change by the earlier period amount (base period).earlier period amount (base period).


Horizontal Analysis

Assume Smart Touch Learning has net Assume Smart Touch Learning has net sales in 2016 of $858,000 and $803,000 in sales in 2016 of $858,000 and $803,000 in

2015. Prepare the horizontal analysis:2015. Prepare the horizontal analysis:


Horizontal Analysis

Assume Smart Touch Learning has net Assume Smart Touch Learning has net sales in 2016 of $858,000 and $803,000 in sales in 2016 of $858,000 and $803,000 in

2015. Prepare the horizontal analysis:2015. Prepare the horizontal analysis:

Step Step


2016 2015 Amount PercentageNet Sales 858,000$ 803,000$ ? ?Cost of Goods Sold 513,000 509,000 ? ?Gross Profit 345,000 294,000 ? ?Operating Expenses: Selling Expenses 126,000 114,000 ? ? Administrative Expenses 118,000 123,000 ? ? Total Expenses 244,000 237,000 ? ?Operating Income 101,000 57,000 ? ?Other Revenues and Expenses Interest Revenue 4,000 - ? ? Interest Expense 24,000 14,000 ? ? Total Other Revenue & Expenses (20,000) (14,000) ? ?Income Before Income Taxes 81,000 43,000 ? ?Income Tax Expense 33,000 17,000 ? ?Net Income 48,000$ 26,000$ ? ?

Increase (Decrease)

SMART TOUCH LEARNINGIncome Statement

Years Ended December 31, 2015 and 2016


2016 2015 Amount PercentageNet Sales 858,000$ 803,000$ 55,000$ ?Cost of Goods Sold 513,000 509,000 4,000 ?Gross Profit 345,000 294,000 51,000 ?Operating Expenses: Selling Expenses 126,000 114,000 12,000 ? Administrative Expenses 118,000 123,000 (5,000) ? Total Expenses 244,000 237,000 7,000 ?Operating Income 101,000 57,000 44,000 ?Other Revenues and Expenses Interest Revenue 4,000 - 4,000 ? Interest Expense 24,000 14,000 10,000 ? Total Other Revenue & Expenses (20,000) (14,000) (6,000) ?Income Before Income Taxes 81,000 43,000 38,000 ?Income Tax Expense 33,000 17,000 16,000 ?Net Income 48,000$ 26,000$ 22,000$ ?

Increase (Decrease)




2016 2015 Amount PercentageNet Sales 858,000$ 803,000$ 55,000$ 6.8%Cost of Goods Sold 513,000 509,000 4,000 0.8%Gross Profit 345,000 294,000 51,000 17.3%Operating Expenses: Selling Expenses 126,000 114,000 12,000 10.5% Administrative Expenses 118,000 123,000 (5,000) -4.1% Total Expenses 244,000 237,000 7,000 3.0%Operating Income 101,000 57,000 44,000 77.2%Other Revenues and Expenses Interest Revenue 4,000 - 4,000 - Interest Expense 24,000 14,000 10,000 71.4% Total Other Revenue & Expenses (20,000) (14,000) (6,000) 42.9%Income Before Income Taxes 81,000 43,000 38,000 88.4%Income Tax Expense 33,000 17,000 16,000 94.1%Net Income 48,000$ 26,000$ 22,000$ 84.6%

Increase (Decrease)




Trend Analysis

• Defined: Defined: A special form of horizontal A special form of horizontal analysis that looks at how ratios analysis that looks at how ratios change over time.change over time.

• Requires two steps:Requires two steps:1.1. Identify a base period amount.Identify a base period amount.

2.2. All subsequent amounts are stated as a All subsequent amounts are stated as a % of the base period amount.% of the base period amount.


Trend Analysis

Smart Touch Learning’s Net Sales were Smart Touch Learning’s Net Sales were $750,000 for 2012 and rose to $858,000 in $750,000 for 2012 and rose to $858,000 in 2016. Compute the trend percentages for 2016. Compute the trend percentages for

each year from 2012 to 2016. each year from 2012 to 2016.

First, compute the trend % for the base First, compute the trend % for the base period of 2012.period of 2012.


2016 2015 2014 2013 2012Net Sales $858,000 $803,000 $780,000 $748,000 $750,000Trend Percentages ? ? ? ? ?

Trend Analysis

Smart Touch Learning’s Net Sales were Smart Touch Learning’s Net Sales were $750,000 for 2012 and rose to $858,000 in $750,000 for 2012 and rose to $858,000 in 2016. Compute the trend percentages for 2016. Compute the trend percentages for

each year from 2012 to 2016. each year from 2012 to 2016.

The base year trend % is always 100%. The base year trend % is always 100%. Now compute the trend % for 2013.Now compute the trend % for 2013.


2016 2015 2014 2013 2012Net Sales $858,000 $803,000 $780,000 $748,000 $750,000Trend Percentages ? ? ? ? 100%

Trend Analysis

Smart Touch Learning’s Net Sales were Smart Touch Learning’s Net Sales were $750,000 for 2012 and rose to $858,000 in $750,000 for 2012 and rose to $858,000 in

2016.2016.

Next compute the trend percentages for Next compute the trend percentages for 2014 to 2016.2014 to 2016.


2016 2015 2014 2013 2012Net Sales $858,000 $803,000 $780,000 $748,000 $750,000Trend Percentages ? ? ? 99.7% 100%

Trend Analysis

Smart Touch Learning’s Net Sales were Smart Touch Learning’s Net Sales were $750,000 for 2012 and rose to $858,000 in $750,000 for 2012 and rose to $858,000 in

2016. 2016.

An assessment of the increase in sales, as a An assessment of the increase in sales, as a percentage of 2012 sales can show whether percentage of 2012 sales can show whether

sales are moving in the desire direction.sales are moving in the desire direction.©2014 Pearson Education, Inc. Publishing as Prentice Hall 15-28

2016 2015 2014 2013 2012Net Sales $858,000 $803,000 $780,000 $748,000 $750,000Trend Percentages 114% 107% 104% 99.7% 100%

Prepare a horizontal analysis of Prepare a horizontal analysis of revenues, cost of goods sold, and gross revenues, cost of goods sold, and gross

profit in $ and % for 2016 and 2015.profit in $ and % for 2016 and 2015.



2016 2015 Amount PercentageNet Sales 10,000$ 8,000$ ? ?Cost of Goods Sold 4,500 3,000 ? ?Gross Profit 5,500 5,000 ? ?

Increase (Decrease)


2016 2015 Amount PercentageNet Sales 10,000$ 8,000$ 2,000$ 25.0%Cost of Goods Sold 4,500 3,000 1,500 50.0%Gross Profit 5,500 5,000 500 10.0%

Increase (Decrease)


Perform a Perform a vertical analysis vertical analysis

of financial of financial statements.statements.


Vertical Analysis

• Defined: Defined: shows the percentage shows the percentage relationship of each item in the relationship of each item in the financial statement to its base amount.financial statement to its base amount.

• Requires two steps:Requires two steps:1.1. Identify the base amount on the Identify the base amount on the

statement. statement.

2.2. Divide all other amounts in the statement Divide all other amounts in the statement by the base amount.by the base amount.


2016Percent of

Total 2015Percent of

TotalNet Sales 858,000$ ? 803,000$ ?Cost of Goods Sold 513,000 ? 509,000 ?Gross Profit 345,000 ? 294,000 ?Operating Expenses: Selling Expenses 126,000 ? 114,000 ? Administrative Expenses 118,000 ? 123,000 ? Total Expenses 244,000 ? 237,000 ?Operating Income 101,000 ? 57,000 ?Other Revenues and Expenses Interest Revenue 4,000 ? - ? Interest Expense (24,000) ? (14,000) ? Total Other Revenue & Expenses (20,000) ? (14,000) ?Income Before Income Taxes 81,000 ? 43,000 ?Income Tax Expense 33,000 ? 17,000 ?Net Income 48,000$ ? 26,000$ ?




Use Net Sales as the Use Net Sales as the base amount.base amount.

2016Percent of


TotalNet Sales 858,000$ 100.0% 803,000$ 100.0%Cost of Goods Sold 513,000 ? 509,000 ?Gross Profit 345,000 ? 294,000 ?Operating Expenses: Selling Expenses 126,000 ? 114,000 ? Administrative Expenses 118,000 ? 123,000 ? Total Expenses 244,000 ? 237,000 ?Operating Income 101,000 ? 57,000 ?Other Revenues and Expenses Interest Revenue 4,000 ? - ? Interest Expense (24,000) ? (14,000) ? Total Other Revenue & Expenses (20,000) ? (14,000) ?Income Before Income Taxes 81,000 ? 43,000 ?Income Tax Expense 33,000 ? 17,000 ?Net Income 48,000$ ? 26,000$ ?




2016Percent of


TotalNet Sales 858,000$ 100.0% 803,000$ 100.0%Cost of Goods Sold 513,000 ? 509,000 ?Gross Profit 345,000 ? 294,000 ?Operating Expenses: Selling Expenses 126,000 ? 114,000 ? Administrative Expenses 118,000 ? 123,000 ? Total Expenses 244,000 ? 237,000 ?Operating Income 101,000 ? 57,000 ?Other Revenues and Expenses Interest Revenue 4,000 ? - ? Interest Expense (24,000) ? (14,000) ? Total Other Revenue & Expenses (20,000) ? (14,000) ?Income Before Income Taxes 81,000 ? 43,000 ?Income Tax Expense 33,000 ? 17,000 ?Net Income 48,000$ ? 26,000$ ?




Prepare the vertical Prepare the vertical analysis for 2015.analysis for 2015.

2016Percent of


TotalNet Sales 858,000$ 100.0% 803,000$ 100.0%Cost of Goods Sold 513,000 ? 509,000 63.4%Gross Profit 345,000 ? 294,000 36.6%Operating Expenses: Selling Expenses 126,000 ? 114,000 14.2% Administrative Expenses 118,000 ? 123,000 15.3% Total Expenses 244,000 ? 237,000 29.5%Operating Income 101,000 ? 57,000 7.1%Other Revenues and Expenses Interest Revenue 4,000 ? - 0.0% Interest Expense (24,000) ? (14,000) -1.7% Total Other Revenue & Expenses (20,000) ? (14,000) -1.7%Income Before Income Taxes 81,000 ? 43,000 5.4%Income Tax Expense 33,000 ? 17,000 2.1%Net Income 48,000$ ? 26,000$ 3.2%




2016Percent of


TotalNet Sales 858,000$ 100.0% 803,000$ 100.0%Cost of Goods Sold 513,000 ? 509,000 63.4%Gross Profit 345,000 ? 294,000 36.6%Operating Expenses: Selling Expenses 126,000 ? 114,000 14.2% Administrative Expenses 118,000 ? 123,000 15.3% Total Expenses 244,000 ? 237,000 29.5%Operating Income 101,000 ? 57,000 7.1%Other Revenues and Expenses Interest Revenue 4,000 ? - 0.0% Interest Expense (24,000) ? (14,000) -1.7% Total Other Revenue & Expenses (20,000) ? (14,000) -1.7%Income Before Income Taxes 81,000 ? 43,000 5.4%Income Tax Expense 33,000 ? 17,000 2.1%Net Income 48,000$ ? 26,000$ 3.2%




Prepare the vertical Prepare the vertical analysis for 2016.analysis for 2016.

2016Percent of


TotalNet Sales 858,000$ 100.0% 803,000$ 100.0%Cost of Goods Sold 513,000 59.8% 509,000 63.4%Gross Profit 345,000 40.2% 294,000 36.6%Operating Expenses: Selling Expenses 126,000 14.7% 114,000 14.2% Administrative Expenses 118,000 13.8% 123,000 15.3% Total Expenses 244,000 28.4% 237,000 29.5%Operating Income 101,000 11.8% 57,000 7.1%Other Revenues and Expenses Interest Revenue 4,000 0.5% - 0.0% Interest Expense (24,000) -2.8% (14,000) -1.7% Total Other Revenue & Expenses (20,000) -2.3% (14,000) -1.7%Income Before Income Taxes 81,000 9.4% 43,000 5.4%Income Tax Expense 33,000 3.8% 17,000 2.1%Net Income 48,000$ 5.6% 26,000$ 3.2%




2016Percent of


TotalAssets

Current Assets: Cash and Cash Equivalents 29,000$ ? 32,000$ ? Accounts Receivable, Net 114,000 ? 85,000 ? Merchandise Inventory 113,000 ? 111,000 ? Prepaid Expenses 6,000 ? 8,000 ?Total Current Assets 262,000 ? 236,000 ?Long-term Investments 18,000 ? 9,000 ?Property, Plant, and Equipment, Net 507,000 ? 399,000 ?Total Assets 787,000$ 100.0% 644,000$ 100.0%

SMART TOUCH LEARNINGBalance Sheet

December 31, 2016 and 2015

Prepare the Vertical Analysis for Smart Touch Learning's Balance Sheet using Total Assets as the base amount.


2016Percent of


TotalAssets

Current Assets: Cash and Cash Equivalents 29,000$ 3.7% 32,000$ 5.0% Accounts Receivable, Net 114,000 14.5% 85,000 13.2% Merchandise Inventory 113,000 14.4% 111,000 17.2% Prepaid Expenses 6,000 0.8% 8,000 1.2%Total Current Assets 262,000 33.3% 236,000 36.6%Long-term Investments 18,000 2.3% 9,000 1.4%Property, Plant, and Equipment, Net 507,000 64.4% 399,000 62.0%Total Assets 787,000$ 100.0% 644,000$ 100.0%



Prepare the Vertical Analysis for Smart Touch Learning's Balance Sheet using Total Assets as the base amount.



2016Percent of


TotalLiabilities

Current Liabilities Accounts Payable 73,000$ ? 68,000$ ? Accrued Liabilities 27,000 ? 31,000 ? Notes Payable 42,000 ? 27,000 ?Total Current Liabilities 142,000 ? 126,000 ?Long-term Liabilities 289,000 ? 198,000 ?Total Liabilities 431,000 ? 324,000 ?

Stockholders' EquityCommon Stock 186,000 ? 186,000 ?Retained Earnings 170,000 ? 134,000 ?Total Stockholders' Equity 356,000 ? 320,000 ?Total Liabilities & Stockholders' Equity 787,000$ 100.0% 644,000$ 100.0%



Use the same base amount throughout the vertial analys on the Balance Sheet.

2016Percent of


TotalLiabilities

Current Liabilities Accounts Payable 73,000$ 9.3% 68,000$ 10.6% Accrued Liabilities 27,000 3.4% 31,000 4.8% Notes Payable 42,000 5.3% 27,000 4.2%Total Current Liabilities 142,000 18.0% 126,000 19.6%Long-term Liabilities 289,000 36.7% 198,000 30.7%Total Liabilities 431,000 54.8% 324,000 50.3%

Stockholders' EquityCommon Stock 186,000 23.6% 186,000 28.9%Retained Earnings 170,000 21.6% 134,000 20.8%Total Stockholders' Equity 356,000 45.2% 320,000 49.7%Total Liabilities & Stockholders' Equity 787,000$ 100.0% 644,000$ 100.0%



Use the same base amount throughout the vertial analys on the Balance Sheet.


Common-Size Statements

• Defined: Defined: Compares companies by Compares companies by looking only at the vertical analysis looking only at the vertical analysis percentages for each company.percentages for each company.

• Requires two steps:Requires two steps:1.1. Identify two companies for comparison. Identify two companies for comparison.

2.2. Compute the vertical analysis Compute the vertical analysis percentages for each company.percentages for each company.



Common-size

statements allow

comparison of different

sized companies.


Compute and Compute and evaluate the evaluate the

standard standard financial ratios.financial ratios.


Working Capital

Measures the ability to meet short-term Measures the ability to meet short-term obligations with current assets.obligations with current assets.


Current Ratio

Measures a company’s ability to pay its Measures a company’s ability to pay its current liabilities with its current assets.current liabilities with its current assets.


Cash Ratio

Helps to determine a company’s ability to Helps to determine a company’s ability to meet its short-term obligations.meet its short-term obligations.


Acid-test or Quick Ratio

Measures whether a company can pay all Measures whether a company can pay all its current liabilities if they came due its current liabilities if they came due

immediately.immediately.


Inventory Turnover

Measures the number of times a Measures the number of times a company sells its average level of company sells its average level of

merchandise inventory during a year.merchandise inventory during a year.


Days’ Sales in Inventory

Measures the average number of days Measures the average number of days merchandise inventory is held by the merchandise inventory is held by the

company.company.


Gross Profit Percentage

Measures the profitability of each net Measures the profitability of each net sales dollar above the cost of goods sales dollar above the cost of goods

sold.sold.


Accounts Receivable Turnover Ratio

Measures the number of times the Measures the number of times the company collects the average company collects the average receivables balance in a year.receivables balance in a year.


Days’ Sales in Receivables

Indicates how many days it takes to Indicates how many days it takes to collect the average level of receivables.collect the average level of receivables.


Debt Ratio

Shows the proportion of assets financed Shows the proportion of assets financed with debt and is calculated by dividing with debt and is calculated by dividing

total liabilities by total assets.total liabilities by total assets.


Debt to Equity Ratio

Shows the proportion of total liabilities Shows the proportion of total liabilities relative to total equity.relative to total equity.


Times-Interest-Earned Ratio

Measures the number of times earnings Measures the number of times earnings before interest and taxes (EBIT) can before interest and taxes (EBIT) can

cover interest expense.cover interest expense.


Profit Margin Ratio

Shows how much net income a business Shows how much net income a business earns on every $1.00 of sales.earns on every $1.00 of sales.


Rate of Return on Total Assets

Measures a company’s success in using Measures a company’s success in using assets to earn a profit.assets to earn a profit.


Asset Turnover Ratio

Measures the amount of net sales Measures the amount of net sales generated for each average dollar of total generated for each average dollar of total

assets invested.assets invested.


Rate of Return on Common Stockholders’ Equity

Shows the relationship between net Shows the relationship between net income available to common income available to common

stockholders and their average common stockholders and their average common equity invested in the company.equity invested in the company.


Earnings per Share (EPS)

Reports the amount of net income for Reports the amount of net income for each share of the company. This is the each share of the company. This is the

only ratio that must appear on the face of only ratio that must appear on the face of the income statement.the income statement.


Price-Earnings Ratio

Shows the market price of $1 of earnings.Shows the market price of $1 of earnings.


Dividend Yield

Measures the percentage of a stock’s Measures the percentage of a stock’s market value that is returned annually as market value that is returned annually as

dividends to shareholders.dividends to shareholders.


Dividend Payout

Measures the percentage of earnings Measures the percentage of earnings paid annually to common shareholders paid annually to common shareholders

as cash dividends.as cash dividends.



Complete a Complete a corporate income corporate income

statement statement including earnings including earnings

per share per share (Appendix 15A).(Appendix 15A).


The Complete Corporate Income Statement

• Continuing Continuing OperationsOperations– Revenue– Cost of Goods Sold– Operating Expenses &

Income– Gains & Losses– Income Taxes– Operating Income

• Special ItemsSpecial Items– Discontinued

Operations– Extraordinary Items

• Net IncomeNet Income• Earnings Per ShareEarnings Per Share

– Continuing Operations– Discontinued Ops– Extraordinary Items– Net Income


Rocky Corporation’s accounting records Rocky Corporation’s accounting records include the following items, listed in no include the following items, listed in no particular order, at December 31, 2015:particular order, at December 31, 2015:



Note the various interim

amounts, such as:

•Gross ProfitGross Profit•Income from Income from

Continuing Continuing OperationsOperations

•Income Before Income Before Extraordinary Extraordinary

ItemsItems•Net IncomeNet Income

End of Chapter 15


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