horizontal analysis formula

8/11/2019 Horizontal Analysis Formula

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PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Statement AnalysisChapter 15


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15-2

Limitations of Financial StatementAnalysis

We use the LIFO method to

value inventory.

We use the average cost

method to value inventory.

Differences in accounting methodsbetween companies sometimes make

comparisons difficult.


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15-3

Limitations of Financial StatementAnalysis

Analysts should look beyond the ratios.

Economicfactors

Industrytrends

Changes withinthe company

Technologicalchanges

Consumertastes


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15-4

Learning Objective 1

Prepare and interpret

financial statements incomparative and

common-size form.


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Statements in Comparative andCommon-Size Form

Dollar and percentagechanges on statements

Common-sizestatements

Ratios

An item on a financialstatement has little

meaning by itself. Themeaning of the numbers

can be enhanced bydrawing comparisons.


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Dollar and Percentage Changes onStatements

Horizontal analysis (or trend analysis) shows thechanges between years in the financial data in

both dollar and percentage form.


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15-7

Horizontal Analysis

The following slides illustrate a horizontalanalysis of Clover Corporations

comparative balance sheets andcomparative income statements for this

year and last year.


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15-8

CLOVER CORPORATIONComparative Balance Sheets

December 31

Increase (Decrease)This Year Last Year Amount %

AssetsCurrent assets: Cash 12,000$ 23,500$

Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200

Total current assets 155,000 164,700 Property and equipment: Land 40,000 40,000

Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000 Total assets 315,000$ 289,700$

Horizontal Analysis


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15-9

Horizontal Analysis

DollarChange

Current YearFigure

Base YearFigure=

The dollaramounts for

last yearbecome thebase year

figures.

Calculating Change in Dollar Amounts


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PercentageChange

Dollar ChangeBase Year Figure

100%=

Horizontal Analysis

Calculating Change as a Percentage


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December 31


AssetsCurrent assets: Cash 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000

Inventory 80,000 100,000 Prepaid expenses 3,000 1,200

Total current assets 155,000 164,700 Property and equipment: Land 40,000 40,000


Horizontal Analysis

($11,500 $23,500) 100% = (48.9%)

$12,000 $23,500 = $(11,500)


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15-12


December 31


AssetsCurrent assets: Cash 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 20,000 50.0 Inventory 80,000 100,000 (20,000) (20.0) Prepaid expenses 3,000 1,200 1,800 150.0

Total current assets 155,000 164,700 (9,700) (5.9)Property and equipment: Land 40,000 40,000 - 0.0 Buildings and equipment, net 120,000 85,000 35,000 41.2Total property and equipment 160,000 125,000 35,000 28.0Total assets 315,000$ 289,700$ 25,300$ 8.7

Horizontal Analysis


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Horizontal Analysis

We could do thisfor the liabilities

and stockholdersequity, but nowlets look at the

income statementaccounts.


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15-14

Horizontal AnalysisCLOVER CORPORATION

Comparative Income StatementsFor the Years Ended December 31

Increase(Decrease)

This Year Last Year Amount %Sales 520,000$ 480,000$Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income 17,500$ 22,400$

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Horizontal AnalysisCLOVER CORPORATION


Increase(Decrease)

This Year Last Year Amount %Sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)

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CLOVER CORPORATIONComparative Income Statements

For the Years Ended December 31Increase

(Decrease)This Year Last Year Amount %

Sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)

Horizontal Analysis

Sales increased by 8.3%, yetnet income decreased by 21.9%.

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For the Years Ended December 31Increase

(Decrease)This Year Last Year Amount %

Sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)

Horizontal AnalysisThere were increases in both cost of goodssold (14.3%) and operating expenses (2.1%).These increased costs more than offset the

increase in sales, yielding an overalldecrease in net income.

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Trend Percentages

Trend percentages

state several yearsfinancial data in termsof a base year , whichequals 100 percent.

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Trend Analysis

TrendPercentage

Current Year AmountBase Year Amount

100%=

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Trend Analysis

Look at the income information for BerryProducts for the years 2007 through 2011. We

will do a trend analysis on these amounts tosee what we can learn about the company.

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Trend Analysis

The baseyear is 2007, and its amounts

will equal 100%.

Year Item 2011 2010 2009 2008 2007

Sales 400,000$ 355,000$ 320,000$ 290,000$ 275,000$Cost of goods sold 285,000 250,000 225,000 198,000 190,000 Gross margin 115,000 105,000 95,000 92,000 85,000

Berry ProductsIncome Information

For the Years Ended December 31

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Year Item 2011 2010 2009 2008 2007

Sales 105% 100%Cost of goods sold 104% 100%Gross margin 108% 100%

Trend Analysis

2008 Amount 2007 Amount 100% ( $290,000 $275,000 ) 100% = 105%( $198,000 $190,000 ) 100% = 104%( $ 92,000 $ 85,000 ) 100% = 108%



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Trend Analysis

By analyzing the trends for Berry Products, wecan see that cost of goods sold is increasing

faster than sales, which is slowing the increasein gross margin.

Year Item 2011 2010 2009 2008 2007

Sales 145% 129% 116% 105% 100%Cost of goods sold 150% 132% 118% 104% 100%Gross margin 135% 124% 112% 108% 100%



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Trend Analysis

100

110

120

130

140

150

160

2007 2008 2009 2010 2011

P e r c e n t a g e

Year

Sales

COGS

GM

We can use the trendpercentages to constructa graph so we can see the

trend over time.

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Common-Size Statements

Vertical analysis focuseson the relationships

among financial

statement items at agiven point in time. Acommon-size financialstatement is a verticalanalysis in which each

financial statement itemis expressed as a

percentage.

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In incomestatements , allitems usuallyare expressed

as a percentageof sales .

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Gross Margin Percentage

Gross MarginPercentage

Gross MarginSales

=

This measure indicates how muchof each sales dollar is left after

deducting the cost of goods sold tocover expenses and provide a profit.

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In balancesheets , all items

usually areexpressed as apercentage oftotal assets .

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Burger King McDonald's

(d o l l a r s i n m i l l i o n s) Dollars Percentage Dollars Percentage2008 Net income 190$ 7.70% 4,313$ 18.30%

Common-size financial statements areparticularly useful when comparing

data from different companies.

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Lets take another look at the informationfrom the comparative income statements

of Clover Corporation for this year andlast year.

This time, lets prepare common -sizestatements.

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For the Years Ended December 31Common-SizePercentages

This Year Last Year This Year Last Year Sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600

Net income 17,500$ 22,400$


Sales is

usually thebase and isexpressedas 100%.


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Common-Size StatementsCLOVER CORPORATION


Common-SizePercentages

This Year Last Year This Year Last Year Sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0

Net income 17,500$ 22,400$ 3.4 4.7

What conclusions can we draw?

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Quick Check Which of the following statements describeshorizontal analysis?a. A statement that shows items appearing

on it in percentage and dollar form.b. A side-by-side comparison of two ormore years financial statements.

c. A comparison of the account balances onthe current years financial statements.

d. None of the above.

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Quick Check Which of the following statements describeshorizontal analysis?a. A statement that shows items appearing

on it in percentage and dollar form.b. A side-by-side comparison of two ormore years financial statements.

c. A comparison of the account balances onthe current years financial statements.

d. None of the above.Horizontal analysis shows the changes

between years in the financial data in bothdollar and percentage form.

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Now, lets look atNorton

Corporations

financial statementsfor this year andlast year.

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NORTON CORPORATIONBalance Sheets

December 31

This Year Last Year Assets

Current assets:

Cash 30,000$ 20,000$Accounts receivable, net 20,000 17,000 Inventory 12,000 10,000 Prepaid expenses 3,000 2,000

Total current assets 65,000 49,000

Property and equipment: Land 165,000 123,000


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NORTON CORPORATION Balance Sheets

December 31

This Year Last Year Liabilities and Stockholders' Equity

Current liabilities: Accounts payable 39,000$ 40,000$

Notes payable, short-term 3,000 2,000 Total current liabilities 42,000 42,000 Long-term liabilities: Notes payable, long-term 70,000 78,000 Total liabilities 112,000 120,000 Stockholders' equity: Common stock, $1 par value 27,400 17,000

Additional paid-in capital 158,100 113,000 Total paid-in capital 185,500 130,000 Retained earnings 48,890 50,000

Total stockholders' equity 234,390 180,000

Total liabilities and stockholders' equity 346,390$ 300,000$

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NORTON CORPORATIONIncome Statements


This Year Last Year Sales 494,000$ 450,000$

Cost of goods sold 140,000 127,000 Gross margin 354,000 323,000 Operating expenses 270,000 249,000 Net operating income 84,000 74,000 Interest expense 7,300 8,000

Net income before taxes 76,700 66,000 Less income taxes (30%) 23,010 19,800 Net income 53,690$ 46,200$

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Compute and interpret

financial ratios thatwould be useful to acommon stockholder.

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Ratio Analysis The CommonStockholder NORTON CORPORATION

Number of common sharesoutstanding

Beginning of year 17,000 End of year 27,400

Net income 53,690$

Stockholders' equity

Beginning of year 180,000

End of year 234,390

Dividends per share 2

Dec. 31 market price per share 20 Interest expense 7,300

Total assets


End of year 346,390

This Year The ratios thatare of the most

interest to

stockholdersinclude those

ratios that focus onnet income,

dividends, andstockholders

equities.


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Earnings Per Share

Earnings per Share Net Income Preferred DividendsAverage Number of CommonShares Outstanding

=

Earnings per Share $53,690 $0($17,000 + $27,400)/2

= = $2.42

This measure indicates how muchincome was earned for each share of

common stock outstanding.

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Price-Earnings Ratio

Price-EarningsRatio

Market Price Per ShareEarnings Per Share=

Price-EarningsRatio

$20.00$2.42= = 8.26 times

A higher price-earnings ratio means thatinvestors are willing to pay a premiumfor a companys stock because of

optimistic future growth prospects.

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Dividend Payout Ratio

DividendPayout Ratio

Dividends Per ShareEarnings Per Share=

DividendPayout Ratio

$2.00$2.42= = 82.6%

This ratio gauges the portion of currentearnings being paid out in dividends. Investorsseeking dividends (market price growth) would

like this ratio to be large (small).

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Dividend Yield Ratio


Dividends Per ShareMarket Price Per Share=


$2.00$20.00= = 10.00%

This ratio identifies the return, in termsof cash dividends, on the current

market price of the stock.

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Return on Total Assets

Adding interest expense back to net incomeenables the return on assets to be comparedfor companies with different amounts of debt

or over time for a single company that haschanged its mix of debt and equity.

Return onTotal Assets

$53,690 + [$7,300 (1 .30)]($300,000 + $346,390) 2

= = 18.19%

Return onTotal Assets

Net Income + [Interest Expense (1 Tax Rate)]Average Total Assets

=

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Return on Common Stockholders

Equity

Return on CommonStockholders Equity

Net Income Preferred DividendsAverage Stockholders Equity

=

Return on CommonStockholders Equity

$53,690 $0($180,000 + $234,390) 2

= = 25.91%

This measure indicates how well thecompany used the owners

investments to earn income.


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Quick Check Which of the following statements is true?a. Negative financial leverage is when the

fixed return to a companys creditors andpreferred stockholders is greater than thereturn on total assets.

b. Positive financial leverage is when thefixed return to a companys creditors andpreferred stockholders is greater than thereturn on total assets.

c. Financial leverage is the expression ofseveral years financial data inpercentage form in terms of a base year.

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Which of the following statements is true?a. Negative financial leverage is when the

fixed return to a companys creditors andpreferred stockholders is greater than thereturn on total assets.

b. Positive financial leverage is when thefixed return to a companys creditors andpreferred stockholders is greater than thereturn on total assets.

c. Financial leverage is the expression ofseveral years financial data inpercentage form in terms of a base year.

Quick Check

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Book Value Per Share

Book Valueper Share

Common Stockholders EquityNumber of Common Shares Outstanding=

This ratio measures the amount that would bedistributed to holders of each share of common

stock if all assets were sold at their balance sheetcarrying amounts after all creditors were paid off.

= $8.55Book Valueper Share $234,39027,400=


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financial ratios thatwould be useful to ashort-term creditor.

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Ratio Analysis The Short TermCreditor

Cash 30,000$

Accounts receivable, net


End of year 20,000

Inventory


End of year 12,000

Total current assets 65,000

Total current liabilities 42,000

Sales on account 494,000

Cost of goods sold 140,000

This Year NORTON CORPORATION

Short-termcreditors, such assuppliers, want tobe paid on time.Therefore, they

focus on thecompanys cash

flows and workingcapital.

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Working Capital

Working capital is notfree. It must be

financed with long-term debt and equity.

The excess of current assets overcurrent liabilities is known as

working capital.

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Working Capital

December 31This Year

Current assets 65,000$

Current liabilities (42,000) Working capital 23,000$

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Current Ratio

A declining ratio may be asign of deteriorating

financial condition, or itmight result from eliminating

obsolete inventories.

CurrentRatio

Current AssetsCurrent Liabilities

=

The current ratio measures acompanys short -term debt paying

ability.

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Current Ratio

CurrentRatio

$65,000$42,000

= = 1.55

CurrentRatio

Current AssetsCurrent Liabilities

=

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Acid-Test (Quick) Ratio

Quick AssetsCurrent Liabilities=

Acid-TestRatio

Quick assets include Cash,Marketable Securities, Accounts Receivable, and

current Notes Receivable.This ratio measures a companys ability to meet

obligations without having to liquidate inventory.

$50,000$42,000 = 1.19=Acid-TestRatio

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Accounts Receivable Turnover

Sales on AccountAverage Accounts Receivable

AccountsReceivableTurnover

=

This ratio measures how manytimes a company converts its

receivables into cash each year.

= 26.7 times$494,000($17,000 + $20,000) 2AccountsReceivableTurnover

=

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Average Collection Period

AverageCollection

Period=

365 DaysAccounts Receivable Turnover

This ratio measures, on average,how many days it takes to collect

an account receivable.

= 13.67 daysAverage

CollectionPeriod

= 365 Days26.7 Times

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Inventory Turnover

If a companys inventory

turnover Is less than itsindustry average, it eitherhas excessive inventory or

the wrong types of inventory.

Cost of Goods SoldAverage Inventory

InventoryTurnover =

This ratio measures how many times a

companys inventory has been sold andreplaced during the year.

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Inventory Turnover

Cost of Goods SoldAverage Inventory

InventoryTurnover =

= 12.73 times$140,000($10,000 + $12,000) 2InventoryTurnover =

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Average Sale Period

AverageSale Period =

365 DaysInventory Turnover

This ratio measures how manydays, on average, it takes to sell

the entire inventory.

= 28.67 daysAverageSale Period =365 Days

12.73 Times

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financial ratios thatwould be useful to along-term creditor.

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Ratio Analysis The Long TermCreditor

Earnings before interestexpense and income taxes 84,000$

Interest expense 7,300

Total stockholders' equity 234,390

Total liabilities 112,000

NORTON CORPORATIONThis Year

This is also referredto as net operating

income.

Long-term creditors are concerned with acompanys ability to repay its loans over the

long-run.

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Times Interest Earned Ratio

This is the most common

measure of a companys abilityto provide protection for its long-term creditors. A ratio of less

than 1.0 is inadequate.

TimesInterestEarned

Earnings Interest Expenseand Income TaxesInterest Expense=

TimesInterestEarned

$84,000$7,300= = 11.51 times


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Debt-to-Equity Ratio

$112,000$234,390

Debt to EquityRatio

= = 0.48

Total LiabilitiesStockholders Equity

Debt to EquityRatio

=

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Published Sources That Provide Comparative Ratio Data

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End of Chapter 15

horizontal analysis formula

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