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14-1

Chapter
FINANCIAL STATEMENT
14 ANALYSIS

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Purpose of Analysis

Financial statement analysis helps users

make better decisions.

Internal Users External Users

Managers Shareholders
Officers Lenders
Internal Auditors Customers
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Purpose of Analysis

Financial measures are often used

to rank corporate performance.
Example measures include:

Growth Return to Profit Return on

in sales stockholders margins equity

Determined by
analyzing the
financial
statements.

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Financial Statements Are Designed
for Analysis
Classified Comparative Consolidated
Financial Financial Financial
Statements Statements Statements

Items with certain Amounts from Information for the

characteristics are several years parent and subsidiary
grouped together. appear side by side. are presented.

Results Helps identify Presented as if

in standardized, significant the two companies
meaningful changes and are a single
subtotals. trends. business unit.

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Tools of Analysis

Dollar &
Trend
Percentage
Percentages
Changes

Component
Ratios
Percentages

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Dollar and Percentage Changes

Dollar Change:

Dollar Analysis Period Base Period

Change = Amount – Amount

Percentage Change:

% Percent
Change = Dollar Change
÷
Base Period
Amount

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Dollar and Percentage Changes

Evaluating Percentage Changes

in Sales and Earnings

Sales and earnings In measuring quarterly

should increase at changes, compare to
more that the rate the same quarter in
of inflation. the previous year.

Percentages may be
misleading when the
base amount is small.
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Dollar and Percentage Changes
Example
Let’s look at the asset section
of Clover Corporation’s
comparative balance sheet and
income statement for 2003 and
2002.
Compute the dollar change and
the percentage for cash.

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CLOVER CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 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
* Percent rounded to one decimal point.
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CLOVER CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $ 155,000–
$12,000 $23,500
$ 164,700 = $(11,500)
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
* Percent rounded to one decimal point.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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CLOVER CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 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 ($11,500 ÷ $23,500)
$ 155,000 × 100% = 48.94%
$ 164,700
Property and equipment:
Land 40,000 40,000 Complete the
Buildings and equipment, net 120,000 85,000 analysis for
Total property and equipment $ 160,000 $ 125,000 the other
Total assets $ 315,000 $ 289,700
assets.
* Percent rounded to one decimal point.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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CLOVER CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2003 2002 Change Change*
Assets
Current assets:
Cash and equivalents $ 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 41.2%
Total property and equipment $ 160,000 $ 125,000 35,000 28.0%
Total assets $ 315,000 $ 289,700 $ 25,300 8.7%
* Percent rounded to one decimal point.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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Trend Analysis

Trend analysis is used to reveal patterns in data

covering successive periods.

Trend Analysis Period Amount

Percent
=
Base Period Amount
× 100%
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Trend Analysis - Example

Berry Products
Income Information
For the Years Ended December 31,
Item 2003 2002 2001 2000 1999
Revenues $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2003 2002 2001 2000 1999

Revenues 145%is the129%
1999 116% so 105%
base period its 100%
Cost of sales 150% 132% 118% 104% 100%
Gross profit amounts124%
135% will equal 100%.108%
112% 100%

(290,000  275,000)  100% = 105%

(198,000  190,000)  100% = 104%
(92,000  85,000)
McGraw-Hill/Irwin  100% = 108% © The McGraw-Hill Companies, Inc., 2002
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Component Percentages

Examine the relative size of each item in the financial

statements by computing component (or common-
sized) percentages.

Component Analysis Amount

Percent
= Base Amount × 100%

Financial Statement Base Amount

Balance Sheet Total Assets
Income Statement Revenues
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14-16 CLOVER CORPORATION 13-16

Comparative Balance Sheets

December 31,
Complete the common-size analysis for the other Common-size
assets. Percents*
2003 2002 2003 2002
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets
($12,000 ÷ $315,000) × 100% = 3.8%
$ 155,000 $ 164,700
Property and equipment:
Land ($23,50040,000
÷ $289,700) × 100% = 8.1%
40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700 100.0% 100.0%
*McGraw-Hill/Irwin
Percent rounded to first decimal point. © The McGraw-Hill Companies, Inc., 2002
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14-17 CLOVER CORPORATION 13-17

Comparative Balance Sheets

December 31,
Common-size
Percents*
2003 2002 2003 2002
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.5%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets $ 155,000 $ 164,700 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment $ 160,000 $ 125,000 50.8% 43.1%
Total assets $ 315,000 $ 289,700 100.0% 100.0%
*McGraw-Hill/Irwin
Percent rounded to first decimal point. © The McGraw-Hill Companies, Inc., 2002
Slide CLOVER CORPORATION
14-18 13-18
Comparative Balance Sheets
December 31,
Complete the common-size analysis for the liabilities and equity Common-size
accounts. Percents*
2003 2002 2003 2002
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 21.3% 15.2%
Notes payable 3,000 6,000 1.0% 2.1%
Total current liabilities $ 70,000 $ 50,000 22.2% 17.3%
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 23.8% 27.6%
Total liabilities $ 145,000 $ 130,000 46.0% 44.9%
Shareholders' equity:
Preferred stock 20,000 20,000 6.3% 6.9%
Common stock 60,000 60,000 19.0% 20.7%
Additional paid-in capital 10,000 10,000 3.2% 3.5%
Total paid-in capital $ 90,000 $ 90,000 28.6% 31.1%
Retained earnings 80,000 69,700 25.4% 24.1%
Total shareholders' equity $ 170,000 $ 159,700 54.0% 55.1%
Total liabilities and shareholders' equity $ 315,000 $ 289,700 100.0% 100.0%
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
* Percent rounded to first decimal point.
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14-19 CLOVER CORPORATION 13-19

Comparative Income Statements

For the Years Ended December 31,
Compute the common-size percentages for Common-size
revenues and expenses. Percents*
2003 2002 2003 2002
Revenues $ 520,000 $ 480,000 100.0% 100.0%
Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes $ 25,000 $ 32,000 4.8% 6.7%
Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income $ 17,500 $ 22,400 3.4% 4.7%
Net income per share $ 0.79 $ 1.01
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.
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Ratios

A ratio is a simple mathematical expression

of the relationship between one item and another.

Along with dollar and percentage changes,

trend percentages, and component percentages,
ratios can be used to compare:

Past performance to Other companies to

present performance. your company.

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NORTON CORPORATION
2003
Cash $ 30,000
Use this Accounts receivable, net
information to Beginning of year 17,000
calculate the End of year 20,000
liquidity ratios Inventory
for Norton Beginning of year 10,000
Corporation. End of year 15,000
Total current assets 65,000
Total current liabilities 42,000
Total liabilities 103,917
Total assets
Beginning of year 300,000
End of year 346,390
Revenues 494,000
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Working Capital

Working capital is the excess of current

assets over current liabilities.

Dec. 31, 2003

Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000

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Current Ratio

This ratio measures

the short-term debt-
paying ability of the
company.

Current Current Assets

=
Ratio Current Liabilities

Current $65,000
= = 1.55 : 1
Ratio $42,000

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Quick Ratio

Quick Quick Assets

=
Ratio Current Liabilities

Quick assets are cash, marketable securities,

and receivables.

This ratio is like the current

ratio but excludes current assets
such as inventories that may be
difficult to quickly convert into cash.

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Quick Ratio

Quick Quick Assets

=
Ratio Current Liabilities

Quick $50,000
= = 1.19 : 1
Ratio $42,000

This ratio is like the current

ratio but excludes current assets
such as inventories that may be
difficult to quickly convert into cash.

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Debt Ratio

A measure of creditor’s long-term risk.

The smaller the percentage of assets that
are financed by debt, the smaller the risk
for creditors.

Debt Total
= ÷ Total Assets
Ratio Liabilities
= $ 103,917 ÷ $ 346,390
= 30.00%

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Uses and Limitations of Financial
Ratios

Uses Limitations

Ratios help users Management may enter

understand into transactions merely
financial relationships. to improve the ratios.

Ratios provide for Ratios do not help with

quick comparison analysis of the company's
of companies. progress toward
nonfinancial goals.

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Measures of Profitability

An income statement can be prepared in either a

multiple-step or single-step format.

The single-step format is simpler.

The multiple-step format provides
more detailed information.

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Income Statement (Multiple-Step) Example

{
Central Company
Income Statement
Proper Heading For the Year Ended 12/31/03

Gross
Margin { Sales, net
Cost of goods sold
Gross margin
Operating expenses:
$

$
785,250
351,800
433,450

Operating
Expenses { Selling expenses
General & Admin.
Depreciation
Income from Operations
$ 197,350
78,500
17,500
$
293,350
140,100
Other revenues & gains:

{
Non- Interest income $ 62,187
operating Gain 24,600 86,787
Items Other expenses:
Interest $ 27,000
Loss 9,000 (36,000)
Remember to Income before taxes $ 190,887
compute EPS. Income taxes 62,500
Net income $ 128,387
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Income Statement (Single-Step) Example

{
Central Company
Proper Heading Income Statement
For the Year Ended 12/31/03
Revenues and gains:
Revenues
& Gains { Sales, net
Interest income
Gain on sale of plant assets
Total revenues and gains
$

$
785,250
62,187
24,600
872,037

Expenses and losses:

{
Cost of goods sold $ 351,800
Expenses Selling Expenses 197,350
General and Admin. Exp. 78,500
& Losses Depreciation 17,500
Interest 27,000
Income taxes 62,500
Loss: sale of investment 9,000
Remember to Total expenses & losses 743,650
compute EPS. Operating income $ 128,387

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NORTON CORPORATION
2003
Use this Number of common
information to shares outstanding all of
calculate the 2003 27,400
profitability Net income $ 53,690
ratios for Shareholders' equity
Norton
Beginning of year 180,000
Corporation.
End of year 234,390
Revenues 494,000
Cost of sales 140,000
Total assets
Beginning of year 300,000
End of year 346,390
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Return On Assets (ROA)

This ratio is generally considered

the best overall measure of a
company’s profitability.

Operating
ROA = ÷ Average total assets
income
= $ 53,690 ÷ ($300,000 + $346,390) ÷ 2
= 16.61%

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Return On Equity (ROE)

This measure indicates how well the

company employed the owners’
investments to earn income.

Operating Average total stockholders'

ROE = ÷
income equity
= $ 53,690 ÷ ($180,000 + $234,390) ÷ 2
= 25.91%

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Sources of Financial Information

Annual and Reports filed Internet and Detailed

quarterly with the SEC by other free analyses by
financial publicly owned sources. financial
reports. companies. analysts.

Can be
audited or
unaudited.

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End of Chapter 14
No more
ratios, please!

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