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Chapter 23

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  1. Chapter 23 Analysis and Interpretation of Financial Statements

  2. The Need for Financial Statement Analysis • Owners, managers, and others use the information on a firm’s financial statements to make judgments and decisions. • However, the raw figures on the financial statements do not provide a complete picture. • To gain a good understanding of the information on the financial statements, it is necessary to make certain comparisons and analyses. Chapter 23

  3. Liquidity and Profitability • For the users of financial statements, two major areas of interest are: • Liquidity of a business • Profitability of a business Chapter 23

  4. Liquidity • Definition: Ability of a business to pay its debts when they become due. Chapter 23

  5. Profitability • Definition: Ability of a business to earn a reasonable return on the investment of the owners. Chapter 23

  6. Comparative Financial Statements • Present a side-by-side comparison of a firm’s statements for two or more accounting periods. • Used to observe trends. • Help to answer the following types of questions: Is net income increasing or decreasing? Is the firm’s cash position improving or getting worse? Chapter 23

  7. Approaches to Comparing Financial Statements • Two basic approaches are used to compare financial statements. • Horizontal Analysis • Vertical Analysis Chapter 23

  8. Horizontal Analysis • Definition: The comparison of each item in a company’s financial statements in the current period with the same item from a previous accounting period or periods. • The changes found in horizontal analysis can be expressed as dollar changes or percent changes. Chapter 23

  9. Horizontal AnalysisComparative Income Statement • In 20X2, the Clay Corporation had sales of $345,000. In 20X1, the amount of sales was $300,000. • Thus, sales increased by $45,000 from 20X1 to 20X2. This is the dollar change. Chapter 23

  10. Horizontal AnalysisComparative Income Statement • To find the percent change, it is necessary to divide the dollar change by the dollar amount for the earlier year. • $45,000  $300,000 = 15.0% increase Chapter 23

  11. Horizontal AnalysisComparative Income Statement • In 20X2, the Clay Corporation had interest expense of $3,500. In 20X1, the amount of interest expense was $4,100. • Thus, interest expense decreased by $600. This is the dollar change. Chapter 23

  12. Horizontal AnalysisComparative Income Statement • To find the percent change, it is necessary to divide the dollar change by the dollar amount for the earlier year. • $600  $4,100 = 14.6% decrease Chapter 23

  13. Interpreting Horizontal Analysis • The horizontal income statement makes it possible to spot strengths and weaknesses in a firm’s operating results. Chapter 23

  14. Interpreting Horizontal Analysis • Example: • If sales increase by 15% but total selling expenses increase by 28%, management should be concerned. • The rate of increase for total selling expenses is almost twice the rate of increase for sales. Chapter 23

  15. Horizontal AnalysisComparative Balance Sheet • In 20X2, the Clay Corporation had cash totaling $34,000. In 20X1, the amount of cash was $25,000. • Thus, cash increased by $9,000 from 20X1 to 20X2. This is the dollar change. Chapter 23

  16. Horizontal AnalysisComparative Balance Sheet • To find the percent change, it is necessary to divide the dollar change by the dollar amount for the earlier year. • $9,000  $25,000 = 36.0% Chapter 23

  17. Vertical Analysis • Definition: The expression of each item on a financial statement as a percent of a base figure in order to see the relative importance of each item. Chapter 23

  18. Vertical Analysis • In 20X2, the income statement of the Clay Corporation shows net sales of $332,000. • The base figure for the income statement is net sales (sales minus sales returns and allowances and sales discounts). Chapter 23

  19. Vertical AnalysisIncome Statement • The income statement of the Clay Corporation for 20X2 shows a gross profit of $150,000. • The dollar amount of each item on the income statement is divided by the dollar amount of net sales (the base figure). • $150,000  $332,000 = 45.2% Chapter 23

  20. Interpreting Vertical Analysis • The vertical income statement makes it possible to compare items from year to year in terms of the base figure. • Example: • In 20X2, the gross profit of the Clay Corporation was 45.2% of net sales. In 20X1, it was 46.1%. Chapter 23

  21. Interpreting Vertical Analysis • Gross profit has decreased slightly. • Management should look at the gross profit percent for prior years to see whether a negative trend is developing. Chapter 23

  22. Vertical AnalysisBalance Sheet • The base figure for vertical analysis of the balance sheet is total assets. • In 20X2, the Clay Corporation had total assets of $270,000. The amount of cash was $34,000. Chapter 23

  23. Vertical AnalysisBalance Sheet • The dollar amount of each item on the balance sheet is divided by the dollar amount of total assets (the base figure). • $34,000  $270,000 = 12.6% Chapter 23

  24. Trend Percentages • Used to compare financial data for a period of several years. • The base year is usually the earliest year. • Each item in the base year is assigned a value of 100%. • The dollar amount of an item for any year is expressed as a percent of the same item for the base year. Chapter 23

  25. Trend Percentages • The Cox Corporation had the following net sales from 20X1 to 20X5. • 20X1 $350,000 20X3 $330,000 20X5 $410,000 • 20X2 $360,000 20X4 $380,000 Chapter 23

  26. Trend Percentages • Using 20X1 as the base year, we calculate the percentages for 20X2 and 20X3 as shown below. • $360,000  $350,000 = 103% for 20X2 • $330,000  $350,000 = 94% for 20X3 Chapter 23

  27. Trend PercentagesExample • At the Cox Corporation, the trend percentages for net sales from 20X1 to 20X5 are as follows. • 20X1 20X2 20X3 20X4 20X5 • 100% 103% 94% 109% 117% Chapter 23

  28. Trend PercentagesExample • The figures show a positive trend except for 20X3. • However, the gain between 20X1 and 20X5 has been very small—only 17%. Chapter 23

  29. Short-term Liquidity Measures • There are certain measures used to evaluate short-term liquidity—the ability to pay debts that will mature within one year. • These measures are often used by creditors and potential creditors such as banks and suppliers of goods. Chapter 23

  30. Working Capital • Definition: The difference between current assets and current liabilities. • Working capital provides the funds needed for the day-to-day operations of a business. Chapter 23

  31. Working Capital • In 20X1, the Drake Corporation had current assets of $135,000 and current liabilities of $40,000. Its working capital was $95,000. • $135,000  $40,000 = $95,000 Chapter 23

  32. Current Ratio • A ratio is a fractional relationship of one number to another. • The current ratio is the ratio of current assets to current liabilities. Chapter 23

  33. Current Ratio • At the end of 20X1, the Drake Corporation had a current ratio of 3.4 to 1. A current ratio of 2 to 1 is usually considered safe. • Current Assets  Current Liabilities = Current Ratio • $135,000  $40,000 = 3.4 to 1 Chapter 23

  34. Acid-test Ratio • Certain current assets can be converted to cash more quickly than others. • Cash, accounts receivable, short-term notes receivable, and marketable securities are called quick assets. • They provide cash more quickly than merchandise inventory and supplies. Chapter 23

  35. Acid-test Ratio • The acid-test or quick ratio is the ratio of quick assets to current liabilities. • At the end of 20X1, the Drake Corporation had quick assets of $84,000 (cash of $21,000 and net receivables of $63,000). Chapter 23

  36. Acid-test Ratio • Drake’s acid-test ratio is 2.1 to 1. An acid-test ratio of 1 to 1 is usually considered safe. • Quick Assets  Current Liabilities = Acid-test Ratio • $84,000  $40,000 = 2.1 to 1 Chapter 23

  37. Accounts Receivable Turnover • Shows how quickly a firm is collecting its accounts receivable. • Specifically, this measure indicates how many times per year the average amount of accounts receivable is collected. • Found by dividing the net credit sales by the average net accounts receivable. Chapter 23

  38. Accounts Receivable Turnover • In 20X1, the Drake Corporation had net credit sales of $250,000 (credit sales minus sales returns and allowances and sales discounts). • The average of the net accounts receivable for 20X1 is calculated as follows. (Net accounts receivable is accounts receivable minus estimated uncollectible accounts.) Chapter 23

  39. Accounts Receivable Turnover • Net accounts receivable at beginning of year $35,000 • Net accounts receivable at end of year 63,000 • Total $98,000 • Average of net accounts receivable: $98,000  2 = $49,000 Chapter 23

  40. Accounts Receivable Turnover • In 20X1, the Drake Corporation had an accounts receivable turnover of 5.1 times. • Net Credit Sales  Average Net Accts. Rec. = Accts. Rec. Turnover • $250,000  $49,000 = 5.1 times • Drake converted its accounts receivable to cash 5.1 times during 20X1. Chapter 23

  41. Average Collection Period for Accounts Receivable • Definition: A rough measure of the length of time it takes the firm to collect its outstanding accounts receivable. • This measure is calculated by dividing 365 days by the accounts receivable turnover. Chapter 23

  42. Average Collection Period for Accounts Receivable • At the Drake Corporation, the average collection period for 20X1 was 71.6 days. • 365 days  Accts. Rec. Turnover = Average Collection Period • 365 days  5.1 times = 71.6 days Chapter 23

  43. Average Collection Period for Accounts Receivable • If Drake provides credit terms of n/30 to its customers, an average collection period of 71.6 days is very poor. Chapter 23

  44. Merchandise Inventory Turnover • Definition: A measure of how many times a firm sells its average inventory during a year. • This measure is calculated by dividing the cost of goods sold by the average inventory. Chapter 23

  45. Merchandise Inventory Turnover • In 20X1, the Drake Corporation had cost of goods sold of $168,000. • The average inventory is calculated as follows. • Merchandise inventory at beginning of year $40,000 • Merchandise inventory at end of year 44,000 • Total $84,000 • Average inventory: $84,000  2 = $42,000 Chapter 23

  46. Merchandise Inventory Turnover • In 20X1, the Drake Corporation turned over (sold and replaced) its merchandise inventory 4.0 times. • Cost of Goods Sold  Average Inventory = Inventory • Turnover • $168,000  $42,000 = 4.0 times Chapter 23

  47. Merchandise Inventory Turnover • To judge the meaning of this figure, it is necessary to know the firm’s inventory turnover in previous years and the inventory turnover of similar types of businesses. Chapter 23

  48. Number of Days in Merchandise Inventory • This measure indicates the number of days it takes a firm to sell its merchandise inventory. • In 20X1, the Drake Corporation had 91.3 days in merchandise inventory. • 365 days  Inventory Turnover = Number of Days in Inventory • 365 days  4.0 times = 91.3 days Chapter 23

  49. Long-term Liquidity Measures • There are certain measures used to evaluate a firm’s ability to pay its long-term liabilities. • Long-term liquidity measures are of particular interest to holders of mortgages and bonds. Chapter 23

  50. Ratio of Plant Assets to Long-term Liabilities • Plant assets are sometimes pledged as security for long-term notes payable. • The ratio of plant assets to long-term liabilities indicates the margin of safety for the holders of notes backed by plant assets. • This ratio is calculated by dividing a firm’s plant assets by its long-term liabilities. Chapter 23