Financial Statement Analysis

1. 17 Financial Statement Analysis

2. 0 After studying this chapter, you should be able to: • List basic financial statement analytical procedures. • Apply financial statement analysis to assess the solvency of a business. • Apply financial statement analysis to stress the profitability of a business. • Describe the contents of corporate annual reports.

3. 0 17-1 Objective 1 List basic financial statement analytical procedures.

4. 0 17-1 Horizontal Analysis The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis.

5. Assets Current assets $ 550,000 $ 533,000 $ 17,000 3.2% Long-term investments 95,000 177,500 (82,500) (46.5%) Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%) Intangible assets 50,000 50,000 Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%) Liabilities Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%) Long-term liabilities 100,000 200,000 100,000) (50.0%) Total liabilities $ 310,000$ 443,000$(133,000) (30.0%) Stockholders’ Equity Preferred 6% stock, $100 par $ 150,000 $ 150,000 — Common stock, $10 par 500,000 500,000 — Retained earnings 179,500 137,500$ 42,000 30.5% Total stockholders’ equity $ 829,500 $ 787,500 $ 42,000 5.3% Total liab. & stockholders’ eq. $1,139,500 $1,230,500 $ (91,000) (7.4%) 5 0 17-1 Exhibit 1 Comparative Balance Sheets Lincoln CompanyComparative Balance SheetDecember 31, 2008 and 2007 2008 2007 Amount Percent Increase (Decrease)

6. Assets Current assets $ 550,000 $ 533,000 $ 17,000 3.2% Long-term investments 95,000 177,500 (82,500) (46.5%) Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%) Intangible assets 50,000 50,000 Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%) Liabilities Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%) Long-term liabilities 100,000 200,000 100,000) (50.0%) Total liabilities $ 310,000$ 443,000$(133,000) (30.0%) Stockholders’ Equity Preferred 6% stock, $100 par $ 150,000 $ 150,000 — Common stock, $10 par 500,000 500,000 — Retained earnings 179,500 137,500$ 42,000 30.5% Total stockholders’ equity $ 829,500 $ 787,500 $ 42,000 5.3% Total liab. & stockholders’ eq. $1,139,500 $1,230,500 $ (91,000) (7.4%) Difference $17,000 Base year (2007) $533,000 = 3.2% 6 0 17-1 Lincoln CompanyComparative Balance SheetDecember 31, 2008 and 2007 2008 2007 Amount Percent Increase (Decrease) Horizontal Analysis:

7. Assets Current assets $ 550,000 $ 533,000 $ 17,000 3.2% Long-term investments 95,000 177,500 (82,500) (46.5%) Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%) Intangible assets 50,000 50,000 Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%) Liabilities Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%) Long-term liabilities 100,000 200,000 100,000) (50.0%) Total liabilities $ 310,000$ 443,000$(133,000) (30.0%) Stockholders’ Equity Preferred 6% stock, $100 par $ 150,000 $ 150,000 — Common stock, $10 par 500,000 500,000 — Retained earnings 179,500 137,500$ 42,000 30.5% Total stockholders’ equity $ 829,500 $ 787,500 $ 42,000 5.3% Total liab. & stockholders’ eq. $1,139,500 $1,230,500 $ (91,000) (7.4%) Lincoln CompanyComparative Balance SheetDecember 31, 2008 and 2007 2008 2007 Amount Percent Increase (Decrease) Difference $(82,500) Base year (2007) $177,500 = (46.5%) 0 17-1 Horizontal Analysis: 7

8. Lincoln CompanyComparative Schedule of Current Assets December 31, 2008 and 2007 Increase (Decrease) 2008 2007 Amount Percent Cash $ 90,500 $ 64,700 $ 25,800 39.9% Marketable securities 75,000 60,000 15,000 25.0% Accounts receivable (net) 115,000 120,000 (5,000) (4.2%) Inventories 264,000 283,000 (19,000) (6.7%) Prepaid expenses 5,500 5,300 200 3.8% Total current assets $550,000 $533,000 $17,000 3.2% 0 17-1 Exhibit 2 Comparative Schedule of Current Assets 8

9. Lincoln CompanyComparative Schedule of Current Assets December 31, 2008 and 2007 Increase (Decrease) 2008 2007 Amount Percent Difference $25,800 Base year (2007) $64,700 = 39.9% Cash $ 90,500 $ 64,700 $ 25,800 39.9% Marketable securities 75,000 60,000 15,000 25.0% Accounts receivable (net) 115,000 120,000 (5,000) (4.2%) Inventories 264,000 283,000 (19,000) (6.7%) Prepaid expenses 5,500 5,300 200 3.8% Total current assets $550,000 $533,000 $17,000 3.2% 0 17-1 Horizontal Analysis: 9 9

10. 0 17-1 Exhibit 3 Comparative Income Statement Lincoln CompanyComparative Income Statement For the Year Ended December 31, 2008 and 2007 2008 2007 Amount Percent Increase (Decrease) Sales $1,530,500 $1,234,000 $296,500 24.0% Sales returns and allowances 32,500 34,000 (1,500) (4.4%) Net sales $1,498,000 $1,200,000 $298,000 24.8% Cost of goods sold 1,043,000 820,000 223,000 27.2% Gross profit $ 455,000$ 380,000 $ 75,000 19.7% Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9% Administrative expenses 104,000 97,400 6,600 6.8% Total operating expenses $ 295,000$ 244,400$ 50,600 20.7% Income from operations $ 160,000 $ 135,600 $ 24,400 18.0% Other income 8,500 11,000 (2,500) (22.7%) $ 168,500 $ 146,600 $ 21,900 14.9% Other expense (interest) 6,000 12,000 (6,000) (50.0%) Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7% Income tax expense 71,500 58,100 13,400 23.1% Net income $ 91,000 $ 76,500 $ 14,500 19.0% 10

11. Horizontal Analysis: Increase amount $296,500 Base year (2007) $1,234,000 = 24.0% 0 17-1 Lincoln CompanyComparative Income Statement For the Year Ended December 31, 2008 and 2007 2008 2007 Amount Percent Increase (Decrease) Current assets $1,530,500 $1,234,000 $296,500 24.0% Sales returns and allowances 32,500 34,000 (1,500) (4.4%) Net sales $1,498,000 $1,200,000 $298,000 24.8% Cost of goods sold 1,043,000 820,000 223,000 27.2% Gross profit $ 455,000$ 380,000 $ 75,000 19.7% Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9% Administrative expenses 104,000 97,400 6,600 6,.8% Total operating expenses $ 295,000$ 244,400$ 50,600 20.7% Income from operations $ 160,000 $ 135,600 $ 24,400 18.0% Other income 8,500 11,000 (2,500) (22.7%) $ 168,500 $ 146,600 $ 21,900 14.9% Other expense (interest) 6,000 12,000 (6,000) (50.0%) Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7% Income tax expense 71,500 58,100 13,400 23.1% Net income $ 91,000 $ 76,500 $ 14,500 19.0% 11

12. Lincoln CompanyComparative Retained Earnings Statement December 31, 2008 and 2007 A percentage analysis that shows the relationship of each component to the total within a single statement is called vertical analysis. Increase (Decrease) 2008 2007 Amount Percent Retained earnings, Jan. 1 $137,500 $100,000 $37,500 37.5% Net income for year 91,000 76,500 14,500 19.0% Total $228,500$176,500$52,000 29.5%) Dividends: On preferred stock $ 9,000 $ 9,000 — On common stock 40,000 30,000 10,000 33.3% Total $ 49,000$ 39,000$10,000 25.6% Total current assets $179,500 $137,500 $42,000 30.5% 0 17-1 17-1 Exhibit 4 Comparative RE Statement 12

13. Lincoln CompanyComparative Retained Earnings Statement December 31, 2008 and 2007 A percentage analysis that shows the relationship of each component to the total within a single statement is called vertical analysis. Increase (Decrease) 2008 2007 Amount Percent Retained earnings, Jan. 1 $137,500 $100,000 $37,500 37.5% Net income for year 91,000 76,500 14,500 19.0% Total $228,500$176,500$52,000 29.5%) Dividends: On preferred stock $ 9,000 $ 9,000 — On common stock 40,000 30,000 10,000 33.3% Total $ 49,000$ 39,000$10,000 25.6% Total current assets $179,500 $137,500 $42,000 30.5% Horizontal Analysis: Increase amount $37,500 Base year (2007) $100,000 = 37.5% 0 17-1 17-1 Exhibit 4 Comparative RE Statement 13

14. Example Exercise 17-1 0 17-1 The comparative cash and accounts receivable for a company are provided below: 20082007 Cash $62,500 $50,000 Accounts receivable (net) 74,400 80,000 Based on this information, what is the amount and percentage of increase or decrease that would be shown in a balance sheet with horizontal analysis? 14

15. Follow My Example 17-1 0 17-1 Cash $12,500 increase ($62,500 – $50,000), or 25% Accounts Receivable $5,600 decrease ($74,400 – $80,000) or –7% 15 For Practice: PE 17-1A, PE 17-1B

16. 0 17-1 Vertical Analysis A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis.

17. 0 17-1 Vertical Analysis of Balance Sheet In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.

18. 0 17-1 Lincoln CompanyComparative Balance SheetFor the Years Ended December 31, 2008 and 2007 2008 2007 Amount Percent Amount Percent Assets Current assets $ 550,000 48.3% $ 533,000 43.3% Long-term investments 95,000 8.3 177,500 14.4 Property, plant, & equip. (net) 444,500 39.0 470,000 38.2 Intangible assets 50,000 4.4 50,000 4.1 Total assets $1,139,500 100.0% $1,230,500 100.0% Liabilities Current liabilities $ 210,000 18.4% $ 243,000 19.7% Long-term liabilities 100,000 8.8 200,000 16.3 Total liabilities$ 310,000 27.2% $ 443,000 36.0% Stockholders’ Equity Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2% 2.2% Common stock, $10 par 500,000 43.9 500,000 40.6 Retained earnings 179,500 15.7 137,500 11.2 Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0% Total liab. & Stockholders’ equity $1,139,500 100.0% $1,230,500 100.0% Total assets $1,139,500 100.0% $1,230,500 100.0% 18 Total liab. & stockholders’ equity $1,139,500 100.0% $1,230,500 100.0%

19. 0 17-1 To demonstrate how vertical analysis percentages are calculated for the balance sheet, let’s see how the 48.3 percent was calculated for the 2008 current assets in the next slide.

20. Vertical Analysis: Current assets $550,000 Total assets $1,139,500 = 48.3% 0 17-1 Lincoln CompanyComparative Balance SheetFor the Years Ended December 31, 2008 and 2007 2008 2007 Amount Percent Amount Percent Assets Current assets $ 550,000 48.3% $ 533,000 43.3% Long-term investments 95,000 8.3 177,500 14.4 Property, plant, & equip. (net) 444,500 39.0 470,000 38.2 Intangible assets 50,000 4.4 50,000 4.1 Total assets $1,139,500 100.0% $1,230,500 100.0% Liabilities Current liabilities $ 210,000 18.4% $ 243,000 19.7% Long-term liabilities 100,000 8.8 200,000 16.3 Total liabilities$ 310,000 27.2% $ 443,000 36.0% Stockholders’ Equity Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 1 2.2% Common stock, $10 par 500,000 43.9 500,000 40.6 Retained earnings 179,500 15.7 137,500 11.2 Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0% Total liab. & Stockholders’ equity $1,139,500 100.0% $1,230,500 100.0% Total assets $1,139,500 100.0% $1,230,500 100.0% 20 Total liab. & stockholders’ equity $1,139,500 100.0% $1,230,500 100.0%

21. 0 17-1 Vertical Analysis of Income Statement In a vertical analysis of the income statement, each item is stated as a percent of net sales. As an example, let’s see how the percent of 12.8% was calculated for 2008 selling expenses.

22. Lincoln CompanyComparative Income StatementFor the Years Ended December 31, 2008 and 2007 2008 2007 Amount Percent Amount Percent Sales $1,530,500 102.2% $1,234,000 102.8% Sales returns and allow. 32,500 2.2 34,000 2.8 Net sales $1,498,000 100.0% $1,200,000 100.0% Cost of goods sold 1,043,000 69.6 820,000 68.3 Gross profit $ 455,000 30.4% $ 380,000 31.7% Selling expenses $ 191,00012.8% $ 147,000 12.3% Administrative expenses 104,000 6.9 97,400 8.1 Total operating expenses $ 295,000 19.7% $ 244,400 20.4% Income from operations $ 160,000 10.7 $ 135,600 11.3% Other income 8,500 0.6 11,000 0.9 $ 168,500 11.3% $ 146,600 12.2% Other expense (interest) 6,000 0.4 12,000 1.0 Income before income tax $ 162,500 10.9% $ 134,600 11.2% Income tax expense 71,500 4.8 58,100 4.8 Net income $ 91,000 6.1% $ 76,500 6.4% 0 17-1 22

23. Lincoln CompanyComparative Income StatementFor the Years Ended December 31, 2008 and 2007 2008 2007 Amount Percent Amount Percent Sales $1,530,500 102.2% $1,234,000 102.8% Sales returns and allow. 32,500 2.2 34,000 2.8 Net sales $1,498,000 100.0% $1,200,000 100.0% Cost of goods sold 1,043,000 69.6 820,000 68.3 Gross profit $ 455,000 30.4% $ 380,000 31.7% Selling expenses $ 191,00012.8% $ 147,000 12.3% Administrative expenses 104,000 6.9 97,400 8.1 Total operating expenses $ 295,000 19.7% $ 244,400 20.4% Income from operations $ 160,000 10.7 $ 135,600 11.3% Other income 8,500 0.6 11,000 0.9 $ 168,500 11.3% $ 146,600 12.2% Other expense (interest) 6,000 0.4 12,000 1.0 Income before income tax $ 162,500 10.9% $ 134,600 11.2% Income tax expense 71,500 4.8 58,100 4.8 Net income $ 91,000 6.1% $ 76,500 6.4% 0 17-1 Vertical Analysis: Selling expenses $191,000 Net sales $1,498,000 = 12.8% 23

24. 0 17-1 Common-Size Statements In a common-sized statements, all items are expressed as a percentage. Common-sized statements are useful in comparing the current period with prior periods, individual businesses, or one business with with industry percentages.

25. 0 17-1 Common-Size Income Statement 25

26. Example Exercise 17-2 0 17-1 Income statement information for Lee Corporation is provided below: Lee Corporation Sales $100,000 Cost of goods sold 65,000 Gross profit $ 35,000 Prepare a vertical analysis of the income statement for Lee Corporation. 26

27. Follow My Example 17-2 0 17-1 AmountPercentage Sales $100,000 100% ($100,000/$100,000) Cost of goods sold 65,000 65 ($65,000/$100,000) Gross profit 35,000 35% ($35,000/$100,000) 27 For Practice: PE 17-2A, PE 17-2B

28. 0 17-2 Objective 2 Apply financial statement analysis to assess the solvency of a business.

29. 0 17-2 Solvency Analysis The ability of a business to meet its financial obligations (debts) is called solvency. The ability of a business to earn income is called profitability.

30. 0 17-2 Current Position Analysis Using measures to assess a business’s ability to pay its current liabilities is called current position analysis. Such analysis is of special interest to short-term creditors.

31. 0 17-2 Working Capital The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company’s ability to meet currently maturing debts.

32. 0 17-2 Lincoln Company • Current asset: • Cash $ 90,500 • Marketable securities 75,000 • Accounts receivable (net) 115,000 • Inventories 264,000 • Prepaid expenses 5,500 • Total current assets $550,000 • Current liabilities 210,000 Working capital (a – b) $340,000 32

33. 0 17-2 Current Ratio The current ratio, sometimes called the working capital ratio or bankers’ ratio, is computed by dividing the total current assets by the total current liabilities.

34. 0 17-2 Lincoln Company 2008 2007 a. Current assets $550,000 $533,000 b. Current liabilities 210,000 243,000 Working capital (a – b) $340,000 $290,000 Current ratio (a/b) 2.6 2.2 34

35. 0 17-2 Quick Ratio A ratio that measures the “instant’ debt-paying ability of a company is called the quick ratio or acid-test ratio.

36. 0 Quick assets are cash and other current assets that can be quickly converted to cash. 17-2 Lincoln Company 2008 2007 Quick assets: Cash $ 90,500 $ 64,700 Marketable securities 75,000 60,000 Accounts receivable (net) 115,000 120,000 a. Total quick assets $280,500 $244,700 b. Current liabilities $210,000 $243,000 Quick ratio (a/b) 1.3 1.0 36

37. Example Exercise 17-3 0 17-2 The following items are reported on a company’s balance sheet: Cash $300,000 Marketable securities 100,000 Accounts receivable (net) 200,000 Inventory 200,000 Accounts payable 400,000 Determine (a) the current ratio and (b) the quick ratio. 37

38. Follow My Example 17-3 0 17-2 • Current Ratio = Current Assets/Current Liabilities • Current Ratio = ($300,000 + $100,000 + $200,000 + $200,000)/$400,000 • Current Ratio = 2.0 • Quick Ratio = Quick Assets (cash, marketable securities, and accounts receivable)/Current Liabilities (accounts payable) • Quick Ratio = ($300,000 + $100,000 + $200,000)/$400,000 • Quick Ratio = 1.5 38 For Practice: PE 17-3A, PE 17-3B

39. 0 17-2 Accounts Receivable Turnover The relationship between sales and accounts receivable may be stated as the accounts receivableturnover. The ratio is to assess the efficiency of the firm in collecting receivables and in the managing of credit.

40. 0 17-2 Lincoln Company 2008 2007 • a. Net sales $1,498,000$1,200,000 • Accounts receivable (net): • Beginning of year $ 120,000 $ 140,000 • End of year 115,500 120,000 • Total $ 235,000 $ 260,000 • Average (Total/2) $ 117,500 $ 130,000 Accounts receivable turnover (a/b) 12.7 9.2 40

41. 0 17-2 Number of Days’ Sales in Receivables Thenumber of days’ sales inreceivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. Comparing this measure with the credit terms provides information on the efficiency in collecting receivables.

42. 0 17-2 Lincoln Company 2008 2007 a. Average (Total/2) $ 117,500 $ 130,000 Net sales $1,498,000 $1,200,000 b. Average daily sales on account (Sales/365) $ 4,104 $ 3,288 Number of days’ sales in receivables (a/b) 28.6 39.5 42

43. Example Exercise 17-4 0 17-2 A company reports the following: Net sales $960,000 Average accounts receivable (net) 48,000 Determine (a) the accounts receivable turnover and (b) the number of days’ sales in receivables. Round to one decimal place. 43

44. Follow My Example 17-4 0 17-2 • Accounts Receivable Turnover = Sales/Average accounts receivable • Accounts Receivable Turnover = $960,000/$48,000 • Accounts Receivable Turnover = 20.0 • Number of Days’ Sales in Receivables = Average accounts receivable/Average daily sales • Number of Days’ Sales in Receivables = $48,000/($960,000/ 365) • Number of Days’ Sales in Receivables = $48,000/$2,630 • Number of Days’ Sales in Receivables = 18.3 days 44 For Practice: PE 17-4A, PE 17-4B

45. 0 17-2 Inventory Turnover The relationship between the volume of goods (merchandise) sold and inventory may be stated as theinventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory.

46. 0 17-2 Lincoln Company 2008 2007 • a. Cost of goods sold $1,043,000$ 820,000 • Inventories: • Beginning of year $ 283,000 $ 311,000 • End of year 264,000 283,000 • Total $ 547,000 $ 594,000 • Average (Total/2) $ 273,500 $ 297,000 Inventory turnover (a/b) 3.8 2.8 46

47. 0 17-2 Number of Days’ Sales in Inventory Lincoln Company 2008 2007 • a. Average (Total/2) $ 273,500 $ 297,000 • Cost of goods sold $1,043,000 $ 820,000 • Average daily cost of goods • sold (COGS/365 days) $2,858 $2,247 Number of days’ sales in inventory (a/b) 95.7 132.2 47

48. Example Exercise 17-5 0 17-2 A company reports the following: Cost of goods sold $560,000 Average inventory 112,000 Determine (a) the inventory turnover and (b) the number of days’ sales in inventory. Round to one decimal place. 48

49. Follow My Example 17-5 0 17-2 a. Inventory Turnover = Cost of Goods Sold/Average Inventory Inventory Turnover = $560,000/$112,000 Inventory Turnover = 5.0 • Number of Days’ Sales in Inventory = Average Inventory/ Average Daily Cost of Goods Sold • Number of Days’ Sales in Inventory = $112,000/ ($560,000/365) • Number of Days’ Sales in Inventory = $112,000/$1,534 • Number of Days’ Sales in Inventory = 73.0 days 49 For Practice: PE 17-5A, PE 17-5B

50. 0 17-2 Ratio of Fixed Assets to Long-Term Liabilities The ratio of fixed assets tolong-term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis.