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1-1 Chapter 16 How to Read, Analyze, and Interpret Financial Reports 1-2 McGraw-Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved. #16 How to Read, Analyze, and Interpret Financial Reports Learning Unit Objectives LU16.1 Balance Sheet -- Report as of a Particular Date 1-3 • Explain the purpose and the key items on the balance sheet • Explain and complete vertical and horizontal analysis #16 How to Read, Analyze, and Interpret Financial Reports Learning Unit Objectives LU16.2 Income Statement -- Report for a Specific Period of Time 1-4 • Explain the purpose and the key items on the income statement • Explain and complete vertical and horizontal analysis #16 How to Read, Analyze, and Interpret Financial Reports Learning Unit Objectives LU16.3 Trend and Ratio Analysis 1-5 • Explain and complete a trend analysis • List, explain, and calculate key financial ratios Accounting Equation Accounting Equation: Assets = Liabilities + Owner’s Equity 1-6 Balance Sheet Gives a financial picture of what a company is worth as of particular date. How much the company owns 1-7 Assets = Liabilities + Owner’s Equity How much the company owes How much the owner is worth Figure 16.1 - Elements of the Balance Sheet MOOL COMPANY Balance Sheet December 31, 2001 Assets a. Current assets: b. Cash c. Accounts receivable d. Merchandise inventory e. Prepaid expenses f. Total current assets g. Plant and equipment: h. Building (net) i. Land j. Total plant and equipment k. Total assets 1-8 $ 7,000 9,000 30,000 15,000 $61,000 $60,000 84,000 $205,000 Liabilities a. Current liabilities: b. Accounts payable c. Salaries payable d. Total current liabilities e. Long-term liabilities: f. Mortgage note payable g. Total liabilities Stockholders Equity 144,000 a. Common stock b. Retained earnings c. Total stockholders equity d. Total liab. and stkhlds equity $ 80,000 12,000 $ 92,000 58,000 $150,000 $ 20,000 35,000 55,000 $205,000 Preparing a Vertical Analysis of a Balance Sheet Step 1. Divide each asset (the portion) as a percent of total assets (the base). Round as indicated. Step 2. Round each liability and stockholders’ equity (the portions) as a percent of total liabilities and stockholders’ equity (the base). Round as indicated. 1-9 Figure 16.2 - Comparative Balance Sheet: Vertical Analysis * Due to rounding ROGER COMPANY Comparative Balance Sheet December 31, 2003 and 2004 2003 Amount Percent Assets Current Assets: Cash Accounts Receivable Merchandise inventory Prepaid rent Total current assets Plant and equipment: Building (net) Land Total plant and equipment Total assets 1-10 2004 Amount Percent $22,000 8,000 9,000 4,000 $43,000 25.88 9.41 10.59 4.71 50.59 $18,000 9,000 7,000 5,000 $39,000 $18,000 24,000 $42,000 $85,000 21.19 28.24 49.41* 100.00 $18,000 24,000 $42,000 $81,000 22.22 11.11 8.64 6.71 48.15* 22.22 29.63 51.85 100.00 Preparing a Horizontal Analysis of a Comparative Balance Sheet Step 1. Calculate the increase or decrease (portion) in each item from the base year. Step 2. Divide the increase or decrease in Step 1 by the old or base year. Step 3. Round as indicated. 1-11 Figure 16.3 - Comparative Balance Sheet: Horizontal Analysis ABBY ELLEN COMPANY Comparative Balance Sheet December 31, 2003 and 2004 2004 Assets Current Assets: Cash Accounts Receivable Merchandise inventory Prepaid rent Total current assets Plant and equipment: Building (net) Land Total plant and equipment Total assets 1-12 2003 Increase(decrease) Amount Percent $ 6,000 5,000 9,000 5,000 $25,000 $ 4,000 6,000 4,000 7,000 $21,000 $ 2,000 (1,000) 5,000 (2,000) $ 4,000 $12,000 18,000 $30,000 $55,000 $12,000 18,000 $30,000 $51,000 0 0 0 $4,000 50.00 -16.67 125.00 -28.57 19.05 0 0 0 7.84 Income Statement A financial report that tells how well a company is performing (its profitability or net profit) during a specific period of time. Retail Business Service Business Revenues Revenues - Cost of merchandise sold -Operating Expenses = Gross profit from sales =Net Income - Operating Expenses = Net Income 1-13 Figure 16.4 MOOL - Income Statement COMPANY Income Statement For Month Ended December 31, 2004 Revenues a. Gross Sales b. Less: Sales returns and allowances c. Sales discounts d. Net Sales Cost of merchandise (goods) sold: a. Merchandise Inventory 12/1/2004 b. Purchases c. Less: Purchases returns and allowances $336 d. Less: Purchase discounts 204 e. Cost of net purchases f. Cost of merchandise (goods available for sale) g. Less: Merchandise inventory 12/31/2004 h. Cost of merchandise (goods sold) Gross profit from sales Operating expenses: a. Salary b. Insurance c. Utilities d. Plumbing e. Rent c. Depreciation Total operating expenses Net income 1-14 $22,080 $ 1,082 432 1,514 $20,566 $ 1,248 $10,512 540 9,972 $11,220 1,600 9,620 $10,946 $ 2,200 1.300 400 120 410 200 4,630 $ 6,316 Key Calculations on Income Statement Net sales = Gross sales - Sales returns and - Sales discounts Allowances Cost of merchandise = Beginning + (goods) sold inventory Net purchases (purchase less - Ending returns & discounts) inventory Gross profit = Net sales - Cost of merchandise from sales (goods) sold Net income = Gross profit - Operating expenses 1-15 Figure 16.5 - Income Statement Vertical Analysis ROYAL COMPANY Comparative Income Statement For Years Ended December 31, 2003 and 2004 2004 Net Sales Cost of merchandise sold Gross profit from sales Operating expenses: Depreciation Selling and Advertising Research Miscellaneous Total operating expenses Income before interest and taxes Interest expense Income before taxes Provision for taxes Net income * Due to rounding 1-16 $45,000 19,000 $26,000 Percent of net 100.00 42.22 57.78 $1,000 4,200 2,900 500 $8,600 $17,400 6,000 $11,400 5,500 $ 5,900 2.22 9.33 6.44 1.11 19.11* 38.67 13.33 25.33* 12.22 13.11 2003 $29,000 12,000 $17,000 $ 500 1,600 2,000 200 $ 4,300 $12,700 3,000 $ 9,700 3,000 $ 6,700 Percent of net 100.00 41.38 58.62 1.72 5.52 6.90 .69 14.83 43.79 10.34 33.45 10.34 23.10* Figure 16.6 - Horizontal Analysis Income Statement FLINT COMPANY Comparative Income Statement For Years Ended December 31, 2003 and 2004 2004 Sales Sales returns and allowances Net Sales Cost of merchandise sold Gross profit from sales Operating expenses: Depreciation Selling and Advertising Research Miscellaneous Total operating expenses Income before interest and taxes Interest expense Income before taxes Provision for taxes Net income 1-17 2003 $ 90,000 2,000 $88,000 45,000 $43,000 $80,000 2,000 $78,000 40,000 $38,000 $ 6,000 16,000 600 1,200 $23,800 $19,200 4,000 $15,200 3,800 $11,400 $ 5,000 12,000 1,000 500 $18,500 $19,500 4,000 $15,500 4,000 $11,500 Increase (decrease) Amount Percent $10,000 0 $10,000 + 12.82 5,000 + 12.50 $ 5,000 + 13.16 $ 1,000 4,000 (400) 700 $ 5,300 $ (300) 0 $ (300) (200) $ (100) + 20.00 + 33.33 - 40.00 + 140.00 + 28.65 - 1.54 - 1.94 5.00 .87 Completing a Trend Analysis Analyzes the changes that occur by expressing each number as a percent of the base year Each Item Base Amount Step 1. Select the base year (100%) 1-18 Step 2. Express each amount as a percent of the base year amount (rounded to the nearest whole percent) Trend Analysis Given (base year 2002) Sales Gross Profit 2005 $750,000 200,000 2004 $650,000 150,000 2003 $625,000 135,000 2002 $650,000 140,000 Net Income 75,000 50,000 35,000 40,000 Trend Analysis Sales* Gross Profit Net Income 2005 2004 2003 2002 115% 143 188 100% 107 125 96% 96 88 100% 100 100 * Round to nearest whole percent 1-19 $625,000 $650,000 Ratio Analysis A relationship of one number to another. Used to make comparisons versus previous performance or other companies Asset Management ratios How well the company manages its assets Profitability ratios The company’s profitability picture 1-20 Debt Management ratios The company’s debt situation Summary of Key Ratios Current ratio = Current assets Current liabilities Industry average, 2 to 1 Acid test (quick ratio) = Current assets - inventory-prepaid expenses Current liabilities Industry average, 1 to 1 Average day’s collection = Accounts receivable Net sales 360 Industry average, 90-120 days Total debt to total assets = Total liabilities Total assets Industry average, 50% - 70% 1-21 Summary of Key Ratios Return on equity = Net Income Stockholders equity Industry average, 15% - 20% Asset turnover = Net sales Total assets Industry average, $.03 to $.08 Profit margin on net sales = Net income Net sales Industry average, 25% - 40% 1-22