College
Accounting,
by Heintz and Parry
Chapter 25:
Analysis of Financial
Statements
“Another thing Rick Swagger’s accountant wants to
do, Eddie, is complete a horizontal analysis and a vertical
analysis of the company’s books. I don’t know about you, man,
but I think his analysis will come out the same whether he’s
lying down or standing up!”
Eddie wasn’t positive that Nick was kidding, so he kept a
straight face as he answered. “Actually, a horizontal analysis
and a vertical analysis can tell you a lot about a company.
Would you like me to demonstrate how?”
“Okay, but no lying down on the job!”
“No problem. A horizontal analysis is just a comparison of this
year’s numbers to last year’s numbers where we calculate
whether the financial statement amounts went up or down, and
also convert the increase or decrease into a percentage.”
Eddie grabbed the financial statements for 2000 and
added to them. He made the single-step income statement into
a horizontal analysis, projecting numbers for the full year of
2001.
The CD Side of Town
Income Statement
For Years Ended Dec. 31, 2000 and 2001
2000
2001
Revenues:
Sales
Rent Revenue
Interest Revenue
Total Revenues
Expenses:
Cost of Goods Sold
Wage Expense
Depn. Exp.-Bldg.
Supply Exp.
Advertising Expense
Insurance Exp.
Bank Credit Card Exp.
Utilities Expense
Miscellaneous Exp.
Interest Expense
Total Expenses
Net Income
increase
(decrease)
percent
$365,876
500
368
366,744
440,925
3,000
1,436
445,361
75,049
2,500
1,068
78,617
21%
500%
290%
21%
$213,675
74,160
6,490
835
7,230
920
4,369
1,853
1,238
2,386
313,156
$53,588
263,984
85,922
8,653
792
7,843
1,100
6,223
2,242
1,385
2,629
380,773
$64,588
50,309
11,762
2,163
(43)
613
180
1,854
389
147
243
67,617
$11,000
24%
16%
33%
(5%)
8%
20%
42%
21%
12%
10%
22%
21%
“If we combine some of the categories, we can draw some
conclusions: Our cost of goods sold has risen more than our
sales (because we have lowered our markups to keep sales
strong), and most of our expenses are creeping up with the
exception of wages (wages aren’t up as much because our more
experienced employees are better able to run the store by
themselves at off-peak sales times).
The CD Side of Town
Income Statement
For Years Ended Dec. 31, 2000 and 2001
2000
2001
Revenues:
Sales
Other Revenue
Total Revenues
Expenses:
Cost of Goods Sold
Wage Expense
Other Op. Exp.
Total Expenses
Net Income
increase
(decrease)
percent
$365,876
868
366,744
440,925
4,436
445,361
75,049
3,568
78,617
21%
411%
21%
$213,675
74,160
25,321
313,156
$53,588
263,984
85,922
30,867
380,773
$64,588
50,309
11,762
5,546
67,617
$11,000
24%
16%
22%
22%
21%
Eddie also prepared a balance sheet using
horizontal analysis. The assets looked like this:
The CD Side of Town
Balance Sheet
Dec. 31, 2000 and 2001
Assets
Current Assets:
Cash
Accounts Receivable
Merchandise Inventory
Supplies
Prepaid Insurance
Total Current Assets
Prop., Plant, & Equip.:
Land
Building, net of depr’n.
Equipment, net
Total P P & E
Total Assets
2000
2001
$8,383 $12,342
1,329
1,886
10,218 13,231
225
232
320
350
$20,475 $28,041
$24,000 $24,000
107,890 99,237
0
4,992
131,890 128,229
$152,365 $156,270
Inc.(Dec.) Percent
3,959
557
3,013
7
30
7,566
0
(8,653)
4,992
(3,661)
3,905
47%
42%
29%
3%
9%
37%
0%
(8%)
n/a
(3%)
3%
Eddie saw little that was significant here. Current
assets crept higher, but plant assets were down due to
depreciation. The overall change was small.
The CD Side of Town
Balance Sheet
Dec. 31, 2000 and 2001
Assets
Current Assets:
Cash
Accounts Receivable
Merchandise Inventory
Supplies
Prepaid Insurance
Total Current Assets
Prop., Plant, & Equip.:
Land
Building, net of depr’n.
Equipment, net
Total P P & E
Total Assets
2000
2001
$8,383 $12,342
1,329
1,886
10,218 13,231
225
232
320
350
$20,475 $28,041
$24,000 $24,000
107,890 99,237
0
4,992
131,890 128,229
$152,365 $156,270
Inc.(Dec.) Percent
3,959
557
3,013
7
30
7,566
0
(8,653)
4,992
(3,661)
3,905
47%
42%
29%
3%
9%
37%
0%
(8%)
n/a
(3%)
3%
Eddie included liabilities and owners’ equity in his
horizontal analysis, as well. Current liabilities crept up as the
business grew, while long-term liabilities went down as they
continued to pay on their mortgage.
The CD Side of Town
Balance Sheet
Dec. 31, 2000 and 2001
Liabilities
Current Liabilities:
Accts. Payable
Wages Payable
Deferred Rent Rev.
Mortgage Pay. (curr. portion)
Tot. Curr. Liabilities
Long-term Liabilities
Mortgage Payable
Total liabilities
Owner’s Equity
Nick Flannery, Capital
Tot. Liab. & Own. Equity
2000
2001
Inc.(Dec.)
Percent
$4,360
867
1,000
1,723
$7,950
6,234
429
250
1,915
8,828
1,874
(438)
(750)
192
878
43%
(51%)
(75%)
11%
11%
32,827
$40,777
31,182
40,010
(1,645)
(767)
(5%)
(2%)
111,588 116,260
$152,365 $156,270
4,672
3,905
4%
3%
“A vertical analysis, by contrast, computes every line
on a financial statement as a percentage of the same total. On
an income statement, for example, each number is calculated as
a percentage of sales.”
The CD Side of Town
Income Statement
For Years Ended Dec. 31, 2000 and 2001
2000
percent
Revenues:
Sales
Rent Revenue
Interest Revenue
Total Revenues
Expenses:
Cost of Goods Sold
Wage Expense
Depn. Exp.-Bldg.
Supply Exp.
Advertising Expense
Insurance Exp.
Bank Credit Card Exp.
Utilities Expense
Miscellaneous Exp.
Interest Expense
Total Expenses
Net Income
2001
percent
$365,876
500
368
366,744
100%
0%
0%
100%
440,925
3,000
1,436
445,361
100%
1%
0%
101%
$213,675
74,160
6,490
835
7,230
920
4,369
1,853
1,238
2,386
313,156
$53,588
58%
20%
2%
0%
2%
0%
1%
1%
0%
1%
86%
15%
263,984
85,922
8,653
792
7,843
1,100
6,223
2,242
1,385
2,629
380,773
$64,588
60%
19%
2%
0%
2%
0%
1%
1%
0%
1%
86%
15%
“Although a vertical analysis
doesn’t compare
numbers between years on an absolute basis (like a horizontal
analysis does), it shows significant statistics like cost of goods
sold as a percent of sales and net income as a percent of sales.
The CD Side of Town
Income Statement
For Years Ended Dec. 31, 2000 and 2001
2000
percent
Revenues:
Sales
Rent Revenue
Interest Revenue
Total Revenues
Expenses:
Cost of Goods Sold
Wage Expense
Depn. Exp.-Bldg.
Supply Exp.
Advertising Expense
Insurance Exp.
Bank Credit Card Exp.
Utilities Expense
Miscellaneous Exp.
Interest Expense
Total Expenses
Net Income
2001
percent
$365,876
500
368
366,744
100%
0%
0%
100%
440,925
3,000
1,436
445,361
100%
1%
0%
101%
$213,675
74,160
6,490
835
7,230
920
4,369
1,853
1,238
2,386
313,156
$53,588
58%
20%
2%
0%
2%
0%
1%
1%
0%
1%
86%
15%
263,984
85,922
8,653
792
7,843
1,100
6,223
2,242
1,385
2,629
380,773
$64,588
60%
19%
2%
0%
2%
0%
1%
1%
0%
1%
86%
15%
When Eddie prepared a balance sheet using vertical
analysis, each number was divided by total assets. The asset
section looked like this:
The CD Side of Town
Balance Sheet
Dec. 31, 2000 and 2001
Assets
Current Assets:
Cash
Accounts Receivable
Merchandise Inventory
Supplies
Prepaid Insurance
Total Current Assets
Prop., Plant, & Equip.:
Land
Building, net of depr’n.
Equipment, net
Total P P & E
Total Assets
2000
$8,383
1,329
10,218
225
320
$20,475
$24,000
107,890
0
131,890
$152,365
Percent
6%
1%
7%
0%
0%
13%
2001
Percent
$12,342
1,886
13,231
232
350
$28,041
8%
1%
8%
0%
0%
18%
16% $24,000
71%
99,237
0%
4,992
87% 128,229
100% $156,270
15%
64%
3%
82%
100%
In Eddie’s vertical analysis of liabilities and owners’
equity, he divided each number by total liabilities and owners’
equity (which is, of course, the same number as total assets). In
this case, the vertical analysis of the balance sheet showed the
same trends noted in the horizontal analysis.
The CD Side of Town
Balance Sheet
Dec. 31, 2000 and 2001
Liabilities
Current Liabilities:
Accts. Payable
Wages Payable
Deferred Rent Rev.
Mortgage Pay. (curr. portion)
Tot. Curr. Liabilities
Long-term Liabilities
Mortgage Payable
Total liabilities
Owner’s Equity
Nick Flannery, Capital
Tot. Liab. & Own. Equity
2000
Percent
2001
Percent
$4,360
867
1,000
1,723
$7,950
3%
1%
1%
1%
5%
6,234
429
250
1,915
8,828
4%
0%
0%
1%
6%
32,827
$40,777
22%
27%
31,182
40,010
20%
26%
111,588
$152,365
73%
116,260
100% $156,270
74%
100%
“The last thing Rick’s accountant is doing is
analyzing our liquidity, profitability, and leverage. I think he can
see our profitability right there on the bottom line, and I’m not
sure what the other two things mean.”
“Don’t worry, Nick, all he’s talking about is the financial
statement analysis we talked about a month or so ago.”
“Oh, you mean ‘working hospitals’ and ‘currents raging’ and all
that stuff?”
“Yes, ‘working capital’ and ‘current ratio’ and all that stuff. I’ll be
glad to go through all of the key ratios again, and I’ll include
some different ones in all three categories you mentioned, but
only if you take notes this time, Mr. Memory!”
“Okay, okay, I’ll get out some paper and a pen to supplement my
usually brilliant memory, uh, Teddy.”
Liquidity measures are an attempt to predict
whether the company can pay it’s current debts.
The first one we will calculate is the store’s working capital. The
calculation is:
Current Assets - Current Liabilities = Working Capital
2000: 20,475 7,950
= 12,525
2001: 28,041
-
8,828
=
19,213
This amount tells us the company can still comfortably pay its
current liabilities today.
As you may remember, it can be useful to
compare the working capital of companies that are very different
in size, so we calculate current ratio, a number that takes out
size as a factor by computing the relative size of a company’s
current assets and current liabilities. The calculation is:
Current Assets / Current Liabilities = Current Ratio
2000: 20,475 /
7,950
= 2.58 to 1
2001:
28,041
/
8,828
=
3.18 to 1
This means that The CD Side of Town now has $3.18 in current
assets for every $1.00 of current liabilities.
Question: Do you remember what most companies try
to maintain as a current ratio?
Answer:
”Most companies want a current ratio of at least
two to one.
Now let’s recalculate the store’s quick ratio (or acid-test ratio)
using our projected numbers for 2001. This compares the
company’s quick assets, the assets normally convertible into
cash in 30 days, with the current liabilities (usually due within 30
days). The quick assets are: 1) cash, 2) temporary investments,
and 3) accounts receivable. Our quick ratio is:
Quick Assets / Curr. Liabilities = Quick Ratio
2000:
2001:
9,712 /
14,228 /
7,950
8,828
= 1.22 to 1
= 1.61 to 1
This means that The CD Side of Town has $1.61 in quick assets
for every $1.00 of current liabilities.”
Question: Do you remember what most companies try
to maintain as a quick ratio?
Answer:
”Most companies want a quick ratio of at least
one to one.
Another leverage measure we’ve already discussed is accounts
receivable turnover. The formula is:
Net Credit Sales for the Period
Average Accounts Receivable = Accts. Rec. Turnover
An easy way to estimate average accounts receivable is to take
an average of beginning accounts receivable and ending
accounts receivable:
2000: ($105 beg. A/R + $1,329 ending A/R) / 2 = $717
2001:
($1,329 + $1,886) / 2 = $1,607.50
Eddie calculated that the net credit sales (sales on account
minus related returns and allowances) and came up with
$12,457.
Question: What is the accounts receivable turnover for 2001,
and is it a “good” number?
Answer:
The store’s accounts receivable turnover is:
$12,457 / $1,607.50 = 7.75 times
To determine whether this is a good number, it helps to calculate
the average collection period using this formula:
365 (days) / accounts receivable turnover
or
365
/ 7.75
=
47 days
This means that the typical credit customer is paying 47 days
after the sale was made. Since the store offers payment terms
of net 30 days, this represents a poor record of collections.
Because the store has few credit customers (mostly disc
jockeys), this could mean that there are one or two customers
who need to be written off, turned over to a collection agency,
and/or set up on a payment plan.
“The final leverage ratio that I’m sure will get
calculated is inventory turnover. It’s the ratio that measures how
long it takes a business to sell inventory after it buys it. The
formula for this ratio is:
Cost of Goods Sold for the Year
Average Inventory
= Inventory Turnover
Again, we will estimate average inventory by averaging the
beginning inventory and ending inventory.
2000: ($7,683 beg. inv. + $10,218 end. inv.) / 2 = $8,950.5
2001:
($10,218
+ $13,231) / 2
= $11,724.5
The average inventory is $11,724.50. We can use our projected
cost of goods sold of $263,984 to estimate our inventory
turnover.”
Question: What is the estimated inventory turnover
for 2001, and is it a “good” number?
Answer:
The store’s inventory turnover is:
$263,984 / $11,724.50 = 22.5 times
To determine whether this is a good number, it helps to calculate
the average days to sell inventory using this formula:
365 (days) / inventory turnover
or
365
/ 22.5
=
16.2 days
This means that the typical CD is being sold 16 days after it is
purchased by the store. This number is 1 day slower than last
year’s, which mainly reflects that there are no “grand opening”
sales included in the 2001 figures. However, that’s still a very
impressive number for this type of inventory.
“That brings us to the profitability measures, of
which there are more than you might think. For example, the
ratio of net sales to assets is just that: a measure of how well
the company uses its assets to generate sales. The formula for
this ratio is:
Net Sales
Average Assets
We will estimate average assets by averaging the beginning
assets and ending assets.
2001: ($152,365 + $156,270) / 2 = $154,317.50
Therefore, the ratio is:
Net Sales / Average Assets
$440,925 / 154,317.50 = 2.86
We would need to look at prior years or industry averages to
decide if this is a good number or not.”
“The next profitability measure is pretty similar to the
last one. The return on total assets is a measure of how well the
company uses its assets to generate net income. The formula
for this ratio is:
Net Income
Average Assets
Since we already calculated average assets, we can quickly
calculate this ratio:
Net Income / Average Assets
$64,588 / 154,317.50 = 41.9%
Again, a look at prior years or industry averages is normally
used to decide if this is a good number or not, but a 41.9%
return on total assets is clearly an impressive number.”
“Another profitability measure is called return on
common stockholders’ equity. This is the corporate equivalent
of the return on owners’ equity that we discussed before. The
formula is:
Net Income Available to Common Stockholders
Average Common Stockholders’ Equity
The formula means that dividends to preferred stockholders
should be subtracted from net income to get the top number,
and preferred stock should be subtracted from owners’ equity to
get the bottom number. If your capital was in the form of
common stock (no preferred stock), the calculation would be:
Net Income/((Jan. 1 Owners’ Equity + Dec. 31 Owners’ Equity)/2)
$64,588 / ((111,588 + 116,260)/2) = 56.7%
Comparison with prior years or industry averages is often
helpful, but a 56.7% return on common stockholders’ equity is
very high.”
“The next profitability measure is called earnings per
share of common stock. This is a major determining factor in
the selling price of publicly traded stocks. The formula is:
Net Income Available to Common Stockholders
Average Number of Common Shares Outstanding
Again, dividends to preferred stockholders should be subtracted
from net income to get the top number. If your capital was in the
form of 500 shares of common stock for the entire year (no
preferred stock), the calculation would be:
Net Income / # of Common Shares
$64,588 /
500
= $129.18 earnings per share
Whether this seems like a good number probably depends upon
how much you paid for the share of stock!”
“The next profitability measure is called book value per
share of common stock. This sometimes acts as an
approximate floor for the selling price of publicly traded stocks.
The formula is:
Common Stockholders’ Equity
Number of Common Shares Outstanding at Year End
Assume once more that your capital was in the form of 500
shares of common stock for the entire year (no preferred stock),
the calculation would be:
Common Stockholders’ Equity / # of Common Shares
$116,260
/
500
= $232.52
This means that, according to your books, each share is worth
$232.52. This probably isn’t an accurate value, even if the
corporation liquidated, because assets (and even liabilities) can
undergo fluctuations in their current market value. However, in
combination with other measures, it gives useful information
about a stock’s value.”
“The last two measures I will show you are called
leverage measures. Their used to measure how much your
business is financed by debt and whether you are able to meet
your debt obligations. The first one is called ratio of liabilities to
stockholders’ equity. The name tells you the calculation (based
on our 2001 projections):
Total Liabilities
40,010
Total Stockholders’ Equity = 116,260 = 0.34 to 1
This number is best evaluated by comparison to industry
averages. Companies and industries that have consistently
good revenues and profitability can afford to maintain a high
ratio of liabilities to stockholders’ equity. Other companies
probably shouldn’t try it.”
“The last leverage measure we’ll calculate is the times
interest earned ratio. The calculation is:
Earnings Before Taxes and Interest
Interest Expense
The top number is calculated like this:
Net Income
$64,588
+ Income Tax
0 (because we are not a corporation)
+ Interest Expense 2,629
$67,217
Therefore, our projected 2001 calculation would be:
$67,217
2,629 =
25.6 times
Generally, 2 or 3 times is an adequate ratio, so ours is very safe.
“Okay, let’s see if you can answer any of
these without referring to the beautiful notes I see you’ve been
taking:
Questions: 1) What is the formula for quick ratio?
2) What is the formula for earnings per share of
common stock?
3) What is the formula for merchandise inventory
turnover?
4) What is the formula for times interest earned ratio?
“Answers: 1) The formula for quick ratio is:
Quick Assets / Current Liabilities
2) The formula for earnings per share of common stock is:
Net Income Available to Common Stockholders
Average Number of Common Shares Outstanding
3) The formula for merchandise inventory turnover is:
Cost of Goods Sold for the Year
Average Inventory
4) The formula for times interest earned ratio is:
Earnings Before Taxes and Interest
Interest Expense”
“Hey, I got all but the last one. That means my ‘brilliance to
ignorance ratio’ is 3 to 1, right, Eddie?”