FINANCIAL STATEMENTS

ANALYSIS

Financial Statement Analysis

Who analyzes financial statements?
Internal users i.e., Management, Shareholders, Internal auditors, Budget Analyst, External users
Examples? Investors, creditors, regulatory agencies & stock market analysts, Business analysts, Financial Analyst, Investment Analyst and auditors

Financial Statement Analysis

What do internal users use it for?
Planning, evaluating and controlling company operations

What do external users use it for?

Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management

Financial Statement Analysis

Information is available from
Published annual reports
(1) (2) (3) (4) (5) Financial statements Notes to financial statements Letters to stockholders Auditors report (Independent accountants) Managements discussion and analysis

Reports filed with the government

Taxation Department, SECP.

Financial Statement Analysis

Information is available from
Other sources
(1) (2) (3) (4) Newspapers (e.g., The News) Periodicals (e.g. The Economist, Fortune) Financial information organizations Other business publications

Methods of Financial Statement Analysis

Horizontal Analysis
Vertical Analysis Common-Size Statements Trend Percentages

Ratio Analysis

Horizontal Analysis

Vertical Analysis

Common-Size Statements

Trend Percentages

Ratio Analysis

Horizontal Analysis Example

The management of ABC Company provides you with comparative balance sheets of the years ended December 31, 2009 and 2010. Management asks you to prepare a horizontal analysis on the information.

ABC CORPORATION Comparative Balance Sheets December 31, 2009 and 2010

2010 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets $ 40,000 120,000 160,000 315,000 $ $ 12,000 60,000 80,000 3,000 155,000 $

2009

In A

23,500 40,000 100,000 1,200 164,700 40,000 85,000 125,000 289,700

Horizontal Analysis Example

Calculating Change in Dollar Amounts
Dollar Change = Current Year Figure Base Year Figure

Since we are measuring the amount of the change between 2010 and 2009, the dollar amounts for 2009 become the base year figures.

Horizontal Analysis Example

Calculating Change as a Percentage
Percentage Change = Dollar Change Base Year Figure

100%

Horizontal Analysis Example

ABC CORPORATION Comparative Balance Sheets December 31, 2010 and 2009 2010 Assets Current assets: Cash $ 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 155,000 164,700 $12,000 $23,500 = $(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 2009 Increase (Decrease) Amount %

Horizontal Analysis Example

ABC CORPORATION Comparative Balance Sheets December 31, 2010 and 2009 2010 Assets Current assets: Cash $ 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 155,000 164,700 ($11,500 $23,500) 100% = 48.9% 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 2009 Increase (Decrease) Amount %

Horizontal Analysis Example

ABC CORPORATION Comparative Balance Sheets December 31, 2010 and 2009 2010 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets $ 12,000 $ 60,000 80,000 3,000 155,000 40,000 120,000 160,000 315,000 $ 23,500 $ (11,500) 40,000 20,000 100,000 (20,000) 1,200 1,800 164,700 (9,700) 40,000 85,000 125,000 289,700 $ 35,000 35,000 25,300 (48.9) 50.0 (20.0) 150.0 (5.9) 0.0 41.2 28.0 8.7 2009 Increase (Decrease) Amount %

Horizontal Analysis Example

Lets apply the same procedures to the liability and stockholders equity sections of the balance sheet.

ABC CORPORATION Comparative Balance Sheets December 31, 2010 and 2009 2010 Liabilities and Stockholders' Equity Current liabilities: Accounts payable Notes payable Total current liabilities Long-term liabilities: Bonds payable, 8% Total liabilities Stockholders' equity: Preferred stock Common stock Additional paid-in capital Total paid-in capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity 2009 Increase (Decrease) Amount %

67,000 $ 3,000 70,000 75,000 145,000 20,000 60,000 10,000 90,000 80,000 170,000 315,000 $

44,000 $ 6,000 50,000 80,000 130,000 20,000 60,000 10,000 90,000 69,700 159,700 289,700 $

23,000 (3,000) 20,000 (5,000) 15,000 10,300 10,300 25,300

52.3 (50.0) 40.0 (6.3) 11.5 0.0 0.0 0.0 0.0 14.8 6.4 8.7

Horizontal Analysis Example

Now, lets apply the procedures to the income statement.

ABC CORPORATION Comparative Income Statements For the Years Ended December 31, 2010 and 2009 Increase (Decrease) 2010 2009 Amount % Net sales $ 520,000 $ 480,000 $ 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) Operating expenses 128,600 126,000 2,600 2.1 Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

ABC CORPORATION Comparative Income Statements For the Years Ended December 31, 2010 and 2009 Increase (Decrease) 2010 2009 Amount % Net sales $ 520,000 $ 480,000 $ 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) Operating expenses 128,600 126,000 2,600 2.1 Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Sales increased by 8.3% while net Net income before taxes 25,000 32,000 (7,000) (21.9) income decreased by 21.9%. Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the ABC CORPORATION increase inComparative Income Statements sales, yielding an overall For the Years Ended December 31, 2010 and 2009 decrease in net income.
Net sales Cost of goods sold Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income 2010 $ 520,000 360,000 160,000 128,600 31,400 6,400 25,000 7,500 $ 17,500 2009 $ 480,000 315,000 165,000 126,000 39,000 7,000 32,000 9,600 $ 22,400 Increase (Decrease) Amount % $ 40,000 8.3 45,000 14.3 (5,000) (3.0) 2,600 2.1 (7,600) (19.5) (600) (8.6) (7,000) (21.9) (2,100) (21.9) $ (4,900) (21.9)

Vertical Analysis Example

The management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company.

Vertical Analysis Example

Sample Company Balance Sheet (Assets) At December 31, 1999 and 1998 % of Total Assets 1999 1998 1999 1998 Cash $ 82,000 $ 30,000 17% 8% Accts. Rec. 120,000 100,000 25% 26% Inventory 87,000 82,000 18% 21% Land 101,000 90,000 21% 23% Equipment 110,000 100,000 23% 26% Accum. Depr. (17,000) (15,000) -4% -4% Total $ 483,000 $ 387,000 100% 100%

Vertical Analysis Example

Sample Company Balance Sheet (Assets) At December 31, 1999 and 1998 % of Total Assets 1999 1998 1999 1998 Cash $ 82,000 $ 30,000 17% 8% Accts. Rec. 120,000 100,000 25% 26% Inventory 87,000 82,000 18% 21% $82,000 $483,000 = 17% rounded Land 101,000 90,000 21% 23% $30,000 $387,000 100,000 rounded = 8% Equipment 110,000 23% 26% Accum. Depr. (17,000) (15,000) -4% -4% Total $ 483,000 $ 387,000 100% 100%

Vertical Analysis Example

Sample Company Balance Sheet (Liabilities & Stockholders' Equity) At December 31, 1999 and 1998 % of Total Assets 1999 1998 1999 1998 Acts. Payable $ 76,000 $ 60,000 16% 16% Wages Payable 33,000 17,000 7% 4% Notes Payable 50,000 10% $76,000 $483,000 = 50,000 rounded 13% 16% Common Stock 170,000 160,000 35% 41% Retained Earnings 154,000 100,000 32% 26% Total $ 483,000 $ 387,000 100% 100%

Trend Percentages Example

Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.
Wheeler, Inc. Operating Data 1998 1997 $ 2,244 $ 2,112 1,966 1,870 $ 278 $ 242

1999 Revenues $ 2,405 Expenses 2,033 Net income $ 372

1996 $ 1,991 1,803 $ 188

1995 $ 1,820 1,701 $ 119

Trend Percentages Example

Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.
Wheeler, Inc. Operating Data 1998 1997 $ 2,244 $ 2,112 1,966 1,870 $ 278 $ 242

1999 Revenues $ 2,405 Expenses 2,033 Net income $ 372

1996 $ 1,991 1,803 $ 188

1995 $ 1,820 1,701 $ 119

$1,991 - $1,820 = $171

Trend Percentages Example

Using 1995 as the base year, we develop the following percentage relationships.
Wheeler, Inc. Operating Data 1998 1997 123% 116% 116% 110% 234% 203%

Revenues Expenses Net income

1999 132% 120% 313%

1996 109% 106% 158%

1995 100% 100% 100%

$1,991 - $1,820 = $171 $171 $1,820 = 9% rounded

140 130
% of 100 Base

Trend line for Sales

120

110
100

90
Sales
Expenses

1995

1996

1997

1998

1999

Years

Ratios
Ratios can be expressed in three different ways:
1. Ratio (e.g., current ratio of 2:1) 2. % (e.g., profit margin of 2%) 3. $ (e.g., EPS of $2.25)

Using ratios and percentages without considering the underlying leads to incorrect conclusions.

Categories of Ratios
Liquidity Ratios Equity (Long-Term Solvency) Ratios Profitability Tests
Show relationship between debt and equity financing in a company Relate income to other variables Help assess relative merits of stocks in the marketplace

Indicate a companys short-term debt-paying ability

Market Tests

Important Considerations
Need for comparable data
Data is provided by different companies. Must compare by industry

Influence of external factors

General business conditions Seasonal nature of business operations

Impact of inflation