23 - 1

Analyzing Financial Statements

Chapter 23

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Preparing comparative

balance sheets.

Learning Objective 1

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Assets 20x8 20x7 Change %

Current Assets:

Cash $ 3,040 $ 4,080 $(1,040)(25.5)

Accounts Receivable Net 20,000 16,000 4,000 25.0

Merchandise Inventory 24,160 26,120 (1,960) (7.5)

Prepaid Expenses 80,000 60,000 200 33.3

Total Current Assets $ 48,000 $ 46,800 $ 1,200 2.6

Plant and Equipment

Office Equipment, Net $125,200 $116,800 $ 8,400 7.2

Total Assets $173,200 $163,600 $ 9,600 5.9

Comparative Balance Sheets

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Liabilities 20x8 20x7 Change %

Current Liabilities:

Notes Payable $20,960 $17,320 $3,640 21.0

Accounts Payable 240 280 (40)(14.3)

Total Current Liabilities $21,200 $17,600 $3,600 20.5

Long-Term Liabilities:

Mortgage Payable $60,000 $60,000 -0- -0-

Total Liabilities $81,200 $77,600 $3,600 4.6

Comparative Balance Sheets

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Stockholders’ Equity 20x8 20x7 Change %

Common Stock, $10 par $ 60,000 $ 60,000 -0- -0-

Retained Earnings 32,000 26,000 $6,000 23.1

Total Stockholders’ Equity $ 92,000 $ 86,000 $6,000 7.0

Total Liabilities andStockholders’ Equity $173,200 $163,600 $9,600 5.9

Comparative Balance Sheets

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Using horizontal and vertical

analysis techniques.

Learning Objective 2

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Learning Unit 23-1

What is horizontal analysis? Comparative balance sheets are analyzed

for percentages of change – increases or (decreases).

Compute the dollar change from the base period to the later period.

Divide the dollar change by the base period amount.

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20x8 20x7 DifferenceCash $3,040 $4,080 $(1,040)

20x8 20x7 DifferenceCash $3,040 $4,080 $(1,040)

$1,040 ÷ $4,080 = .2549, or 25.5%$1,040 ÷ $4,080 = .2549, or 25.5%

Learning Unit 23-1

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Learning Unit 23-1

Vertical analysis compares each item on a report to a base number set to 100%.

The base will be either total assets or total liabilities and stockholders’ equity on a balance sheet.

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Learning Unit 23-1

Assets 20x8 %Current Assets:Cash $ 3,040 1.8Accounts Receivable Net 20,000 11.5Merchandise Inventory 24,160 13.9Prepaid Expenses 800 .5Total Current Assets $ 48,000 27.7Plant and EquipmentOffice Equipment, Net $125,200 72.3Total Assets $173,200 100.0

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Learning Unit 23-2

Comparative income statement changes are shown also as percentage increases or decreases.

In the case of the income statement, each item is shown as a percentage of net sales.

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Learning Unit 23-2

20x8 %Net Sales $317,600 100.0Cost of Goods Sold 198,000 62.3Gross Profit from Sales $119,600 37.7Total Operating Expenses 83,600 26.3Operating Income $ 36,000 11.3Less Interest Expense 4,200 1.3Income Before Taxes $ 31,800 10.0Income Taxes 15,900 5.0Net Income $ 15,900 5.0

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Trend % = Any year $ ÷ Base year $Trend % = Any year $ ÷ Base year $

Learning Unit 23-2

What is trend analysis? It is a special type of horizontal analysis

that deals with the percentage of changes in certain key items over several years.

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Year 20x8 20x7 20x5Sales $317,600 $302,000 $270,000Cost of Goods Sold 198,000 194,000 142,000Gross Profit $119,600 $108,000 $128,00020x5 is the base year.

Year 20x8 20x7 20x5Sales $317,600 $302,000 $270,000Cost of Goods Sold 198,000 194,000 142,000Gross Profit $119,600 $108,000 $128,00020x5 is the base year.

What are the trend percentages?What are the trend percentages?

Learning Unit 23-2

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Year 20x8 20x7 20x5Sales 118% 112% 100%Cost of Goods Sold 139% 137% 100%Gross Profit 93% 84% 100%

Year 20x8 20x7 20x5Sales 118% 112% 100%Cost of Goods Sold 139% 137% 100%Gross Profit 93% 84% 100%

Learning Unit 23-2

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Calculating the four different types of ratios: liquidity

ratios, asset management ratios, debt management ratios,and profitability ratios.

Learning Objective 3

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Learning Unit 23-3

A ratio is the relationship of two quantities or numbers, one divided by the other.

Ratios can be compared over time for one business.

They also can be compared to readily available industry ratios.

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Acid test ratio =(Current assets – Merchandise inventory– Prepaid expenses) ÷ Current liabilities

Acid test ratio =(Current assets – Merchandise inventory– Prepaid expenses) ÷ Current liabilities

Current ratio =Total current assets ÷ Total current liabilities

Current ratio =Total current assets ÷ Total current liabilities

Liquidity RatiosLiquidity Ratios

Learning Unit 23-3

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Learning Unit 23-3

The current ratio indicates ability to pay short-term obligations.

The acid test, or quick, ratio shows availability of assets that can easily be converted to cash to pay current liabilities.

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Average collection period =365 days ÷ Accounts receivable turnover

Average collection period =365 days ÷ Accounts receivable turnover

Accounts receivable turnover =Net credit sales ÷ Average accounts receivable

Accounts receivable turnover =Net credit sales ÷ Average accounts receivable

Asset Management RatiosAsset Management Ratios

Learning Unit 23-3

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Accounts receivable turnover shows how many times accounts receivable is

converted to cash in one year.

Accounts receivable turnover shows how many times accounts receivable is

converted to cash in one year.

Learning Unit 23-3

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Asset turnover = Net sales ÷ Total assetsAsset turnover = Net sales ÷ Total assets

Inventory turnover = Cost of goods sold÷ Average inventory

Inventory turnover = Cost of goods sold÷ Average inventory

Learning Unit 23-3

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Learning Unit 23-3

The inventory turnover calculates the number of times inventory turns over in one period.

The asset turnover indicates whether or not assets have been used efficiently to generate sales.

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Debt to stockholders’ equity =Total liabilities ÷ Stockholders’ equity

Debt to stockholders’ equity =Total liabilities ÷ Stockholders’ equity

Debt to total assets =Total liabilities ÷ Total assets

Debt to total assets =Total liabilities ÷ Total assets

Debt Management RatiosDebt Management Ratios

Learning Unit 23-3

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Learning Unit 23-3

The debt-to-total-assets ratio indicates the amount of assets that are financed by creditors.

The debt-to-stockholders’-equity ratio shows stockholders’ risk compared to creditors’ risk.

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Times interest earned =Income before taxes and interest expense

÷ Interest expense

Times interest earned =Income before taxes and interest expense

÷ Interest expense

It reveals ability to meet interestpayment due dates.

It reveals ability to meet interestpayment due dates.

Learning Unit 23-3

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Return on sales =Net income before taxes ÷ Net sales

Return on sales =Net income before taxes ÷ Net sales

Gross profit rate = Gross profit ÷ Net salesGross profit rate = Gross profit ÷ Net sales

Profitability RatiosProfitability Ratios

Learning Unit 23-3

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SALES

Learning Unit 23-3

The gross profit ratio indicates how much of the sales income is available to pay expenses and generate a net income.

A high return on sales ratio usually means that inventory consists of high priced items such as autos and furniture.

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Learning Unit 23-3

Rate of return on common stockholders’ equity =(Net income before taxes – preferred dividends) ÷

Common stockholders’ equity

Rate of return on common stockholders’ equity =(Net income before taxes – preferred dividends) ÷

Common stockholders’ equity

Rate of return on total assets =Net income before interest and taxes ÷ Total assets

Rate of return on total assets =Net income before interest and taxes ÷ Total assets

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Learning Unit 23-3

The rate of return on total assets indicates earning power.

The rate of return on common stockholders’ equity shows the amount of the net income share that remains for the common stockholders (after preferred dividends are deducted).

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End of Chapter 23