23–1McQuaig Bille

11College Accounting10th Edition

McQuaig Bille Nobles

© 2011 Cengage Learning

PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University

Chapter 23Comparative Financial Statements

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Accounting LanguageAccounting Language Accounting is the process of analyzing,

classifying, recording, summarizing, and interpreting business transactions.

Everybody is interested in two aspects of an enterprise:

1. Its solvency, or its ability to pay its debts.

2. Its profitability, or its ability to earn a reasonable profit on the owners’ investment.

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Types of ComparisonsTypes of Comparisons

A company’s financial statements are meaningful only if you analyze them on a comparative basis. Three bases are useful for making such a comparison:

1. Statements of the same company for the current year and one or more prior years.

2. Financial data for other companies in the same industry.

3. Previously established financial standards or objectives.

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Horizontal Analysis—Income Statement

Horizontal Analysis—Income Statement

Horizontal analysis is a comparison of the same item in a company’s financial statements for two or more periods.

We will analyze the comparative income statements for Dynamo Bike Shop, Inc.

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$120,400

$861,700= 14.0%Sales

Horizontal Analysis—Income Statement

Horizontal Analysis—Income Statement

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$(600)

$13,100= (4.6)%

Sales Returns and Allowances

Horizontal Analysis—Income Statement

Horizontal Analysis—Income Statement

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$20,070

$184,400= 10.9%

Total Operating Expenses

Horizontal Analysis—Income Statement

Horizontal Analysis—Income Statement

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$6,360

$69,530= 9.1%Net Income

Horizontal Analysis—Income Statement

Horizontal Analysis—Income Statement

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By using the Total Asset section of the comparative balance sheet, let’s calculate the percentage change for Cash and Merchandise Inventory. Then, we will calculate the change in Accounts Payable using the Liabilities and Stockholders’ Equity sections of Dynamo Bike Shop Inc.’s balance sheet.

Horizontal Analysis—Balance SheetHorizontal Analysis—Balance Sheet

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$(16,900)

$38,900= (43.7)%Cash

Horizontal Analysis—Balance SheetHorizontal Analysis—Balance Sheet

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$141,900

$206,500= 68.7%

Merchandise Inventory

Horizontal Analysis—Balance SheetHorizontal Analysis—Balance Sheet

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$41,100

$29,000= 141.7%

Accounts Payable

Horizontal Analysis—Balance SheetHorizontal Analysis—Balance Sheet

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Using vertical analysis, you can see in a single statement the relationship of each part to the whole.

When you arrange an income statement for vertical analysis, you express each item as a percentage of net sales.

Vertical Analysis—Income StatementVertical Analysis—Income Statement

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$306,700

$969,600= 31.6%

Gross Profit, 2011

Vertical Analysis—Income StatementVertical Analysis—Income Statement

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$279,800

$848,600= 33.0%

Gross Profit, 2010

Vertical Analysis—Income StatementVertical Analysis—Income Statement

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In 2011, the vertical analysis provided a 31.6 percent ratio of Gross Profit to Net Sales. This can be interpreted to mean that for every $100 in net sales, gross profit was $31.60.

In 2010, the ratio of Gross Profit to Net Sales was 33.0%. This means that for every $100 in net sales, gross profit was $33.00.

Vertical Analysis—Income StatementVertical Analysis—Income Statement

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When you perform a vertical analysis of a comparative balance sheet, you express the figure for each item as a percentage of total assets.

Or, you can express the figure for each item as a percentage of the total of liabilities and stockholders equity, which is the same figure.

Vertical Analysis—Balance SheetVertical Analysis—Balance Sheet

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$21,800

$708,200= 3.1%Cash, 2011

Vertical Analysis—Balance SheetVertical Analysis—Balance Sheet

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$38,700

$604,500= 6.4%Cash, 2010

(continued)

Vertical Analysis—Balance SheetVertical Analysis—Balance Sheet

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$76,400

$708,200= 10.8%

Accounts Receivable (net) 2011

Vertical Analysis—Balance SheetVertical Analysis—Balance Sheet

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$78,800

$604,500= 13.0%Accounts

Receivable (net) 2011

rounded

Vertical Analysis—Balance SheetVertical Analysis—Balance Sheet

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$348,400

$708,200= 49.2%Merchandise

Inventory, 2011

Vertical Analysis—Balance SheetVertical Analysis—Balance Sheet

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$206,500

$604,500= 34.2%Merchandise

Inventory, 2010

Vertical Analysis—Balance SheetVertical Analysis—Balance Sheet

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Trend PercentagesTrend Percentages

1. Select a representative year as the base year.

2. Label the base year 100 percent.

3. Express all other years a percentages of the base year.

Here is the way to calculate trend percentages:

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Trend PercentagesTrend Percentages

100.0%

For 2008: $782,380$714,200

= 1.095 x 100 = 109.5%

109.5%

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Trend PercentagesTrend Percentages

100.0%

For 2009: $806,400$714,200

= 1.129 x 100 = 112.9%

109.5% 112.9%

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Trend PercentagesTrend Percentages

100.0%

For 2010: $848,600$714,200

= 1.188 x 100 = 118.8%

109.5% 112.9% 118.8%

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Trend PercentagesTrend Percentages

100.0%

For 2011: $969,600$714,200

= 1.358 x 100 = 135.8%

109.5% 112.9% 118.8% 135.8%

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Trend PercentagesTrend Percentages

Repeat the procedure for Cost of Goods Sold and Gross Profit to get the trend percentage chart.

Observe that, over the five-year period, the trend of Net Sales is upward. However, Cost of Goods Sold is going up at a more rapid rate than Net Sales. This resulted in smaller increases in Gross Profit.

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Industry ComparisonsIndustry Comparisons Vertical analysis, using percentage figures, is

useful when you wish to compare the figures for one company with the average figures for the given industry.

The format of the financial statement defines it as a common-size statement.

Common-size statements can be used to compare one company with another as well as with the industry averages.

Trade and marketing associations often gather information and publish common-size statements.

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Analysis by Creditors and Management

Analysis by Creditors and Management

Bankers and other short-term creditors are primarily interested in the current position of a given firm, which can be assessed using comparative financial statements.

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Working CapitalWorking Capital

Working capital is the excess of current assets over current liabilities.

Working Capital = Current Assets – Current Liabilities

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Current RatioCurrent Ratio

The relationship of a company’s current assets to its current liabilities is its current ratio.

Current Ratio =Current Assets

Current Liabilities

A firm’s current ratio reveals its current debt-paying ability.

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Quick RatioQuick Ratio

The relationship of a company’s current assets that can be quickly converted into cash to its current liabilities is known as is its quick ratio or acid-test ratio.

Quick assets are Cash, Notes receivable, net Accounts Receivable, Interest Receivable, and Marketable Securities.

Quick assets do not include inventories and prepaid expenses.

Quick Ratio =Quick Assets

Current Liabilities

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Quick RatioQuick Ratio

A quick ratio of 1 is considered satisfactory.

Although working capital and a current ratio are two indicators of a firm’s ability to meet its current obligations, they don’t reveal the composition of its current assets—a very important factor.

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Relationship of Each Current Asset to Total Current AssetsRelationship of Each Current Asset to Total Current Assets

$21,800$448,600

= 0.0486 = 4.9%

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Accounts Receivable Turnover

Accounts Receivable Turnover

Accounts receivable turnover is the number of times charge accounts are turned over (or paid off) per year.

A turnover implies a sale on account followed by payment of the debt in cash.

Accounts Receivable

Turnover

Net Sales on AccountAverage Accounts Receivable (Net)=

Average Accounts

Receivable

Beginning Accounts Receivable (Net)

=

Ending Accounts Receivable (Net)+

2

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Merchandise Inventory Turnover

Merchandise Inventory Turnover

Merchandise Inventory Turnover

Cost of Goods SoldAverage Merchandise Inventory

=

Merchandise inventory turnover is the number of times a company’s average inventory is sold during a given year.

Average Merchandise

Inventory

Beginning Merchandise

Inventory=

+

Ending Merchandise

Inventory2

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Ratio of Stockholders’ Equity to Liabilities

Ratio of Stockholders’ Equity to Liabilities

The ratio of stockholders’ equity to liabilities is the ratio of the stockholders’ investment to the creditors’ claims.

Ratio of Stockholders’ Equity to Liabilities

Stockholders’ Equity Liabilities

=

Creditors like to see a high proportion of stockholders’ equity because stockholders’ equity acts as a buffer in case the company has to absorb losses.

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Ratio of Property and Equipment to Long-Term Liabilities

Ratio of Property and Equipment to Long-Term Liabilities

Another factor that provides a margin of safety to mortgage holders and bondholders is the ratio of the value of a firm’s total property and equipment to its long-term liabilities.

This ratio also indicates the potential ability of the enterprise to borrow more money on a long-term basis.Ratio of Property and

Equipment to Long-Term Liabilities

Property and Equipment Long-Term Liabilities

=

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Analysis by Owners and Management

Analysis by Owners and Management

Owners and managers are vitally interested in the value of and return on investment in the company.

In many cases, the owners are the managers.

In other situations, managers are employed by the owners.

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Equity per ShareEquity per Share When you examine the annual report of a

corporation, you encounter the term book value per share, also referred to as equity per share.

If a corporation has only one class of common stock outstanding, the formula for equity per share is straight-forward.

Equity per

Share

Total Stockholders’ Equity Available to a Class of Stock

Number of Shares Issued and Outstanding

=

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Equity per ShareEquity per Share

The term equity per share does not mean the cash value or market value of a share.

It means the amount that would be distributed per share of stock on a book basis if the corporation were to liquidate without incurring any expenses, gains, or losses in selling assets and paying its liabilities.

When there are preferred stock outstanding, you must deduct the liquidation value of the preferred stockholders’ equity, including any dividends in arrears on cumulative preferred stock, to arrive at the stockholders’ equity available to holders of common stock.

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Rate of Return on Common Stockholders’ Equity

Rate of Return on Common Stockholders’ Equity

A corporation exists first and foremost to earn a net income for its stockholders.

The rate of return on the common stockholders’ equity is important as a means of measuring how good or bad the investment is.

The formula:

Rate of Return on Common Stockholders’ Equity =

Net Income Available to Common Stockholders

Average Common Stockholders’ Equity

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Rate of Return on Common Stockholders’ Equity

Rate of Return on Common Stockholders’ Equity

First, you must calculate the average common stockholders’ equity.

Beginning Common Stockholders’ Equity +

Ending Common Stockholders’ Equity

2

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Earnings per Share of Common Stock

Earnings per Share of Common Stock

Earnings per Share of

Common Stock

Net Income Available to Common Stockholders

Average Number of Shares of Common Stock Outstanding

=

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Price-Earnings RatioPrice-Earnings Ratio

The price-earnings ratio is a measure commonly used to determine whether the market price of a corporation’s stock is reasonable.

Price-Earnings Ratio =Market Price per Share

Earnings per Share

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Summary of Analytical ToolsSummary of Analytical Tools

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Summary of Analytical ToolsSummary of Analytical Tools