ANALYZING FINANCIAL STATEMENTS -- 8



ANALYZING FINANCIAL STATEMENTS – 12.3

➢ Used by owners/managers/investors/creditors/shareholders to evaluate the stability and growth of a business

➢ To make it easier to understand meaningful information, comparative, common size and trend analysis may be used

➢ Management will attempt to find reason for change

➢ The longer the period compared, the better for observing trends

1. COMPARATIVE ANALYSIS

When comparing financial statements for two consecutive years, find the:

a. dollar amount of the increase/decrease from year 1 to year 2

Year 1 Year 2 Increase/decrease

Company A 270 000 290 000 ______________

Company B 10 000 30 000 ______________

➢ can indicate the direction of the business; if all numbers are increasing, then there should be an overall increase in company performance

➢ not as useful as percentage change

b. percentage amount of the increase/decrease from year 1 to year 2

Percentage Change = Difference/Base Year x 100

Both Companies A & B increase by $20 000, however, Company A’s percentage increase is only __% compared to Company B’s percentage increase of __%.

➢ Useful for year to year comparisons showing owner/manager areas to investigate

➢ Indicates whether amounts are within proper range

➢ Percentages can depend on many different factors (ie. size of market, competition, product etc.)

1. COMMON-SIZE ANALYSIS

Common-size financial statements are based on a common percentage framework.

a. Income Statement – net sales (revenue) will represent 100% and all other account balances will be compared to this figure and analyzed

b. Balance Sheet -- total assets will represent 100% and the % of each asset will be compared to this figure; total liabilities and owner’s equity will represent 100% and liability and owner’s equity figures will be compared to this figure

➢ Data in common-size form can be easily analyzed, not only within one company, but by comparing percentages relative between two companies.

2. TREND ANALYSIS

Trend analysis shows financial data (as figures and percentages) over a number of consecutive periods.

Year 1 Year 2 Year 3 Year 4 Year 5

Sales 55 000 60 000 75 000 45 000 105 000

Sales % 100% ____% ____% ____% ____%

Comparison Year/Base Year * 100 = Percentage change

➢ Not easy to interpret figures by just looking at them; so convert them to percentages or to a graph and they can be more easily analyzed

➢ For meaningful analysis, one trend must be compared with some other related trend, ie. what do you think if current assets increase by 7% when current liabilities increase by 70%?

3. Accountability, Users of Financial Statements, Quality of Financial Statements, and 3 new GAAPs.

3. Assignment:

12.3 Read p. 567-573 (t) and answer review questions #1 to 5, p. 583 (t), p. 470 (w).

Complete all parts of exercises 1, 2 p. 584 (t), p. 471-473 (w).

Trend Analysis:

1.

a) prepare a percentage trend analysis for the following sales data and complete the chart

| |Year 1 |Year 2 |Year 3 |Year 4 |Year 5 |

|Sales |$20 700 |$22 356 |$23 184 |$23 805 |$24 219 |

|Percent of Year 1 | | | | | |

|Increase in Percentage | | | | | |

b) Describe the sales performance that these data indicate:

2.

a) Complete the percentage trend analysis in the space provided. Do your calculations to one decimal place.

| |

|Year End December 31, 20-8 |

| |Company A |Company B |

|Revenue | | | | |

| Sales |$197 000 |________% |$421 000 |________% |

| | | | | |

|Expenses | | | | |

| Automotive Expense |$ 40 200 |________% |$ 80 279 |________% |

| Bank Interest Expense |3 500 |________% | 27 050 |________% |

| Rent Expense |12 000 |________% |30 000 |________% |

| Wages Expense |86 750 |________% |214 860 |________% |

| Other Expenses | 1 800 |________% |__10 900 |________% |

| Total Expenses |$144 250 |________% |$363 080 |________% |

| | | | | |

|Net Income |$ 52 750 |________% |$ 57 920 |________% |

a) Convert the above statements to common-size form

b) Suppose that you are an investor interested in purchasing one of these two companies. Evaluate the two companies, giving reasons. State which company appears to be the better buy. What additional important data do you require before you can make a final decision?

KEY RATIOS & PERCENTAGE ANALYSIS – Chapter 12.3

Now that we have worked with percentage changes in comparative, common-size, and trend analysis, let’s apply these changes as ratios and percentages that will help to interpret the financial statements of a business.

1. Define the following terms:

a. SOLVENCY –

b. LIQUIDITY –

2. Accounting ratios may be divided into two distinct groups:

a. liquidity or solvency ratios—used to decide how easily a company can pay its debts

b. profitability ratios—used to evaluate a company’s ability to earn profit

Complete the chart below for the ratios indicated. For each ratio, include the formula and a brief explanation of what the ratio represents (ie. Why it is a useful ratio for financial statement analysis). Refer to pages 573-577 in textbook for the necessary information to complete the chart.

RATIO ANALYSIS

|RATIO |FORMULA |PURPOSE OF RATIO |

|Current Ratio or Working Capital Ratio | | |

| | | |

|DEBT RATIO | | |

| | | |

| | | |

|EQUITY RATIO | | |

| | | |

| | | |

|Rate of Return on Sale | | |

| | | |

| | | |

|Rate of Return on Owner’s Equity | | |

| | | |

3. Calculate the five ratios above for Ex. 3 p. 585 (t) & Ex. 7 p.607-608 (t) on a separate piece of paper. Be sure to include the formula, numbers used to calculate the ratio and a brief explanation of whether the ratio calculation is poor, fair, good, or very good.

4. Optional: Complete Ex. 4 p. 586 (t), p. 586 (w)

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