Chapter 16

How to Read, Analyze,

and Interpret
Financial Reports

McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

#16

How to Read, Analyze, and Interpret

Financial Reports

Learning Unit Objectives

Balance
Sheet
-Report
as
of
a
LU16.1
Particular Date
1. Explain the purpose and the key items

on the balance sheet

2. Explain and complete vertical and

horizontal analysis

16-2

#16

How to Read, Analyze, and Interpret

Financial Reports

Learning Unit Objectives

Income Statement -- Report for a
LU16.2
Specific Period of Time
1. Explain the purpose and the key items

on the income statement

2. Explain and complete vertical and

horizontal analysis

16-3

#16

How to Read, Analyze, and Interpret

Financial Reports

Learning Unit Objectives

LU16.3 Trend and Ratio Analysis
1. Explain and complete a trend analysis
2. List, explain, and calculate key

financial ratios

16-4

Accounting Equation

Accounting Equation: Assets = Liabilities + Owners Equity

16-5

Balance Sheet
Gives a financial picture of what a company is worth as
of particular date.

How
much the
company
owns
16-6

Assets

Liabilities
+
Owners
Equity

How
much the
company
owes

How
much the
owner is
worth

Figure 16.1 - Elements of the Balance Sheet

MOOL COMPANY
Balance Sheet
December 31, 2011

Assets broken down

into current assets and
plant and equipment.

Assets
a. Current assets:
b. Cash

$ 7,000

c. Accounts receivable
9,000
d. Merchandise inventory
30,000
e. Prepaid expenses
15,000
f.
Total current assets
g. Plant and equipment:
h. Building (net)
$60,000
i. Land
84,000
j.
Total plant and equipment

k. Total assets

Liabilities
a. Current liabilities:
b. Accounts payable

$61,000

$205,000
Total of current assets
and plant and equipment.
(Total is double- ruled)

16-7

Liabilities broken
down into current
and long-term

$ 80,000

c. Salaries payable
d.
Total current liabilities
e. Long-term liabilities:
f.
Mortgage note payable
g.
Total liabilities

144,000 a.
b.
c.
d.

12,000
$ 92,000
58,000
$150,000

Stockholders Equity
Common stock
Retained earnings
Total stockholders equity
Total liab. and stkhlds equity

$ 20,000
35,000
55,000
$205,000

Total of all liabilities

and stockholders
equity.

Preparing a Vertical Analysis of a Balance Sheet

Step 2. Round each liability
and stockholders equity (the
portions) as a percent of total
liabilities and stockholders
equity (the base). Round as
indicated.

Step 1. Divide

each asset
(the portion) as a percent
of total assets (the base).
Round as indicated.

16-8

Figure 16.2 - Comparative Balance Sheet:

Vertical Analysis
* Due to rounding

Assets

ROGER COMPANY
Comparative Balance Sheet
December 31, 2010 and 2011
2011
Amount Percent

Current Assets:
Cash
Accounts Receivable
Merchandise inventory
Prepaid rent
Total current assets
Plant and equipment:
Building (net)
Land
Total plant and equipment
Total assets

16-9

2010
Amount Percent

$22,000
8,000
9,000
4,000
$43,000

25.88
9.41
10.59
4.71
50.59

$18,000
9,000
7,000
5,000
$39,000

$18,000
24,000
$42,000
$85,000

21.19
28.24
49.41*
100.00

$18,000
24,000
$42,000
$81,000

22.22
11.11
8.64
6.71
48.15*
22.22
29.63
51.85
100.00

Figure 16.2 - Comparative Balance Sheet:

Vertical Analysis
* Due to rounding

Liabilities

ROGER COMPANY
Comparative Balance Sheet
December 31, 2010 and 2011
2011
Amount Percent

Current liabilities:
Accounts payable
Salaries payable
Total current liabilities
Long-term liabilities:
Mortgage note payable
Total liabilities

2010
Amount Percent

$14,000
18,000
$32,,000

16.47
21.18
37.65

$8,000
17,000
$25,000

9.88
20.99
30.86*

$12,000
$44,000

14.12
51.76*

$20,000
$25,000

24.69
30.86*

Common stock
$20,000
Retained earnings
21,000
Total Stockholders equity
$41,000
Total Liabilities and Stockholders Equity $85,000

23.53
24.71
48.24
100.00

$20,000
16,000
$36,000
$81,000

24.69
19.75
44.44
100.00

Stockholders Equity

16-10

Preparing a Horizontal Analysis

of a Comparative Balance Sheet
Step 1. Calculate the increase
or decrease (portion) in each
item from the base year.

Step 2. Divide the increase or

decrease in Step 1 by the old or
base year.
Step 3. Round as
indicated.
16-11

Figure 16.3 - Comparative Balance Sheet:

Horizontal Analysis
ABBY ELLEN COMPANY
Comparative Balance Sheet
December 31, 2010 and 2011
Assets
Current Assets:
Cash
Accounts Receivable
Merchandise inventory
Prepaid rent
Total current assets
Plant and equipment:
Building (net)
Land
Total plant and equipment
Total assets
16-12

2011

2010

Increase(decrease)
Amount Percent

$ 6,000
5,000
9,000
5,000
$25,000

$ 4,000
6,000
4,000
7,000
$21,000

$ 2,000
(1,000)
5,000
(2,000)
$ 4,000

$12,000
18,000
$30,000
$55,000

$12,000
18,000
$30,000
$51,000

0
0
0
$4,000

50.00
-16.67
125.00
-28.57
19.05
0
0
0
7.84

Figure 16.3 - Comparative Balance Sheet:

Horizontal Analysis
ABBY ELLEN COMPANY
Comparative Balance Sheet
December 31, 2010 and 2011

Liabilities
Current liabilities:
Accounts payable
Salaries payable
Total current liabilities
Long-term liabilities:
Mortgage note payable
Total Liabilities

2010

2011

Increase(decrease)
Amount Percent

$ 3,200
2,900
$ 6,100

$ 1,800
3,200
5,000

$ 1,400
(300)
1,100

77.78
-9.38
22.00

17,000
$ 23,100

15,000
20,000

2,000
3,100

13.33
15.50

$31,900
$55,000

31,000
51,000

$ 900
$4,000

2.90
7.84

Owners Equity
Abby Ellen, capital
Total liabilities and owners equity

16-13

Income Statement
e
Incom nt
e
Statem

A financial report that tells how well a

company is performing (its profitability or net
profit) during a specific period of time.

Retail Business
Service Business

Revenues (Sales)

Revenues

- Cost of merchandise sold

-Operating Expenses

= Gross profit from sales

=Net Income

- Operating Expenses
= Net Income (Profit)

16-14

Figure 16.4 - Income Statement

MOOL COMPANY
Income Statement
For Month Ended December 31, 2011

16-15

Revenues
a. Gross Sales
b. Less: Sales returns and allowances
c.
Sales discounts
d. Net Sales
Cost of merchandise (goods) sold:
a. Merchandise Inventory 12/1/2004
b. Purchases
c. Less: Purchases returns and allowances $336
d. Less: Purchase discounts
204
e. Cost of net purchases
f. Cost of merchandise (goods available for sale)
g. Less: Merchandise inventory 12/31/2004
h. Cost of merchandise (goods sold)
Gross profit from sales
Operating expenses:
a. Salary
b. Insurance
c. Utilities
d. Plumbing
e.
Rent
410
f. Depreciation
g.
Total operating expenses
Net income

$ 1,082
432

$10,512
540

$22,080
1,514
$ 1,248

9,972
$11,220
1,600

$20,566

9,620
$10,946

$ 2,200
1.300
400
120
200

4,630
$ 6,316

Key Calculations on Income Statement

Net sales = Gross sales - Sales returns and - Sales discounts
Allowances
Cost of
merchandise = Beginning +
(goods) sold
inventory

Net purchases
(purchase less
- Ending
returns & discounts) inventory

Gross profit = Net sales - Cost of merchandise

from sales
(goods) sold

Net income = Gross profit - Operating expenses

16-16

Figure 16.5 - Income Statement

Vertical Analysis
ROYAL COMPANY
Comparative Income Statement
For Years Ended December 31, 2010 and 2011
2011
Percent
2010
of net
Net Sales
$45,000
100.00
$29,000
Cost of merchandise sold
19,000
42.22
12,000
Gross profit from sales
$26,000
57.78
$17,000
Operating expenses:
Depreciation
$1,000
2.22
$ 500
Selling and Advertising
4,200
9.33
1,600
Research
2,900
6.44
2,000
Miscellaneous
500
1.11
200
Total operating expenses
$8,600
19.11*
$ 4,300
Income before interest and taxes
$17,400
38.67
$12,700
Interest expense
6,000
13.33
3,000
Income before taxes
$11,400
25.33*
$ 9,700
Provision for taxes
5,500
12.22
3,000
Net income
$ 5,900
13.11
$ 6,700
* Due to rounding
16-17

Percent
of net
100.00
41.38
58.62
1.72
5.52
6.90
.69
14.83
43.79
10.34
33.45
10.34
23.10*

Figure 16.6 - Horizontal Analysis

Income Statement
FLINT COMPANY
Comparative Income Statement
For Years Ended December 31, 2010 and 2011
2011
2010
Increase (decrease)
Amount Percent
Sales
$ 90,000 $80,000
$10,000
Sales returns and allowances
2,000
2,000
0
Net Sales
$88,000 $78,000
$10,000 + 12.82
Cost of merchandise sold
45,000
40,000
5,000
+ 12.50
Gross profit from sales
$43,000 $38,000
$ 5,000 + 13.16
Operating expenses:
Depreciation
$ 6,000 $ 5,000
$ 1,000 + 20.00
Selling and Advertising
16,000
12,000
4,000
+ 33.33
Research
600
1,000
(400) - 40.00
Miscellaneous
1,200
500
700
+ 140.00
Total operating expenses
$23,800 $18,500
$ 5,300 + 28.65
Income before interest and taxes
$19,200 $19,500
$ (300)
- 1.54
Interest expense
4,000
4,000
0
Income before taxes
$15,200 $15,500
$ (300) - 1.94
Provision for taxes
3,800
4,000
(200) - 5.00
Net income
$11,400
$11,500
$ (100) .87
16-18

Completing a Trend Analysis

Analyzes the changes that occur by expressing
each number as a percent of the base year
Each Item
Base Amount
Step 1.
Select the
base year
(100%)

16-19

Step 2. Express
each amount as a
percent of the base
year amount
(rounded to the
nearest whole
percent)

Trend Analysis
Given (base year 2009)
2012

2011

2010

2009

$621,000

$460,000

$340,000

$420,000

Gross Profit

182,000

141,000

112,000

124,000

Net Income

48,000

41,000

22,000

38,000

Sales

Trend Analysis
2012

2011

2010

2009

Sales*

148%

110%

81%

100%

Gross Profit

147

114

90

100

Net Income

126

108

58

100

* Round to nearest whole percent

16-20

$340,000
$420,000

Ratio Analysis
A relationship of one number to another. Used
to make comparisons versus previous performance
or other companies

Asset Management ratios

How well the company
manages its assets

Profitability ratios
The companys
profitability picture

16-21

Debt Management ratios

The companys debt
situation

Summary of Key Ratios

Current ratio = Current assets
Current liabilities
Industry average, 2 to 1
Acid test (quick ratio) = Current assets - inventory-prepaid expenses
Current liabilities
Industry average, 1 to 1
Average days collection = Accounts receivable
Net sales
360
Industry average, 90-120 days
Total debt to total assets = Total liabilities
Total assets

Industry average, 50% - 70%

16-22

Summary of Key Ratios

Return on equity =

Net Income
Stockholders equity

Industry average, 15% - 20%

Asset turnover =

Net sales
Total assets

Industry average, $.03 to $.08

Profit margin on net sales = Net income
Net sales
Industry average, 25% - 40%
16-23

Problem 16-15:
Return on equity: X = 10%
$15.2
X = 0.10 ($15.2)
X = $1.52 million

16-24

Problem 16-17:
a.
b.

16-25

Total liabilities
Total assets
Net income
Stockholders' equity

$1,768
$2,015 = 87.74%
$147
$427 = 34.43%

c.

Net sales
Total assets

$265
$2015 = 13

d.

Net income
Net sales

$147
$265 = 55.47%

Problem 16-18:
2009
Sales 98%
$3,154
$3,216
= 98.072139
= 98%
16-26

2008

2007

2006

106%

100%

98%

100%

$3,414
$3,216

$3,208
$3,216

$3,152
$3,216

$3,216
$3,216

= 106.15671
=106%

= 99.751243
= 100%

= 98.00995
= 98%

2005

=100%