Chapter 10 - Financial Statement

Analysis
Blast From the Past

BFTP10-1

Below is a listing, in random order, of Joonan Ltd. for the year ended
September 30, 2017. Produce the multiple step income statement, the
statement of retained earnings, and the classified balance sheet in good
form. Additional information has been provided for you.

Additional information: The current portion of long term debt is $13,958.

1|CH10
What will you learn in this chapter?

You know that the goal of accounting is to produce financial statements that
can be used for decision making. Financial statements are used to both
understand and evaluate (assess, judge) the results of business activities.
Managers of a business use financial statements to review past performance
and make decisions for the future. Creditors (banks) assess a business to
make decisions with regards to loans. Owners review the financial
statements to make decisions about future investments. Every stakeholder
which was introduced in Chapter 1 uses the financial statements to make
informed decisions but they can only do that if they analyze the financial
statements in a systematic (organized, orderly) way.

Throughout the chapters, you have reviewed specific financial statement

accounts in isolation but you can only understand and evaluate a business
when you look at the financial statements as a whole. In this chapter, you
will be introduced to vertical and horizontal analysis as well as reviewing the
gross margin and gross profit ratios. By combining your understanding of the
different accounts with the analysis you complete in this chapter will allow
you to gain a deep understanding of a business's financial performance. This
will allow you to assess the past and make decisions about the future.

What is needed to perform an analysis of the financial statements?

Comparative financial statements are required for the business. Note that
the word "comparative" means that the business is providing both the
current year's statements as well as the prior year's statements (sometimes
as many as 4 prior years are provided). This allows stakeholders to
"compare" the financial position and performance over time.

What are the two main types of analysis you will complete?

Businesses can perform horizontal analysis. Horizontal analysis calculates

the trend between one year and the next. It allows you to see the important
changes that have occurred over time. For instance, comparing inventory
balances over time allows a business to see if their inventory levels are
increasing, decreasing, or similar to the prior year. Knowing that, however, is
not enough. Moving on to compare that information to change in sales over
time allows the stakeholder to determine if their inventory levels are
2|CH10
appropriate given change in sales over time. If inventory levels are
increasing from one year to the next but sales have not changed that would
indicate that the business is not controlling their inventory purchases. Recall
from the inventory chapter that rising inventory levels have a cost in that
cash would not be available for other things such as paying down debt. In
addition, rising inventory levels may be problematic because technology
changes may make your existing inventory difficult to sell.

So what is the main goal of horizontal analysis?

The main goal is to identify important trends. Why is this important to

stakeholders, including the business owner? For the business owner it is
important because, sometimes, business owners focus on the day to day
operations and they loss focus on the overall company. Trend analysis helps
the business owner to look at the business as a whole and see which
direction they are headed in.

How is horizontal analysis calculated?

Assume a business has the following information from the income statement
and the balance sheet:

How can we determine if the business has improved their position or not? We
can look at absolute dollar amounts to do so, meaning the amount of the
dollar change. We do this by deducting the new year (2017) from the prior
year (2016) (New - Old):

However, that does not help us compare to another business which may be
larger or smaller. We would want to do this comparison because this is a
3|CH10
benchmark that we can use to see how well we are doing in comparison to
other businesses in the same industry. For instance, there may be a smaller
business, Business B, that has the following balances:

We can do the same analysis using Business B, taking new (2017) and
deducting old (2016):

Let's compare the dollar changes between the two business's in a chart:

Which business has improved the most between 2016 and 2017? It looks
like Business A is in a better position because their change in sales revenue
has been greater ($227,400 compared to only $194,000). Their cash has
gone up by more, their accounts payable has decreased by more Finally,
their owners' capital has increased more. Overall, it looks like Business A is
the better business....or so you think!

It is actually difficult to tell which business did better because absolute

dollars do not allow us to compare businesses (or years) that are different
sizes. To remove the size factor we have to use percentages.

The formula to calculate the horizontal percentage change is as follows:

4|CH10
You can remember this as NOO

Let's do this analysis for Business A and Business B and then see if we can
better compare the two businesses.

Let's put them next to each other so we can see the change between 2017
and 2016 for both businesses clearly:

You can now see that Business B actually increased their sales by more (10%
compared to 6% by Business A). You can also see that they increased their
cash position by 4% more (22% compared to 14%), did a better job at paying
down their accounts payable (18% compared to 6%) and received more
investment from their owners (8% compared to 4%).

Even though, when you were looking at absolute dollar changes, Business A
looked better than Business B, by looking at the percentage change using

5|CH10
horizontal analysis, you discovered that Business B has actually done a
better job at managing their business.

Horizontal analysis can be used to compare different years for the same
business OR compare two businesses to see which has done a better job of
managing their assets, paying off their liabilities, or growing their sales or
profit.

Is there any number where horizontal analysis does not make sense? Yes!
You can not apply horizontal analysis to retained earnings on the balance
sheet. Why not? Because retained earnings is a combination of profit (or
loss) and dividends. Profit increases retained earnings but dividends
decrease retained earnings. Those two changes move in opposite directions
and, therefore, a calculation of the change in retained earnings would not
provide you with any information that you can use for decision making (since
it depends both on profit and dividends, both moving in different directions).
Therefore, it is important to realize that horizontal analysis should never be
used for retained earnings.

Check your understanding (CYU10-1)

The comparative income statement and balance sheet of Akindio Inc. is

provided below for their November 30 year end.

Akindio Inc.
Horizo
Year ended Nov. 30 ntal
Analysi
s
Income Statement 2016 2015
450,0 371,2
Sales revenue 00 50 21.2%
275,0 225,0
Cost of goods sold 00 00 22.2%
175,0 146,2
Gross profit 00 50 19.7%
133,2 113,4
Operating expenses 50 00 17.5%
Interest expense 6,750 5,850 15.4%
35,00 27,00
Profit before income taxes 0 0 29.6%
10,00
Income tax expense 0 6,750 48.1%
Profit 25,00 20,25 23.5%

6|CH10
 0 0

Balance Sheet
10,00 18,00
Cash 0 0 -44.4%
47,50 51,75
Accounts receivable (net) 0 0 -8.2%
100,0 78,75
Inventory 00 0 27%
112,5 85,50
Equipment (net) 00 0 31.6%
270,0 234,0
Total assets 00 00 15.4%
40,00 42,75
Current liabilities 0 0 -6.4%
Long-term liabilities (6% 112,5 101,2
interest) 00 50 11.1%
87,50 78,75
Common shares 0 0 11.1%
30,00 11,25
Retained earnings 0 0 166.7%
270,0 234,0
Total liabilities and equity 00 00 15.4%

Did the business pay any dividends in 2016? If so, how much was paid in
dividends?

Opening retained earnings + profit - dividends = closing retained earnings.

11,250 + 25,000 - X = 30,000

X = 6,250

Should horizontal analysis be performed on retained earnings? No

Complete a horizontal analysis of the income statement and the balance

sheet. Is there anything significant that you can see from your trend
analysis? Be sure to explain why you think it is significant and speculate as
to why it might have happened.

7|CH10
What other analysis can be performed to aid decision making?

You can also perform vertical analysis. Vertical analysis shows the
relationship between different items on the same financial statement. For
instance, you might calculate current assets as a percentage of total assets
for the balance sheet. This shows the contribution that current assets made
to the overall asset position of the business. If you compare this percentage
between two years you can then see if the business has increased or
decreased their current asset position. This is also seen as trend analysis
because you are comparing different years to see if there is a trend
(improving or declining).

Vertical analysis can also be performed between two different businesses

within the same industry. Even if the businesses are different sizes the use of
percentages will allow you to compare them because it removes the factor of
size. When vertical analysis is used to compare two businesses it is called
"common-size" analysis.

Let's see an example to make this clear. Say Bleaue Inc. has current assets of
$82,000,000 and total assets are $196,000,000. Cooper Inc. Is a much
smaller business. They have current assets of $546,000 and total assets of
$982,000. To be able to compare these two businesses you cannot use
absolute dollar amount: 82,000,000 compared to $546,000 does not give
you any information that will allow you to make a choice between the two
businesses. However, by changing the amounts in a percentage of total
assets you gain a better understanding of the performance and financial
position of each of these businesses. Using Bleaue and Cooper as an
example you can see the following:

Bleaue Cooper
Inc. Inc.
Current 82,000,0 546,000
Assets 00
Total 192,000, 982,000
Assets 000
Percentage 43% 56%

Even though Bleaue has a larger dollar amount in current assets the
comparison of current assets to total assets allows you to see that Cooper
has a larger percentage of current assets when compared to total assets.
When assets are current they are more liquid (easier to turn into cash). Note
that, before we make any conclusions, we would have to review the accounts
8|CH10
that make up the current assets. If much of the current assets are in prepaid
expenses (which are used or consumed but not converted into cash) then the
current assets would not be very liquid.

What is the formula for vertical analysis?

The formula for vertical analysis of the balance sheet is as follows:

But what if you want to use horizontal analysis on liabilities or

equity?

If you wish to perform vertical analysis on liabilities or equity you use the
same formula!! Why does that work? Because, for liabilities and equity you
would otherwise use "total liabilities AND equity" as the denominator.
However, remember from Chapter 2 that:

Total Assets = Total Liabilities + Total Equity

That's why the formula is the same regardless of whether you are analyzing
assets OR liabilities OR equity. Everything is simply divided by Total Assets to
obtain the percentage change.

Can you perform vertical analysis on the income statement?

Absolutely! For the income statement you calculate every amount as a

percentage of net sales. You can then compare that amount between
years in one business OR compare the vertical analysis between two
different businesses within the same industry. Both will provide information
that will allow you to assess the business's performance.

Let's look at an example. Below are two years of Joonan Ltd., 2017 and 2016.
Note that we can perform horizontal analysis on this business also but, right
now, we are only focused on vertical analysis. First let's just look at the
information available for Joonan Ltd.

9|CH10
Remember - to perform vertical analysis on an income statement use the
following formula:

In the case of Joonan Ltd. the net sales is the Service Revenue.

10 | C H 1 0
What can we see from this analysis? A lot actually!

Salary expense has decreased from 55.4% to 51.8% of service

revenue. Even though, when we look at absolute dollars, it looks like
the amount has gone down a bit (and it has), considering the increase
in revenues between 2016 and 2017, salaries have actually declined as
a percentage of service revenue, indicating they increased revenue
with no increase in salaries.

Repairs and Maintenance has declined as a percentage of service

revenue, meaning the business has done a better job of controlling for
this expense.

Utilities expenses have increased as a percentage of service revenue

(the absolute dollar amount has increased), and by more than the

11 | C H 1 0
 increase in revenue (why is the business not conserving energy? What
can they do to conserve energy in the future?)

Total operating expenses has decreased from 84.3% of service revenue

to 79.2%, which indicates the business has controlled their expenses at
a time when their service revenue was increasing.

This savings in expenses has resulted in a Profit that is 7.4% of service

revenue compared to last year, when it was 2.1% of service revenue.

As you can see, vertical analysis on the income statement steps away from
absolute dollar comparisons and moves to a comparison to net sales (in this
case, service revenue) to provide a better basis for determining how the
business did. Remember that this comparison has been performed on one
business for 2 years but we can also use vertical analysis to compare two
business.

Check your understanding (CYU10-2)

The comparative income statement and balance sheet of Akindio Inc. is

provided below for their November 30 yearend. Complete a vertical analysis
of the income statement and the balance sheet.

Akindio Inc.
Year ended Nov. 30
Vertic Vertic
al al
Analy Analy
sis sis
Income Statement 2016 2015
450,0 371,2
Sales revenue 00 100% 50 100%
275,0 61.1 225,0 60.6
Cost of goods sold 00 % 00 %
175,0 38.9 146,2 39.4
Gross profit 00 % 50 %
133,2 29.6 113,4 30.5
Operating expenses 50 % 00 %
Interest expense 6,750 1.5% 5,850 1.6%
35,00 27,00
Profit before income taxes 0 7.8% 0 7.3%
10,00
Income tax expense 0 2.2% 6,750 1.8%

12 | C H 1 0
 25,00 20,25
Profit 0 5.6% 0 5.5%

Balance Sheet
10,00 18,00
Cash 0 3.7 0 7.7
47,50 51,75
Accounts receivable (net) 0 17.6 0 22.1
100,0 78,75
Inventory 00 37 0 33.7
112,5 85,50
Property, plant, & equipment 00 41.7 0 36.5
270,0 234,0
Total assets 00 100 00 100
40,00 42,75
Current liabilities 0 14.8 0 18.3
Long-term liabilities (6% 112,5 101,2
interest) 00 41.7 50 43.3
87,50 78,75
Common shares 0 32.4 0 31.5
30,00 11,25
Retained earnings 0 11.1 0 4.8
270,0 234,0
Total liabilities and equity 00 100 00 100

Is there anything significant that you can see from your trend analysis?

Vertical analysis of the income statement shows no major changes.

There is a slight decrease in gross profit as a % of sales revenue but

it is very small.

In line with the horizontal analysis you can see that cost of goods
sold has increased slightly as a % of sales revenue. The business
should watch that in future to ensure this trend does not continue
as it will cause a reduction in gross profit if it does continue.

Vertical analysis of the balance sheet shows that accounts

receivable have decreased (meaning the business is collecting from
their customers).

Inventory has increased as a % of total assets but that is normal

considering that sales have increased by 21.2% (see horizontal
analysis).
13 | C H 1 0
 Property, plant, and equipment have also increased as a % of total
assets but, if the business is expanding to support their higher
sales, this would also be normal.

Current liabilities have declined as a % of total assets, which is

excellent as it means that the business is paying down their debts
as they come due.

Retained earnings is now a larger portion of the total liabilities and

equity but that is because of the high profit from 2015 being added
to the retained earnings for 2016.

What is the most important thing about financial statement

analysis?

Interpreting the results! Students are often able to do the calculations but,
unless you take that additional step and make connections between the
different calculations you have made, your calculations never progress the
analysis necessary to make decisions. You also have to understand the type
of business, such as their industry, in order to better assess the business.
Sometimes that information is not available but, by reviewing the financial
statements, you can learn more. Remember that understanding a business
means understanding something of the industry that business operates in.
That understanding is important to your analysis.

What about the statement of cash flows?

Remember that the purpose of the statement of cash flows is to explain the
change in cash from the beginning of the year to the end of the year by
looking at the inflows and outflows of cash within the three different
activities. Cash is an important asset because it allows a business to pay for
their debts as they come due. Without cash a business would not be able to
pay off their accounts payable or the interest on their debt. It is for this
reason that the statement of cash flows is considered an important
statement for stakeholders to understand and analyze.

What are the three business activities on the statement of cash

flows?

Recall that the statement of cash flows is divided between operating,

investing, and financing activities. All of these activities are important when

14 | C H 1 0
analyzing the statement of cash flows and understanding the three activities
helps stakeholders to assess a business.

What is cash flow from operating activities and why is it important?

Cash from operating activities is often called the life blood of a business.
Although businesses can increase their cash inflow through investing
activities (selling property, plant, equipment, intangibles) and financing
activities (increasing their loans or capital contributions from owners) these
sources of cash cannot be used forever. Consider: if a business sells the
majority of their property, plant, and equipment how will they continue to
operate? Selling old equipment in order to replace them is expected but if a
business sells their property, plant, and equipment to generate cash inflows
long term they will, eventually, have no long term assets to run their
business! The same is true of financing activities: a business may need to
borrow from banks or get additional capital contributions from the owners in
order to expand but they cannot do that forever. Eventually the banks will
stop lending the business money or owners will no longer contribute cash,
particularly if this is the only way the business has to increase cash.

Long term, the only sustainable source of cash are positive cash inflows from
operating activities. Why? Because sustainable cash flows are recurring cash
flows and this can only be from a business's operations. Cash flows from
operations is a renewable resource!

How do you analyze the cash flow from operating activities?

Step 1: Is there a positive inflow of cash from operating activities? Over the
years (if you have comparative cash flow statements) are the cash flows
from operating activities increasing or decreasing? Because it is the only
sustainable source of cash you want to see a cash inflow from operations
either increasing over time or holding steady.

Step 2: Compare the cash flow from operating activities with the profit on the
income statement. If cash flows from operations is higher than the profit on
the income statement that is considered positive because it means that the
business is collecting the cash from their customers and paying off their
expenses (and not owing them in the future through accounts payable). If
operating cash flows is far less than the profit on the income statement a red
flag is raised: why is income statement profit not turning into cash?

15 | C H 1 0
What is cash flow from investing activities and why is it important?

You now know that cash flow from operating activities is a life blood of a
business because it is the only sustainable source of cash in the long term.
However, the other activities on the statement of cash flows need to be
considered to develop a complete picture of the business's inflows and
outflows of cash. You may recall that investing activities include the purchase
and sale of property, plant, equipment, and intangibles. It also includes the
purchase and sale of bonds and shares of another business. (Like when you,
as an individual, buy Apple shares as an investment. Businesses do the
same with spare cash they may have!) Investing activities involve making
purchases that will help the business to earn revenue in the future; therefore,
a net cash outflow from investing activities is not a bad thing! Sometimes
you have to spend money in order to make money and, for investing
activities, this is definitely true. A cash outflow from investing activities may
indicate that the business is investing in equipment so that it can produce
more products and therefore sell more. This will then translate into higher
sales and higher cash inflows from operating activities! Although a business
can foolishly expand too rapidly (take Target's expansion into the Canadian
market as an example), in general a cash outflow from investing activities is
considered a positive because it means the business is growing by
expanding their business, generating more cash inflows in the future from
operations.

Does this mean that positive cash flows from investing activities is
something you never want to see? Not at all. Say a business has a division
that is not generating cash flows. They may want to sell that division so that
they can focus on other parts of their business. The sale of the division would
bring in cash which the business can use to expand their main business
division. What is important to realize is that cash generated from selling long
term assets such as property, plant, equipment, intangibles and investments
are never a re-occurring cash flow. If you sell a division this year you cannot
sell it again next year! The reason behind the sale is important to understand
and, sometimes, you can only guess at what that reason may be.

How do you analyze the cash flow from investing activities?

Step 1: Is the overall cash flow from investing activities negative or positive?
If it is positive that may be a bad sign as it may indicate that the business is
selling their long term assets to create positive cash inflows. If it is negative
it may indicate that the business has been purchasing assets to generate
revenue in the future. The word MAY is highlighted because, without looking
16 | C H 1 0
at the details of the investing activities section, you cannot know. You do
know, however, that positive cash flows from investing activities are not
sustainable (you can't sell your long lived assets forever as you will run out
of things to sell!)

Step 2: Compare the changes from investing activities as a whole. Is the

business selling old equipment to purchase new equipment that will make
the business more efficient revenue generation in the future? Look at all the
activity to see if there is a relationship that may help you determine what the
business is doing in the future.

Step 3: Was there enough of a cash inflow from operating activities to pay for
the outflow from investing activities? For example, if the business had an
outflow of $100,000 to buy new equipment was there an inflow from
operating activities that was greater than $100,000? Did the cash inflow from
operations cover all of the cash needed for the purchase? This is important
to review as most stakeholders want the purchase of new assets to be
covered by an inflow of cash from either operating activities or existing cash
on the balance sheet.

Step 4: What is the trend over time? Check, year to year, if the business has
continued to invest in the future buy purchasing property, plant, equipment,
and intangibles. Remember that when a business invests in their future they
help to generate more cash from operations in the coming years.

What is cash flow from financing activities and why is it important?

Recall that financing activities include both the inflow and outflow of cash
due to capital contributions by owners as well as the payment of dividends.
Financing activities also include debt transactions such as taking out and
repaying debit (money borrowed from creditors such as banks). Companies
often have to make major purchases and they use equity (capital
contributions) and debt (borrowed cash) to do this. Although a business can
fund foolish expenditures, in general a cash inflow from financing activities
may be positive if it is combined with either a current outflow from investing
activities or a planned outflow in the near future. However, although
stakeholders understand that funding purchases is sometimes required, they
would prefer to see investing activities supported by inflows from operations
if at all possible.

Does this mean that negative cash flows from financing activities (outflows)
is something you never want to see? Not at all. Cash outflows from financing

17 | C H 1 0
activities can indicate that the business is paying down their loans, which
would decrease interest costs in the future, reducing cash outflows under
operating activities. It can also indicate that the business is making dividend
payments, which owners are glad to see! Just because cash flows are
negative for financing activities does not mean it is good or bad....it simply
means that you have to look deeper at the reasons WHY so you can better
assess the business's activities.

How do you analyze the cash flow from financing activities?

Step 1: Is the overall cash flow from financing activities negative or positive?
If it is positive that may be a sign that the business needs cash to fund either
operations or purchases under the investing activities section (if cash flows
from operations are not enough to cover those outflows). If it is negative it
may indicate that the business is paying down their debt or paying dividends
to shareholders, both of which can be considered positive things. The word
MAY is highlighted because, without looking at the details of the financing
activities section, you cannot know. You do know, however, that positive cash
flows from financing activities are not sustainable but they may be necessary
to grow as a business.

Step 2: Compare the changes from financing activities as a whole (all the
changes in the financing section against each other). Did the business get
additional contributions from their owners so they could pay down debt? If
so, that's positive because it reduces future interest costs but may increase
future dividend payments. Look at all the activity to see if there is a
relationship that may help you determine what the business is doing with
regards to the future.

Step 3: If there is an inflow (source) of cash from financing activities, was

there an outflow from investing activities that needed to be funded because
there was not enough of an inflow from operating activities? Although
stakeholders generally want the purchase of new assets to be covered by an
inflow of cash from either operating activities or existing cash on the balance
sheet sometimes you have to borrow money to make money and
stakeholders understand the long term outlook when assessing cash flows.

Check your understanding (CYU10-3)

Below is information from Blackberry Ltd. for 2011 to 2015. Provided is

information about their profit (loss) as well as the three activities on the cash
flow statement. Analyze the cash flow statement and provide an assessment

18 | C H 1 0
of the trend over time as well as anything significant that you see. Compare
it to the income statement - are you surprised about the cash flow statement
considering the results of the income statement?

NOTE: NO DIVIDENDS WERE PAID DURING THE YEARS SHOWN ON THE

CHART.

NOTE: B indicates billions and M indicates millions. Be sure to check carefully

which is indicated under each activity.

The source of this information:

http://www.marketwatch.com/investing/stock/bbry/financials/cash-flow

Descripti 2011 2012 2013 2014 2015

on
Profit 3.48 B 1.15B (627.33M) (6.15B) (342.08M)
(loss)
Operating 4.09B 2.89B 2.3B (166.39M) 914.84M
Investing (1.73B) (3.0B) (2.24B) (1.09B) (1.32B)
Financing (2.13B) (147.77M) (35.96M) 1.28B 18.9M

Analysis:

Overall, what is the value of analyzing the financial statements of a

business?

Whether you are an external stakeholder who is deciding to invest in a

business (investor) or to loan the business cash (creditor) or you are a
business owner trying to make decisions about the future, analyzing the
financial statements will help you to make those decisions. Using vertical
and horizontal analysis on the income statement and balance sheet and
reviewing the different activities on the statement of cash flows are critical to
understanding the business. Yes, analyzing statements is complex but it is
extremely important as it allows stakeholders to gain a better understanding
of the financial health of a business.

Putting it all together!

In this book you started out by gaining a better understanding of why

financial statements are necessary (improve decision making). You then
moved to understanding how the statements are developed (transaction
analysis) and you learned how to develop actual financial statements. Next,
you moved on to understanding individual accounts (accounts receivable,
19 | C H 1 0
inventory, long lived assets, etc.) and how you can manage those accounts
to ensure your decision making is appropriate given what is happening in the
business. As a last step you have covered the analysis of all the financial
statements and how the information gathered from the analysis can be used
to improve future decision making.
Running a business is complex but using financial information as a basis for
your decision making can help you, the business owner, make decisions that
will allow the business to expand and grow in the future.

Going forward!

You have now completed this course. The final step in the process is to write
the final exam. In order to help you study for the final exam the final chapter
of this textbook will be a series of review questions. Remember that you
should be able to complete all of the review questions without the help of
your notes or this textbook. In addition, it is recommended that you write all
the questions from the end of every chapter.
Best of luck on the final exam!

What do I need to know for the final exam?

A. Define horizontal analysis. What does this type of analysis provide to
the owner?
B. Define vertical analysis. Why is it important to complete this type of
analysis?
C. Complete a horizontal analysis of a business (both income statement
and balance sheet) and analyze the results.
D. Complete a vertical analysis of a business (both income statement and
balance sheet) and analyze the results.
E. Review and analyze a statement of cash flows. Be sure to analyze
each activity individually but also review how the inflow or outflow of
the individual activities tie into the other activities.

Watch out for....

Students often do not practice analyzing the financial statements. Often

they look at the questions provided but they don't write down their analysis.
Sometimes they read the questions and flip immediately to the solutions.
When they read the solutions it seems so easy, so they tend not to practice.

Be smart - practice these questions without looking at the solution. Be sure

you write down your answers. The analysis question(s) on the final exam will
20 | C H 1 0
be a significant part of your overall grade and practice is the only way you
will become proficient (skillful, an expert).

21 | C H 1 0
In Class Demo Questions
ICDQ10-1

Below is the income statement, statement of retained earnings and the

balance sheet for Greene Inc., all comparative. Complete a horizontal
analysis of the appropriate statements and answer the questions which
follow.

Greene Inc.
Horizo
Income Statement ntal
Analys
Year ended December 31 is
2016 2015
Net Sales $550,000 $582,000
Cost of goods sold 350,000 372,480
Gross Profit 200,000 209,520
Total operating expenses 138,000 104,200
Operating profit (loss) 62,000 105,320
Other expenses or losses
Interest expense 12,000 15,600
Profit before income tax 50,000 89,720
Income tax expense 24,000 43,066
Profit $26,000 $46,654

Greene Business
Statement of Retained Horizo
Earnings ntal
Analy
Year ended December 31 sis
2016 2015
Opening
retained $232, $185,
earnings 000 346
Plus: Net 26,00 46,65
Income 0 4
Less: Dividends 7,000 0

22 | C H 1 0
Closing retained $251, $232,
earnings 000 000

23 | C H 1 0
 Greene Business
Balance Sheet
At December 31
Horizo
2016 2015 ntal
Analys
Assets is
Current assets
Cash $24,000 $40,000
Accounts receivable 90,000 75,000
Inventory 80,000 95,000
Prepaid expenes 12,000 16,000
Total current assets 206,000 226,000
Total property, plant, and
equipment 690,000 520,000
$896,00 $746,00
Total assets 0 0

Liabilities
Current liabilities
$160,00 $148,00
Accounts payable 0 0
Other current liabilities 35,000 36,000
Total current liabilities 195,000 184,000
Long term liabilities
Bank loan payable 100,000 130,000
Total liabilities 295,000 314,000

Equity
Capital contributions 350,000 200,000
Retained earnings 251,000 232,000
Total equity 601,000 432,000
$896,00 $746,00
Total liabilities and equity 0 0

24 | C H 1 0
Does Greene Inc. sell a goods or service? Explain how you know this.

Income Statement:

What is the trend that you see with regards to sales and cost of sales? What
is good and bad about this? What does this tell you about the business?
What does that tell you about gross profit?

What about total operating expenses? What is the trend there and what
does this say about the business? Explain WHY what you see in operating
expenses has happened.

What is the trend in operation profit (loss)? Can you explain why this has
happened?

25 | C H 1 0
26 | C H 1 0
What is the trend in interest expense? Looking at the balance sheet can you
guess why this decline has occurred?

What is the trend in income tax expense? Does this make sense? Explain
why.

The decrease in sales was much smaller than the decrease in profit for the
year. What was the decrease in profit and why is it so much larger than the
decrease in net sales?

Statement of Retained Earnings

Can you use horizontal analysis on the statement of retained earnings?

27 | C H 1 0
Balance Sheet
Looking at the current assets on the balance sheet, what is the change in
cash? Is this a surprise? Why or why not? Be sure to explain.

Accounts receivable have increased. Did you expect this? Would it be of

concern? Check out the income statement and explain why.

What is the change in inventory? Did you expect this? If so, why? (HINT:
look at the income statement, cost of goods sold.)

Property, plant, and equipment have increased. What has it increased by?
What, on the income statement, ties into this increase?

28 | C H 1 0
29 | C H 1 0
Review the increases in current liabilities. What is the only item which might
concern you and why are you NOT surprised by the change? (HINT: check
out the income statement to get your answer!)

Comparing the change in total current liabilities to the change in total

current assets, what do you see and why are you concerned about it?

Review the change in capital contributions. Why did you think the business
has additional contributions from the owners? What did the business likely
do with that cash inflow?

30 | C H 1 0
ICDQ10-2

Below is the income statement, statement of retained earnings and the

balance sheet for Greene Inc., all comparative. Complete a vertical analysis
of the appropriate statements and answer the questions which follow.

Greene Inc.
Vertic Vertic
Income Statement al al
Analy Analy
Year ended December 31 sis sis
2016 2015
$550,0 $582,0
Net Sales 00 00
350,00 372,48
Cost of goods sold 0 0
200,00 209,52
Gross Profit 0 0
138,00 104,20
Total operating expenses 0 0
105,32
Operating profit (loss) 62,000 0
Other expenses or losses
Interest expense 12,000 15,600
Profit before income tax 50,000 89,720
Income tax expense 24,000 43,066
$26,00 $46,65
Profit 0 4

31 | C H 1 0
 Greene Business
Balance Sheet
At December 31
Verti Verti
2016 cal 2015 cal
Analy Analy
Assets sis sis
Current assets
$24,00 $40,00
Cash 0 0
Accounts receivable 90,000 75,000
Inventory 80,000 95,000
Prepaid expenes 12,000 16,000
206,00 226,00
Total current assets 0 0
Total property, plant, and 690,00 520,00
equipment 0 0
$896,0 $746,0
Total assets 00 00

Liabilities
Current liabilities
$160,0 $148,0
Accounts payable 00 00
Other current liabilities 35,000 36,000
195,00 184,00
Total current liabilities 0 0
Long term liabilities
100,00 130,00
Bank loan payable 0 0
295,00 314,00
Total liabilities 0 0

Equity
350,00 200,00
Capital contributions 0 0
251,00 232,00
Retained earnings 0 0
601,00 432,00
Total equity 0 0
$896,0 $746,0
Total liabilities and equity 00 00

32 | C H 1 0
Income Statement

Reviewing the vertical analysis of cost of goods sold and gross profit, what do
you see that is good? Compare this to the horizontal analysis and explain
why this is not surprising.

Compare the percentage of total operating expenses for 2015 and 2016.
What does this tell you about operating expenses? How does this compare
to what you found in your horizontal analysis.

When you review operating profit, profit before income tax, and profit what
do they all show when you use vertical analysis? Considering what you see
with regards to total operating expenses are you surprised by this or not?
Explain why.

33 | C H 1 0
Balance Sheet

What has happened to total current assets between 2015 and 2016
compared to total property, plant, and equipment? Does this concern you?
Why or why not?

From your horizontal analysis you know that total current liabilities increased
between 2015 and 2016 by 6%, which was a concern. In the vertical
analysis you see something totally different: current liabilities decreased!
Can you explain what looks like an opposite change compared to your
horizontal analysis?

Compare total liabilities and total equity as a percentage of total assets over
the 2 years. What do you see is happening and, considering your horizontal
analysis, why are you not surprised by this change?

34 | C H 1 0
ICDQ10-3

Jacques started Telemark Inc, a retail sporting goods store specializing

in cross-country skiing, snow shoeing, hiking and climbing equipment, ten
years ago in Montreal. The store started slowly but grew steadily with the
growing popularity of the four activities. Last year Jacques opened a second
store in the Laurentians, 100 km away, that is operated by his brother. This
year they added a third store run by his son, in another recreational area to
the east. The initial store, in a rented suburban retail space, had grown
slowly and steadily and as a result Jacques has never needed to borrow
money. Both of the new stores have been successful, meeting their sales
targets in their first year.
Jacques wants to continue to expand in the coming years but he is
unsure if he will have the necessary cash.
Below are the statement of cash flows for Telemark for this year and last.
Required:
Using the process demonstrated in the chapter analyze Telemark Inc.'s
Statement of Cash Flows for 2015 and 2016.

HINT: the description of a business can provide CRITICAL

information that you will need to appropriately analyze what is
happening on the statement of cash flows! Therefore, read the
above carefully before you look at the statement of cash flows.

35 | C H 1 0
 Telemark Inc.
Statement of Cash Flows
Year ended April 30
2016 2015
Net cash provided by operating 445,50 356,15
activities 0 0

Cash flows from investing activities

- -
550,00 450,00
Purchase of land and buildings 0 0
Purchase of equipment -20,000 -18,000
- -
Net cash used by investing 570,00 468,00
activities 0 0

Cash flows from financing activities

Additional contributions by owners 10,000 10,000
-
110,00
Payment of cash dividends 0 -80,000
-
Net cash provided by financing 100,00
activities 0 -70,000

- -
224,50 181,85
Net decrease in cash 0 0
145,35 327,20
Cash balance, January 1 0 0
-
$79,15 $145,3
Cash balance, December 31 0 50

Additional Information:
2016 2015
$425,0 $350,0
Net income 00 00

Cash flow from operating activities:

Step 1: (from the chapter!)

36 | C H 1 0
Step 2:

Cash flow from investing activities:

Step 1: (from the chapter!)

Step 2:

Step 3:

Step 4:

37 | C H 1 0
38 | C H 1 0
Cash flow from financing activities:
Step 1: (from the chapter!)

Step 2:

Do you feel that Jacque should expand in 2017? Why or why not?

39 | C H 1 0
Practice Questions
PQ10-1
Your friend owns Capital One Ltd. She knows you have taken ACC100 and he
would like some help analyzing her cash flow statement for the last 3 years.

Capital One Ltd.

Cash flow statement
Years ended December 31st

2016 2015 2014

Net cash flows (75,000) (25,000) 40,000
from operating
activities
Net cash flows 25,000 10,000 (20,000)
from investing
activities
Net cash flows 30,000 5,000 (15,000)
from financing
activities
Net change in (20,000) (10,000) 5,000
cash
Cash at the 35,000 45,000 40,000
beginning of the
year
Cash at the end 15,000 35,000 45,000
of the year

i. Analyze the cash flow from operating activities and explain/describe what
has happened over the 3 years. Be sure to indicate if it is good or bad and
why. In addition, explain to your friend why cash flow from operations is
important.

40 | C H 1 0
ii. Analyze the cash flow from investing activities. Do you think what you see
is good for the business? Explain why or why not and be sure to support
your answer with facts from the chart.

iii. Analyze the cash flow from financing activities. Do you think what you
see is good for the business?

41 | C H 1 0
PQ10-2
The following information is available for Singn Ltd. For 2017 and 2016.

Perform vertical analysis on the income statement and analyze the results.

Additional space on the next page.

42 | C H 1 0
43 | C H 1 0
Now perform horizontal analysis on Singn Ltd. Analyze the results.
Does the results support the information you discovered from the vertical
analysis?

Additional space is provided on the next page.

44 | C H 1 0
45 | C H 1 0
PQ10-3

At the beginning of the year Starlight Inc. had $124,300 in assets and
$42,900 in liabilities.
During the year the company had revenue of $92,500, expenses of $63,200
and dividends of $5,000 and the company issued shares for $20,000.
Liabilities increased by $22,100.

What was the ending accounting equation at December 31?

Assets Liabilities Equity

Calculations:

PQ10-4

For each of the following companies identify which sector the company is in
and explain why they are in that sector.

i. Rogers Communication
ii. Western Manufacturing
iii. Goldcorp Inc.

i.

ii.

iii.

46 | C H 1 0
PQ10-5

You are the owner of Acer Ltd., a new business you started on Sept. 1. You
use the FIFO method for tracking your inventory and the perpetual inventory
system. You had the following transactions for the past month. All of your
purchases and sales are in cash.
Oct. 1, 20 units at $30 each.
openi
ng
Oct. 5 Purchased 60 units at $31 each.
Oct Sold 45 units to a customer $75 each.
10
Oct Purchased 50 units at $32 each.
15
Oct 25 Sold 48 units for $75 each to a customer.
Calculate the cost of goods sold and the ending inventory, using a perpetual
inventory system. NOTE: more rows have been provided than you require.
For every entry into the inventory control system record the transaction into
the expanded accounting equation using account names. NOTE: only the
cash account has been provided for you.
Date Purchases Cost of goods sold Inventory on hand
Quantit Unit Total Quanti Unit Total Quanti Unit Total
y cost Cost ty cost Cost ty cost Cost

Totals
:

47 | C H 1 0
The accounting equation is provided on the next page.

What if anything do you have to do if you found out at the end of the month
that you can only sell your product for $28 per unit? Explain why.

48 | C H 1 0
PQ10-6

Julies pet store pays their employees every week on a Friday. The company
has 2 full time employees who work 7.5 hours per day from Monday to
Friday and 1 part-time staff that works on Saturday and Sundays for 7.5
hours per day. The full-time employees are paid $20 per hour and the part-
time employee is paid $15 per hour.
The employees were last paid on Friday October 28th. This has already been
recorded. Record the entry required on October 31st. The employee portion
of the CPP is $40, EI is $35 and income taxes are $147. The company paid
the government the amounts owed to them on November 1st and paid the
employees on November 4th. The employee portion of the CPP is $84, EI is
$53 and income taxes are $336. Record all the entries related to salary in
the expanded accounting equation using account names.

Assets Liabilities Equity

Owne Retained Earnings
r's Reven Expenses
Capita ue
Date

l
Cash

49 | C H 1 0
PQ10-7
The following accounts have been provided for Puddle Inc., a business that
has been running for 5 years. Using the information provided answer the
questions which follow.
Amou
Account Name
nt
Supplies expense 27,00
0
Interest expense 14,40
0
Bank loan payable, due 2019 36,00
0
Supplies 21,00
0
Owners' Capital 64,00
0
Insurance expense 14,70
0
Dividends 35,60
0
Income tax expense 17,84
0
Accounts receivable 69,80
0
Cash 72,00
0
Retained earnings, beg 50,98
0
Service revenue 300,0
00
Prepaid insurance 14,40
0
Salaries expense 114,0
00
Rent expense 43,28
0
Website Design 19,12
0
Travel and entertainment 22,80
expense 0
Business Licence 1,140
Accounts payable 24,72

50 | C H 1 0
 0
Unearned revenue 3,200
Income tax payable 8,000
Interest payable 180
i. What is the total current assets $___________

ii. What is the total intangible assets $__________

iii. What is the total current liabilities $___________

iv. What is the total equity $_____________

51 | C H 1 0
PQ10-8
i. Which method is the most accurate to use when estimating bad
debt expense: a percentage of total accounts receivable or the
aging of accounts receivable? Explain why.

ii. What is the normal balance in the allowance for doubtful account?
Why is this its normal balance?

iii. Is it possible for the allowance for doubtful account to have a

positive balance? Explain.

52 | C H 1 0
PQ10-9
You purchase equipment and have following information:

Cost $64,500
Ready for use date Sept 1, 2016
Estimated useful life 3 years
Residual value (or salvage $1,500
value)
Your yearend is December 31.
Complete the chart:
Year ended Depreciation Accumulate Book value
expense d
depreciation
31-Dec-16
31-Dec-17
31-Dec-18
31-Dec-19

Record the depreciation expense for December 31, 2016.

2016:
Equity
Retained
Owner
Liabiliti Earnings
Asset s'
es Profit
Capita
Reven Expen
l
ue se
Cash

Balan
ce

53 | C H 1 0
Assume that, INSTEAD, you sold the equipment on March 1, 2018, for
$30,000.
Record all the entries you would make in 2018.

Equity
Owne Retained Earnings
Liabilit
Asset rs' Profit
ies
Capit
Revenue Expense
al
2018

Cash

Balan
ce

PQ10-10
You start a t-shirt business for sports teams. In order to start the business
you borrow $5,000 from the bank. In addition your friend Sue and you each
invest $1,000 into the business. You hire Tharshika to attend events and to
sell the t-shirts. Wholesaler Inc. provides you with the t-shirts that you sell.
List the stakeholders of your business and what their main objective is.

Stakeholder Main objective

54 | C H 1 0
PQ10-11
You decide to start your own import business. You buy goods from China
and India and sell the goods to local stores in the area. In order to get your
business up and running on October 14th you write a business plan and
apply to your local credit union to borrow $20,000. Your credit union likes
your business plan, and advances you the money on November 1st, 2016.
The credit union offers you 3.5 percent interest rate based on your past
credit history and the current interest rate. The loan agreement requires
that you make interest payments at the beginning of every month and that
you repay the loan in full in 2 years.
i. Record the transactions required into the expanded accounting
equation using account names for 2016.

Assets Liabilities Equity

Owner Retained earnings
's Profit
capita Reven Expens
Date

l ue es
Cash

55 | C H 1 0
Blast From The Past - SOLUTIONS
BFTP10-1

56 | C H 1 0
57 | C H 1 0
Check Your Understanding -
SOLUTIONS

Is there anything significant that you can see from your trend analysis? Be
sure to explain why you think it is significant (important) and speculate
(guess) as to why it might have happened.

Cash showed a large increase (44%) that is because it has a small

dollar amount in 2015, so any increase looks bigger as a parentage.

58 | C H 1 0
 One strange change is that sales increased by 21% but accounts
receivable decreased by 8%, which is unusual. Usually an increase in
sales results in an increase in accounts receivable.
Another unusual change is that inventory increased by 27% but current
liabilities decreased 6.4%. If inventory increases it is normal for A/P to
increase also. This may be due to additional contributions by the
owners as that may have been used to pay down the A/P.

CYU10-2

Is there anything significant that you can see from your trend analysis? Be
sure to explain why you think it is significant (important) and speculate
(guess) as to why it might have happened.
Vertical analysis of the income statement shows not major changes.
There is a slight decrease in gross profit as a % of sales revenue but
it is very small.

59 | C H 1 0
 In line with the horizontal analysis you can see that cost of goods
sold has increased slightly as a % of sales revenue.
The business should watch that in future to ensure this trend does
not continue as it will cause a reduction in gross profit if it does
continue.
Vertical analysis of the balance sheet shows that accounts
receivable have decreased (meaning the business is collecting from
their customers).
Inventory has increased as a % of total assets but that is normal
considering that sales have increased by 21.2% (see horizontal
analysis).
Property, plant, and equipment have also increased as a % of total
assets but, if the business is expanding to support their higher
sales, this would also be normal.
Current liabilities have declined as a % of total assets, which is
excellent as it means that the business is paying down their debts
as they come due.
Retained earnings is now a larger portion of the total liabilities and
equity but that is because of the high profit from 2015 being added
to the retained earnings for 2016.

CYU10-3

Descripti 2011 2012 2013 2014 2015

on
Profit 3.48 B 1.15B (627.33M) (6.15B) (342.08M)
(loss)
Operating 4.09B 2.89B 2.3B (166.39M) 914.84M
Investing (1.73B) (3.0B) (2.24B) (1.09B) (1.32B)
Financing (2.13B) (147.77M) (35.96M) 1.28B 18.9M
There is a downward trend to profit for 2011 and 2012 and then losses
for all the remaining years.
The loses on the income statement first increase (2013 to 2014) and
then decline (2015) but it is still a loss.
This likely will translate into an outflow of cash from operating
activities, which it does for 2014 and 2015.
Cash flow from operations decreases every year (2011, 2012, and
2013) before there is a net outflow in 2014.
There is a recovery in 2015 (cash inflow of 914.84M).
It is not possible to determine if this will improve in the coming years.

60 | C H 1 0
 Investing activities shows as negative, meaning that Blackberry is still
investing in property, plant, equipment, intangibles, and investments,
which is good.
The investments are decreasing after 2012, moving from a high of 3.0B
to a low of 1.09B in 2014.
Financing first shows an outflow for 2011 to 2013, likely for the paying
off of debt or repurchasing shares from shareholders.
Considering Blackberry's reducing cash flow from operations it is clear
that, in 2014 and 2015, the business had to have an inflow of cash
from financing activities to support their purchases in investing
activities.
Unless there was a turnaround in the cash flow from operations that
was consistent I would not invest in Blackberry considering their cash
flow statement results.

61 | C H 1 0