Chapter 16

How to Read, Analyze,

and Interpret
Financial Reports

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved

#16 How to Read, Analyze, and Interpret
Financial Reports

Learning Unit Objectives

LU16.1 Balance Sheet -- Report as of a
Particular Date

• Explain the purpose and the key items

on the balance sheet
• Explain and complete vertical and
horizontal analysis

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#16 How to Read, Analyze, and Interpret
Financial Reports

Learning Unit Objectives

Income Statement -- Report for a
LU16.2
Specific Period of Time

• Explain the purpose and the key items

on the income statement
• Explain and complete vertical and
horizontal analysis

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#16 How to Read, Analyze, and Interpret
Financial Reports

Learning Unit Objectives

LU16.3 Trend and Ratio Analysis
• Explain and complete a trend analysis
• List, explain, and calculate key
financial ratios

16-4
 Accounting Equation

Accounting Equation: Assets = Liabilities + Owner’s Equity

16-5
 Balance Sheet
Gives a financial picture of what a company is worth as
of particular date.

How
much the
company
owes
Liabilities
+
Owner’s
How Assets = Equity How
much the much the
company owner is
owns worth

16-6
 Figure 16.1 - Elements of the Balance Sheet

Assets broken down MOOL COMPANY Liabilities broken

into current assets and Balance Sheet down into current
plant and equipment. December 31, 2009 and long-term
Assets Liabilities
a. Current assets: a. Current liabilities:
b. Cash $ 7,000 b. Accounts payable $ 80,000
c. Accounts receivable 9,000 c. Salaries payable 12,000
d. Merchandise inventory 30,000 d. Total current liabilities $ 92,000
e. Prepaid expenses 15,000 e. Long-term liabilities:
f. Total current assets $61,000 f. Mortgage note payable 58,000
g. Plant and equipment: g. Total liabilities $150,000
h. Building (net) $60,000
i. Land 84,000 Stockholders Equity
j. Total plant and equipment 144,000 a. Common stock $ 20,000
b. Retained earnings 35,000
c. Total stockholders equity 55,000
k. Total assets $205,000 d. Total liab. and stkhlds equity $205,000

Total of current assets

Total of all liabilities
and plant and equipment. and stockholders’
(Total is double- ruled) equity.

16-7
 Preparing a Vertical Analysis of a Balance Sheet
Step 1. Round each liability
and stockholders’ equity (the
portions) as a percent of total
liabilities and stockholders’
equity (the base). Round as
indicated.

Step 2. Divide each asset

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

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 Figure 16.2 - Comparative Balance Sheet:
Vertical Analysis
ROGER COMPANY
* Due to rounding Comparative Balance Sheet
December 31, 2008 and 2009
2009 2008
Amount Percent Amount Percent
Assets
Current Assets:
Cash $22,000 25.88 $18,000 22.22
Accounts Receivable 8,000 9.41 9,000 11.11
Merchandise inventory 9,000 10.59 7,000 8.64
Prepaid rent 4,000 4.71 5,000 6.71
Total current assets $43,000 50.59 $39,000 48.15*
Plant and equipment:
Building (net) $18,000 21.19 $18,000 22.22
Land 24,000 28.24 24,000 29.63
Total plant and equipment $42,000 49.41* $42,000 51.85
Total assets $85,000 100.00 $81,000 100.00

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 Figure 16.2 - Comparative Balance Sheet:
Vertical Analysis
ROGER COMPANY
Comparative Balance Sheet
* Due to rounding December 31, 2008 and 2009
2009 2008
Amount Percent Amount Percent
Liabilities
Current liabilities:
Accounts payable $14,000 16.47 $8,000 9.88
Salaries payable 18,000 21.18 17,000 20.99
Total current liabilities $32,,000 37.65 $25,000 30.86*
Long-term liabilities:
Mortgage note payable $12,000 14.12 $20,000 24.69
Total liabilities $44,000 51.76* $25,000 30.86*
Stockholders’ Equity
Common stock $20,000 23.53 $20,000 24.69
Retained earnings 21,000 24.71 16,000 19.75
Total Stockholders’ equity $41,000 48.24 $36,000 44.44
Total Liabilities and Stockholders’ Equity $85,000 100.00 $81,000 100.00

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.

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 Figure 16.3 - Comparative Balance Sheet:
Horizontal Analysis
ABBY ELLEN COMPANY
Comparative Balance Sheet
December 31, 2008 and 2009
Increase(decrease)
2009 2008 Amount Percent
Assets
Current Assets:
Cash $ 6,000 $ 4,000 $ 2,000 50.00
Accounts Receivable 5,000 6,000 (1,000) -16.67
Merchandise inventory 9,000 4,000 5,000 125.00
Prepaid rent 5,000 7,000 (2,000) -28.57
Total current assets $25,000 $21,000 $ 4,000 19.05
Plant and equipment:
Building (net) $12,000 $12,000 0 0
Land 18,000 18,000 0 0
Total plant and equipment $30,000 $30,000 0 0
Total assets $55,000 $51,000 $4,000 7.84

16-12
 Figure 16.3 - Comparative Balance Sheet:
Horizontal Analysis
ABBY ELLEN COMPANY
Comparative Balance Sheet
December 31, 2008 and 2009
Increase(decrease)
2009 2008 Amount Percent
Liabilities
Current liabilities:
Accounts payable $ 3,200 $ 1,800 $ 1,400 77.78
Salaries payable 2,900 3,200 (300) -9.38
Total current liabilities $ 6,100 5,000 1,100 22.00
Long-term liabilities:
Mortgage note payable 17,000 15,000 2,000 13.33
Total Liabilities $ 23,100 20,000 3,100 15.50
Owner’s Equity
Abby Ellen, capital $31,900 31,000 $ 900 2.90
Total liabilities and owner’s equity $55,000 51,000 $4,000 7.84

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 Income Statement
e
Incoment
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)

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 Figure 16.4 - Income Statement
MOOL COMPANY
Income Statement
For Month Ended December 31, 2009
Revenues
a. Gross Sales $22,080
b. Less: Sales returns and allowances $ 1,082
c. Sales discounts 432 1,514
d. Net Sales
Cost of merchandise (goods) sold: $20,566
a. Merchandise Inventory 12/1/2004 $ 1,248
b. Purchases $10,512
c. Less: Purchases returns and allowances $336
d. Less: Purchase discounts 204 540
e. Cost of net purchases 9,972
f. Cost of merchandise (goods available for sale) $11,220
g. Less: Merchandise inventory 12/31/2004 1,600
h. Cost of merchandise (goods sold) 9,620
Gross profit from sales $10,946
Operating expenses:
a. Salary $ 2,200
b. Insurance 1.300
c. Utilities 400
d. Plumbing 120
e. Rent 410
f. Depreciation 200
g. Total operating expenses 4,630
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Net income $ 6,316
 Key Calculations on Income Statement

Net sales = Gross sales - Sales returns and - Sales discounts

Allowances

Cost of Net purchases

merchandise = Beginning + (purchase less - Ending
(goods) sold inventory returns & discounts) inventory

Gross profit = Net sales - Cost of merchandise

from sales (goods) sold

Net income = Gross profit - Operating expenses

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 Figure 16.5 - Income Statement
Vertical Analysis
ROYAL COMPANY
Comparative Income Statement
For Years Ended December 31, 2006 and 2007
2007 Percent 2006 Percent
of net of net
Net Sales $45,000 100.00 $29,000 100.00
Cost of merchandise sold 19,000 42.22 12,000 41.38
Gross profit from sales $26,000 57.78 $17,000 58.62
Operating expenses:
Depreciation $1,000 2.22 $ 500 1.72
Selling and Advertising 4,200 9.33 1,600 5.52
Research 2,900 6.44 2,000 6.90
Miscellaneous 500 1.11 200 .69
Total operating expenses $8,600 19.11* $ 4,300 14.83
Income before interest and taxes $17,400 38.67 $12,700 43.79
Interest expense 6,000 13.33 3,000 10.34
Income before taxes $11,400 25.33* $ 9,700 33.45
Provision for taxes 5,500 12.22 3,000 10.34
Net income $ 5,900 13.11 $ 6,700 23.10*

* Due to rounding

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 Figure 16.6 - Horizontal Analysis
Income Statement
FLINT COMPANY
Comparative Income Statement
For Years Ended December 31, 2008 and 2009
2009 2008 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

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 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. Step 2. Express

Select the each amount as a
base year percent of the base
(100%) year amount
(rounded to the
nearest whole
percent)

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 Trend Analysis
Given (base year 2007)
2010 2009 2008 2007
Sales $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
Trend Analysis
2010 2009 2008 2007
Sales* 148% 110% 81% 100%
Gross Profit 147 114 90 100
Net Income 126 108 58 100
* Round to nearest whole percent $340,000
$420,000
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 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
Debt Management ratios
The company’s
profitability picture The company’s debt
situation

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 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 day’s collection = Accounts receivable

Net sales
360
Industry average, 90-120 days

Total debt to total assets = Total liabilities

Total assets
Industry average, 50% - 70%
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 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%

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 Problem 16-15:

$4.30 million
- 3.55 million
$ .75 million increase

$.75 million = 21.12676% = 21.13%

$3.55 million

16-24
 Problem 16-17:
a. Total liabilities $1,768
Total assets $2,015 = 87.74%
b. Net income $147
Stockholders' equity $427 = 34.43%
c. Net sales $265
Total assets $2015 = 13¢

d. Net income $147

Net sales $265 = 55.47%

16-25
 Problem 16-18:

2005 2004 2003 2002 2001

Sales 98% 106% 100% 98% 100%

$3,154 $3,414 $3,208 $3,152 $3,216
$3,216 $3,216 $3,216 $3,216 $3,216

= 98.072139 = 106.15671 = 99.751243 = 98.00995 =100%

= 98% =106% = 100% = 98%

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