ANALYSIS AND

INTERPRETATION OF
FINANCIAL STATEMENTS
-Taskin Shakib
 Financial Statement Analysis
• Non-accounting majors, especially, should
relate well to this chapter
It looks at accounting information from users’
perspective
• Relates very closely to topics you will study
in your finance course
Therefore, we will use a somewhat broader
brush on this chapter
• What is financial statement analysis?
”Tearing apart” the financial statements
 Financial Statement Analysis
625
Who analyzes financial statements?
– Internal users (i.e., management)
– External users (emphasis of chapter)
• Examples?
• Investors, creditors, regulatory agencies & …
• stock market analysts and
• auditors
 Financial Statement Analysis
• What do internal users use it for?
Planning, evaluating and controlling company
operations
• What do external users use it for?
Assessing past performance and current financial
position and making predictions about the future
profitability and solvency of the company as well
as evaluating the effectiveness of management
• First sentence in chapter says...
• Financial reports are the most important
sources of information available to a financial
analyst
• A financial analyst should have a strong
understanding of the information provided in
a company’s financial reports, notes and
supplementary information
Scope of Financial Statement Analysis

Financial Reporting: Financial Statement

Companies provide
information on
performance, financial
position and changes in
financial position
Other
information
Analysis:
Evaluate past, present and
future Performance of a
company or subsidiary
In order to make
investment, credit and
other business decisions

Performance: Profit, profitability,

liquidity, solvency, cash flow
 Financial Statement Analysis
Information is available from 627 628
– Published annual reports
• (1) Financial statements
• (2) Notes to financial statements
• (3) Letters to stockholders
• (4) Auditor’s report (Independent accountants)
• (5) Management’s discussion and analysis
– Reports filed with the government
• e.g., Form 10-K, Form 10-Q and Form 8-K
 Financial Statement Analysis
Information is available from 627 628
– Other sources
• (1) Newspapers (e.g., Wall Street Journal )
• (2) Periodicals (e.g. Forbes, Fortune)
• (3) Financial information organizations such

as: Moody’s,
Standard & Poor’s, Dun & Bradstreet, Inc., and Robert
Morris Associates
• (4) Other business publications
• Interim financial reports:
– Presents key 4 financial statements and footnotes, but is not audited
 MD & A and Auditor’s report
• Management Decision and Analysis (MD&A):
– Discussion and analysis regarding a company’s future prospects and
outlook
– Management should establish adequate internal control over financial
reporting: objective is provide reasonable assurance regarding the
reliability of financial reporting
• Auditor’s Report:
– A company’s reports are often required to be audited by an independent
accounting firm
– After examination an audit report is published which must express one
of the following:
• Unqualified: reasonable assurance that financial statements are fairly presented
• Qualified: some misstatements or exception to accounting standards
• Adverse: financial statements are materially misstated
Financial Statement Analysis Framework
Financial Statement Analysis Framework
Financial Statement Analysis Framework
 Methods of
Financial Statement Analysis

• Horizontal Analysis
• Vertical Analysis
• Common-Size Statements
• Trend Percentages
• Ratio Analysis
 Horizontal Analysis

Using
Using comparative
comparative financial
financial
statements
statements toto calculate
calculate dollar
dollar
or
or percentage
percentage changes
changes in
in aa
financial
financial statement
statement item
item from
from
one
one period
period to
to the
the next
next
 Vertical Analysis

For
For aa single
single financial
financial
statement,
statement, each each item
item
isis expressed
expressed as as aa
percentage
percentage of of aa significant
significant
total,
total,
e.g.,
e.g., all
all income
income statement
statement
items
items areare expressed
expressed as as aa
percentage
percentage of of sales
sales
 Common-Size Statements

Financial
Financial statements
statements that
that show
show only
only
percentages
percentages and
and no
no absolute
absolute dollar
dollar
amounts
amounts
 Trend Percentages

Show
Show changes
changes over
over time
time in
in
given
given financial
financial statement
statement items
items
(can
(can help
help evaluate
evaluate financial
financial
information
information ofof several
several years)
years)
 Ratio Analysis
Expression
Expression of of logical
logical relationships
relationships
between
between items
items inin aa financial
financial statement
statement of
of
aa single
single period
period
(e.g.,
(e.g., percentage
percentage relationship
relationship between
between
revenue
revenue andand net
net income)
income)
 Horizontal Analysis Example
The management of Clover Company provides you
with comparative balance sheets of the years
ended December 31, 1999 and 1998.
Management asks you to prepare a horizontal
analysis on the information.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
Horizontal Analysis Example
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

Change = Figure – Figure
Horizontal Analysis Example
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

Change = Figure – Figure

Since we are measuring the amount of the

change between 1998 and 1999, the dollar
amounts for 1998 become the “base” year
figures.
 Horizontal Analysis Example
Calculating Change as a Percentage

Percentage Dollar Change

Change = Base Year Figure × 100%
 Horizontal Analysis Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment: $12,000 – $23,500 = $(11,500)
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
 Horizontal Analysis Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment: ($11,500 ÷ $23,500) × 100% = 48.9%
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
 Horizontal Analysis Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
Horizontal Analysis Example
Let’s apply the same
procedures to the
liability and stockholders’
equity sections of the
balance sheet.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
Horizontal Analysis Example

Now, let’s apply the

procedures to the
income statement.
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense
Sales increased by 8.3% while6,400 7,000 by
net income decreased (600) (8.6)
Net income 21.9%.
before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
 There were increases in both cost of goods sold (14.3%) and operating
expenses (2.1%). These increased costs more than offset the increase
in sales, yielding an overall decrease in net income.
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
 Vertical Analysis Example
The management of Sample Company asks you to
prepare a vertical analysis for the comparative
balance sheets of the company.
 Vertical Analysis Example
S a m p le C o m p a n y
B a la n ce S h e e t (A sse ts)
A t D e ce m b e r 31, 1999 a n d 1998
% o f T o ta l A sse ts
1999 1998 1999 1998
C a sh $ 82,000 $ 30,000 17% 8%
A ccts. R e c. 120,000 100,000 25% 26%
In ve n to ry 87,000 82,000 18% 21%
La nd 101,000 90,000 21% 23%
Eq u ip m e n t 110,000 100,000 23% 26%
A ccu m . D e p r. (17,000) (15,000) -4% -4%
T o ta l $ 483,000 $ 387,000 100% 100%
 Vertical Analysis Example
S a m p le C o m p a n y
B a la n ce S h e e t (A sse ts)
A t D e ce m b e r 31, 1999 a n d 1998
% o f T o ta l A sse ts
1999 1998 1999 1998
C a sh $ 82,000 $ 30,000 17% 8%
A ccts. R e c. 120,000 100,000 25% 26%
In ve n to ry 87,000 82,000 18% 21%
La nd 101,000 90,000 21% 23%
Eq u ip$82,000
m e nt ÷ $483,000
110,000 = 17%100,000 rounded 23% 26%
A ccu m $30,000
. D e p r. ÷ $387,000
(17,000)= 8% rounded
(15,000) -4% -4%
T o ta l $ 483,000 $ 387,000 100% 100%
 Vertical Analysis Example
Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Acts. Payable $ 76,000 $ 60,000 16% 16%
Wages Payable 33,000 17,000 7% 4%
Notes Payable 50,000 50,000 10% 13%
$76,000
Common Stock ÷ $483,000
170,000 = 160,000
16% rounded
35% 41%
Retained Earnings 154,000 100,000 32% 26%
Total $ 483,000 $ 387,000 100% 100%
 Trend Percentages Example
Wheeler, Inc. provides you with the following
operating data and asks that you prepare a trend
analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119
 Trend Percentages Example
Wheeler, Inc. provides you with the following
operating data and asks that you prepare a trend
analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119

$1,991 - $1,820 = $171

 Trend Percentages Example
Using 1995 as the base year, we develop the
following percentage relationships.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 132% 123% 116% 109% 100%
Expenses 120% 116% 110% 106% 100%
Net income 313% 234% 203% 158% 100%

$1,991 - $1,820 = $171

$171 ÷ $1,820 = 9% rounded
 Trend line
140 for Sales
130
% of 100 Base

120

110

100

90
1995 1996 1997 1998 1999
Sales
Years
Expenses