Financial Statement Analysis

LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS

Changes within
the company
Industry Consumer
trends tastes

Technological
changes
Economic
factors

Analysts should look beyond

the ratios.
 STATEMENTS IN COMPARATIVE AND COMMON-SIZE
FORM
 Dollar and percentage
changes on statements

An item on a financial
statement has little  Common-size
meaning by itself. The statements
meaning of the numbers
can be enhanced by
drawing comparisons.
 Ratios
 DOLLAR AND PERCENTAGE CHANGES ON STATEMENTS
Horizontal analysis (or trend analysis) shows the changes between years in
the financial data in both dollar and percentage form.
 HORIZONTAL ANALYSIS
Example

The following slides illustrate a horizontal analysis of Clover Corporation’s

December 31, 2005 and 2004, comparative balance sheets and comparative
income statements.
HORIZONTAL ANALYSIS
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 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
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

The dollar
amounts for
2004 become
the “base” year
figures.
 HORIZONTAL ANALYSIS
Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
HORIZONTAL ANALYSIS
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 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 $12,000 –155,000
$23,500164,700
= $(11,500)
Property and equipment:
Land 40,000 40,000
($11,500
Buildings and equipment, net ÷ $23,500)
120,000 × 100% = 48.9%
85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
HORIZONTAL ANALYSIS
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 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
We could do this for the liabilities
& stockholders’ equity, but now
let’s look at the income statement
accounts.
HORIZONTAL ANALYSIS
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2005 2004 Amount %
Sales $ 520,000 $ 480,000
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
Net operating income 31,400 39,000
Interest expense 6,400 7,000
Net income before taxes 25,000 32,000
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400
HORIZONTAL ANALYSIS
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2005 2004 Amount %
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)
HORIZONTAL ANALYSIS
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2005 2004 Amount %
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)
OperatingSales increased
expenses by 8.3%
128,600 yet
126,000 2,600 2.1
net income
Net operating incomedecreased
31,400by 21.9%.
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)
 HORIZONTAL ANALYSIS
There were increasesCLOVER CORPORATION
in both cost of goods
Comparative Income Statements
sold (14.3%) and operating expenses (2.1%).
For the Years Ended December 31
These increased costs more than offset theIncrease
increase in sales, yielding an overall (Decrease)
decrease in net income.2004
2005 Amount %
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)
TREND PERCENTAGES

Trend percentages
state several years’
financial data in terms
of a base year, which
equals 100 percent.
 TREND ANALYSIS
Trend = Current Year Amount
Percentage Base Year Amount
× 100%
 TREND ANALYSIS

Example

Look at the income information for Berry Products for the years 2001 through
2005. We will do a trend analysis on these amounts to see what we can learn
about the company.
 TREND ANALYSIS
Berry Products
Income Information
For the Years Ended December 31
Year
Item 2005 2004 2003 2002 2001
Sales $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of goods sold 285,000 250,000 225,000 198,000 190,000
Gross margin 115,000 105,000 95,000 92,000 85,000

The base
year is 2001, and its amounts
will equal 100%.
 TREND ANALYSIS
Berry Products
Income Information
For the Years Ended December 31
Year
Item 2005 2004 2003 2002 2001
Sales 105% 100%
Cost of goods sold 104% 100%
Gross margin 108% 100%

2002 Amount ÷ 2001 Amount × 100%

( $290,000 ÷ $275,000 ) × 100% = 105%
( $198,000 ÷ $190,000 ) × 100% = 104%
( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
 TREND ANALYSIS
Berry Products
Income Information
For the Years Ended December 31
Year
Item 2005 2004 2003 2002 2001
Sales 145% 129% 116% 105% 100%
Cost of goods sold 150% 132% 118% 104% 100%
Gross margin 135% 124% 112% 108% 100%

By analyzing the trends for Berry Products, we

can see that cost of goods sold is increasing
faster than sales, which is slowing the increase
in gross margin.
TREND ANALYSIS

160 We can use the trend

150
percentages to construct a
graph so we can see the
140
Percentage

trend over time.

130

120 Sales
COGS
110 GM
100
2001 2002 2003 2004 2005
Year
COMMON-SIZE STATEMENTS

Vertical analysis focuses

on the relationships
among financial statement
items at a given point in
time. A common-size
financial statement is a
vertical analysis in which
each financial statement
item is expressed as a
percentage.
COMMON-SIZE STATEMENTS

In income
statements, all
items are
usually
expressed as a
percentage of
sales.
GROSS MARGIN PERCENTAGE
Gross Margin Gross Margin
=
Percentage Sales

This measure indicates how much

of each sales dollar is left after
deducting the cost of goods sold to
cover expenses and provide a profit.
COMMON-SIZE STATEMENTS
In balance
sheets, all items
are usually
expressed as a
percentage of
total assets.
 COMMON-SIZE STATEMENTS
Wendy's McDonald's
(dollars in millions) Dollars Percentage Dollars Percentage
2002 Net income $ 219 8.00% $ 893 5.80%

Common-size financial statements are

particularly useful when comparing
data from different companies.
COMMON-SIZE STATEMENTS

Example

Let’s take another look at the information from the comparative income
statements of Clover Corporation for 2005 and 2004.
This time let’s prepare common-size statements.
COMMON-SIZE STATEMENTS
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005 2004 2005 2004
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000 Sales is
Operating expenses 128,600 126,000 usually the
Net operating income 31,400 39,000 base and is
Interest expense 6,400 7,000 expressed
Net income before taxes 25,000 32,000
as 100%.
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400
COMMON-SIZE STATEMENTS
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005 2004 2005 2004
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
2005 Cost
Net operating ÷ 2005 Sales
income 31,400× 100%
39,000
( $360,000
Interest expense ÷ $520,000 ) × 100%
6,400 = 69.2%
7,000
Net income before taxes 25,000 32,000
Less income 2004 Cost ÷ 2004
taxes (30%) 7,500 Sales × 100%
9,600
Net income ( $315,000 $÷17,500 $480,000 ) × 100% = 65.6%
$ 22,400
COMMON-SIZE STATEMENTS
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
What conclusions can we draw? Percentages
2005 2004 2005 2004
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000 30.8 34.4
Operating expenses 128,600 126,000 24.8 26.2
Net operating income 31,400 39,000 6.0 8.2
Interest expense 6,400 7,000 1.2 1.5
Net income before taxes 25,000 32,000 4.8 6.7
Less income taxes (30%) 7,500 9,600 1.4 2.0
Net income $ 17,500 $ 22,400 3.4 4.7
QUICK CHECK 
Which of the following statements describes
horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c. A comparison of the account balances on
the current year’s financial statements.
d. None of the above.
QUICK CHECK 
Which of the following statements describes
horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c.Horizontal
A comparison of theshows
analysis account
thebalances
changes on
the current
between yearsyear’s
in thefinancial
financialstatements.
data in both
d. Nonedollar
of theand
above.
percentage form.
Now, let’s look at
Norton
Corporation’s
2005 and 2004
financial
statements.
 NORTON CORPORATION
Balance Sheets
December 31

2005 2004
Assets
Current assets:
Cash $ 30,000 $ 20,000
Accounts receivable, net 20,000 17,000
Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000
Property and equipment:
Land 165,000 123,000
Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000
Total assets $ 346,390 $ 300,000
 NORTON CORPORATION
Balance Sheets
December 31

2005 2004
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 39,000 $ 40,000
Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000
Long-term liabilities:
Notes payable, long-term 70,000 78,000
Total liabilities 112,000 120,000
Stockholders' equity:
Common stock, $1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000

Total liabilities and stockholders' equity $ 346,390 $ 300,000

 NORTON CORPORATION
Income Statements
For the Years Ended December 31

2005 2004
Sales $ 494,000 $ 450,000
Cost of goods sold 140,000 127,000
Gross margin 354,000 323,000
Operating expenses 270,000 249,000
Net operating income 84,000 74,000
Interest expense 7,300 8,000
Net income before taxes 76,700 66,000
Less income taxes (30%) 23,010 19,800
Net income $ 53,690 $ 46,200
 This is your home
activity. You need to
conduct the horizontal
and vertical analysis
of Norton Corporation
financial statements.