ANALYSIS AND

INTERPRETATION OF
FINANCIAL STATEMENTS
(Financial Policy and Planning)
 OUTLINE
PART 1:
FINANCIAL STATEMENTS
 Definition
 Significance
 Types
PART 2:
FINANCIAL STATEMENT ANALYSIS
 Uses
 Methods
 PART 1:
DEFINITION OF
FINANCIAL STATEMENTS
 Financial statements are summaries of the
operating, financing, and investment
activities of a firm.
 According to the Financial Accounting
Standards Board (FASB), the financial
statements of a firm should provide
sufficient information that is useful to:
 Investors;

 Creditors; and
 In making their investment and
credit decisions in an informed way.
 The financial statements are expected to
be prepared in accordance with a set of
standards known as generally accepted
accounting principles (GAAP).
 The financial statements of publicly
traded firms must be audited at least
annually by independent public
accountants.
 The auditors are expected to attest to the
fact that these financial statements of a
firm have been prepared in accordance
with GAAP.
 PART 1:
SIGNIFICANCE OF
FINANCIAL STATEMENTS
 Financial statement analysis helps
identify a firm’s strengths,
weaknesses, and so that management
can take advantage of a firm’s
strengths and make plans to counter
weaknesses of the firm.
 For example, are inventories adequate to
support the projected level of sales?
 Does large account receivable reflect a lax
collection policy?
 To ensure efficient operations of a firm’s
manufacturing facility, does the firm have too
much or too little invested in plant and
equipment?

Financial statement analysis

provides answers to all of
these questions.
 PART 1:
TYPES OF
FINANCIAL STATEMENTS
 The Income Statement

 The Balance Sheet

 The Statement of Changes in Equity

 The Statement of Cash Flows

 Income Statement
 An income statement is a summary of the
revenues and expenses of a business over a
period of time, usually either one month, three
months, or one year.
 Summarizes the results of the firm’s operating
and financing decisions during that time.
 Operating decisions of the company apply to
production and marketing such as sales /
revenues, cost of goods sold, administrative and
general expenses (advertising, office salaries)
 Balance Sheet
A summary of the assets, liabilities, and equity of a business at a
particular point in time, usually at the end of the firm’s fiscal year.

Assets = Liabilities + Equity

(Resources of the (Obligations of (ownership left over
business enterprise) the business) Residual)

Fixed Assets Long-term Common stock outstanding

(Plant, Machinery, Equipment (Notes, bonds, & Additional paid-in capital
Buildings) Capital Lease Retained Earnings
Current Assets Obligation)
(Cash, Marketable Securities, Current Liabilities
Account Receivable, Inventories) (Accounts Payable,
Wages and salaries,
Short-term loans,
Any portion of long-term
Indebtedness due in one-year)
 Statement of Retained Earnings
Also known as a statement of owner's equity or a
statement of shareholders' equity.
is a financial statement outlining the changes
in retained earnings for a specified period.
The statement is prepared in accordance
with generally accepted accounting principles
(GAAP). It reconciles the beginning and ending
retained earnings for the period. Includes
information regarding a firm’s retained earnings,
along with the net income that was directed to
stockholders in the form of dividends.
 Statement of Cash Flows
The statement is designed to show how the firm’s
operations have affected its cash position and to
help answer questions such as:
 Is the firm generating the cash needed to
purchase additional fixed assets for growth?
 Is the growth so rapid that external financing
is required both to maintain operations and
for investment in new fixed assets?
 Does the firm have excess cash flows that
can be used to repay debt or to invest in new
products?
 PART 2:
FINANCIAL STATEMENTS
ANALYSIS
 Non-accounting majors, especially,
should relate well to this chapter
It looks at accounting information
from users’ perspective

 What is financial statement

analysis?
”Tearing apart” the financial
statements and looking at the
relationships
Who analyzes financial statements?
 Internalusers (i.e., management)
 External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory
agencies, stock market analysts, and
auditors
 PART 2:
USES OF
FINANCIAL STATEMENTS
ANALYSIS
 INTERNAL USES OF
FINANCIAL STATEMENTS
 PLAN -- Focus on assessing the current
financial position and evaluating potential
firm opportunities.
 CONTROL -- Focus on return on
investment for various assets and asset
efficiency.
 UNDERSTAND -- Focus on understanding
how suppliers of funds analyze the firm.
 EXTERNAL USES OF
FINANCIAL STATEMENTS
 TRADE CREDITORS -- Focus on the
liquidity of the firm.
 BONDHOLDERS -- Focus on the
long-term cash flow of the firm.
 SHAREHOLDERS -- Focus on the
profitability and long-term health of the
firm.
 PART 2:
METHODS OF
FINANCIAL STATEMENTS
ANALYSIS
Horizontal Analysis
Vertical Analysis
Trend Percentages
Ratio Analysis
 Horizontal Analysis

Using comparative financial

statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
Vertical Analysis
For a single financial
statement, each item
is expressed as a
percentage of a
significant total,
e.g., all income
statement items are
expressed as a
percentage of sales
 Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)
 Ratio Analysis
Expression of logical relationships
between items in a financial
statement of a single period
(e.g., percentage relationship
between revenue and net income)
Example of Horizontal Analysis
The management of Clover Company provides
you with comparative balance sheets of the
years ended December 31, 2016 and 2017.
Management asks you to prepare a horizontal
analysis on the information.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 2016 and 2017

Incre
2017 2016 Am
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
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

Since we are measuring the amount of

the change between 2016 and 2017, the
dollar amounts for 2016 become the
“base” year figures.
 Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 2016 and 2017
Increase (Decrease)
2017 2016 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
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 2016 and 2017
Increase (Decrease)
2017 2016 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
 2017 2016 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
Example of Horizontal Analysis
Let’s apply the same
procedures to the
liability and stockholders’
equity sections of the
balance sheet.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 2016 and 2017
Increase (Decrease)
2017 2016 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000
Notes payable 3,000 6,000
Total current liabilities 70,000 50,000
Long-term liabilities:
Bonds payable, 8% 75,000 80,000
Total liabilities 145,000 130,000
Stockholders' equity:
Preferred stock 20,000 20,000
Common stock 60,000 60,000
Additional paid-in capital 10,000 10,000
Total paid-in capital 90,000 90,000
Retained earnings 80,000 69,700
Total stockholders' equity 170,000 159,700
Total liabilities and stockholders' equity $ 315,000 $ 289,700
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 2016 and 2017
Increase (Decrease)
2017 2016 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
Example of Horizontal Analysis
Now, let’s apply the
procedures to the
income statement.
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 2016 and 2017
Increase (Decrease)
2017 2016 Amount %
Net 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
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 2016 and 2017
Increase (Decrease)
2017 2016 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, 2016 and 2017
Increase (Decrease)
2017 2016 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 6,400 7,000
8.3% while net (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
income
Less income taxes (30%)
decreased
7,500
by 21.9%.
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
CLOVERmore than offset the
CORPORATION
increase inComparative
sales, yielding anStatements
Income overall
Fordecrease
the Years Ended
in netDecember
income. 31, 2016 and 2017
Increase (Decrease)
2017 2016 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)
Example of Vertical Analysis
The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the
company.
 Sample Company
Balance Sheet (Assets)
At December 31, 2016 and 2017
% of Total Assets
2017 2016 2017 2016
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
 Sample Company
Balance Sheet (Assets)
At December 31, 2016 and 2017
% of Total Assets
2017 2016 2017 2016
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
$82,000 ÷ $483,000 = 17% rounded
Land 101,000 90,000 21% 23%
Equipment
$30,000110,000
÷ $387,000 100,000
= 8% rounded
23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
 Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
At December 31, 2016 and 2017
% of Total Assets
2017 2016 2017 2016
Acts. Payable $ 76,000 $ 60,000 16% 16%
Wages Payable 33,000 17,000 7% 4%
Notes Payable 50,000
$76,000 ÷ $483,000 = 50,000 10%
16% rounded 13%
Common Stock 170,000 160,000 35% 41%
Retained Earnings 154,000 100,000 32% 26%
Total $ 483,000 $ 387,000 100% 100%
 Example of Trend Percentages
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
 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

 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
 140
Trend line
130 for Sales
% of 100 Base

120

110

100

90
1995 1996 1997 1998 1999
Sales
Years
Expenses
 THAT’S ALL,
THANK YOU!!!