Financial Statement Analysis Study Notes

Copyright Information: Financial Accounting, Sixth Edition, by Spiceland, Thomas, and Herrmann. Copyright ©2022 McGraw-Hill. All rights reserved.

Introduction to three methods of financial analysis that can be performed on financial statements.

Vertical Analysis Definition: Expresses each item in a financial statement as a percentage of the same base amount measured in the same period.
Examples:
- Income statement items expressed as a percentage of sales.
- Balance sheet items expressed as a percentage of total assets.

Illustration (Nike and VF for fiscal years 2020):
- Nike:
- Net sales = $10,489 million
- Cost of goods sold = $4,691 million (44.7% of net sales)
- Gross profit = $5,798 million (55.3% of net sales)
- Operating expenses = $4,870 million (46.4% of net sales)
- Operating income = $928 million (8.8% of net sales)
- Other income (expense) = -$201 million (–1.9% of net sales)
- Income before tax = $727 million (6.9% of net sales)
- Income tax expense = $98 million (0.9% of net sales)
- Net income = $629 million (6.0% of net sales)
- VF:
- Net sales = $37,403 million
- Cost of goods sold = $21,162 million (56.6% of net sales)
- Gross profit = $16,241 million (43.4% of net sales)
- Operating expenses = $13,126 million (35.1% of net sales)
- Operating income = $3,115 million (8.3% of net sales)
- Other income (expense) = -$228 million (–0.6% of net sales)
- Income before tax = $2,887 million (7.7% of net sales)
- Income tax expense = $348 million (0.9% of net sales)
- Net income = $2,539 million (6.8% of net sales)

Illustration of Common-Size Balance Sheets (as a percentage of total assets):
- Nike (March 31, 2020):
- Current assets = $5,027 million (45.2% of total assets)
- Property and equipment = $954 million (8.6% of total assets)
- Intangible assets = $3,011 million (27.0% of total assets)
- Other assets = $2,141 million (19.2% of total assets)
- Total Assets = $11,133 million (100% total)
- VF (March 31, 2020):
- Total assets reported as $31,342 million
- Current liabilities = $8,284 million (26.4% of total assets)
- Long-term liabilities = $15,003 million (47.9% of total assets)
- Stockholders’ equity = $8,055 million (25.7% of total assets)

Vertical analysis requires expressing each item as a percentage of a base amount, such as:
- Income Statement: Percentage of sales.
- Balance Sheet: Percentage of total assets.

Income Statement Items are expressed as a percentage of:
- Net income
- Sales
- Gross profit
- Total assets.
Balance Sheet Items are expressed as a percentage of:
- Total assets
- Total liabilities
- Total equity
- Total revenues.

Analyzing trends in financial statement data for a single company over time using the formula:
$Percentage ext{ Increase (Decrease)} = \frac{Current-year\, amount - Prior-year\, amount}{Prior-year\, amount}$

FY 2020 vs FY 2019 (amounts in millions):
- Net sales increase of $222 signifying a 2.2% increase.
- Cost of goods sold increase showing trends in expenses.
- Operating expenses increase demonstrating management efficiency or challenges in controlling costs.
- Operating income and net income changes reflecting profitability over time.

Used to analyze trends over years for:
- A single company.
- Between companies in the same year.
- As a percentage of sales in every financial statement.

Receivables Turnover Ratio:
- Measures how many times receivables are collected during the year. The appropriate turnover ratio would vary by industry standards.
Average Collection Period:
- Measures the days it takes to convert receivables into cash. Shorter periods are better as it indicates quicker cash recovery.
Inventory Turnover Ratio:
- Measures how many times average inventory is sold during the year. A high ratio reflects efficient inventory management.
Current Ratio:
- Compares current assets to current liabilities. A higher ratio indicates less risk.
Acid-Test Ratio:
- A more conservative measure eliminating inventory as it may not be easily liquidated.
Debt to Equity Ratio:
- An indicator of financial leverage and bankruptcy risk.
Times Interest Earned Ratio:
- Compares the company's income available to pay interest expenses, classified as a solvency metric.

Risk ratios divided into liquidity ratios (current liabilities) and solvency ratios (long-term liabilities).
Liquidity ratios focus on a company’s short-term obligations while solvency ratios assess long-term financial health.

Gross Profit Ratio:
- Portion of sales remaining after covering the cost of goods sold.
Return on Assets (ROA):
- Measures income per dollar invested in assets. Higher ROA signifies effective asset utilization.
Return on Equity (ROE):
- Reflects the income earned for each dollar invested by shareholders. A higher ROE is favorable.
Price-Earnings Ratio:
- Compares share price to earnings per share; a higher PE ratio indicates higher expected growth from investors.

Profitability ratios evaluate how well a company operates and generates earnings. Investors often prioritize these metrics as critical indicators of company success.

Certain items included in current net income that are not likely to recur, such as gains/losses from sales of fixed assets.

Defined as sales or disposal of a business segment that represents a strategic shift and can significantly affect financial results. Gains and losses from these operations must be reported separately on income statements.

Considered the reliability of reported earnings to reflect actual earnings.
- Conservative practices typically report lower income, lower assets, and higher liabilities, while aggressive practices yield the opposite results.

Changes in accounting estimates affect reported figures but not cash flows. Conservative practices contrast with aggressive accounting practices based on reported earnings treatment.