Management Accounting: Financial Statement Analysis Guide

Chapter 14: Financial Statement Analysis and Management Accounting

  • Chapter 14: Financial Statement Analysis.

  • Instructor: Tien-Shih Hsieh, Ph.D.

  • Course: ACT 212 Management Accounting.

Learning Objectives

  • 14.1 Perform a horizontal analysis of financial statements (Very Important).

  • 14.2 Perform a vertical analysis of financial statements (Very Important).

  • 14.3 Prepare and use common-size financial statements.

  • 14.4 Compute the standard financial ratios (Very Important).

Common Methods of Financial Analysis

  • Horizontal analysis: This method provides a year-to-year comparison of a company’s performance across different periods.

  • Vertical analysis: This is a means of evaluating the relative size of each line item in the financial statements. It is particularly helpful for comparing companies of different total sizes.

  • Ratio analysis: This provides a means of evaluating the relationship between key components of the financial statements.

Source Data: Supermart Comparative Financial Statements

  • Supermart Income Statement for the Years Ended December 31, 2017 and 2016 (amounts in thousands):   - Sales revenues: 2017: $858,000; 2016: $803,000.   - Less: Cost of goods sold: 2017: $513,000; 2016: $509,000.   - Gross profit: 2017: $345,000; 2016: $294,000.   - Less: Operating expenses: 2017: $244,000; 2016: $237,000.   - Operating income: 2017: $101,000; 2016: $57,000.   - Less: Interest expense: 2017: $20,000; 2016: $14,000.   - Income before income taxes: 2017: $81,000; 2016: $43,000.   - Less: Income tax expense: 2017: $33,000; 2016: $17,000.   - Net income: 2017: $48,000; 2016: $26,000.

  • Supermart Balance Sheets as of December 31, 2017 and 2016 (amounts in thousands):   - Assets:     - Cash: 2017: $29,000; 2016: $32,000.     - Accounts receivable: 2017: $114,000; 2016: $85,000.     - Inventory: 2017: $113,000; 2016: $111,000.     - Other current assets: 2017: $6,000; 2016: $8,000.     - Total current assets: 2017: $262,000; 2016: $236,000.     - Property, plant, and equipment, net: 2017: $507,000; 2016: $399,000.     - Other noncurrent assets: 2017: $18,000; 2016: $9,000.     - Total assets: 2017: $787,000; 2016: $644,000.   - Liabilities:     - Accounts payable: 2017: $73,000; 2016: $68,000.     - Notes payable: 2017: $42,000; 2016: $27,000.     - Accrued liabilities: 2017: $27,000; 2016: $31,000.     - Total current liabilities: 2017: $142,000; 2016: $126,000.     - Long-term liabilities: 2017: $289,000; 2016: $198,000.     - Total liabilities: 2017: $431,000; 2016: $324,000.   - Stockholders' Equity:     - Common stock, no par: 2017: $186,000; 2016: $186,000.     - Retained earnings: 2017: $170,000; 2016: $134,000.     - Total stockholders' equity: 2017: $356,000; 2016: $320,000.     - Total liabilities and equity: 2017: $787,000; 2016: $644,000.

Performing Horizontal Analysis

  • Definition: Horizontal analysis is the study of percentage changes in comparative statements.

  • Two-Step Process:   - Step 1: Compute the dollar amount of the change from the earlier period to the later period.   - Step 2: Divide the dollar amount of change by the earlier period (base period) amount.

  • Calculations Formula:   - Percentage Change=Dollar Amount of ChangeBase Period Amount\text{Percentage Change} = \frac{\text{Dollar Amount of Change}}{\text{Base Period Amount}}

  • Example Calculation (Sales Revenue 2016 to 2017):   - Sales Change: $858,000−$803,000=$55,000\$858,000 - \$803,000 = \$55,000   - Percentage Change: $55,000$803,000=6.8%\frac{\$55,000}{\$803,000} = 6.8\%

  • Example Calculation (Net Income 188,488 vs 156,200):   - Step 1 Change: 188,488−156,200=32,288188,488 - 156,200 = 32,288   - Step 2 % Change: 32,288156,200=20.67%\frac{32,288}{156,200} = 20.67\%

  • Comprehensive Horizontal Analysis of Balance Sheet (Select Items):   - Cash Change: $29,000−$32,000=($3,000)\$29,000 - \$32,000 = (\$3,000), which is −3,00032,000=−9.4%\frac{-3,000}{32,000} = -9.4\%   - Accounts Receivable: $114,000−$85,000=$29,000\$114,000 - \$85,000 = \$29,000, which is 29,00085,000=34.1%\frac{29,000}{85,000} = 34.1\%   - Other noncurrent assets: $18,000−$9,000=$9,000\$18,000 - \$9,000 = \$9,000, which is 100.0%100.0\%   - Long-term liabilities: $289,000−$198,000=$91,000\$289,000 - \$198,000 = \$91,000, which is 46.0%46.0\%

  • Trend Percentage:   - A form of horizontal analysis that indicates the direction a business is taking over a longer period.   - Steps: Select a base year; set the base year to 100%; express each following year as a percentage of the base amount.   - Formula: \text{Trend Percentage} = \frac{\text{Any year } \}{\text{Base year } \}   - Example (Base Year 2012 at $600,000 sales):     - 2013 (Sales $618,000): 618,000600,000=103%\frac{618,000}{600,000} = 103\%     - 2014 (Sales $648,000): 648,000600,000=108%\frac{648,000}{600,000} = 108\%     - 2015 (Sales $690,000): 690,000600,000=115%\frac{690,000}{600,000} = 115\%     - 2016 (Sales $803,000): 803,000600,000=134%\frac{803,000}{600,000} = 134\%     - 2017 (Sales $858,000): 858,000600,000=143%\frac{858,000}{600,000} = 143\%

Performing Vertical Analysis

  • Definition: Vertical analysis shows the relationship of each item on a financial statement to a base amount, which is represented as 100%.

  • Base Amounts:   - Income Statement: Sales revenue is used as the base (100%). Each line item is divided by Sales Revenue.   - Balance Sheet: Total Assets is used as the base (100%). Each line item is divided by Total Assets.

  • Supermart Income Statement Vertical Analysis (2017):   - Sales revenue: $858,000\$858,000 (100.0%)   - Cost of goods sold: $513,000\$513,000 (513,000858,000=59.8%\frac{513,000}{858,000} = 59.8\%   - Gross profit: $345,000\$345,000 (40.2%)   - Operating expenses: $244,000\$244,000 (28.4%)   - Operating income: $101,000\$101,000 (11.8%)   - Interest expense: $20,000\$20,000 (2.3%)   - Net income: $48,000\$48,000 (5.6%)

  • Supermart Balance Sheet Vertical Analysis (2017):   - Total Assets: $787,000\$787,000 (100.0%)   - Cash: $29,000\$29,000 (3.7%)   - Accounts receivable: $114,000\$114,000 (14.5%)   - Property, plant, and equipment, net: $507,000\$507,000 (64.4%)   - Total current liabilities: $142,000\$142,000 (18.0%)   - Total liabilities: $431,000\$431,000 (54.8%)   - Total stockholders' equity: $356,000\$356,000 (45.2%)

Common-Size Financial Statements

  • Benchmarking: This involves comparing a company against competitors or industry averages.

  • Purpose: Common-size statements report only percentages (no dollar amounts) to remove the impact of company size and allow direct comparison.

  • Example Comparison (Supermart vs Target):   - Supermart Gross Profit %: 40.2%   - Target Gross Profit %: 29.5%   - Supermart Net Income %: 5.6%   - Target Net Income %: 4.5%

Standard Financial Ratios

1. Measuring Ability to Pay Current Liabilities

  • Current Liabilities definition: Short-term obligations to be paid within the current operating cycle or one year, including accounts payable, accrued liabilities, deferred revenues, notes payable, and current portion of long-term debt.

  • Working Capital:   - Formula: Working Capital=Current Assets−Current Liabilities\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}   - Supermart 2017: $262,000−$142,000=$120,000\$262,000 - \$142,000 = \$120,000

  • Current Ratio:   - Formula: Current Ratio=Current AssetsCurrent Liabilities\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}   - A ratio of 1.5 to 2.0 is generally considered strong.   - Supermart 2017: $262,000$142,000=1.85\frac{\$262,000}{\$142,000} = 1.85   - Supermart 2016: $236,000$126,000=1.87\frac{\$236,000}{\$126,000} = 1.87

  • Acid-Test Ratio (Quick Ratio):   - Quick assets include cash, marketable securities (short-term investments), and net current receivables.   - Formula: Acid-Test Ratio=Cash+Short-term investments+Net current receivablesCurrent Liabilities\text{Acid-Test Ratio} = \frac{\text{Cash} + \text{Short-term investments} + \text{Net current receivables}}{\text{Current Liabilities}}   - Acceptable range is typically 0.90 to 1.00.   - Supermart 2017: $29,000+$0+$114,000$142,000=1.01\frac{\$29,000 + \$0 + \$114,000}{\$142,000} = 1.01   - Supermart 2016: $32,000+$0+$85,000$126,000=0.93\frac{\$32,000 + \$0 + \$85,000}{\$126,000} = 0.93

2. Measuring Ability to Sell Inventory and Collect Receivables

  • Inventory Turnover:   - Formula: Inventory Turnover=Cost of Goods SoldAverage Inventory\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}   - Supermart 2017: $513,000($111,000+$113,000)/2=4.6 times\frac{\$513,000}{(\$111,000 + \$113,000) / 2} = 4.6 \text{ times}

  • Days in Inventory:   - Formula: Days in Inventory=365 daysInventory Turnover Ratio\text{Days in Inventory} = \frac{365 \text{ days}}{\text{Inventory Turnover Ratio}}   - Supermart 2017: 3654.6=79.35 days\frac{365}{4.6} = 79.35 \text{ days}

  • Accounts Receivable Turnover:   - Formula: Accounts Receivable Turnover=Net Credit SalesAverage Net Accounts Receivable\text{Accounts Receivable Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Net Accounts Receivable}}   - Supermart 2017: $858,000($85,000+$114,000)/2=8.6\frac{\$858,000}{(\$85,000 + \$114,000) / 2} = 8.6

  • Days' Sales in Receivables:   - One day's sales calculation: Net sales365 days\frac{\text{Net sales}}{365 \text{ days}}   - Supermart One Day's Sales: $858,000365=$2,351\frac{\$858,000}{365} = \$2,351   - Formula: Days’ Sales in Receivables=Average Net Accounts ReceivableOne Day’s Sales\text{Days' Sales in Receivables} = \frac{\text{Average Net Accounts Receivable}}{\text{One Day's Sales}}   - Supermart 2017: ($85,000+$114,000)/2$2,351=42 days\frac{(\$85,000 + \$114,000) / 2}{\$2,351} = 42 \text{ days}

3. Measuring Ability to Pay Long-Term Debt

  • Debt Ratio:   - Formula: Debt Ratio=Total LiabilitiesTotal Assets\text{Debt Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}   - Measures portion of assets financed by debt. Higher ratio = higher risk.   - Supermart 2017: $431,000$787,000=0.55\frac{\$431,000}{\$787,000} = 0.55   - Supermart 2016: $324,000$644,000=0.50\frac{\$324,000}{\$644,000} = 0.50

  • Times-Interest-Earned Ratio:   - Formula: Times-Interest-Earned Ratio=Operating IncomeInterest Expense\text{Times-Interest-Earned Ratio} = \frac{\text{Operating Income}}{\text{Interest Expense}}   - Supermart 2017: $101,000$20,000=5.05\frac{\$101,000}{\$20,000} = 5.05   - Supermart 2016: $57,000$14,000=4.07\frac{\$57,000}{\$14,000} = 4.07

4. Measuring Profitability

  • Gross Profit Percentage:   - Formula: Gross Profit %=Gross ProfitNet Sales\text{Gross Profit \%} = \frac{\text{Gross Profit}}{\text{Net Sales}}   - Supermart 2017: $345,000$858,000=40.2%\frac{\$345,000}{\$858,000} = 40.2\%

  • Operating Income Percentage:   - Formula: Operating Income %=Operating IncomeNet Sales\text{Operating Income \%} = \frac{\text{Operating Income}}{\text{Net Sales}}   - Supermart 2017: $101,000$858,000=11.7%\frac{\$101,000}{\$858,000} = 11.7\%

  • Rate of Return on Net Sales:   - Formula: Return on Sales=Net IncomeNet Sales\text{Return on Sales} = \frac{\text{Net Income}}{\text{Net Sales}}   - Supermart 2017: $48,000$858,000=5.6%\frac{\$48,000}{\$858,000} = 5.6\%

  • Rate of Return on Total Assets (ROA):   - Formula: ROA=Net Income+Interest ExpenseAverage Total Assets\text{ROA} = \frac{\text{Net Income} + \text{Interest Expense}}{\text{Average Total Assets}}   - Supermart 2017: $48,000+$20,000($644,000+$787,000)/2=9.5%\frac{\$48,000 + \$20,000}{(\$644,000 + \$787,000) / 2} = 9.5\%

  • Rate of Return on Common Stockholders' Equity (ROE):   - Formula: ROE=Net Income−Preferred DividendsAverage Common Stockholders’ Equity\text{ROE} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Average Common Stockholders' Equity}}   - Supermart 2017 (assuming no preferred dividends): $48,000−$0($320,000+$356,000)/2=14.2%\frac{\$48,000 - \$0}{(\$320,000 + \$356,000) / 2} = 14.2\%

  • Earnings per Share (EPS):   - Formula: EPS=Net Income−Preferred DividendsShares of Common Stock Outstanding\text{EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Shares of Common Stock Outstanding}}   - Supermart 2017: $48,000−$010,000=$4.80\frac{\$48,000 - \$0}{10,000} = \$4.80   - Supermart 2016: $26,000−$010,000=$2.60\frac{\$26,000 - \$0}{10,000} = \$2.60

5. Analyzing Stock Investments

  • Price/Earnings Ratio (P/E):   - Formula: P/E Ratio=Market Price per Share Common StockEPS\text{P/E Ratio} = \frac{\text{Market Price per Share Common Stock}}{\text{EPS}}   - Supermart 2017 (Price $60): $60.00$4.80=12.5\frac{\$60.00}{\$4.80} = 12.5   - Supermart 2016 (Price $35): $35.00$2.60=13.5\frac{\$35.00}{\$2.60} = 13.5

  • Dividend Yield:   - Formula: Dividend Yield=Dividend per Share of Common StockMarket Price per Share of Common Stock\text{Dividend Yield} = \frac{\text{Dividend per Share of Common Stock}}{\text{Market Price per Share of Common Stock}}   - Supermart 2017 (Div $1.20, Price $60): $1.20$60=2.0%\frac{\$1.20}{\$60} = 2.0\%   - Supermart 2016 (Div $1.00, Price $35): $1.00$35=2.9%\frac{\$1.00}{\$35} = 2.9\%

  • Book Value per Share of Common Stock:   - Formula: Book Value=Total Stockholders’ Equity−Preferred EquityNumber of Shares of Common Stock Outstanding\text{Book Value} = \frac{\text{Total Stockholders' Equity} - \text{Preferred Equity}}{\text{Number of Shares of Common Stock Outstanding}}   - Supermart 2017: $356,000−$010,000=$35.60\frac{\$356,000 - \$0}{10,000} = \$35.60   - Supermart 2016: $320,000−$010,000=$32.00\frac{\$320,000 - \$0}{10,000} = \$32.00

Red Flags in Financial Statement Analysis

  • Movement of Sales, Inventory, and Receivables (e.g., Buildup of inventories, inability to collect receivables).

  • Earnings problems.

  • Decreased cash flow.

  • Too much debt.

Questions & Discussion

  • Question: Which type of analysis includes the computation of the percentage change in total assets between two balance sheet dates?   - Answer: C. Horizontal.

  • Question: Based on the provided income statements for Clark and Dartmouth, which company has the better relationship between gross profit and net sales revenue?   - Data for Clark: Net sales revenue $487,000 (100%), COGS $400,300 (82.2%), Gross Profit $86,700 (17.8%).   - Data for Dartmouth: Net sales revenue $500,000 (100%), COGS $395,000 (79%), Gross Profit $105,000 (21%).   - Answer: D. Dartmouth (21% gross profit margin vs 17.8%).

  • Question: A managerial accountant presents statements showing only percentages (Sales 100%, COGS 23%, Net Income 55%). What type of statement is this?   - Answer: D. Common-size statement.

  • Question: Which financial ratio cannot be used to measure a company's ability to pay current liabilities?   - Answer: A. Accounts Receivable Turnover.

  • In-Class Exercise: Stevenson Corporation data: quick assets $26,000; total assets $400,000; noncurrent assets $180,000; noncurrent liabilities $240,000; total equity $84,000.   - Step 1: Find Current Liabilities (CL). TL+TSE=TA→CL+240,000+84,000=400,000→CL=76,000TL + TSE = TA \rightarrow CL + 240,000 + 84,000 = 400,000 \rightarrow CL = 76,000.   - Step 2: Find Current Assets (CA). CA+180,000=400,000→CA=220,000CA + 180,000 = 400,000 \rightarrow CA = 220,000.   - Quick Ratio: 26,00076,000=0.34\frac{26,000}{76,000} = 0.34   - Working Capital: $220,000−$76,000=$144,000\$220,000 - \$76,000 = \$144,000

  • Trust Corporation Comprehensive Exercise (2.5 million shares outstanding at $34.50):   - Inventory Turnover: 5,400(1500+2100)/2=3\frac{5,400}{(1500+2100)/2} = 3   - Days' sales in receivables: Avg AR is $2,300. One day's sale is 14,600365=40\frac{14,600}{365} = 40. Ratio is 230040=57.5 days\frac{2300}{40} = 57.5 \text{ days}. (Company has trouble collecting if industry avg is 15 days).   - Current Ratio: 900010000=0.9\frac{9000}{10000} = 0.9   - Acid-test Ratio: 3000+0+240010000=0.54\frac{3000 + 0 + 2400}{10000} = 0.54   - Times-interest-earned: 4700200=23.5\frac{4700}{200} = 23.5   - ROE: 2300(13000+10000)/2=20%\frac{2300}{(13000+10000)/2} = 20\%   - EPS: 23002500 (Correction: per exercise text)=$0.92\frac{2300}{2500 \text{ (Correction: per exercise text)}} = \$0.92   - P/E Ratio: $34.500.92=37.5\frac{\$34.50}{0.92} = 37.5

  • Winder Corporation Results:   - Current Year Quick Ratio: 34,000+42,000100,000=0.76\frac{34,000 + 42,000}{100,000} = 0.76   - Current Year Inventory Turnover: 220,000(120,000+100,000)/2=2\frac{220,000}{(120,000+100,000)/2} = 2   - Days' Sales in Receivables: One day's sales = 445,400365=1,220\frac{445,400}{365} = 1,220. Ratio is (42,000+62,000)/21,220=42.62 days\frac{(42,000+62,000)/2}{1,220} = 42.62 \text{ days}.   - Dollar Change Net Sales: $445,400−$362,000=$83,400 (23.04%)\$445,400 - \$362,000 = \$83,400 \text{ (23.04\%)}.   - Dollar Change Gross Profit: $225,400−$177,000=$48,400 (27.34%)\$225,400 - \$177,000 = \$48,400 \text{ (27.34\%)}.   - Dollar Change Net Income: $40,000−$35,000=$5,000 (14.29%)\$40,000 - \$35,000 = \$5,000 \text{ (14.29\%)}.