Lesson notes

Lesson 8 : Financial Analysis and Interpretation

Learning Objectives
After careful study , students will be able to: 1. Use horizontal analysis to compare financial statements from different periods. 2. Use vertical analysis to compare financial statement items with each other and with industry averages. 3. Analyze and interpret the financial solvency of a business by computing working capital and the current ratio.. 4. Compute the ratio of net sales to assets as a measure of how effectively a business is using its assets.

Teaching Hours
3 hours

Teaching contents
1. Horizontal analysis

1.1 Use horizontal analysis to compare financial statements from different periods. Financial statements are prepared to communicate information to owners, managers, and others interested in a business performance. One technique used to assess trends of the items on financial statements is horizontal analysis. By discussing this analytical technique, the text emphasizes that both preparation and interpretation of financial statements are essential in the field of accounting. 1.2 Demonstration problem Textbook give simple financial statements. Use these simple financial statements to illustrate horizontal analysis. To begin this illustration, please compute the increase in fees earned between 2005 and 2006. Then please compute the percentage change in fees earned. The correct

answer (rounded to the nearest whole percentage) is 17%, which is computed as follows: Increase in Fees Earned between 2005 & 2006 Fees Earned in 2005(base year) The base year is the starting point2005 in this case. Please compute the increase/decrease in each of the expenses, total operating expenses, and net income. Also please compute the percentage change in each item. Applying horizontal analysis to an income statement helps assess trends in revenues and expenses. This same technique can be used to examine trends in balance sheet accounts. 2. Vertical analysis Under vertical analysis, all financial statement items are shown as a percentage of a significant total on the statement. On an income statement, all items are shown as a percentage of revenues. On a balance sheet, all items are shown as a percentage of total assets. 2.1 Vertical Analysis - Income Statement The textbook presents a simple income statement which can be used to illustrate vertical analysis. Remind that vertical analysis shows all income statement amounts as a percentage of revenues. Therefore, the percentage is determined by dividing each amount on the income statement by the revenue amount. Fill in 100% for the Fees Earned account. Next, demonstrate that Wages Expense is 40% of Fees Earned ($800/$2,000 = 0.40). Ask students to compute percentages for the remaining income statement items. An income statement which shows percentages calculated using vertical analysis is also called a common-size income statement. Refer students to Exhibit 9 in the text, which shows common-size income statements for two years. Use this exhibit to stress the importance of comparing trends from year-to-year. 2.2 Vertical Analysis - Balance Sheet The text presents a balance sheet for illustrating vertical analysis. Remind students = $37,500 $150,000 = 25%

that all balance sheet amounts are stated as a percentage of total assets. Ask them to compute the percentages for the balance sheet. INTERNET ACTIVITY Vertical Analysis and Industry Averages The text reminds students that comparing percentages computed under vertical analysis with industry averages can provide valuable information in assessing a companys performance. One web site where students can find some data on industry averages without paying a subscription is http://www.MarketGuide.com. After reaching this web site, students will need to click on the Industries tab and select the industry they wish to view. Under the profitability section of the industry statistics, they will find the Net Profit Margin %. This number compares to the percentage computed for Net Income on a common-size income statement. 3 . Working capital and the current ratio Explain solvency and allow students to compute and interpret working capital and the current ratio. The text presents the formulas for working capital and the current ratio. It also gives current assets and current liabilities amounts for two companies. Ask students to compute these ratios and state which company is more solvent. Ask students to complete this activity in small groups. Emphasize that the current ratio is helpful when comparing two companies of unequal size. The current ratio compares the relative size of current assets and current liabilities, rather than looking at absolute dollar figures. INTERNET ACTIVITY Current Ratio A web site which provides a variety of information on financial ratios is www.investopedia.com. If students visit http://www.investopedia.com/university/ratios/workingcapital.asp, they will find a tutorial on the current ratio which explains the purpose of the ratio and gives an example of how to calculate the ratio. From the home page of this web site, the information on financial ratios can be accessed by selecting the tutorials tab. The current ratio is listed as one of the industry statistics provided by www.MarketGuide.com. This web site provides some information on industry averages without requiring a subscription. After reaching this web site, students will need to click on the Industries tab and select the industry they wish to view. Remind students that to have an accurate picture of a companys solvency, it is important to compare the current ratio with other companies in the same line of business and look at trends in the current ratio over several years.

. 4 . Ratio of net sales to assets The ratio of net sales to assets is used to measure how efficiently a business is using its assets to generate sales. The formula for this ratio is: Net Sales Ratio of Net Sales to Assets = Average Total Assets It is important to explain the meaning of this ratio and illustrate its calculation. The following examples can be used to help students interpret the ratio of net sales to assets: If a business has $1,000 in assets and $2,000 of sales, the ratio of net sales to assets is 2.0 ($2,000/$1,000). Every dollar invested in assets generates two dollars of sales. If a business with a ratio of net sales to assets of 1.5 has $1,000 in assets, what amount of sales revenue did the business generate? (Answer: $1,500.) The actual formula for computing the ratio of net sales to assets uses Average Total Assets. A business sales are earned across an entire year. As a result, annual sales needs to be compared to the average amount of assets used during the year. While it would be better to average total assets at the end of each month, as a short-cut, the beginning and end of year amounts can be averaged.