Katy Trail: Day 268 of 365 of Training for Trek across Missouri via the ...

Accounting: The Language of Business - Vol. 1 (Part 102)

Creative accounting is an absolute curse to a civilization. One could argue that double-entry bookkeeping was one of history’s great advances. Using accounting for fraud and folly is a disgrace. In a democracy, it often takes a scandal to trigger reform. Enron was the most obvious example of a business culture gone wrong in a long, long time.

– Charlie Munger

 Financial Statement Analysis (Part B)

by

Charles Lamson

Solvency Analysis

Some aspects of a business's financial condition and operations are of greater importance to some users of financial statements than others. However, all users are interested in the ability of a business to pay its debts as they are due and to earn income. The ability of a business to meet its financial obligations (debts) is called solvency. The ability of a business to earn income is called profitability.

The factors of solvency and profitability are interrelated. A business that cannot pay its debts on a timely basis may experience difficulty in obtaining credit. A lack of available credit may, in turn, lead to a decline in the businesses profitability. Eventually, the business may be forced into bankruptcy. Likewise, a business that is less profitable than its competitors is likely to be at a disadvantage in obtaining credit or new capital from stockholders.

In the next few posts we discuss various types of financial analyses that are useful in evaluating the solvency of the business. In the next section, we discuss various types of profitability analysis. The examples in both sections are based on Lincoln Company's financial statements presented in part 101. In some cases, data from Lincoln company's financial statements of the preceding year and from other sources are also used. These historical data are useful in assessing the past performance of the business and in forecasting its future performance. The results of financial analyses may be even more useful when they are compared with those of competing businesses and with industry averages.

Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and noncurrent liabilities. It is normally assessed by examining balance sheet relationships, using the following major analyses:

1. Current position analysis

2. Accounts receivable analysis

3. Inventory analysis

4. The ratio of fixed assets to long-term liabilities

5. The ratio of liabilities to stockholders equity

6. The number of times interest charges are earned 

Current Position Analysis

To be useful in assessing solvency a ratio or other financial measure must relate to a business's ability to pay or otherwise satisfy its liabilities. Using measures to assess a business's ability to pay its current liabilities is called current position analysis. Such analysis is of special interest to short-term creditors.

An analysis of a firm's current position normally includes determining the working capital, the current ratio, and the quick ratio. The current and quick ratios are most useful when analyzed together and compared to previous periods and other firms in the industry.

Working Capital

The excess of the current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company's ability to meet currently maturing debts. It is especially useful in making monthly or other period-to-period comparisons for a company. However, amounts of working capital are difficult to assess when comparing companies of different sizes or in comparing such amounts with industry figures. For example, working capital of $250,000 may be adequate for a small local hardware store, but it would be inadequate for all of Lowe's.

Current Ratio

Another means of expressing the relationship between current assets and current liabilities is the current ratio. This ratio is sometimes called the working capital ratio or banker's ratio. The ratio is computed by dividing the total current assets by the total current liabilities. For Lincoln Company, working capital and the current ratio for 2023 and 2022 are as follows.

The current ratio is a more reliable indicator of solvency than is working capital. To illustrate, assume that as of December 31, 2023, the working capital of a competitor is much greater than $340,000, but its current ratio is only 1.3. Considering these facts alone, Lincoln Company, with its current ratio of 2.6, is in a more favorable position to obtain short-term credit than the competitor, which has the greater amount of working capital.

Quick Ratio

The working capital and the current ratio do not consider the makeup of the current assets. To illustrate the importance of this consideration, the current position data for Lincoln Company and Jefferson Corporation as of December 31, 2023, are as follows:

Both companies have a working capital of $340,000 and a current ratio of 2.6. But the ability of each company to pay its current debts is significantly different. Jefferson Corporation has more of its current assets in inventories. Some of these inventories must be sold and the receivables collected before the current liabilities can be paid in full. Thus, a large amount of time may be necessary to convert these inventories into cash. Declines in market prices and a reduction in demand could also impair its ability to pay current liabilities. In contrast, Lincoln company has cash and current assets (marketable securities and accounts receivable) that can generally be converted to cash rather quickly to meet its current liabilities.

A ratio that measures the "instant" debt paying ability of a company is called the quick ratio or acid-test ratio. It is the ratio of the total quick assets to the total current liabilities. Quick assets are cash and other current assets that can be quickly converted to cash. Quick assets normally indicate cash, marketable securities, and receivables. The quick ratio data for Lincoln Company are as follows: 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 697-699*

end

Ireland and the Druids

Accounting: The Language of Business - Vol. 1 (Part 101)

It sounds extraordinary, but it’s a fact that balance sheets can make fascinating reading.

– Mary Archer

Financial Statement Analysis (Part A)

by

Charles Lamson

Google Finance reported that the common stock of Microsoft Corporation was selling for $273.24 per share. if you had funds to invest, would you invest in Microsoft common stock?

Microsoft is a well-known, international company. However, United Airlines, Worldcom, Kmart, Polaroid, and Planet Hollywood were also well-known companies. These latter companies share the common characteristic of having declared bankruptcy.

Obviously, being well-known is not necessarily a good basis for investing. Knowledge that a company has a good product, by itself, may also be an inadequate basis for investing in the company. Even with a good product, a company may go bankrupt for a variety of reasons, such as inadequate financing. For example, Planet Hollywood sought bankruptcy protection, even though it was owned and promoted by such prominent Hollywood stars as Bruce Willis, Whoopi Goldberg, and Arnold Schwarzenegger.

How, then, does one decide on the companies in which to invest? The next several posts describe and illustrate common financial data that can be analyzed to assist you in making investment decisions. In addition, the contents of corporate annual reports are also discussed.

Basic Analytical Procedures

The basic financial statements provide much of the information users need to make economic decisions about businesses. In the next several posts, we illustrate how to perform a competitive analysis of these statements by integrating individual analytical measures.

Analytical procedures may be used to compare items on a current statement with related items on earlier statements. For example, cash of $150,000 on the current balance sheet may be compared with cash of $100,000 on the balance sheet of a year earlier. The current year's cash may be expressed as 1.5 or 150% of the earlier account, or as an increase of 50% or $50,000.

Analytical procedures are also widely used to examine relationships within a financial statement. To illustrate, assume that cash of $50,000 and inventories of $250,000 are included in the total assets of $1,000,000 on a balance sheet. In relative terms, the cash balance is 5% of the total assets, and the inventories are 25% of the total assets.

In the next few posts, we will illustrate a number of common analytical measures. The measures are not ends in themselves. They are only guides in evaluating financial and operating data. Many other factors, such as trends in the industry and general economic conditions, should also be considered.

Horizontal Analysis

The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis. The amount of each item on the most recent statement is compared with the related item on one or more earlier statements. The amount of increase or decrease in the item is listed, along with the percent of increase or decrease.

Horizontal analysis may compare two statements. In this case, the earlier statement is used as the base. Horizontal analysis may also compare three or more statements. In this case, the earliest date or period may be used as the base for comparing all later dates or periods. Alternatively, each statement may be compared to the immediately preceding statement. Exhibit 1 is a condensed comparative balance sheet for two years for Lincoln Company, with horizontal analysis.

EXHIBIT 1 Comparative Balance Sheet---Horizontal Analysis

We cannot fully evaluate the significance of the various increases and decreases in the items shown in Exhibit 1 without additional information. Although total assets at the end of 2023 were $91,000 (7.4%) less than at the beginning of the year, liabilities were reduced by $133,000 (30%), and stockholder equity increased $42,000 (5.3%). It appears that the reduction of $100,000 in long-term liabilities was achieved mostly through the sale of long-term investments.

The balance sheet in Exhibit 1 may be expanded to include the details of the various categories of assets and liabilities. An alternative is to present the details in separate schedules. Exhibit 2 is a supporting schedule with horizontal analysis. 

The decrease in accounts receivable may be due to changes in credit terms or improved collection policies. Likewise, a decrease in inventories during a period of increased sales may indicate an improvement in the management of inventories.

The changes in the current assets in Exhibit 2 appear favorable. This assessment is supported by the 24.8% increase in net sales shown in Exhibit 3.

EXHIBIT 3 Comparative Income Statement---Horizontal Analysis

An increase in net sales may not have a favorable effect on operating performance. The percentage increase in Lincoln Company's net sales is accompanied by a greater percentage increase in the cost of goods (merchandise) sold. This has the effect of reducing gross profit. Selling expenses increased significantly, and administrative expenses increase slightly. Overall, operating expenses increased by 20.7%, whereas gross profit increased by only 19.7%.

The increase in income from operations and in net income is favorable. However, a study of the expenses and additional analyses and comparisons should be made before reaching a conclusion as to the cause.

Exhibit 4 illustrates a comparative retained earnings statement with horizontal analysis. It reveals that retained earnings increased 30.5% for the year. The increase is due to net income of $91,000 for the year, less dividends of $49,000.

EXHIBIT 4 Comparative Retained Earnings Statement---Horizontal Analysis

Vertical Analysis

A percentage analysis may also be used to show the relationship of each component to the total width in a single statement. This type of analysis is called vertical analysis. Like horizontal analysis, the statements may be prepared in either detailed or condensed form. In the latter case, additional details of the changes in individual items may be presented in supporting schedules. In such schedules, the percentage analysis may be based on either the total of the schedule or the statement total. Although vertical analysis is limited to an individual statement, its significance may be improved by preparing comparative statements.

In vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each liability and stockholders' equity item is stated as a percent of the total liabilities and stockholders' equity. Exhibit 5 is a condensed comparative balance sheet with vertical analysis for Lincoln Company.

EXHIBIT 5 Comparative Balance Sheet---Vertical Analysis

 The major percentage changes in Lincoln Company's assets are in the current asset and long-term investment categories in the liabilities and stockholders' equity section of the balance sheet, the greatest percentage changes are in long-term liabilities and retained earnings. Stockholders' equity increased from 64% to 72.8% of total liabilities and stockholders' equity in 2023. There is a comparable decrease in liabilities.

In a vertical analysis of the income statement, each item is stated as a percent of net sales. Exhibit 6 is a condensed comparative income statement with vertical analysis for Lincoln Company.

EXHIBIT 6 Comparative Income Statement---Vertical Analysis

We must be careful when judging the significance of differences between percentages for the first 2 years. For example, the decline of the gross profit rate from 31.7% in 2022 to 30.4% in 2023 is only 1.3 percentage points. In terms of dollars of potential gross profit, however, it represents a decline of approximately $19,500 (1.3% * $1,498,000).

Common-Size Statements

Horizontal and vertical analyses with both dollar and percentage amounts are useful in assessing relationships and trends in financial conditions and operations of a business. Vertical analysis with both dollar and percentage amounts is also useful in comparing one company with another or with industry averages. Such comparisons are easier to make with the use of common-size statements. In a common-size statement, all items are expressed in percentages.

Common-size statements are useful in comparing the current period with prior periods, individual businesses, or one business with industry percentages. Industry data are often available from trade associations and financial Information services. Exhibit 7 is a comparative common-size income statement for two businesses.

EXHIBIT 7 Common-Size Income Statement

Exhibit 7 indicates that Lincoln Company has a slightly higher rate of gross profit than Madison Corporation. However, this advantage is more than offset by Lincoln Company's higher percentage of selling and administrative expenses. As a result, the income from operations of Lincoln Company is 10.7% of net sales, compared with 14.4% for Madison Corporation---an unfavorable difference of 3.7 percentage points.

Other Analytical Measures

In addition to the preceding analyses, other relationships may be expressed in ratios and percentages. Often, these items are taken from the financial statements and thus are a type of vertical analysis. Comparing these items with items from earlier periods is a type of horizontal analysis. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 692-697*

end

Accounting: The Language of Business - Vol. 1 (Part 100)

We must investigate without fear or favour the so-called 'accounting irregularities' that cause turmoil in the markets and wipe billions off the investments of ordinary South Africans.

Cyril Ramaphosa

 Statement of Cash Flows (Part F)

by

Charles Lamson

Gain on Sale of Land

The income statement for Rundell Inc. in Exhibit 7, from part 99 and reintroduced below, reports a gain of $12,000 on the sale of land. As we discussed previously, the gain is included in the proceeds from the sale of land which is reported as part of the cash flows from investing activities.

EXHIBIT 7 Balance Sheet and Income Statement Data for Direct Method

Interest Expense

The income statement for Rundell Inc. in Exhibit 7 reports interest expense of $8,000. The interest expense is related to the bonds payable that were outstanding during the year. We assume that interest on the bond is paid on June 30 and December 31. Thus, $8,000 cash outflow for interest expense is reported on the statement of cash flows as an operating activity.

If interest payable had existed at the end of the year, the interest expense would be adjusted for any increase or decrease in interest payable from the beginning to the end of the year. That is, a decrease in interest payable would be added to interest expense and an increase in interest payable would be subtracted from interest expense. This is similar to the adjustment for changes in income taxes payable, which will be illustrated in the following paragraphs.

Cash Payments for Income Taxes

The adjustment to convert the income tax reported on the income statement to the cash basis is summarized below.

For Rundell Inc., cash payments for income tax are $85,500, determined as follows:

The cash outflow for income taxes exceeded the income tax deducted as an expense during the period by $500. Thus, $500 is added to the amount of income tax reported on the income statement in determining the cash payments for income tax.

Reporting Cash Flows from Operating Activities---Direct Method

Exhibit 8 is a complete statement of cash flows for Rundell Inc., using the direct method for reporting cash flows from operating activities. The portions of this statement that differ from the indirect method are highlighted in color. Exhibit 8 also includes the separate schedule reconciling net income and net cash flow from operating activities. The schedule must accompany the statement of cash flows when the direct method is used. The schedule is similar to the cash flows from operating activities section of the statement of cash flows prepared using the indirect method. 

EXHIBIT 8 Statement of Cash Flows---Direct Method

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 657-658*

end

Accounting: The Language of Business - Vol. 1 (Part 99)

You can't make a manager have a coach he doesn't want. I can't make the head of the accounting department work with someone he doesn't want.

Jerry Reinsdorf

 Statement of Cash Flows (Part E)

by

Charles Lamson

Statement of Cash Flows---The Direct Method

As we discussed in a previous post, the manner of reporting cash flows from investing and financing activities is the same under the direct and indirect methods. In addition, the direct method and the indirect method will report the same amount of cash flows from operating activities. However, the methods differ in how the cash flows from operating activities data are obtained, analyzed, and reported.

To illustrate the direct method, we will use the comparative balance sheet and the income statement for Rundell Inc. In this way, we can compare the statement of cash flows under the direct method and the indirect method.

 Exhibit 7 shows the changes in the current asset and liability account balances for Rundell Inc. The income statement in Exhibit 7 shows additional data for Rundell Inc.

EXHIBIT 7 Balance Sheet and Income Statement Data for Direct Method

The direct method reports cash flows from operating activities by major classes of operating cash receipts and operating cash payments. The difference between the major classes of total operating cash receipts and total operating cash payments is the net cash flow from operating activities.

Cash Received from Customers

The $1,180,000 of sales for Rundell Inc. is reported by using the accrual method [revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid (bench.co)]. To determine the cash received from sales to customers, the $1,180,000 must be adjusted. The adjustment necessary to convert the sales reported on the income statement to the cash received from customers is summarized below.

For Rundell Inc., the cash received from customers is $1,171,000, as shown below.

The additions to accounts receivable for sales on account during the year was $9,000 more than the amount collected from the customers on account. Sales reported on the income statement therefore included $9,000 that did not result in a cash inflow during the year. In other words, the increase of $9,000 in accounts receivable during 2023 indicates that sales on account exceeded cash received from customers by $9,000. Thus, $9,000 is deducted from sales to determine the cash received from customers. The $1,171,000 of cash received from customers is reported in the cash flows from operating activities section of the cash flow statement.

Cash Payments for Merchandise

The $790,000 of cost of merchandise sold is reported on the income statement for Rundell Inc., using the accrual method. The adjustments necessary to convert the cost of merchandise sold to cash payments for merchandise during 2023 are summarized below.

For Rundell Inc., the amount of cash payments for merchandise is $785,200, as shown below:

The $8,000 decrease in inventories indicates that the merchandise sold exceeded the cost of the merchandise purchased by $8,000. The amount reported on the income statement for cost of merchandise sold therefore includes $8,000 that did not require a cash outflow during the year. Thus, $8,000 is deducted from the cost of merchandise sold in determining the cash payments for merchandise.

The $3,200 decrease in accounts payable (merchandise creditors) indicates a cash outflow that is excluded from cost of merchandise sold. In other words, the decrease in accounts payable indicates that cash payments for merchandise were $3,200 more than the purchases on account during 2023. Plus $3,200 is added to the cost of merchandise sold in determining the cash payments for merchandise.  

Cash Payments for Operating Expenses

The $7,000 of depreciation expense reported on the income statement did not require a cash outflow. Thus, under the direct method, it is not reported on the statement of cash flows. The $196,000 reported for other operating expenses is adjusted to reflect the cash payments for operating expenses, as summarized below.

For Rundell Inc., the amount of cash payments for operating expenses is $193,800, determined as follows:

The increase in accrued expenses (operating expenses) indicates that operating expenses include $2,200 for which there was no cash outflow (payment) during the year. In other words, the increase in accrued expenses indicates that the cash payments for operating expenses were $2,200 less than the amount reported as an expense during the year. Thus $2,200 is deducted from the operating expenses on the income statement in determining the cash payments for operating expenses. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 654-657*

end