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*

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