Accounting: The Language of Business - Vol. 2 (Intermediate: Part 61)

Derivatives serve practically no purpose except to enrich bankers through opaque pricing and to deceive investors through off-the-balance-sheet accounting.

James Rickards

Statements of Net Income and Comprehensive Income (Part P)

by

Charles Lamson

Financial Statement Analysis

 The objective of financial reporting is to provide financial information that investors and creditors can use to make rational resource allocation decisions. The annual report contains a significant amount of information about a company's financial performance and financial position for use in decision making. In this post, we discuss financial statement analysis, which provides the tools and techniques necessary to evaluate a company's performance over time, relative to certain benchmarks or compared to similar entities.

The Importance of Financial Statement Analysis

Financial statements should provide information that allows users to understand important relationships among financial statement line items and changes in them for a company over time. Consider the following scenarios:

1. Assume an auditor observes that accounts receivable is increasing as a percent of total assets. She may seek additional information such as whether sales are also increasing, collections are decreasing, or the firm has relaxed credit extension practices.

2. If the percentage of cost of goods sold to sales has increased, a company's manager would seek to determine the reason. Higher cost of sales percentages could be due to higher raw material costs.

3. Consider a bank reviewing a credit line application for a company. If the company's existing debt is high or its cash flows are decreasing, the bank would be concerned about its ability to repay the loan.

Horizontal Analysis and Vertical Analysis of Financial Statements

Johnson & Johnson's annual report includes a balance sheet for the past two years and income and cash flow statements for a three-year period reporting results of operations, financial position and the cash flows for more than one year results in comparative financial statements. Companies issue comparative financial statements in order to provide financial information for more than one reporting period, thus allowing a user to compare the company on a year-to-year basis. Year-to-year changes in a company's financial position, operating performance, or cash flows can identify changes in activities, confirm projections, or identify trends to consider for the future.

Comparative financial statements can also be used to create common-size financial statements. Common-size financial statements measure each financial statement line item relative to some key amount or total. For example, to convert all income statement line items into a common size percentage, divide each line by sales. Financial statement users can use common size financial statements to compare a company to itself over time or to compare different firms of varying size.

There are two types of financial statement analyses: vertical analysis and horizontal analysis. Vertical analysis uses common-size financial statements. Horizontal analysis examines financial statements over time. In this section, we use horizontal and vertical analysis to compare one company to itself over time.

Horizontal Analysis

Horizontal analysis examines the percentage change in financial statement items from year to year. Horizontal analysis can provide information about increases or decreases in a company's income and expenses, which could indicate growth or a change in business strategy. For example, a company entering a new line of business could experience rapid sales growth or higher advertising costs. Example 5A.1 presents an illustration of a horizontal analysis for Johnson & Johnson.

EXAMPLE 5A.1 Horizontal Analysis of Johnson & Johnson's 2015 and 2016 Income Statements

PROBLEM: Use the excerpts from Johnson & Johnson's income statements provided to answer the following questions about changes in line items from the income statement from 2015 to 2016.

1. Compute the difference in each line item from 2015 to 2016.

2. Using 2015 as a base year, determine the change and percentage change in each line item from 2015 to 2016.

3. Did sales to customers increase or decrease from 2015 to 2016?

4. Did net income increase or decrease from 2015 to 2016?

5. What line of item(s) is (are) driving the differences between sales to customers and net income from 2015 to 2016? 

Note: The line item in process research and development is a loss that relates to asset right off in process research and development assets acquired when Johnson & Johnson purchased other companies. Source: Johnson & Johnson Company's 2015 and 2016 income statements.

SOLUTION:

1. The table below computes the dollar difference from 2015 to 2016 and the percentage change by dividing the 2016 changes by the 2015 amounts.

2. Same as above: The table below computes the dollar difference from 2015 to 2016 and the percentage change by dividing the 2016 changes by the 2015 amounts.

3. Sales to customers increased by $1,816 million dollars from 2015 to 2016. Net earnings increased by  2.6%.

4. Net income increased by $1,131 million from 2015 to 2016. Net earnings increased by 7.3%.

5. The increase in net income is due primarily to an increase of $1,816 million in sales; a decrease in selling, marketing and administrative expense of $1,258 million, and a decrease in provision for taxes of $524 million.

Vertical Analysis

Vertical analysis expresses financial information in relation to some relevant total or amount within one year. On the income statement, each income statement line item is expressed as a proportion of sales. On the balance sheet, each item is expressed as a percent of total assets. Sales and total assets do not have to be used as the denominator for vertical analyses. However, they are the most common bases used in practice.

 

EXAMPLE 5A.2 Vertical Analysis of Johnson & Johnson's 2015 and 2016 Income Statements

PROBLEM: Use the excerpts of Johnson & Johnson's income statements to answer the following questions about changes in sales from 2015 to 2016.

1. Compute each line item as a percentage of sales for 2015 and 2016.

2. Which line item makes up the largest proportion of sales in 2015 and 2016? Keep in mind that some of the items like gross profit and earnings before provision for taxes on income are subtotals.

3. Comment on any changes in the income and expenses as a percent of sales from 2015 and 2016.

SOLUTION:

1. The preceding table computes the percent of each line item to sales for 2015 and 2016. For example, net earnings of $16,540 million in 2016 is 23% of sales ($16,540 million divided by $71,890 million).

2.  In 2016 and 2015, cost of products sold made up over 30.2% and 10.7% of sales in 2016 and 2015, respectively.

3. The percent of cost of products sold, research and development expense, in-process research and development expense, interest income, interest expense, and the provision for taxes on income to sales remains very similar from year to year with most items changing less than 1% of sales. Selling, marketing, and administrative expenses is a smaller percentage of sales in 2016 at 27.7% compared to 30.3% in 2015. Other (income) expense was positive and 0.2%, 0.7% of sales. It is a greater percentage of sales in 2015 when compared to 2016. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 228-231*

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