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Subject Management Accounting

Chapter Analysis of Financial Statements

By
R Narayanaswamy
M Com, MBA, M Phil, CPFA & AFP (Investments)
Knowledge Initiator
 Financial Accounting

Financial Statement Analysis

- Let us probe
 Financial Statement Analysis - Basic Jargons
• Liquid Assets = C + B + AR
• Current Assets = LA + STOCK + PREPAID
• Current Liabilities = AP + PAYABLES + O/D
• Working Capital = CA - CL
• Fixed Assets = L&B, P&M, F&F, VEHICLES, ETC
• Capital Employed = FA + WC or SC + R&S + LTL
• Shareholders’ Net worth = CE - LTL
• Equity Shareholders’ Net worth = SHNW - PSC
Financial Statement Analysis - Tools
• Horizontal Analysis
• Vertical Analysis
• Trend Analysis
• Common Size Analysis
• Ratio Analysis
• Cash Flow Analysis
 Financial Statement Analysis
- Points to remember
• Analysis should be done for as many
years as possible
• Analysis should also include competitors
in the same industry
• Analysis should also verify Industry
average
 Horizontal Analysis

What is horizontal
analysis?
Horizontal Analysis

It’s an analysis of the percentage

increases and decreases of related
items in comparative financial
statements.
 Lincoln Company
Comparative Balance Sheet Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Liabilities
Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
 Lincoln Company
Comparative Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 Analysis:
Horizontal 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets Difference
$1,139,500 $1,230,500$17,000
$ (91,000) (7.4%)
Liabilities = 3.2%
Base year (2005) $533,000
Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par$ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
 Lincoln Company
Comparative Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Horizontal Analysis:
Liabilities
Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)
Difference $(82,500)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
= (46.5%)
Total liabilities Base year (2005)
$ 310,000 $177,500
$ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
 Lincoln Company
Comparative Balance Sheet
Okay,
December 31, go
2006to
andthe
2005next
slideIncrease (Decrease)
Assets and calculate
2006 the
2005 Amount Percent
Current assets percentage
$ 550,000
change$ 533,000
for $ 17,000
fixed 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) assets. 470,000 (25,500) (5.4%)
444,500
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Liabilities
Current liabilities Horizontal
$ 210,000 Analysis:
$ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ Difference
310,000 $ 443,000 ? $(133,000) (30.0%)
Stockholders’ Equity = ?
Base year (2005) ?
Preferred 6% stock, $100 par$ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
 Lincoln Company
Comparative Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000$ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500
$ (91,000) (7.4%)
Liabilities
Current liabilities
(5.4%)
$ 210,000 $ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par$ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
 Lincoln Company
Comparative Income Statement Income Statement
December 31, 2006 and 2005
Increase (Decrease)
2006 2005 Amount Percent
Sales $1,530,500 $1,234,000 $296,500 24.0%
Sales returns 32,500 34,000 (1,500) (4.4%)
Net sales $1,498,000 $1,200,000 $298,000 24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%
Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%
Administrative expenses 104,000 97,400 6,600 6.8%
Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7%
Operating income $ 160,000 $ 135,600 $ 24,400 18.0%
Other income 8,500 11,000 (2,500) (22.7%)
$ 168,500 $ 146,600 $ 21,900 14.9%
Other expense 6,000 12,000 (6,000) (50.0%)
Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%
Income tax 71,500 58,100 13,400 23.1%
Net income $ 91,000 $ 76,500 $ 14,500 19.0%
 Lincoln Company
Comparative Income Statement
December 31, 2006 and 2005
Increase (Decrease)
2006 2005 Amount Percent
Sales $1,530,500 $1,234,000 $296,500 24.0%
Sales returns 32,500 34,000 (1,500) (4.4%)
Net sales $1,498,000 $1,200,000 $298,000 24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%
Horizontal Analysis:
Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%
Administrative expenses 104,000
Increase amount97,400
$296,500 6,600 6.8%
Total operating expenses $ 295,000 $ 244,400 $ 50,600 = 24.0%20.7%
Operating income Base year (2005)
$ 160,000 $1,234,000
$ 135,600 $ 24,400 18.0%
Other income 8,500 11,000 (2,500) (22.7%)
$ 168,500 $ 146,600 $ 21,900 14.9%
Other expense 6,000 12,000 (6,000) (50.0%)
Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%
Income tax 71,500 58,100 13,400 23.1%
Net income $ 91,000 $ 76,500 $ 14,500 19.0%
 Lincoln Company
Comparative Income Statement
December 31, 2006 and 2005
Increase (Decrease)
2006 2005 Amount Percent
Sales $1,530,500 $1,234,000 $296,500 24.0%
Sales returns 32,500 34,000 (1,500) (4.4%)
Net sales $1,498,000 $1,200,000 $298,000 24.8%
24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%
Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%
Administrative expenses 104,000 97,400 6,600 6.8%
Total operating expensesHorizontal
$ 295,000 $ 244,400 $ 50,600
Analysis: 20.7%
Operating income $ 160,000 $ 135,600 $ 24,400 18.0%
Other income 8,500
Increase amount11,000
$298,000 (2,500) (22.7%)
$ 168,500 $ 146,600 $ 21,900= 24.8%14.9%
Other expense Base year
6,000(2005)12,000
$1,200,000(6,000) (50.0%)
Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%
Income tax 71,500 58,100 13,400 23.1%
Net income $ 91,000 $ 76,500 $ 14,500 19.0%
Vertical Analysis

A percentage analysis can be

used to show the relationship of
each component to a total
within a single statement.
Vertical Analysis

The total, or 100% item,

on the balance sheet is
“total assets.”
 Lincoln Company Balance
Comparative Balance Sheet
December 31, 2006 Sheet
December 31, 2005
Amount Percent Amount Percent
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total assets $1,139,500 100.0% $1,230,500 100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Vertical
Total Analysis:
liabilities $ 310,000 27.2% $ 443,000 36.0%
Stockholders’ Equity
Current assets $550,000
Preferred stock, 6%, $100 par $ 150,000 = 13.2%
48.3% $ 150,000 12.2%
Totalstock,
Common assets $10 par $1,139,500
500,000 43.9 500,000 40.6
Retained earnings 179,500 15.7 137,500 11.2
Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0%
Total liab. & SE $1,139,500 100.0% $1,230,500 100.0%
 Lincoln Company
Comparative Balance Sheet
December 31, 2006 December 31, 2005
Amount Percent Amount Percent
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total assets $1,139,500 100.0% $1,230,500 100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Total liabilities Vertical Analysis:27.2%
$ 310,000 $ 443,000 36.0%
Stockholders’ Equity
Current assets $533,000
Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2%
= 43.3%
Common stock, $10 par Total assets 500,000 $1,230,500500,000
43.9 40.6
Retained earnings 179,500 15.7 137,500 11.2
Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0%
Total liab. & SE $1,139,500 100.0% $1,230,500 100.0%
 Lincoln Company
Comparative Balance Sheet
December 31, 2006 December 31, 2005
Amount Percent Amount Percent
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total assets $1,139,500 100.0% $1,230,500 100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Total liabilities $ 310,000 27.2% $ 443,000 36.0%
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2%
Common stock, $10 par 500,000 43.9 500,000 40.6
Retained earnings 179,500 15.7 137,500 11.2
Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0%
Total liab. & SE $1,139,500 100.0% $1,230,500 100.0%
 Lincoln Company Income
Comparative Income Statement
Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 Net12.8%
sales $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 is 100.0%
19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
$ 168,500 11.3% $ 146,600 12.2%
Other expense 6,000 0.4 12,000 1.0
Income before income tax $ 162,500 10.9% $ 134,600 11.2%
Income tax expense 71,500 4.8 58,100 4.8
Net income $ 91,000 6.1% $ 76,500 6.4%
 Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 12.8% $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
Vertical Analysis: $ 168,500 11.3% $ 146,600 12.2%
Other expense
Selling expenses $191,0006,000 0.4 12,000 1.0
Income before income tax $ 162,500= 12.8%
10.9% $ 134,600 11.2%
Nettax
Income sales
expense $1,498,000
71,500 4.8 58,100 4.8
Net income $ 91,000 6.1% $ 76,500 6.4%
 Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 12.8% $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
$ 168,500 11.3% $ 146,600 12.2%
Other expense 6,000 0.4 12,000 1.0
Income before income tax $ 162,500 10.9% $ 134,600 11.2%
Income tax expense 71,500 4.8 58,100 4.8
Net income $ 91,000 6.1% $ 76,500 6.4%
 Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 12.8% $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
$ 168,500 11.3% $ 146,600 12.2%
Other expense 6,000 0.4 12,000 1.0
Income before income tax $ 162,500 10.9% $ 134,600 11.2%
Income tax expense 71,500 4.8 58,100 4.8
Net income $ 91,000 6.1% $ 76,500 6.4%
Common Size Statements

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
which all items are expressed in
percentages.
Common-Size Income Statement
Financial Accounting

Ratio Analysis
- Let us relate
Profitability-Related Ratios
Profitability-Related Ratios
Turnover-Related Ratios
Turnover-Related Ratios
Debt-Related Ratios
Debt-Related Ratios
Financial Accounting

Cash Flow Analysis

- Let us count cash
AS – 3 – Cash Flow Statement Format
Cash Flows from Operating Activities XXXXX
Cash Flows from Investing Activities XXXXX
Cash Flows from Financing Activities XXXXX
Opening Cash and Cash Equivalents XXXXX

Closing Cash and Cash Equivalents XXXXX

Statement of Cash Flows - Example
Operating
Cash Flow is
generated as
a result of
cash inflows
and outflows
associated
with selling
goods and
providing
services.
Investing Cash Flow results with
the acquisition of noncurrent
Financing Cash Flow results from
assets, particularly property,
transactions related to borrowing or
plant, and equipment.
issuing stock.
 Cash Flows from Operations
• Direct Method

Cash received from Customers

Less: Cash paid to suppliers and employees
Cash generated from Operations
Less: Tax paid

= Cash flow from Operations

 Cash Flows from Operating Activities
— Direct Method
Calculating Cash Received from Customers
Operating Activities - Direct Method
Calculating Cash Paid for Inventory
 Cash Paid for Operating Expenses
Cash
outflows for
operating = Operating Beginning Ending
expenses expenses + Payable – Payable
Cash Paid for Operating Expenses (Insurance)
Summary of Adjustments – Direct Method
 Cash Flow from Operations
• Indirect Method
PAT = OI + NOI + CI + NCI – OE – NOE – CE - NCE

CFO = PAT – NOI – NCI + NOE + NCE

Add: Decrease in Current Assets ( except C,B)
Less: Increase in Current Assets ( except C,B)
Add: Increase in Current Liabilities
Less: Decrease in Current Liabilities
Cash Flows from Investing Activities
• Purchase of Fixed Assets
• Purchase of Investments
• Disbursements of Loans
• Sale of Fixed Assets
• Sale of Investments
• Collection of Loans given
• Interest and Dividends received
Cash Flows from Financing Activities
• Issue of Shares and Debentures
• Bank borrowings
• Share Buybacks
• Redemption of Debentures
• Payment of Bank Loans
• Interest and Dividends paid
 Non Cash Items
• Conversion of Debt and Preference into
Equity
• Issue of Bonus Shares
• Stock Splits and Consolidation
• Acquiring Assets on account
• Exchange of Assets
• Conversion of Existing Liabilities into new one
Happy Learning

Thank You