In Class Notes UNDERSTAND THIS FOR EXAM/no calculations
Life Cycle of a Business
4 Phases
o Start-up
Little operating cash flow
Negative investing
Positive financing
o Growth
Increasing operating cash flow
Investing less negative but may be lower than before
Financing decreasing and may even be negative
o Maturity
Operating still positive but increase is slow
Investing and financing may be neutral
o Decline
Operating is frequently negative
Investing may be positive as sell off assets
Financing may be small negative or neutral as do not want to invest more
in company
Efficiency Ratio
o How well a company is managing its assets and liabilities
o Only ratio that combines Income statement and balance sheet
o Receivables as % of sales – lower the better
o A/R turnover ratio = net sales / average A/R
o Higher turnover, the better
o Inventory turnover = COGS / average ending inventory
o Depends on type of business as to how good number is
Profitability Ratio
o From income statement
o Gross profit ratio
o Net profit ratio
o Higher is better
Liquidity Ratio
o From balance sheet
o Ability to pay current liabilities
o Current ratio which is current assets/ current liabilities
o Higher is better
Solvency Ratio
o From balance sheet
o Ability to pay long-term debts
o Measure of risk – more long-term debt, the riskier it is
o Total debt/ total equity
o Lower is better
Financial Statement Analysis
Chapter Ten
Comparative financial statements are required for business
o Stakeholders compare financial position over time
2 types of analysis
Horizontal Analysis: calculates trend between one year and the next
Main goal: identify important trends
Helps see what direction business is headed in
2 types
o Comparative analysis: compare one year to the one before 2012 to 2011
o Trend analysis: compare each year to base year Base Year: 2009 so 2012 to 2009
Current year is always the first column, closest to account names
New −Old
Formula: , express as a percentage by multiplying by 100
Old
The percentage change for total assets should equal the one for total liabilities and equity
o Just like how their dollar amounts always equal
You add each asset to give you total assets, but you can’t add every %change for the
assets to give you the total assets %change
Can be done for balance sheets and income statements
Akindio Inc.
Horizont
Year ended Nov. 30 al
Analysis
Income Statement 2016 2015
450,00 371,25
Sales revenue 0 0 21.2%
275,00 225,00
Cost of goods sold 0 0 22.2%
175,00 146,25
Gross profit 0 0 19.7%
133,25 113,40
Operating expenses 0 0 17.5%
Interest expense 6,750 5,850 15.3%
Profit before income taxes 35,000 27,000 29.6%
Income tax expense 10,000 6,750 48.2%
Profit 25,000 20,250 23.5%
Balance Sheet
Cash 10,000 18,000 -44.4%
Accounts receivable (net) 47,500 51,750 -8.2%
100,00
Inventory 0 78,750 26.9%
112,50
Equipment (net) 0 85,500 31.6%
270,00 234,00
Total assets 0 0 15.4%
Current liabilities 40,000 42,750 -6.4%
Long-term liabilities (6% 112,50 101,25
interest) 0 0 11.1%
Owners’ equity 87,500 78,750 11.1%
Retained earnings 30,000 11,250 166.7%
270,00 234,00
Total liabilities and equity 0 0 15.4%
Vertical Analysis: shows relationship between different items on the financial statement
Can calculate current assets as a percentage of total assets
o Shows contribution of current assets to overall asset position of business
o Compare with another year to see improvement or not
Seen as trend analysis because you’re comparing different years to see a trend
Can be performed between two different businesses for different items
Bleaue Inc. Cooper
Inc.
Current Assets 82,000,000 546,000
Total Assets 192,000,00 982,000
0
Percentage 43% 56%
You can perform on income statement too
o Calculate every amount as a percentage of net sales
o Can compare that amount between years or businesses
Calculations: take the account’s value and divide it by total assets amount
o Cash= 200 and Total Assets = 750 (200 / 750) x 100 = 26.7%
In this, you can add up all the percentages to give you 100% in total assets and total
liabilities and owner’s equity
Akindio Inc.
Year ended Nov. 30
Vertical Vertical
Analysi Analysi
s s
Income Statement 2016 2015
450,00 371,25
Sales revenue 0 100% 0 100%
275,00 225,00
Cost of goods sold 0 61.1% 0 60.6%
175,00 146,25
Gross profit 0 38.9% 0 39.4%
133,25 113,40
Operating expenses 0 29.6% 0 30.5%
Interest expense 6,750 1.5% 5,850 1.6%
Profit before income taxes 35,000 7.8% 27,000 7.3%
Income tax expense 10,000 2.2% 6,750 1.8%
Profit 25,000 5.6% 20,250 5.5%
Balance Sheet
Cash 10,000 3.7% 18,000 7.7%
Accounts receivable (net) 47,500 17.6% 51,750 22.1%
100,00
Inventory 0 37% 78,750 33.7%
112,50
Property, plant, & equipment 0 41.7% 85,500 36.5%
270,00 234,00
Total assets 0 100% 0 100%
Current liabilities 40,000 14.8% 42,750 18.3%
Long-term liabilities (6% 112,50 101,25
interest) 0 41.7% 0 43,3%
Common shares 87,500 32.4% 78,750 33.7%
Retained earnings 30,000 11.1% 11,250 4.8%
270,00 234,00
Total liabilities and equity 0 100% 0 100%
ON FINALS: percentages will be given so marks are based off of actual explanation of analysis
Cash is an important asset because it allows a business to pay for their debts
o Statement of cash flows is important for stakeholders for this reason
3 main business activities on statement of cash flows
Operating: lifeblood of a business b/c it is the only sustainable source of cash long-term
o Is there a positive inflow?
o Over the years, is it increasing or decreasing?
Only sustainable if it is increasing or holding steady
o Is it higher than profit?
Means they are paying off expenses which is good
Investing: involve making purchases that will help business earn revenue
o Is there a positive or negative outflow?
If positive, may be a bad sign; business selling long-term assets
Negative may indicate purchasing assets to generate revenue
However, you don’t know without looking at details
o Compare changes
Is business selling old equipment to purchase new?
To generate revenue so good
o Was there enough inflow from operating to pay for outflow in investing?
o What is the trend over time?
Did the business continue to invest year to year?
Generates revenue so it’s good
Financing: includes inflow and outflow of cash due to capital contributions, payment of
dividends and debt transactions
o Is overall cash flow negative or positive?
Positive may be a sign that business needs cash to fund investing activities
Negative may indicate business is paying off debt or dividends to
shareholders
However, you need details to indicate if its good or bad
o Did business get more contributions to pay debt?
Good, reduces future interest costs
May increase future dividend payments which isn’t so good
If there is an inflow of cash, was there outflow from investing due to lack
of inflow in operating?
Watch to help with analysis: https://www.youtube.com/watch?v=IHWIzDcWWT8
Using vertical and horizontal analysis on the income statement and balance sheet and
reviewing the different activities on the statement of cash flows are critical to
understanding the business
o Allows stakeholders to gain a better understanding of the financial health of a
business
Extra notes on Financial Ratio Analysis
There are four aspects of a company’s performance that specific ratios can help you
analyze:
o Profitability
High numbers are good
Negative is very bad
Company should see ratios increasing or at least stable year to year
o Liquidity: ability to pay current liabilities as they come due
Difference between cur assets and cur liabilities is called working capital
Quick (acid-test) ratio: only cash and AR in the numerator no inventory
o Solvency: ability to pay long-term debt
Measure of risk – more long-term debt, the riskier it is
Debt has to be repaid but equity does not
Debt to equity ratio: analyze leverage (solvency) and gearing (risk)
Total debt/ total equity
Lower is better
o Efficiency: how well company manages assets and liabilities
A/R turnover ratio: net sales / average A/R
Higher the better
