LESSON Trend Analysis and Component Percentages. CENTURY 21 ACCOUNTING 2009 South-Western, Cengage Learning

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1 Trend Analysis and Component Percentages

2 Trend Analysis and Component Percentage 2 Financial statements report the financial condition and progress of a business for a fiscal period. Accounting concepts Adequate Disclosure and Consistent Reporting are important concepts to consider when preparing the financial statements and supporting schedules. Various groups use the financial information in different ways to assist with decision making; therefore, all information must be disclosed, even if it doesn t make the company look good.

3 Trend Analysis and Component Percentage 3 Comparative Financial Statements Financial statements providing information for two or more fiscal periods in order to compare specific items from one fiscal period to past fiscal periods. The Consistent Reporting concept states that the same accounting procedures must be followed in the same way in each accounting period. Ratio A comparison between two numbers showing how many times one number exceeds the other; it may be stated as either a ratio, percentage, or fraction. All three ways of expressing the ratios are essentially the same. Example: For a business with net sales of $2,000, and net income of $200,000.00, the relationship may be stated as any of these ratios:

4 4 RATIO ANALYSIS page 495 Net Sales Net Income = Stated Ratio $2,000, $200, = 10 times (10 to 1 or 10:1) The stated ratio means net sales is 10 times net income. Net Income Net Sales = Percentage Ratio $200, $2,000, =.10 or 10% Net income is 10% of sales. Net Income Net Sales = Fractional Ratio $200, $2,000, = 1/10 Net income is one-tenth of net sales.

5 5 Trend Analysis on the Income Statement Trend Analysis also called Horizontal Analysis Comparison of the relationship between one item on a financial statement and the same item on a previous fiscal period s financial statement. Various trend analysis calculations include a trend analysis of the Income Statement, trend analysis of the Statement of Stockholder s Equity, trend analysis of the Balance Sheet. Trend analysis is one method of financial analysis used to help predict how well a business will perform in the future. It is often performed using financial statement for a 3-5 year period.

6 TREND ANALYSIS ON THE INCOME STATEMENT 6 page Current Year Net Sales $4,767, Prior Year Net Sales 3,633, = Increase or Decrease in Net Sales $1,134, Prior Year Net Sales 3,633, = % Increase or Decrease in Net Sales 31.2% 4

7 TREND ANALYSIS ON THE STATEMENT OF STOCKHOLDERS EQUITY page 497 7

8 TREND ANALYSIS ON THE BALANCE SHEET 8 Trend analysis of the Balance Sheet (p. 498) one method of financial analysis used to help predict how well a business will perform in the future. Often performed using financial statements for a three-to-five year period. Favorable trends over a period of several years often indicate that management is making good decisions. Calculate Amount of Increase/ Decrease from Prior Year Increase/Decrease Prior Year = % Increase/Decrease

9 TREND ANALYSIS ON THE BALANCE SHEET 9 page 498

10 TREND ANALYSIS ON THE BALANCE SHEET 10 page 498

11 11 COMPONENT PERCENTAGE ANALYSIS also called Vertical Analysis. Component percentages (usually shown as a percent of net sales) on comparative statements show changes in a specific item from year to year. The cause of significant unfavorable changes should be investigated so that corrective action can be taken. Usually done on the Income Statement, but can also be done on other financial statements such as the Statement of Stockholders Equity and Balance Sheet.

12 COMPONENT PERCENTAGES ON THE INCOME STATEMENT 12 page 499

13 COMPONENT PERCENTAGES ON THE INCOME STATEMENT 13 page 499

14 COMPONENT PERCENTAGES ON THE STATEMENT OF STOCKHOLDERS EQUITY 14 Component percentages on the Statement of Stockholders Equity (p. 500) is calculated as a percentage of total stockholders equity.

15 COMPONENT PERCENTAGES ON THE STATEMENT OF STOCKHOLDERS EQUITY page

16 COMPONENT PERCENTAGES ON THE BALANCE SHEET 16 Component percentages on the Balance Sheet (p. 501). Component percentages for assets are normally calculated as a percentage of total assets. Liabilities and stockholders equity amounts are calculated as a percentage of total liabilities and stockholders equity.

17 COMPONENT PERCENTAGES ON THE BALANCE SHEET 17 page 501

18 COMPONENT PERCENTAGES ON THE BALANCE SHEET 18 page 501

19 Two major guides to determine acceptable levels of financial performance: Prior company performance 2. Comparison with published trade performance standards. Example (p. 500): Wiseman Grocery considers a component percentage of 3.0% for income from operations to be very good. However, Mitchell Manufacturing Co. considers 12% component percentage for income from operations the minimum acceptable result. The difference is due to the different financial characteristics of the two businesses. -Grocery store has a low investment in plant assets and sells inventory quickly. -The manufacturing co. has a high investment in plant assets and holds its inventory much longer. Their higher investment per sales dollar means that the company must earn a higher rate on sales.

20 Other sources of performance guides include: Financial and credit-reporting companies such as Dun and Bradstreet 2. The company s planned financial objectives (budget schedules) 3. Current interest rates that could be earned by investing capital elsewhere 4. Financial information available on the Internet.

21 21 TERMS REVIEW page 502 ratio trend analysis

22 LESSON Calculating Earnings Performance and Efficiency Analysis Earnings Performance Analysis the amount and consistency of earnings are importance measures of a business s success. Common earnings performance ratios: 1. Rate earned on average total assets 2. Rate earned on average stockholders equity 3. Rate on earned on net sales 4. Earnings per share 5. Price-earnings ratio

23 RATE EARNED ON AVERAGE TOTAL ASSETS 23 page 503 January 1 Total Assets December = Total Assets Average Total Assets ($1,759, $2,067,700.00) 2 = $1,913, Net Income after Federal Income Tax Average Total = Assets Rate Earned on Average Total Assets $222, $1,913, = 11.6% The earned shows how well a business is using its assets to earn net income. LESSON 17-2

24 CALCULATING THE RATE EARNED ON AVERAGE TOTAL ASSETS 24 page 504 Current Year Prior Year Net Income after Federal Income Tax $ 222, $ 128, January 1 Total Assets 1,759, ,437, December 31 Total Assets 2,067, ,759, Average Total Assets 1,913, ,598, Rate Earned on Average Total Assets 11.6% 8.0% Goal 10% (comparable to rates of return on other investments such as bonds, etc.) LESSON 17-2

25 RATE OF RETURN EARNED ON AVERAGE STOCKHOLDERS EQUITY 25 page 505 January 1 Stockholders Equity December 31 + Stockholders 2 = Equity Average Total Stockholders Equity ($849, $1,051,600.00) 2 = $950, Net Income after Federal Income Tax Average Total Stockholders = Equity Rate Earned on Average Stockholders Equity $222, $950, = 23.4% Rate earned on average stockholders equity Investors compare the rate earned on stockholders equity to determine the best investment. LESSON 17-2

26 26 RATE EARNED ON NET SALES Rate earned on net sales A business that carefully controls costs should earn a consistent rate on net sales from year to year. If costs suddenly change, the rate earned on net sales also changes. Compare the rate with businesses similar and to the company s own past experience. If the rate declines, the company must increase sales or reduce costs to maintain an acceptable rate.

27 27 RATE EARNED ON NET SALES page 506 Net Income after Federal Income Tax Net Sales = Rate Earned on Net Sales $222, $4,767, = 4.7% LESSON 17-2

28 28 EARNINGS PER SHARE Earnings per share The amount of net income earned on one share of common stock during a fiscal period. Management and stockholders use earnings per share as a measure of success. As earning per share increase, more people are interested in buying the company s stock which in turn makes the price go up. Information from the Income Statement and Statement of Stockholders Equity is needed to calculate earnings per share. One of the most widely recognized financial ratios

29 29 EARNINGS PER SHARE page 507 Net Income after Shares of Capital Earnings per = Federal Income Tax Stock Outstanding Share $222, , = $3.71 LESSON 17-2

30 30 PRICE-EARNINGS RATIO page 508 Market Price per Share Earnings per = Share Price-Earnings Ratio $43.50 $3.71 = 11.7 times Price-earnings ratio Investors want to buy stock in companies that will earn a reasonable return on their investment. The relationship between the market value per share of stock and the earnings per share is the priceearnings ratio. Market Price is determined by the amount that investors are willing to pay for a share of stock. Compare ratio with prior years to see if there is a favorable trend. LESSON 17-2

31 31 Efficiency Analysis Efficiency Analysis Profitability and continued growth of the business are influenced by how efficiently the business utilizes its assets (mainly accounts receivable and merchandise inventory). Three phases of the operating cycle are: 1) purchase merchandise, 2) Sell merchandise, 3) Collect accounts receivable. Accounts Receivable Turnover Ratio The number of times the average amount of accounts receivable is collected annually. Use information from the Balance Sheet and Income Statement

32 ACCOUNTS RECEIVABLE TURNOVER RATIO 32 page 509 Beginning Book Value of Accounts Receivable Ending Book + Value of Accounts 2 = Receivable Average Book Value of Accounts Receivable ($569, $474,000.00) 2 = $521, Net Sales on Account Average Book Value of Accounts = Receivable Accounts Receivable Turnover Ratio $4,767, $521, = 9.1 times LESSON 17-2

33 AVERAGE NUMBER OF DAYS FOR PAYMENT 33 page 510 Days in Year Accounts Receivable = Turnover Ratio Average Number of Days for Payment = 40 days LESSON 17-2

34 34 Merchandise Inventory Turnover Ratio Merchandise Inventory Turnover Ratio The number of times the average amount of merchandise inventory is sold annually. The faster a company sells its merchandise inventory, the more efficient and more profitable the business. The ratio can be used to monitor merchandise inventory efficiency.

35 MERCHANDISE INVENTORY TURNOVER RATIO 35 page 510 January 1 Merchandise Inventory December 31 + Merchandise 2 = Inventory Average Merchandise Inventory ($423, $547,900.00) 2 = $485, Cost of Merchandise Sold Average Merchandise = Inventory Merchandise Inventory Turnover Ratio $2,602, $485, = 5.4 times Days in year Merchandise Inventory = Average # of days sales in Turnover Ratio inventory = 68 LESSON 17-2

36 36 Merchandise Inventory Turnover Ratio page 511 The optimum merchandise inventory turnover ratio is determined by two factors: 1) Amount of sales. 2) Number of days needed to replenish inventory. The lower-than-desired level of inventory results in lost sales because some items are out of stock before the new inventory arrives. LESSON 17-2

37 LESSON Calculating Financial Strength Analysis Short-Term Financial Strength Analysis for a business to be successful, they need adequate capital. Capital comes from two sources 1) Owners investments and retained earnings and 2) Loans. Capital invested in assets of over long periods of time is called long-term assets or plant assets. Capital invested in assets over short periods of time is called current assets. 3 Measures to analyze short-term financial strength: Working Capital Current Ratio Acid-test Ratio

38 38 WORKING CAPITAL page 512 Total Current Assets Total Current = Liabilities Working Capital Current Year $1,254, $596, = $658, Prior Year $1,118, $685, = $433, Working Capital the amount of current assets available after current liabilities are paid. Used mainly to compare one period to the next, not with other companies. Increased favorable trend LESSON 17-3

39 39 CURRENT RATIO page 513 Total Current Assets Total Current = Liabilities Current Ratio Current Year $1,254, $596, = 2.1 times Prior Year $1,118, $685, = 1.6 times Current Ratio a ratio that shows the numeric relationship of current assets to current liabilities. The current ratio of 2.1 means that the company owns $2.10 in current assets for each $1.00 needed to pay current liabilities. The industry standard for companies similar to this has a current ratio of at least 2.0. LESSON 17-3

40 40 ACID-TEST RATIO page 513 Total Quick Assets (Cash + Accounts Receivable) Total Current Liabilities = Acid-Test Ratio Current Year ($206,100 + $474,000) $596, = 1.1 times Prior Year ($104,300 + $569,200) $685, = 1.0 times Acid-Test Ratio this ratio shows the ability of a business to pay all current liabilities almost immediately if necessary. The acid-test ratio that shows the numeric relationship of quick assets to current liabilities Quick Assets Current assets such as cash or assets that can be quickly turned into cash, such as Accounts Receivable. The current year s ratio of 1.1 indicates that for each $1.00 needed to pay current liabilities, there is $1.10 available in quick assets In comparison of other companies similar to this one, the desired industry standard is between 0.9 and 1.3. Also, in comparison with the previous year, there is a favorable trend LESSON 17-3

41 41 Long-term Financial Strength Analysis Long-Term Financial Strength Analysis requires a balance between stockholders capital and borrowed capital. Borrowed capital (money) must be used wisely. One thing to remember is that borrowed capital must be repaid with interest; therefore, you would not want to continue operating with a large percentage of borrowed capital which may use much of your net income for repaying the loan and if the net income declines you would not be able to make the loan payments. Also, it s hard to get a loan with a high level of liabilities. 3 Measures to analyze long-term financial strength: Debt Ratio Equity Ratio Equity Per Share

42 42 DEBT RATIO page 514 Total Liabilities Total Assets = Debt Ratio Current Year $1,016, $2,067, = 49.1% Prior Year $ 910, $1,759, = 51.7% Debt Ratio this ratio shows the percentage of assets that are financed with borrowed capital (liabilities). The current year ratio show that for each $1.00 of assets owned, the company has borrowed 49.1 cents. Compare this with other companies similar (average debt ratio is 43.0%) to this company and you can see that it is unfavorable. The company should consider issuing more capital stock to reduce the total liabilities to the industry average of 43.0%. LESSON 17-3

43 43 EQUITY RATIO page 515 Total Stockholders Equity Total Assets = Equity Ratio Current Year $1,051, $2,067, = 50.9% Prior Year $ 849, $1,759, = 48.3% Equity Ratio this ratio shows the percentage of assets that are provided by stockholders equity. LESSON 17-3

44 44 EQUITY RATIO page 515 The current year ratio show that for each $1.00 of assets owned by the company, 50.9 cents worth was acquired with stockholders capital. Compare this with other companies similar (average equity ratio is 57.0%) to this company and you can see that it is unfavorable and below the industry average. The company should continue its efforts to increase the equity ratio by reducing its liabilities and issuing additional stock. The debt and equity ratios show the mix of capital provided by capital borrowed and capital provided by stockholders. The sum of the two ratios should equal 100% as shown below. The totals always equal 100% because the total liabilities and stockholders equity represent the source of all asset ownership. Current Year Prior Year Debt Ratio 49.1% 51.7% Equity Ratio 50.9% 48.3% Totals 100.0% 100.0% LESSON 17-3

45 45 EQUITY PER SHARE page 515 Shares of Total Stockholders Equity Capital Stock = Equity per Share Outstanding Current Year $1,051, $60, = $17.53 Prior Year $ 849, $50, = $16.99 Equity Per Share the amount of total stockholders equity belonging to a single share of stock. It tells stockholders how much ownership of the company each share represents. The current year equity per share indicates that each share of capital stock represents ownership in $17.53 of the total company s assets on that date. There is a favorable trend because it increased from the prior year. LESSON 17-3

46 46 TERMS REVIEW page 517 working capital current ratio quick assets acid-test ratio debt ratio equity ratio LESSON 17-3