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12.4: Financial Statement Analysis

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  • Learning Objective

    1. Evaluate a company’s performance using financial statements and ratio analysis.

    Now that you know how financial statements are prepared, let’s see how they’re used to help owners, managers, investors, and creditors assess a firm’s performance and financial strength. You can glean a wealth of information from financial statements, but first you need to learn a few basic principles for “unlocking” it.

    The Comparative Income Statement

    Let’s fast-forward again and assume that your business—The College Shop—has just completed its second year of operations. After creating your second-year income statement, you decide to compare the numbers from this statement with those from your first statement. So you prepare the comparative income statement in Figure 12.19 “Comparative Income Statement for The College Shop”, which shows income figures for year 2 and year 1 (accountants generally put numbers for the most recent year in the inside column).

    Figure 12.19 Comparative Income Statement for The College Shop


    Vertical Percentage Analysis

    What does this statement tell us about your second year in business? Some things look good and some don’t. Your sales went up from $500,000 to $600,000 (a 20 percent increase—not bad). But your profit was down—from $30,000 to $18,000 (a bad sign). As you stare at the statement, you’re asking yourself the question: Why did my profit go down even though my sales went up? Does this result make sense? Is there some way of comparing two income statements that will give me a more helpful view of my company’s financial health? One way is called vertical percentage analysis. It’s useful because it reveals the relationship of each item on the income statement to a specified base—generally sales—by expressing each item as a percentage of that base.

    Figure 12.20 “Comparative Income Statement Using Vertical Percentage Analysis” shows what comparative income statements look like when you use vertical percentage analysis showing each item as a percentage of sales. Let’s see if this helps clarify things. What do you think accounted for the company’s drop in income even though The College Shop sales went up?

    Figure 12.20 Comparative Income Statement Using Vertical Percentage Analysis


    The percentages help you to analyze changes in the income statement items over time, but it might be easier if you think of the percentages as pennies. In year 1, for example, for every $1.00 of sales, $0.55 went to pay for the goods that you sold, leaving $0.45 to cover your other costs and leave you a profit. Operating expenses (salaries, rent, advertising, and so forth) used up $0.35 of every $1.00 of sales, while interest and taxes took up $0.02 each. After you covered all your costs, you had $0.06 profit for every $1.00 of sales.

    Asking the Right Questions

    Now, compare these figures to those for year 2. Where is the major discrepancy? It’s in Cost of goods sold. Instead of using $0.55 of every $1.00 of sales to buy the goods you sold, you used $0.64. As a result, you had $0.09 less ($0.64 – $0.55) to cover other costs. This is the major reason why you weren’t as profitable in year 2 as you were in year 1: your Gross profit as a percentage of sales was lower in year 2 than it was in year 1. Though this information doesn’t give you all the answers you’d like to have, it does, however, raise some interesting questions. Why was there a change in the relationship between Sales and Cost of goods sold? Did you have to pay more to buy goods for resale and, if so, were you unable to increase your selling price to cover the additional cost? Did you have to reduce prices to move goods that weren’t selling well? (If your costs stay the same but your selling price goes down, you make less on each item sold.) Answers to these questions require further analysis, but at least you know what the useful questions are.