3.3: Comparing and Analyzing Financial Statements
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\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)- Explain the use of common-size statements in financial analysis.
- Discuss the design of each common-size statement.
- Demonstrate how changes in the income and cash flow statements may explain changes in the balance sheet.
- Identify the purposes and uses of ratio analysis.
- Describe the value of comparing financial statements over time.
Financial statements are valuable summaries of financial activities because they organize information, making it easier to see and understand. Each one (the income statement, cash flow statement, and balance sheet) conveys a different aspect of the financial picture; put together, the picture is pretty complete. The three provide a summary of earnings and expenses, cash flows, and assets and debt.
Since the three statements offer different kinds of information, it is sometimes useful to examine each in the context of the others and to consider specific items within the larger context. The purpose of financial statement analysis is to create comparisons and contexts to gain a better understanding of the financial picture.
Common-Size Statements
On common-size statements, each item's value is listed as a percentage of another. This comparison shows the relative size and significance of items (see Table 3.3.1 ). On the income statement, each income and expense is listed as a percentage of the total income. This illustrates the contribution of each type of income to the total, thereby demonstrating the diversity of income sources. It also illustrates the burden of each expense on total income, showing how much income is required to support each expense.
On the cash flow statement, each cash flow can be listed as a percentage of total positive cash flows, again highlighting the relative significance and diversification of cash sources, as well as the relative size of each cash use.
On the balance sheet, each item is listed as a percentage of total assets, indicating the relative significance and diversification of assets, and highlighting the use of debt as a financing source for these assets.
| Income Statement | Cash Flow Statement | Balance Sheet | |
|---|---|---|---|
| Items as a % of | Total Income | Total Positive Cash Flows | Total Assets |
Common-Size Income Statement
Alice can analyze a common-size income statement by examining her expenses as a percentage of her income and comparing the size of each expense to a common denominator: her total income. This shows her how much of her income is allocated to each expense proportionally (Table 3.3.2 ).
| Gross wages | $ 44,650 | 100.00% | ||
|---|---|---|---|---|
| Income taxes and deductions | $ 8,930 | 20.00% | ||
| Disposable income | $ 35,720 | 80.% | ||
| Rent expense | $ 10,800 | 24.19% | ||
| Food | $ 3,900 | 8.73% | ||
| Car expense | $ 3,600 | 8.06% | ||
| Clothing | $ 1,800 | 4.03% | ||
| Cell phone | $ 1,200 | 2.69% | ||
| Internet and streaming services | $ 1,200 | 2.69% | ||
| Entertainment, travel, etc. | $ 2,700 | 6.05% | ||
| Total living expenses | $ 25,200 | 56.44% | ||
| Car loan interest | $ 240 | 0.54% | ||
| Student loan interest | $ 4,240 | 9.50% | ||
| Total interest expense | $ 4,480 | 10.03% | ||
| Net income | $ 6,040 | 13.53% |
Seeing the common-size statement as a tree map makes the relative size of the slices even clearer (Figure 3.3.3 ).
The most significant portion of Alice's wages is spent on rent, followed by food, car expenses, and entertainment. Her income tax expense is a big use of her wages, but it is unavoidable and non-discretionary. Ranking expenses by size offers a fascinating insight into lifestyle choices. It is also valuable in framing financial decisions, as it highlights which expenses have the greatest impact on income and thus on the resources available for making informed financial decisions. If Alice wanted more discretionary income to make different choices, she could easily see that reducing rent expenses would have the most impact on freeing up some of her wages for other uses.
Common-Size Cash Flow Statement
Looking at Alice's negative cash flows as percentages of her positive cash flow (on the cash flow statement), or the uses of cash as percentages of the sources of cash, creates the common-size cash flows. As with the income statement, this provides Alice with a clearer and more immediate view of the largest uses of her cash (Tables 3.3.4 and 3.3.6 ).
| Cash from gross wages | $ 44,650 | 100.00% | |
|---|---|---|---|
| Cash paid for: | |||
| Income taxes and deductions | $ 8,930 | -20.00% | |
| Rent expense | $ 10,800 | -24.19% | |
| Food | $ 3,900 | -8.73% | |
| Car expenses | $ 3,600 | -8.06% | |
| Clothing | $ 1,800 | -4.03% | |
| Cell phone | $ 1,200 | -2.69% | |
| Internet and streaming services | $ 1,200 | -2.69% | |
| Entertainment, travel, etc. | $ 2,700 | -6.05% | |
| Car loan interest | $ 240 | -0.54% | |
| Student loan interest | $ 4,240 | -9.50% | |
| Operating cash flows | $ 6,040 | -13.53% | |
| Cash for repayment of car loan | $ 2,160 | -4.84% | |
| Cash for repayment of student loan | $ 3,480 | -7.79% | |
| Financing cash flows | $ 5,640 | -12.63% | |
| Net cash flow | $ 400 | 0.00% |
Again, rent is the biggest discretionary use of cash for living expenses, but debts demand the most significant portion of cash flows. Repayments and interest together account for 30 percent of Alice's cash, which is equivalent to the amount she pays for rent and food. Eliminating those debt payments would create substantial liquidity for Alice.
Common-Size Balance Sheet
On the balance sheet, examining each item as a percentage of total assets enables the measurement of how much of the assets' value is allocated to cover each debt, or how much of the assets' value is claimed by each debt (Figure 3.3.6 ).
| Assets | Liabilities | ||||
|---|---|---|---|---|---|
| Car | $ 5,000 | 95.00% | Car Loan | $ 2,700 | 51.00% |
| Savings | $ 250 | 5.00% | Student Loan | $ 53,000 | 1,010.00% |
| Total | $ 5,250 | 100.00% | Total | $ 55,700 | 1,061.00% |
| Net Worth | -$ 50,450 | -961.00% | |||
This common-size balance sheet makes "oversized" items more apparent. For example, it is immediately apparent that Alice's student loan exceeds her asset value, resulting in a negative net worth. Diversification reduces risk, so it is advisable to diversify the sources of income and assets you can utilize to create value.
For example, Alice has only two assets, and one, her car, accounts for 95 percent of the value of her assets. If something were to happen to her car, her assets would lose 95 percent of their value. Her asset value would be less exposed to risk if she had other assets.
Likewise, both her income and her positive cash flows come from only one source, her paycheck. Because her positive net earnings and positive net cash flows depend on this one source, she is exposed to risk, which she could decrease by diversifying her sources of income. She could diversify by adding earned income, such as taking on a second job, or by creating investment income. To create investment income, however, she needs to have a surplus of liquidity, or cash, to invest.
Relating the Financial Statements
Common-size statements put the details of the financial statements in clear contrast relative to a common factor for each statement, but each financial statement is also related to the others. Each is a piece of a larger picture, and as important as it is to see each piece, it is also essential to see that larger picture. To make sound financial decisions, you need to be able to foresee the consequences of a decision and understand how it may affect the various aspects of the broader picture.
There are many other possible scenarios and transactions. Still, you can begin to see that the balance sheet at the end of a period is changed from what it was at the beginning of the period by what happens during the period, and what happens during the period is shown on the income statement and the cash flow statement.
The significance of these relationships becomes even more important when evaluating alternatives for financial decisions. When you understand how the statements are related, you can use that understanding to project the effects of your choices on different aspects of your financial reality and see the consequences of your decisions.
Ratio Analysis
Creating ratios is another way to see the numbers in relation to each other. Any ratio shows the relative size of the two items compared, just as a fraction compares the numerator to the denominator or a percentage compares a part to the whole. The percentages on the common-size statements are ratios, although they only compare items within a financial statement. Ratio analysis is used to make comparisons across statements.
The financial ratios you use depend on the perspective you need or the question(s) you need answered. Some of the more common ratios (and questions) are presented in the following chart (Table 3.3.8 ).
| Ratio | Calculation | Question it helps to answer |
|---|---|---|
|
Net income margin |
Net income Total income | How much income is used up by expenses? |
|
Return on assets |
Net income / Total assets | How big is the income supporting the assets? |
| Return on net worth | Net income Net worth | How big is income relative to net worth? |
| Debt to assets | Total debt Total assets | How much asset value is financed by debt? Or how much asset value is there to satisfy debt? |
| Total debt | Total debt Net worth | How large is debt relative to net worth? |
| Interest coverage | Income before interest Interest expense | How well does income cover interest expenses? |
| Cash flow to income | Net cash flow Net income | How much do payments for investments and financing take from income? |
| Cash flow to assets | Net cash flow Total assets | How much cash flow supports assets? |
| Free cash flow | Free cash flow Net cash flow | How much cash is left to invest after covering living expenses and debt repayments? |
These ratios all get "better" or show improvement as they get bigger, with two exceptions: debt-to-assets and total debt. Those two ratios measure levels of debt, and the smaller the ratio, the less the debt. Ideally, the two debt ratios would be less than one. If your debt-to-assets ratio is greater than one, then debt is greater than assets, and you are insolvent. If the total debt ratio is greater than one, then debt is greater than net worth, and you "own" less of your assets' value than your creditors do.
Some ratios will naturally be less than one, but the bigger they are, the better. For example, net income margin will always be less than one because net income will always be less than total income (net income = total income − expenses). The larger the ratio, and the fewer expenses that are deducted from the total income, the better.
Some ratios should be greater than one, and the bigger they are, the better. For example, the interest coverage ratio should be greater than one, because you should have more income to cover interest expenses than you have interest expenses, and the more you have, the better. Table 3.3.9 suggests what to look for in the results of your ratio analyses.
| Ratio | Calculation | Question it helps to answer | Better as it gets |
|---|---|---|---|
| Net income margin | Net income - Total income | How much income is used up by expenses? | Bigger Will be <1 |
| Return on assets | Net income - Total assets | How big is the income supporting the assets? | Bigger |
| Return on net worth | Net income Net worth | How big is income relative to net worth? | Bigger |
| Debt to assets | Total debt Total assets | How much asset value is financed by debt? Or how much asset value is there to satisfy debt? | Smaller Should be <1 |
| Total debt | Total debt- Net worth | How large is debt relative to net worth? | Smaller Should be <1 |
| Interest coverage | Income before interest Interest expense | How well does income cover interest expenses? | Bigger Should be>1 |
| Cash flow to income | Net cash flow Net income | How much do payments for investments and financing take from income? | Bigger |
| Cash flow to assets | Net cash flow / Total assets | How much cash flow supports assets? | Bigger |
| Free cash flow | Free cash flow Net cash flow | How much cash is left to invest after covering living expenses and debt repayments? | Bigger |
While you may have a pretty good "feel" for your situation just by paying the bills and living your life, it so often helps to have the numbers in front of you. Here is Alice's ratio analysis for 2023 (Table 3.3.10 ).
| Ratio | Calculation | Result |
|---|---|---|
| Net income margin | Net income + Total assets | 0.1353 |
| Return on assets | Net income + Net worth | 1.1505 |
| Return on net worth | Total debt + Total assets | -0.1197 |
| Debt to assets | Total debt + Net worth | 10.6095 |
| Interest coverage | Income before interest + interest expense | 2.3482 |
| Cash flow to income | Net cash flow + Net income | 0.0662 |
| Cash flow to assets | Net cash flow + Total assets | 0.0762 |
| Free cash flow | Free cash flow + Net cash flow | 1.0000 |
The ratios that involve net worth—return-on-net-worth and total debt—are negative for Alice, because she has negative net worth, as her debts are larger than her assets. She can see how much larger her debt is than her assets by looking at her debt-to-assets ratio. Although she has a lot of debt (relative to assets and net worth), she can earn enough income to cover the cost of interest expense, as shown by the interest coverage ratio.
Alice has good earnings. Her income exceeds her assets. She can live efficiently. Her net income is a healthy 13.53 percent of her total income (net income margin), which means that her expenses are only 86.47 percent of it. Still, her cash flows are significantly lower (cash flow to income), meaning that a substantial portion of her earnings is used up in making investments or, in Alice's case, debt repayments. Her debt repayments don't leave her with much free cash flow; that is, cash flow which is not used up on living expenses or debts.
Examining the ratios, it becomes even more apparent how substantial—and yet subtle—a burden Alice's debt is. In addition to giving her a negative net worth, it prevents her from increasing her assets and creating a positive net worth, as well as potentially generating more income, by obligating her to use up her cash flows. Debt repayment keeps her from being able to invest.
Comparisons over Time
Another useful way to compare financial statements is to examine how the situation has evolved. Comparisons over time provide insights into the effects of past financial decisions and changes in circumstances. That insight can guide you in making future financial decisions, particularly in foreseeing the potential costs or benefits of a choice. Looking backward can be very helpful in looking forward.
Fast-forward ten years: Alice is now in her early thirties. Her career has progressed, and her income has grown. She has paid off her student loan and has started saving for retirement, as well as possibly a down payment on a house.
A comparison of Alice's financial statements shows the change over the decade, both in absolute dollar amounts and as a percentage (see Table 3.3.11 , Table 3.3.12 , and Table 3.3.13 ). In this example, the assumption is that inflation has not significantly increased during the decade.
| For the Year Ending | 12/31/2023 | 12/31/2033 | Change | % Change |
|---|---|---|---|---|
| Gross wages | $ 44,650 | $ 74,000 | $ 29,350 | 65.73% |
| Income taxes and deductions | $ 8,930 | $ 18,500 | $ 9,570 | 107.17% |
| Disposable income | $ 35,720 | $ 55,500 | $ 19,780 | 55.38% |
| Rent expense | $ 10,800 | $ 18,000 | $ 7,200 | 66.67% |
| Food | $ 3,900 | $ 3,900 | 0.00% | |
| Car expenses | $ 3,600 | $ 3,600 | 0.00% | |
| Clothing | $ 1,800 | $ 1,800 | 0.00% | |
| Cell phone | $ 1,200 | $ 1,200 | 0.00% | |
| Internet and streaming services | $ 1,200 | $ 1,200 | 0.00% | |
| Entertainment travel, etc. | $ 2,700 | $ 5,200 | $ 2,500 | 92.59% |
| Total living expenses | $ 25,200 | $ 34,900 | $ 9,700 | 38.49% |
| Car loan interest | $ 240 | $ 757 | $ 517 | 215.42% |
| Student loan interest | $ 4,240 | -$ 4,240 | -100.00% | |
| Total interest expenses | $ 4,480 | $ 757 | -$ 3,723 | -83.10% |
| Net income | $ 6,040 | $ 19,843 | $ 13,803 | 228.53% |
| For the Year Ending | 12/31/2023 | 12/31/2033 | Change | % Change |
|---|---|---|---|---|
| Cash from gross wages | $ 44,650 | $ 74,000 | $ 29,350 | 65.73% |
| Cash paid for: | ||||
| Income taxes and deductions | -$ 8,930 | -$ 18,500 | -$ 9,570 | 107.17% |
| Rent expense | -$ 10,800 | -$ 18,000 | -$ 7,200 | 66.67% |
| Food | -$ 3,900 | -$ 3,900 | 0.00% | |
| Car expenses | -$ 3,600 | -$ 3,600 | 0.00% | |
| Clothing | -$ 1,800 | -$ 1,800 | 0.00% | |
| Cell phone | -$ 1,200 | -$ 1,200 | 0.00% | |
| Internet and cable TV | -$ 1,200 | -$ 1,200 | 0.00% | |
| Entertainment, travel, etc. | -$ 2,700 | -$ 5,200 | -$ 2,500 | 92.59% |
| Car loan interest | -$ 240 | -$ 757 | -$ 517 | 215.42% |
| Student loan interest | -$ 4,240 | $ 4,240 | -100.00% | |
| Operating cash flows | -$ 6,040 | $ 19,843 | $ 13,803 | 228.53% |
| Cash invested in 401k | -$ 3,000 | -$ 3,000 | 100.00% | |
| Cash invested in car | -$ 6,300 | -$ 6,300 | 100.00% | |
| Investing cash flows | -$ 9,300 | -$ 9,300 | 100.00% | |
| Cash for repayment of car loan | -$ 2,160 | -$ 4,610 | -$ 2,450 | 113.43% |
| Cash for repayment of student loan | -$ 3,480 | -100.00% | ||
| Financing cash flows | -$ 5,640 | -$ 4,610 | $ 1,030 | -18.26% |
| Net cash flow | $ 400 | $ 5,933 | $ 5,533 | 1383.25% |
| As of | 12/31/2023 | 12/31/2033 | Change | % Change |
|---|---|---|---|---|
| Assets | ||||
| Cash/checking | $ 5,000 | $ 5,000 | 100.00% | |
| Savings | $ 250 | $ 250 | 0.00% | |
| Money market | $ 2,600 | $ 2,600 | 100.00% | |
| Retirement 401(k) | $ 13,000 | $ 13,000 | 100.00% | |
| Retirement IRA | $ 7,400 | $ 7,400 | 100.00% | |
| Car | $ 5,000 | $ 15,000 | $ 10,000 | 200.00% |
| Total assets | $ 5,250 | $ 43,250 | $ 38,000 | 723.81% |
| Liabilities | ||||
| Car loan | $ 2,700 | $ 4,610 | $ 1,910 | 70.74% |
| Student loan | $ 53,000 | -$ 53,000 | -100.00% | |
| Total liabilities | $ 55,700 | $ 4,610 | -$ 51,090 | -91.72% |
| Net worth | -$ 50,450 | $ 38,640 | $ 89,090 |
Starting with the income statement, Alice's income has increased. Her income tax withholding and deductions have also increased, but she still has higher disposable income (Net or take-home pay). Many of her living expenses have remained consistent; rent and entertainment have increased. Interest expense on her car loan has increased, but since she has paid off her student loan, that interest expense has been eliminated, so her total interest expense has decreased. Overall, her net income or personal surplus, which she clears after covering her living expenses, has almost doubled.
Her cash flows have also improved. Operating cash flows, like net income, have almost doubled, primarily due to the elimination of student loan interest payments. The improved cash flow allowed her to make a down payment on a new car, invest in her retirement, make the payments on her car loan, and still increase her net cash flow by a factor of ten.
Alice's balance sheet is most telling about the changes in her life, especially her now positive net worth. She has more assets. She has begun saving for retirement and has more liquidity, distributed in her checking, savings, and money market accounts. Since she has less debt, because she paid off her student loan, she now has a positive net worth.
Comparing the relative results of the common-size statements provides an even deeper view of the relative changes in Alice's situation (Table 3.3.14 , Table 3.3.15 , and Table 3.3.16 ).
| For the Year Ending | 12/31/2023 | 12/31/2033 |
|---|---|---|
| Gross wages | 100.00% | 100.00% |
| Income taxes and deductions | 20.00% | 25.00% |
| Disposable income | 80.00% | 75.00% |
| Rent expense | 24.19% | 24.32% |
| Food | 8.73% | 5.27% |
| Car expenses | 8.06% | 4.86% |
| Clothing | 4.03% | 2.43% |
| Cell phone | 2.69% | 1.62% |
| Internet and streaming services | 2.69% | 1.62% |
| Entertainment, travel, etc. | 6.05% | 7.03% |
| Total living expenses | 56.44% | 47.16% |
| Car loan interest | 0.54% | 1.02% |
| Student loan interest | 9.50% | 0.00% |
| Total interest expenses | 10.03% | 1.02% |
| Net income | 13.53% | 26.81% |
| For the Year Ending | 12/31/2023 | 12/31/2033 |
|---|---|---|
| Cash from gross wages | 100.00% | 100.00% |
| Cash paid for: | ||
| Income taxes and deductions | -20.00% | -25.00% |
| Rent expense | -24.19% | -24.32% |
| Food | -8.73% | -5.27% |
| Car expenses | -8.06% | -4.86% |
| Clothing | -4.03% | -2.43% |
| Cell phone | -2.69% | -1.62% |
| Internet and streaming services | -2.69% | -1.62% |
| Entertainment, travel, etc. | -6.05% | -7.03% |
| Car loan interest | -0.54% | -1.02% |
| Student loan interest | -9.50% | 0.00% |
| Operating cash flows | 13.53% | 26.81% |
| Cash invested in 401(k) | 0.00% | -4.05% |
| Cash invested in car | 0.00% | -8.51% |
| Investing cash flows | 0.00% | -12.57% |
| Repayment of car loan | -4.84% | -6.23% |
| Repayment of student loan | -7.79% | 0.00% |
| Financing cash flows | -12.63% | -6.23% |
| Net cash flow | 0.90% | 8.02% |
| As of | 12/31/2023 | 12/31/2033 |
|---|---|---|
| Assets | ||
| Cash/checking | 0.00% | 11.56% |
| Savings | 4.76% | 0.58% |
| Money market | 0.00% | 6.01% |
| Retirement 401(k) | 0.00% | 30.06% |
| Retirement IRA | 0.00% | 17.11% |
| Car | 95.24% | 34.68% |
| Total Assets | 100.00% | 100.00% |
| Liabilities | 0.00% | 0.00% |
| Car loan | 51.43% | 10.66% |
| Student loan | 1009.52% | 0.00% |
| Total Liabilities | 1060.95% | 10.66% |
| Net worth | -960.95% | 89.34% |
Although income taxes and rent have increased as a percentage of income, living expenses have decreased, showing real progress for Alice in raising her standard of living: it now costs her less of her income to sustain herself. Interest expense has decreased substantially as a portion of income, resulting in a net income or personal profit that is not only larger, but is larger relative to income. More of her income is profit, left for other discretionary uses.
The change in operating cash flows confirms this. Although her investing activities now represent a significant use of cash, her need to use cash in financing activities, specifically debt repayment, is substantially less, resulting in a substantial increase in her net cash flow. The cash that used to have to go toward supporting debt obligations now goes toward building an asset base, some of which (her retirement) may provide income in the future.
Changes in the balance sheet reveal a more diversified and, therefore, less risky asset base. Although almost half of Alice's assets are restricted for a specific purpose, such as her retirement, she still has significantly more liquidity and a higher proportion of liquid assets. Debt has fallen from ten times the assets' value to one-tenth of it, creating positive net worth for Alice.
By analyzing over time, you can spot trends that may occur too slowly or too subtly to notice in daily life, but which may become significant over time. You would want to keep a closer eye on your finances than Alice does, however, and review your situation at least every year.
- Each financial statement shows a piece of the larger picture. Financial statement analysis puts the financial statement information into context, making it sharper in focus.
- Common-size statements show the size of each item relative to a common denominator.
- On the income statement, each income and expense is shown as a percentage of total income.
- On the cash flow statement, each cash flow is shown as a percentage of the total positive cash flow.
- On the balance sheet, each asset, liability, and net worth is shown as a percentage of total assets.
- The income and cash flow statements explain the changes in the balance sheet over time.
- Ratio analysis is a way of creating a context by comparing items from different statements.
- Comparisons made over time can demonstrate the effects of past decisions to understand the significance of future decisions better.
- Financial statements should be analyzed at least annually.
- Prepare common-size statements for your income statement, cash flow statement, and balance sheet. What do your common-size statements reveal about your financial situation? How will your common-size statements influence your personal financial planning?
- Calculate your debt-to-income ratio and other ratios using online financial tools. According to the calculation, are you carrying a healthy debt load? Why, or why not? If not, what can you do to improve your situation?
- If you increase your income and assets, and reduce your expenses and debt, your personal wealth and liquidity will grow. In your personal financial journal, outline a general plan for how you would use or allocate your growing wealth to reduce your expenses and debt further, to acquire more assets or improve your standard of living, and to increase your real or potential income further.