ACCT 2113 1st Edition Lecture 12 Outline of Last Lecture II Statement of Cash Flows A Formatting B Classification of transactions operating investing and financing C Reporting cash flow activities III Relationship between financial statements IV Operating activities direct and indirect V Preparing statement of cash flows A Direct and Indirect B Adjustments for change C Example VI Operating Activities Direct and Indirect A Example VII Cash Flow Analysis Outline of Current Lecture II Comparison of Financial Accounting Information A Vertical vs Horizontal analysis III Ratios to asses risk and profitability A Liquidity and Solvency IV Earnings persistence and earnings quality A Discontinued operations B Extraordinary items C Quality of earnings Current Lecture Chapter 12 Financial Statement Analysis Comparison of financial account information We use ratios to make comparisons every day Likewise we can use ratios to help evaluate a firm s performance and financial position Ratios are most useful when compared to some standard That standard of comparison may be These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute the performance of a competing company last year s performance by the same company or an industry average Here is a summary of these three different types of comparisons Vertical Analysis In performing vertical analysis we express each item in a financial statement as a percentage of the same base amount For instance we can express each line item in an income statement as a percentage of sales In a balance sheet we can express each item as a percentage of total assets The Illustration provides common size income statements for Under Armour and Nike Notice that the two companies end their fiscal years on different dates Under Armour s year end is December 31 while Nike s is May 31 Even though the year ends do not exactly match we can still make meaningful comparisons between the two companies Nike reports net income of almost 1 5 billion while Under Armour reports only 47 million Does this mean Nike s operations are nearly 30 times more profitable than Under Armour s Not necessarily Nike is a much larger company reporting sales over 19 Billion compared to 856 4 million for Under Armour Because of its greater size we expect Nike to report a greater amount of net income To better compare the performance of the two companies we use vertical analysis to express each income statement item as a percentage of sales Under Armour s gross profit equals 48 2 of sales 413 0 856 4 compared to Nike s 44 9 This means that Under Armour earns a higher gross profit for each item sold consistent with its business strategy of focusing on high quality performance apparel However Under Armour s higher gross profit is offset almost entirely by its proportionately higher operating expenses 38 3 of sales compared to only 35 2 for Nike The net result is that operating income income before tax and net income as a percentage of sales are quite similar for the two companies UNDER AMROUR AND NIKE Common Size Income Statements For the Years Ended December 31 2009 and May 31 2009 in millions For the year ended UNDER ARMOUR NIKE December 31 2009 May 31 2009 Amount Amount 856 4 100 0 100 0 443 4 51 8 19 176 1 10 571 7 413 0 48 2 8 604 4 44 9 327 7 38 3 6 745 9 35 2 85 3 9 9 1 858 5 9 7 2 9 0 3 98 0 0 5 82 4 9 6 1 956 5 10 2 Income tax expense 35 6 4 1 469 8 2 4 Net income 46 8 5 5 1 486 7 7 8 Net Sales Cost of goods sold Gross profit Operating expenses Operating income Other income expense Income before tax 55 1 Vertical analysis of the balance sheet is useful too For this we divide each balance sheet item by total assets to get an idea of its relative significance Here common size balance sheets are presented for Under Armour and Nike Focusing on the asset portion of the balance sheet we discover that Under Armour has a higher percentage of current assets than Nike and a slightly lower share of assets invested in property and equipment Looking at liabilities and stockholders equity we see that the two companies maintain a similar proportion of current liabilities but differ in their proportion of long term liabilities Under Armour is financed more by equity than by debt its long term liabilities represent only 4 7 of total assets In comparison Nike reports a higher level of long term liabilities at 9 7 Finally it s interesting to note the relative contributions of common stock and retained earnings for the two companies Under Armour reports a higher proportion of common stock and a lower proportion of retained earnings in comparison to Nike Newer companies like Under Armour tend to have a greater portion of equity from investment in the company common stock than from earnings retained in the company retained earnings Just the opposite is true for many well established companies like Nike Profitable operations over many years have created a retained earnings balance for Nike that exceeds the original investment in the company Horizontal Analysis We use horizontal analysis to analyze trends in financial statement data for a single company over time Consider here the income statements over two years for Under Armour The final two columns show the dollar amount and percentage changes We calculate the amount of the increase or decrease by subtracting the 2008 balance from the 2009 balance A positive difference indicates the amount increased in 2009 A negative amount represents a decrease which we record in parentheses UNDER ARMOUR Income Statement For the Years Ended December 31 in millions Year Increase Decrease 2009 2008 Amount Sales 856 4 725 2 131 2 18 1 Cost of goods sold 443 4 370 3 73 1 19 7 413 0 354 9 58 1 16 4 Gross profit Operating expenses 327 7 278 0 49 7 17 9 Operating income 85 3 76 9 8 4 10 9 2 9 7 0 4 1 58 6 Income before tax 82 4 69 9 12 5 17 9 Income tax expense 35 6 31 7 3 9 12 3 Net income 46 8 38 2 8 6 22 5 Other expenses We calculate the percentage increase or decrease based on the following formula Increase Decrease Current Year Amount Prior Year Amount Prior Year Amount For example the amount of sales increased 131 2 million equal to sales of 856 4 million in 2009 minus sales of 725 2 million in 2008 We calculate the percentage increase of 18 1 by dividing the 131 2 million increase in sales by 2008 sales of 725 2 million If the base year amount 2008 in our example is ever zero we can t