ACCT 2113 1st Edition Lecture 12 Outline of Last Lecture II. Statement of Cash FlowsA. FormattingB. Classification of transactions- operating, investing, and financingC. Reporting cash flow activitiesIII. Relationship between financial statementsIV. Operating activities- direct and indirectV. Preparing statement of cash flowsA. Direct and IndirectB. Adjustments for changeC. ExampleVI. Operating Activities- Direct and IndirectA. ExampleVII. Cash Flow AnalysisOutline of Current Lecture II. Comparison of Financial Accounting InformationA. Vertical vs Horizontal analysisIII. Ratios to asses risk and profitabilityA. Liquidity and SolvencyIV. Earnings persistence and earnings qualityA. Discontinued operationsB. Extraordinary itemsC. Quality of earningsCurrent Lecture Chapter 12: Financial Statement AnalysisComparison of financial account informationWe 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 AnalysisIn performing vertical analysis, we express each item in a financial statement as a percentage ofthe same base amount. For instance, we can express each line item in an income statement as apercentage 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 greateramount 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 ÷ $856.4) compared to Nike’s 44.9%. This means that Under Armour earns a higher gross profit for each item sold, consistent with its business strategy of focusing on high-quality performance apparel. However, Under Armour’s higher gross profit is offset almost entirely by its proportionately higher operating expenses, 38.3% of sales compared to only 35.2% for Nike. The net result is that operating income, incomebefore tax, and net income as a percentage of sales are quite similar for the two companies.Vertical analysis of the balance sheet is useful, too. For this, we divide each balance sheet item by total assets to get an idea of its relative significance. Here, common-size balance sheets are presented for Under Armour and Nike. Focusing on the asset portion of the balance sheet, we discover that Under Armour has a higherpercentage of current assets than Nike and a slightly lower share of assets invested in property and equipment. Looking at liabilities and stockholders’ equity, we see that the two companies maintain a similar proportion of current liabilities but differ in their proportion of long-term liabilities. Under Armour is financed more by equity than by debt; its long-term liabilities UNDER AMROUR AND NIKECommon-Size Income StatementsFor the Years Ended December 31, 2009 and May 31, 2009($ in millions)UNDER ARMOUR NIKEFor the year ended: December 31, 2009 May 31, 2009Amount % Amount %Net Sales $856.4 100.0 $19,176.1100.0Cost of goods sold 443.4 51.8 10,571.7 55.1 Gross profit 413.0 48.2 8,604.4 44.9Operating expenses 327.7 38.3 6,745.9 35.2 Operating income 85.3 9.9 1,858.5 9.7Other income (expense) (2.9) (0.3) 98.0 0.5 Income before tax 82.4 9.6 1,956.5 10.2Income tax expense 35.6 4.1 469.8 2.4Net income 46.8 5.5 1,486.7 7.8represent 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 AnalysisWe 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 ARMOURIncome StatementFor the Years Ended December 31(in millions)Year Increase (Decrease)2009 2008 Amount %Sales $856.4 $725.2 $131.2 18.1Cost of goods sold 443.4 370.3 73.1 19.7 Gross profit 413.0 354.9 58.1 16.4Operating expenses 327.7 278.0 49.7 17.9 Operating income 85.3 76.9 8.4 10.9Other expenses 2.9 7.0 (4.1) (58.6) Income before tax 82.4 69.9 12.5 17.9Income tax expense 35.6 31.7 3.9 12.3Net income $46.8 $38.2 $8.6 22.5We calculate the percentage increase or decrease based on the following formula: % Increase (Decrease) = (Current-Year Amount (−) Prior-Year Amount) / Prior-Year AmountFor 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