Ch. 2 Financial Statements and Adjusting Entries
2.4 Financial Statements: Analysis
Learning Objectives
After finishing this section, student will be able to:
- calculate working capital.
- analysis an income statement using the vertical analysis method.
Not understanding how the accounting and finance are different often frustrates students. In accounting, we understand where the numbers come from in financial statements. In finance, we learn how to evaluate financial statements. To understand the importance of creating a multi-step income statement and a classified balance sheet, we will learn two simple evaluation methods.
Accurate financial statements can only be created by the accounting system if the classification is set up correctly in the computer system. Many businesses do not hire accountants, so accounts are not listed on the correct financial statement causing incorrect evaluation.
Working Capital
If a company has an accurate balance sheet, you can quickly determine if a company is healthy and has enough cash to meet its obligations.
Working capital is the difference between a company’s current assets (money available in the next year to use) and current liabilities (bills and obligations that are required to be paid in the next year).
If Company A has current assets of $150,000 and current liabilities of $120,000, then its working capital is $30,000. Company A is healthy and can meet obligations.
If Company B has current assets of $100,000 and current liabilities of $130,000, then its working capital is negative $30,000. Company B is not healthy and will struggle to pay bills, employees, and other obligations.
Vertical Analysis of an Income Statement
If a company has an accurate multi-step income statement, a vertical analysis can be performed to help a company understand proportions of accounts and trends.
Vertical analysis of an income statement is calculated by dividing each account by total sales revenue. This allows numbers to be analyzed as a percentage instead of a number.
Sales will always be 100%. In 20X8, the gross profit percentage is calculated as follows: 94,000 / 198,000 = 47.47%.
| 20X8 | 20X7 | ||||
| Amount ($) | % | Amount ($) | % | ||
| Sales | 198,000 | 100.00 | 176,000 | 100.00 | |
| Cost of Goods Sold | 104,000 | 52.53 | 98,000 | 55.68 | |
| Gross Profit | 94,000 | 47.47 | 78,000 | 44.32 | |
| Operating Expenses | 7,600 | 3.84 | 8,000 | 4.55 | |
| Income before Taxes | 86,400 | 43.63 | 70,000 | 39.77 | |
| Income Tax | 21,600 | 10.91 | 17,500 | 9.94 | |
| Net Income | 64,800 | 32.72 | 52,500 | 29.83 | |
Looking at the example above, cost of goods sold has improved because the percentage has decreased by 3.15% in 20X8 compared to 20×7. At the same time, Income Tax has increased because as sales increased and costs decreased, the Income before Tax increased. Increased taxes are a good problem to have. This is validated by the fact that our net income percentage has also increased from 20X8 to 20X7.
If the cost of goods sold percentage increased, you would need to evaluate this account to determine what has increased and if your sales price needs to increase to continue to provide the company profit. On the flip side of this, you also cannot increase your sales price if it will drive customers away.
2.4a Homework
On the www.sec.gov website, locate THREE companies that you are interested in.
For EACH company, answer the following questions using complete sentences.
- What is the name of the company and what is their business operation?
- Using the Balance Sheet, what does the working capital of the company tell you?
- Using the Income Statement, perform a vertical analysis for two difference years. Based on your analysis, list three accounts that have significant percentage changes that you feel management should evaluate for errors, fraud, or increased spending.
is the difference between a is the difference of the company’s current assets (money available in the next year to use) and current liabilities (bills and obligations that are required to be paid in the next year).
is calculated by dividing each account by total sales revenue.
