Analysis and interpretation of financial statements

CHAPTER 25
Analysis and
interpretation
of financial
statements
CONTENTS
25.1 Horizontal and vertical analysis
25.2 Trend analysis
25.3 Effect of transactions on ratios
25.4 Ratio analysis
25.5 Ratio analysis comparing two entities

---

CHAPTER 25: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
25-1

Problem 25.1 Horizontal and vertical analysis

The comparative financial statements of Corella Ltd are shown below.

CORELLA LTD
Comparative Income Statements
for the years ended 30 June 2007 and 2006
(000 omitted)

2007
2006
Sales revenue
$10 500
$9 300
Less: Cost of sales
6 000
5 900
GROSS PROFIT
4 500
3 400
Selling expenses
1 300
1 220
Administrative expenses
1 250
990

2 550
2 210
PROFIT BEFORE INCOME TAX
1 950
1 190
Less: Income tax expense
680
415
PROFIT
$ 1 270
$ 775
CORELLA LTD
Comparative Balance Sheet
as at 30 June 2007 and 2006
(000 omitted)

2007
2006
ASSETS


Cash at bank
$ 50
$ 60
Accounts receivable
250
210
Inventory
510
475
Long-term investments
90
100
Plant and equipment
2 200
1 850

$3 100
$2 695
LIABILITIES AND SHAREHOLDERS’ EQUITY


Accounts payable
$ 260
$ 235
Bills payable
70
80
Non-current liabilities
1 150
1 150
Share capital
1 000
850
Retained earnings
620
380

$3 100
$2 695






Required:
A. Calculate the changes in the financial statements from 2006 to 2007 in both dollar
amounts and percentages.
B. Prepare common size financial statements for 2006 and 2007.
C. Comment on any relationships revealed by the horizontal and vertical analyses.

---

CHAPTER 25: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
25-2


Solution


A.

CORELLA
LTD

Income Statement Horizontal Analysis

for the years ended 30 June 2007 and 2006
Change during the year

Dollar amount
Percentage
(000
omitted)
Sales revenue
$1 200
12.9%
Cost of sales
(100)
(1.7)
Gross profit
1 100
32.3
Selling expenses
80
6.6
Administrative expenses
260
26.3

340
15.4
Profit before income tax
760
63.9
Income tax expense
265
63.9
Profit
$495 63.9


CORELLA LTD
Balance Sheet Horizontal Analysis
as at 30 June 2007 and 2006

Change during the year

Dollar amount
Percentage

(000 omitted)
Assets:

Cash at bank
$(10)
(16.7)%
Accounts receivable
40
19.0
Inventory
35
7.4
Long-term investments
(10)
(10.0)
Plant and equipment
350
18.9
405 15.0
Liabilities and shareholders' equity:

Accounts payable
12
10.6
Bills payable
(10)
(12.5)
Non-current liabilities
0
0.0
Capital
150
17.6
Retained earnings
240
63.2
405
15.0

---

CHAPTER 25: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
25-3



B.
CORELLA
LTD

Comparative Common-size Income Statements

for the years ended 30 June 2007 and 2006

Per cent of net sales

2007
2006
Sales revenue
100.0 %
00.0%
Less: Cost of sales
57.1
63.4
Gross profit
42.9
36.6
Selling expenses
12.4
13.1
Administrative expenses
11.9
10.7
24.3

23.8
Profit before income tax
18.6
12.8
Income tax expense
6.5
4.5
Profit
12.1
8.3


CORELLA LTD
Comparative Common-size Balance Sheet
as at 30 June 2007 and 2006


Per cent of total assets
Asset

2002
2001
Cash at bank

1.6 %
2.2%
Accounts receivable

8.0
7.8
Inventory

16.5
17.6
Long-term investments

2.9
3.7
Plant and equipment

71.0
68.7

100.0

100.0



Liabilities and shareholders' equity


Accounts payable

8.4
8.7
Bills payable

2.3
3.0
Non-current liabilities

37.1
42.7
Capital

32.2
31.5
Retained earnings

20.0
14.1

100.0
100.0

C.
Corella Ltd appears to be doing well. Sales have increased while the cost of goods sold
has decreased. Although total expenses as a percentage of sales have increased slightly,
the dollar amount of profit has nearly doubled.
Corella Ltd has invested in additional plant and equipment, apparently using funds
obtained from the sale of ordinary shares and from the 2007 profit.

---

CHAPTER 25: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
25-4




Problem 25.2 Trend analysis

The comparative income statements and balance sheets of Quokka Ltd are shown below:

QUOKKA LTD
Comparative Income Statements
for the years ended 31 December 2002–2007
(000 omitted)



2002 2003 2004 2005
2006 2007

Sales revenue
$250 $263 $262 $270
$325 $348

Less: Cost of sales
152
156
153
157
180
215

GROSS PROFIT
98
107
109
113
145
133

Operating expenses
68
71
69
84
94
95

PROFIT
$ 30
$ 36
$ 40
$ 29
$ 51 $ 38

QUOKKA LTD
Comparative Balance Sheets
as at 31 December 2002-2007
(000 omitted)



2002 2003 2004 2005 2006
2007

ASSETS



Cash at bank
$ 15
$ 16
$ 15
$ 22 $ 21
$ 12
Trade debtors
21
25
23
36
43
62
Inventory
62
70
74
98
125
133
Plant and equipment
150
162
173
290
286
283

$248 $273 $285 $446 $475
$490
LIABILITIES AND EQUITY



Trade creditors
$ 53
$ 65
$ 70
$ 96 $116
$126
Non-current liabilities
60
58
55
125
121
119
Share capital
100
100
100
150
150
150
Retained earnings
35
50
60
75
88
95

$248 $273 $285 $446 $475
$490





Required:
A. Prepare a trend analysis of the data.
B. Comment on any significant trends revealed by the analysis.

---

CHAPTER 25: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
25-5






Solution

A.
QUOKKA
LTD

Comparative Income Statements

for the years ended 31 December 2002 - 2007

2002
2003
2004
2005
2006
2007
Sales revenue
100
105
105
108
130
139
Cost of sales
100
103
101
103
118
141
Gross profit
100
109
111
115
148
138
Operating expenses
100
104
110
124
138
140
Operating profit
100
120
133
97
170
127


QUOKKA LTD
Comparative Balance Sheets Trend analysis
as at 31 December 2002-2007

2002 2003
2004
2005
2006
2007
Assets



Cash at bank
100
107
100
147
140
80
Trade debtors
100
119
110
171
205
295
Inventory
100
113
119
158
202
215
Plant & equipment
100
108
115
193
191
189
Total assets
100
110
115
180
192
198


2002
2003
2004
2005
2006 2007
Liabilities and equity


Trade
creditors

100 123 132 181
219
238
Non-current liabils.
100
97
92
208
202
198
Share
capital

100 100 100 150
150
150
Retained
earnings

100 143 171 214
251
271
Total liabs and equity
100
110
115
180
192
198

B.
From 2002 to 2005 sales revenue increased at a faster rate than cost of sales, resulting in
increased gross profit. The reversal in these items in 2006 should be analysed. The wide
fluctuations in profit is an unfavourable situation indicates instability and requires further
investigation.
During 2004, the company financed investments in plant and equipment and other assets
by issuing non-current liabilities and ordinary shares. The large increase in sales

---

CHAPTER 25: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
25-6

during 2005 was probably a result of this investment. The increase in retained earnings
indicates that the company is financing part of its growth internally.
The substantial increase in profit between 2004 and 2005, as shown in the
trend figures, is misleading because of the relative size of the absolute dollar amounts.

---

CHAPTER 25: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
25-7

Problem 25.3 Effect of transactions on ratios

Numbat Ltd completed the transactions listed below in the left-hand column.

Transaction
Ratio


1.Redeemed debentures by issuing ordinary shares
Rate of return on ordinary

shareholders’ equity
2.Purchased inventory on credit
Quick ratio
3.Sold inventory for cash
Current ratio
4.Issued additional ordinary shares for cash
Debt ratio
5.Declared a cash dividend on ordinary shares
Dividend payout
6.Paid the cash dividend
Dividend yield
7.Wrote off bad debt against Allowance for Doubtful Debts
Current ratio
8.Collected an account receivable
Receivables turnover
9.Paid accounts payable
Rate of return on total
assets

10.Sold obsolete inventory at cost
Profit margin
11.Issued a share dividend on ordinary shares
Earnings per share
12.Sold inventory on account
Inventory turnover

Required:
State whether each transaction would cause the ratio listed opposite it to increase,
decrease or remain unchanged.

Solution

NUMBAT LTD
1. Decrease
2. Decrease
3. Remain unchanged if sales price is equal to cost.
Increase if sales price is greater than cost.
4. Decrease
5. Increase
6. Remain unchanged
7. Remain unchanged
8. Increase
9. Increase
10. Decrease — will increase sales and cost of goods sold by the same amount resulting in a
zero change in operating profit.
11. Decrease
12. Increase

---

CHAPTER 25: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
25-8


Problem 25.4 Ratio analysis

You are presented with the following summarised information:

JABIRU LTD
Income Statement
for the year ended 30 September 2006
Net sales revenue


$567 000
Less: Cost of sales


378 000
GROSS PROFIT


189 000
Less: Operating expenses (including tax and interest)

126 000
PROFIT


$ 63 000
JABIRU LTD
Balance Sheet
as at 30 September 2006
CURRENT ASSETS




Cash at bank

$25 200


Accounts receivable
$199 500



Less: Allowance for doubtful debts 12 600
186 900


Inventory

168 000
$380 100

NON-CURRENT ASSETS




Land

42 000


Building
126 000



Less: Accumulated depreciation
25 200
100 800


Store equipment
31 500



Less: Accumulated depreciation
14 700
16 800
159 600




$539 700

CURRENT LIABILITIES




Provision for preference dividends

$ 2 520


Provision for ordinary dividends

16 800


Accounts payable

180 600


Accrued expenses

8 400
$208 320

NON-CURRENT LIABILITIES




10% mortgage payable


42 000

EQUITY




Share capital:




6% preference shares

42 000


Ordinary shares

168 000




210 000


Retained earnings

79 380
289 380




$539 700

---

CHAPTER 25: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
25-9



Additional information
1. The balances of certain accounts at the beginning of the year are:
Accounts
receivable

$210
000
Allowance for doubtful debts
(18 900)
Inventory

147
000
2. Total assets and total equity at the beginning of the year were $504 000 and $245 700
respectively.
3. Income tax expense for the year is $42 000. Interest expense is $4200.

Required:
A. Name the ratios that a financial analyst might calculate to give some indication of the
following:
1. a company’s earning power
2. the extent to which internal sources have been used to finance acquisitions of
assets
3. rapidity with which accounts receivable are collected
4. the ability of a business to meet quickly unexpected demands for working capital
5. the ability of the entity’s earnings to cover its interest commitments
6. the length of time taken by the business to sell its inventory.
B. Calculate and briefly discuss the suitability of the ratios mentioned for each of the
above cases.

Solution

A.
JARIBU LTD
1. Rate of return on assets, and rate of return on ordinary shareholders' equity.
2. Equity ratio, as well as comparative statement analysis, especially horizontal and
vertical analysis.
3. Average collection period for receivables.
4. Quick ratio.
5. Times interest earned.
6. Inventory turnover, or average days per turnover.

B.
1. Rate of return on assets = 63 000 + 42 000 + 4 200 = 20.9%
(539 700 + 504 000)/2

This ratio measures the return earned by management through use of the assets in the
firm's operations, ie. before financing and tax costs are considered. The ratio depends
heavily on the accuracy of the figures used, and the method of measurement, eg.
fluctuations may occur depending on the accounting methods used for inventory,
depreciation, etc. Trends across time should be considered.

---