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Chapter

7
Comparing Financial Statements
One final way of evaluating financial performance is to simply compare financial statements
from period to period and to compare financial statements with other companies. This can be
facilitated by vertical and horizontal analysis.

Vertical Analysis

Vertical analysis compares line items on a financial statement over an extended period of
time. This helps us spot trends and restate financial statements to a common size for quick
analysis. For the Balance Sheet, we will use total assets as our base (100%) and for the
Income Statement, we will use Sales as our base (100%). We will compare different line
items on the financial statements to these bases and express the line items as a percentage
of the base.

EXAMPLE â€” Income Statements for the last three years are summarized
below:
1990 1991 1992
Sales \$ 300,000 \$ 310,000 \$ 330,000
Cost of Goods Sold (110,000) (105,000) (110,000)
G & A Expenses ( 80,000) (100,000) (105,000)
Net Income \$ 110,000 \$ 105,000 \$ 115,000

< - - - - - - - Vertical Analysis - - - - - - - - - >
Sales 100% 100% 100%
Cost of Goods Sold 37% 34% 33%
G & A Expenses 27% 32% 32%
Net Income 37% 34% 35%

By expressing balances as percentages, we can easily notice that G & A
Expenses are trending up while Cost of Goods Sold is moving down. This
may require further analysis to determine what is behind these trends.

Horizontal Analysis

Horizontal analysis looks at the percentage change in a line item from one period to the next.
This helps us identify trends from the financial statements. Once we spot a trend, we can dig
deeper and investigate why the change occurred. The percentage change is calculated as:

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(Dollar Amount in Year 2 - Dollar Amount in Year 1) / Dollar Amount in Year 1

EXAMPLE â€” Sales were \$ 310,000 in 1991 and \$ 330,000 in 1992. The
percentage change in sales is:

(\$ 330,000 - \$ 310,000) / \$ 310,000 = 6.5%

We can apply this analysis "horizontally" down the financial statement for
the year 1992:

Sales 6.5%
Cost of Goods Sold 4.8%
G & A Expenses 5.0%
Net Income 9.5%

Summary
We started our look at ratio analysis with Return on Equity since this one ratio is at the heart
of financial management; namely we want to maximize returns for the shareholders of the
company. Secondly, we have three ways of influencing Return on Equity. We can change our
profit margins, we can change our turnover of assets, or we can change our use of financial
leverage. Next, we looked at how we can influence the three components of Return on
Equity.

There are several detail ratios that we can monitor, such as acid test, inventory turnover, and
debt to equity. Detail ratios help us monitor specific financial conditions, such as liquidity or
profitability.

Ratios are best used when compared or benchmarked against another reference, such as an
industry standard or "best in class" within our industry. This type of comparison helps us
establish financial goals and identify problem areas.

We also can use vertical and horizontal analysis for easy identification of changes within
financial balances.

It should be noted that ratios do have limitations. After all, ratios are usually derived from
financial statements and financial statements have serious limitations. Additionally,
comparisons are usually difficult because of operating and financial differences between
companies. None-the-less, if you want to analyze a set of financial statements, ratio analysis
is probably one of the most popular approaches to understanding financial performance.

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Final Exam
internet at www.exinfm.com/training.

1. Which ratio is best used for measuring how well management did in managing the funds
provided by shareholders?

a. Profit Margin

b. Debt to Equity

Return on Equity
c.

d. Inventory Turnover

2. If sales are \$ 600,000 and assets are \$ 400,000, then asset turnover is:

a. .67

b. 1.50

c. 2.00

d. 3.50

3. An extremely high current ratio implies:

a. Management is not investing idle assets productively.

b. Current assets have been depleted and the company is insolvent.

c. Total assets are earning a very low rate of return.

d. Current liabilities are higher than current assets.

4. If we have cash of \$ 1,500, accounts receivables of \$ 25,500 and current liabilities of \$
30,000, our quick or acid test ratio would be:

a. 1.88

b. 1.33

c. 1.11

d. .90

5. The number of times we convert receivables into cash during the year is measured by:

a. Capital Turnover

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b. Asset Turnover

c. Accounts Receivable Turnover

d. Return on Assets

6. If our cost of sales are \$ 120,000 and our average inventory balance is \$ 90,000, then our
inventory turnover rate is:

a. .50

b. .75

c. 1.00

d. 1.33

7. We can estimate our Operating Cycle by taking the sum of:

a. Receivable Turnover + Inventory Turnover

b. Days in Receivables + Days in Inventory

c. Asset Turnover + Return on Sales

d. Days in Sales + Days in Assets

8. If Operating Income (Earnings Before Interest Taxes) is \$ 63,000 and Net Sales are \$
900,000, then Operating Income to Sales is:

a. 18%

b. 12%

c. 7%

d. 4%

9. If the price of the stock is \$ 45.00 and the Earnings per Share is \$ 9.00, then the P / E
Ratio is:

a. 2

b. 5

c. 9

d. 15

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10. Net Income for 1996 was \$ 400,000 and Net Income for 1997 was \$ 420,000. The
percentage change in Net Income is:

a. 1%

b. 3%

c. 5%

d. 10%

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