Chapter 8

Financial Analysis and

Interpretation

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Key Terms
 solvency
 working capital
 current ratio
 quick ratio

2
 Objectives
Objectives
1. Use horizontal analysis to compare financial
statements from different periods.
2. Use vertical analysis to compare financial
statement items with each other and with industry
averages.
3. Analyze and interpret the financial solvency of a
business by computing working capital and the
current ratio..
4. Compute the ratio of net sales to assets as a
measure of how effectively a business is using
its assets.

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Contents of Chapter 8
 1. Horizontal analysis
 2. Vertical analysis
 3. Working capital and current ratio
 4. Ratio of net sales to assets

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1. Horizontal analysis

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 Comparing
Comparing an an item
item in
in aa
current
current statement
statement withwith the
the
same
same itemitem in
in prior
prior statements
statements
isis called
called horizontal
horizontal analysis.
analysis.

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 J Holmes, Attorney-at-Law
Income Statement
For the Year Ended December 31, 2005 and 2006
Increase (Decrease)
2006 2005 Amount Percent
Fees earned $187,500 $150,000 $37,500 25.0%
Operating expenses:
Wages expense $ 60,000 $ 45,000 $15,000 33.3%
Rent expense 15,000 12,000 3,000 25.0%
Utilities expense 12,500 9,000 3,500 38.9%
Supplies expense 2,700 3,000 (300) (10.0)%
Misc. expense 2,300 1,800 500 27.8%
Total operating
expenses $ 92,500 $ 70,800 $21,700 30.6%
Net income $ 95,000 $ 79,200 $15,800 19.9%
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2. Vertical analysis

8
 Vertical
Analysis and
Interpretation

9
 J. Holmes, Attorney-at-Law
Income Statements
For the Years Ended December 31, 2005 and 2006
2006 2005
Amount Percent Amount Percent
Fees earned $187,500 $150,000
Operating expenses:
Wages expense $60,000 $45,000
Rent expense 15,000 12,000
Utilities expense 12,500 9,000
Supplies expense 2,700 3,000
Miscellaneous exp. 2,300 1,800
Total operating
expenses $92,500 $70,800
Net income $95,000 $79,200
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 2006 2005
Amount Percent Amount Percent
Fees earned $187,500 100.0% $150,000 100.0%
Operating expenses:
Wages expense $60,000 $45,000
Rent expense 15,000 12,000
Utilities expense 12,500 9,000
Supplies expense 2,700 3,000
Miscellaneous exp. 2,300 1,800
Total operating
expenses $92,500 $70,800
Net income $95,000 $79,200
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 2006 2005
Amount Percent Amount Percent
Fees earned $187,500 100.0% $150,000 100.0%
Operating expenses: $60,000
$60,000
Wages expense $60,000 32.0% $45,000
$187,500
$15,000
$187,500
$15,000
Rent expense 15,000 38.0% 12,000
$187,500
$187,500
Utilities expense 12,500 9,000
Supplies expense 2,700 3,000
Miscellaneous exp. 2,300 1,800
Total operating
expenses $92,500 $70,800
Net income $95,000 $79,200
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 2006 2005
Amount Percent Amount Percent
Fees earned $187,500 100.0% $150,000 100.0%
Operating expenses:
Wages expense $60,000 32.0% $45,000 30.0%
Rent expense 15,000 38.0% 12,000 8.0%
Utilities expense 12,500 6.7% 9,000 6.0%
Supplies expense 2,700 1.4% 3,000 2.0%
Miscellaneous exp. 2,300 1.2% 1,800 1.2%
Total operating
expenses $92,500 49.3% $70,800 47.2%
Net income $95,000 50.7% $79,200 52.8%
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3. Working capital and current ratio

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 Financial
Financial Analysis
Analysis for
for
NetSolutions
NetSolutions
Working Current Current
= –
Capital Assets Liabilities
Working
= $7,845 – $1,390
Capital
Working $6,455
Capital =

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 Financial
Financial Analysis
Analysis for
for
NetSolutions
NetSolutions
Current Current Current
Ratio = Assets ÷ Liabilities

Current
Ratio = $7,845 ÷ $1,390
Current
= 5.6
Ratio

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Financial
Financial Analysis
Analysis for
for
NetSolutions
NetSolutions
This
This ratio
ratio implies
implies that
that
NetSolutions
NetSolutions isis able
able to
to pay
pay
its
its current
current liabilities.
liabilities.

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 Financial
Financial Analysis
Analysis for
for
NetSolutions
NetSolutions
Current Current Current
ratio = Assets ÷ Liabilities

Current
= $7,845 ÷ $1,390
ratio
Current
= 5.6
ratio

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Financial
Financial Analysis
Analysis for
for
NetSolutions
NetSolutions
NetSolutions
NetSolutions can
can use
use the
the current
current ratio
ratio
to
to make
make comparisons
comparisons across
across
companies
companies and
and with
with industry
industry averages.
averages.

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4. Ratio of net sales to assets

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 Profitability Measures -- Effective Use of Assets
Ratio
Ratio of
of Net
Net Sales
Salesto
to Assets
Assets
Sears Penney
Net sales $41,366,000 $31,846,000
Total assets:
Beginning of year $50,409,000 $19,742,000
End of year $44,317,000 $20,908,000
Average $47,363,000 $20,325,000
Ratio of net sales to assets .87 to 1 1.57 to 1

Ratio
Ratio Use:
Use: To
To assess
assess the
the effectiveness
effectiveness in
in the
the
use
useofof assets
assets to
to generate
generate sales.
sales.
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Chapter 8

The
The End
End

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