Demo Doc 1 Financial Statement Analysis

Carter, Corp., had the following information at December 31, 2009:

Carter, Corp. Balance Sheet December 31, 2009 and 2008

2009 Assets Cash................................................ Accounts receivable......................... Inventory......................................... Total assets ..................................... Liabilities Accounts payable ............................ Loans payable ................................. Total liabilities ................................ Equity Ordinary shares............................... Retained earnings............................ Total equity ..................................... Total liabilities and equity ............... 2008

$100 30 80 $210

$110 25 70 $205

$ 40 90 $130

$ 35 100 $135

5 75 80 $210

5 65 70 $205

Carter, Corp. Income Statement Years Ended December 31, 2009 and 2008
2009 Sales revenue ................................... Less: Cost of goods sold .................. Gross profit ..................................... Salary expense................................. Rent expense ................................... Net income...................................... $500 300 $200 160 30 $ 10 $ 2008 $450 250 $200 150 42 8

(Note that all dollar amounts in this example are in millions.)

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At December 31, 2007, Carters inventory was $60 and total equity was $65. Requirements 1. Prepare horizontal and vertical analyses for Carters financial statements. What insight do these analyses give you into Carters profitability and cash flow? 2. Calculate Carters inventory turnover and rate of return on shareholders equity ratios for both years. What do these ratios indicate about Carters financial performance? 3. Calculate Carters book value per ordinary share for 2009, assuming that Carter has 60 million ordinary shares outstanding. 4. Calculate Carters cash flow from operating activities using the indirect method. Does this number indicate that Carter is in good financial health? 5. Calculate Carters Economic Value Added (EVA) for 2009, assuming a cost of capital of 15%.

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Demo Doc 1 Solutions

Requirement 1 Prepare horizontal and vertical analyses for Carters financial statements. What insight do these analyses give you into Carters profitability and cash flow? Horizontal Analysis

Carter, Corp. Horizontal Analysis of Balance Sheet December 31, 2009 and 2008
2009 2008 Increase (Decrease) Amount Assets Cash................................................ Accounts receivable......................... Inventory......................................... Total assets ..................................... Liabilities Accounts payable ............................ Loans payable ................................. Total liabilities ................................ Equity Ordinary shares................................ Retained earnings............................ Total equity ..................................... Total liabilities and equity ............... Percent

$100 30 80 $210

$110 25 70 $205

$(10) 5 10 $ 5

(9.1)% 20.0 14.3 2.4 %

$ 40 90 130

$ 35 100 135

$ 5 (10) (5)

14.3 % (10)% (3.7)%

5 75 80 $210

5 65 70 $205

0 10 10 $ 5

0.0 % 15.4 14.3 % 2.4 %

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Carter, Corp. Horizontal Analysis of Comparative Income Statement Years Ended December 31, 2009 and 2008
2009 2008 Increase (Decrease) Amount Percent $ 50 50 0 10 (12) $ 2 11.1 % 20.0 % 0% 6.7 (28.6) 25.0 %

Sales revenue ................................... Less cost of goods sold .................... Gross profit ..................................... Salary expense................................. Rent expense ................................... Net income......................................

$500 300 $200 $160 30 $ 10

$450 250 $200 $150 42 $ 8

Teaching Tip 1

As its name implies, horizontal analysis goes across the financial statements, looking at one account and how it has changed. For each number on the balance sheet and income statement, we calculate the dollar change and the percent change.
Dollar change = This years balance Last years balance

For example, the dollar change in:

Cash = $100 $110 = $(10) change Sales = $500 $450 = $50 change

Note that all dollar amounts in this example are in millions. The parentheses around the change in Cash indicates that this account has decreased, while no parentheses on the change in Sales Revenue indicates that this account has increased. Teaching Tip 2 Extra care must be taken when using this calculation on expenses (because they are assumed to be subtracted/negative numbers on the income statement). The absolute value of the expense (that is, ignoring the fact that they are already negative numbers) must be used to calculate dollar change.

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 For example, the dollar change in:

COGS = $300 $250 = $50 change Rent Expense = $30 $42 = $(12) change

The positive value indicates (correctly) that COGS increased and the negative value indicates (correctly) that Rent Expense decreased (as compared to the base year of 2008).
Dollar change Last years balance

Percent change =

For example, the percent change in:

Cash = $(10) $110

= (9.1)% change

Sales Revenue =

$50 $450

= 11.1% change

The percent change numbers are negative for Cash (which decreased in 2009) and positive for Sales Revenue (which increased in 2009). Teaching Tip 2 The percent change is calculated the same way for expenses, again using the absolute value of the expenses. For example, the percent change in:
$50 $250

COGS =

= 20% change

Rent Expense =

$(12) $42

= (28.6)% change

The horizontal analysis shows us that Cash has decreased during the year, while Inventory and Accounts Receivable have increased and Loans Payable has decreased. What do you think this could mean? Perhaps Cash decreased because it was used to buy more Inventory (causing the increase to Inventory) or to pay off Loans Payable (causing the decrease to Loans Payable). It is also possible that Cash decreased because collections were worse on Accounts Receivable (causing an increase there).
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 These changes could all indicate that Carter has insufficient cash flow. We can also see that Sales Revenue has increased, but gross profit has not. Why would this be of concern? This is an interesting situation because normally if revenues increase (that is, more units are sold and/or there is a higher selling price per unit), you would expect to see an increase in gross profit as well. Carters results may indicate that it is moving to selling more items with a lower gross profit percent, or perhaps it increased units sold by decreasing the selling price. In any case, this development is troubling and bears further investigation. Net Income has increased, but because there was no change in gross profit, this has all come from reduced expensesspecifically reduced Rent Expense. While an increase in Net Income is good, we would prefer to see this stemming from an increase in sales more so than from cutting expenses. In any case, we should investigate further to see whether this drop in expenses is a permanent change and whether it can be sustained or if it is just relevant to this one year. Vertical Analysis

Carter, Corp. Vertical Analysis of Balance Sheet December 31, 2009 and 2008
2009 Assets Cash................................................ Accounts receivable......................... Inventory......................................... Total assets ..................................... Liabilities Accounts payable ............................ Loans payable ................................. Total liabilities ................................ Shareholders Equity Ordinary shares................................ Retained earnings............................ Total equity ..................................... Total liabilities and equity ............... 2009 % 2008 2008 %

$100 30 80 $210

47.6% 14.3 38.1 100.0%

$110 25 70 $205

53.7% 12.2 34.1 100.0%

$ 40 90 130

19.0% 42.9 61.9%

$ 35 100 135

17.1% 48.8 65.9%

5 75 80 $210

2.4% 35.7 38.1% 100.0%

5 65 70 $205

2.4% 31.7 34.1% 100.0%

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Carter, Corp. Vertical Analysis of Comparative Income Statement Years Ended December 31, 2009 and 2008
2009 2009 % 2008 2008 %

Sales revenue ................................... Less cost of goods sold .................... Gross profit ..................................... Salary expense................................. Rent expense ................................... Net income......................................

$500 300 $200 160 30 $ 10

100.0% 60.0 40.0% 32.0 6.0 2.0%

$450 250 $200 150 42 $ 8

100.0% 55.6 44.4% 33.3% 9.3 1.8%

Teaching Tip 1

As its name implies, vertical analysis takes each number on the financial statements and compares it to others in the same year (that is, down the columns of the financial statements). Vertical analysis is sometimes called common-size analysis because it allows 2 companies of different sizes to be compared (through the use of percentages). Balance Sheet Vertical Analysis On the balance sheet, each number is calculated as a percentage of total assets. Total assets is the base number.
Account balance Total assets

Vertical analysis percent (balance sheet) =

For example (Note again that all numbers in this example are in millions):
$100 $210

Vertical analysis percent (2009 cash) =

= 47.6%

In other words, almost 48% of Carters assets are in cash. Looking at the vertical analysis, we can see that Carter has been moving assets away from Cash (53.7% to 47.6% of total assets) and into Accounts Receivable (12.2% to 14.3% of total assets) and Inventory (34.1% to 38.1% of total assets). This indicates that Carter is less liquid than in the prior year.

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Income Statement Vertical Analysis On the income statement, each number is calculated as a percentage of net sales revenues.
Account balance Net sales revenues

Vertical analysis percent (income statement) =

For example: Teaching Tip 3

$200 $500

Vertical analysis percent (2009 gross profit) =

= 40%

In other words, 40% of sales is our gross profit. For expenses, the calculation is the same. For example:
Vertical analysis percent (2009 COGS) = $300 $500

= 60% Vertical analysis percent (2009 rent expense) = $30 $500

= 6%

Teaching Tip 3

The gross profit percentage has decreased, from 44.4% to 40%, which may be of concern. Why? The gross profit percentage is an important indicator of overall profitability. A decrease in this ratio might indicate that selling prices have been lowered, that costs of production are rising, or that more low-profit goods are being sold. This is an issue that would require further investigation. This seems to be counterbalanced by a decreased emphasis on other expenses. The results of the horizontal and vertical analyses complement each other (in other words, they are both pointing to the same issues: lower cash, higher inventory and receivables, lower gross profit). Requirement 2 Calculate Carters inventory turnover and rate of return on shareholders equity ratios for both years. What do these ratios indicate about Carters financial performance?
COGS Average inventory

Inventory turnover =

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 Remember that average (when used in a financial ratio) generally means the beginning balance plus the ending balance divided by 2. (All dollar amounts in this example are in millions.)
$300 ($70 + $80)/2

2009 inventory turnover =

= 4 times

2008 inventory turnover =

$250 ($60 + $70)/2

= 3.8 times

Inventory turnover increased in 2009, despite an increase in the inventory balance. This implies that Carter is selling more units more quickly than in 2008.
Rate of return on shareholders equity = 2009 rate of return on shareholders equity = Net income Preference dividends Average ordinary share equity $10 $0 ($70 + $80)/2 $8 $0 ($65 + $70)/2

= 13.3% 2008 rate of return on shareholders equity =

= 11.9%

The rate of return on stockholders equity improved from 2008 to 2009 due to an increase in net income. Requirement 3 Calculate Carters book value per ordinary share for 2009, assuming that Carter has 60 million ordinary shares outstanding.
Total shareholders equity Preference equity Number of shares of ordinary shares outstanding $80 0 60 shares

Book value per ordinary share of common stock = 2009 book value per ordinary share =

= $1.33

(Note that all dollar amounts in this example are in millions.)

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Requirement 4 Calculate Carters cash flow from operating activities using the indirect method. Does this number indicate that Carter is in good financial health? If necessary, review the preparation of the statement of cash flows in Chapter 12. Using the indirect method, we begin with net income, which is $10 million. Because Carter has no depreciation expense or gains or losses on its income statement, we do not have to make any adjustments to net income. The non-cash current assets are accounts receivable and inventory, which both increased. These increases (calculated in Requirement 1 of this question) would decrease cash flow. The only current liability is accounts payable, which increased (increase calculated in Requirement 1 of this question). This would increase cash flow. So, cash flow from operating activities would be calculated as follows (in millions):
Net income..................................................... Increase in accounts receivable ....................... Increase in inventory ...................................... Increase in accounts payable .......................... Cash flow from operating activities................ $ 10 (5) (10) 5 $ 0

The cash flow from operating activities is zero. This would indicate that Carter is in financial trouble, because it is not generating any cash flow from its regular business activities. Requirement 5 Calculate Carters Economic Value Added (EVA) for 2009, assuming a cost of capital of 15%. (Note that all dollar amounts in this example are in millions.)
Economic value added = Net income + Interest expense Capital charge where Capital charge = [Notes payable + Long-term debt + Shareholders equity] Cost of capital 2009 Capital charge = [$90 Loans payable + $80 Total equity] 15% = 25.5 2009 EVA = $10 Net Income $25.5 = $(15.5)

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