## Analysis and Interpretation of Financial Statements

Read this chapter, which discusses how to analyze financial statements and demonstrates the use of ratios and the horizontal and vertical analysis tools that everyone from creditors to investors, vendors, and top management use when they want to identify the strengths and weaknesses in an organization. Analysis tools can help you compare companies of different sizes, companies in different industries, and the same company over time.

### Horizontal analysis and vertical analysis: An illustration

The comparative financial statements of Synotech, Inc., will serve as a basis for an example of horizontal analysis and vertical analysis of a balance sheet and a statement of income and retained earnings. Recall that horizontal analysis calculates changes in comparative statement items or totals, whereas vertical analysis consists of a comparison of items on a single financial statement.

Imagine that you are a prospective investor interested in Synotech, Inc. You have acquired the 2010 Annual Report of the company and want to perform some horizontal and vertical analyses of the financial statements.

First, we begin with the balance sheets. Exhibit 133 shows the comparative balance sheets for 2010 and 2009 in Columns (1) and (2). Take a few minutes to study the balance sheets. Then review Columns (3) and (4), which show the horizontal analysis that would be performed on the comparative balance sheets.

Column (3) shows the change that occurred in each item between 2009 December 31, and 2010 December 31. If the change between the two dates is an increase from 2009 to 2010, the change is a positive figure. If the change is a decrease, the change is a negative figure and is shown in parentheses. Column (4) shows the percentage change in each item. You can calculate the percentage change by dividing the dollar change by the dollar balance of the earlier year (2009). While examining the horizontal analysis in Exhibit 133 note that:

• Total current assets have increased USD 14.3 million, consisting largely of increases in cash, marketable securities, and other current assets despite a USD 63.0 million decrease in net receivables, while total current liabilities have increased USD 181.4 million, largely as a result of increases in the current portion of long-term debt and other accruals.
• Total liabilities have decreased USD 114.1 million, while total assets increased by USD 311.0 million.

Next, study Column (4), which expresses as a percentage the dollar change in Column (3). Frequently, these percentage increases are more informative than absolute amounts, as illustrated by the current asset and current liability changes. Although the absolute amount of current liabilities has increased tremendously over the amount of current assets, the percentages reveal that current assets increased .5 per cent, while current liabilities increased 8.6 per cent. Thus, current liabilities are increasing at a faster rate than current assets. Current assets still exceed current liabilities. This fact indicates that the company will be able to pay its debts as they come due.

Studying the percentages in Column (4) could lead to several other observations. For instance, the 6.9 per cent decrease in long-term debt indicates that interest charges will be lower in the future, having a positive effect on future net income. The 14.2 per cent increase in retained earnings could be a sign of increased dividends in the future; in addition, the increase in cash of 19 per cent could support this conclusion.

Now examine Columns (5) and (6) to see the vertical analysis that would be performed. A vertical analysis of the company's balance sheet discloses each account's significance to total assets or total equities. This comparison aids in assessing the importance of the changes in each account. Columns (5) and (6) in Exhibit 133 express the dollar amount of each item in Columns (1) and (2) as a percentage of total assets or equities. For example, although other assets declined USD 6.3 million in 2010, the decrease of 1.4 per cent in the account represents only approximately 4.8 per cent of total assets and, therefore, probably does not have great significance. Vertical analysis also shows that total debt financing decreased from 78.0 per cent of total equities (liabilities and stockholders' equity) in 2009, to 74.3 per cent in 2010. At the same time, the percentage of stockholder financing to total assets of the company increased from 22.0 per cent to 25.7 per cent.

Synotech, Inc.

Comparative balance sheets

2010 December 31, and 2009

 December 31 Horizontal Analysis Increase or 2010 over (Decrease) 2009 Vertical Analysis Per cent of Total Assets (1) (2) (3) (4) (5) (6) Assets 2010 2009 Dollars* Per cent* 2010 2009 Current assets Cash and cash equivalents $298.0$ 250,5 $47.5 19.0% 3.1 % 2.7 % Marketable securities 71.3 57.5 13.8 24.0 0.8 0.6 Receivables, net 1,277.3 1,340.3 (63.0) (4.7) 13.5 14.6 Inventories 924.8 929.8 (5.0) (0.5) 9.8 10.1 Other current assets 275.3 254.3 21.0 8.3 2.9 2.8 Total current assets$2,846.7 $2,832.4$14.3 0.5 30.0 30.9 Property, plant and equipment, net 2,914.7 2,586.2 328.5 12.7 30.7 28.2 Goodwill and other intangibles, net 3,264.5 3,290.0 (25.5) (0.8) 34.4 35.9 Other assets 455.9 462.2 (6.3) (1.4) 4.8 5.0 Total assets Liabilities and shareholders' equity Current liabilities $9,481.8$9,170.8 $311.0 3.4 100.0 100.0 Notes and loans$ 206.8 payable $245.3$ (38.5) (15.7) 2.2 2.7 Current portion of long-term debt 132.5 44.4 88.1 198.4 1.4 0.5 Accounts payable 902.0 886.4 15.6 1.8 9.5 9.7 Accrued income taxes 111.7 92.1 19.6 21.3 1.2 1.0 Other accruals 932.2 835.6 96.6 11.6 9.8 9.1 Total current $2,285.2 liabilities$2,103.8 $181.4 8.6 24.1 22.9 Long-term debt 3,344.2 3,590.4 (246.2) (6.9) 35.3 39.2 Deferred income taxes 281.2 284.8 (3.6) (1.3) 3.0 3.1 Other liabilities 1,130.4 1,176.1 (45.7) (3.9) 11.9 12.8 Total liabilities$7,041.0 $7,155.1$(114.1) (1.6) 74.3 78.0 Shareholders' equity Preferred stock $471.2$ 484.2 $(13.0) (2.7) 5.0 5.3 Common stock, par value (500,000,000 shares authorized, 183,213,295 shares issued)$1.20 219.9 219.9 0.0 0.0 2.3 2.4 Additional paid-in capital 1,321.9 1,240.4 81.5 6.6 13.9 13.5 Retained earnings 3,277.1 2,870.6 406.5 14.2 34.6 31.3 Cumulative translation adjustments (641.6) (615.6) (26.0) 4.2 -6.8 -6.7 $4,648.5$4,199.5 $449.0 10.7 49.0 45.8 Unearned compensation (445.1) (453.6) 8.5 (1.9) -4.7 -4.9 Treasury stock, at cost (1,762.6) (1,30.2) (32.4) 1.9 -18.6 -18.9 Total shareholders' equity$2,440.8 $2,015.7$425.1 21.1 25.7 22.0 Total liabilities and stockholders equity $9,481.8$9,170.8 $311.0 3.4 100.0 100.0 *Dollars = (1) – (2); Per cent = (3)/(2) Exhibit 133: Comparative balance sheets Exhibit 134 provides the information needed to analyze Synotech's comparative statements of income and retained earnings. Such a statement merely combines the income statement and the statement of retained earnings. Columns (7) and (8) in Exhibit 134 show the dollar amounts for the years 2010 and 2009, respectively. Study these statements for a few minutes. Then examine Columns (9) and (10) which show the horizontal analysis that would be performed on the company's comparative statements of income and retained earnings. Columns (9) and (10) show the absolute and percentage increase or decrease in each item from 2009 to 2010. The absolute change is determined by deducting the 2009 amount from the 2010 amount. If the change between two dates is an increase from 2009 to 2010, the change is a positive figure. If the change is a decrease, the change is a negative figure and is shown in parentheses. You calculate the percentage change by dividing the dollar change by the dollar amount for 2009.  Horizontal analysis Vertical analysis Year ended (7) 2007 December 31 (8) 2006 Increase or 2010 over (9) Dollars* (decrease) 2009 (10) Per cent* Per cent sales (11) 2010 Net of (12) 2009 Net sales$10,498.8 $10,029.8$469.0 4.7% 100.0% 100.0% Cost of goods sold 5,341.3 5,233.7 117.6 2.3 50.9 52.1 Gross profit $5,157.5$4,806.1 $351.4 7.3 49.1 47.9 Selling, general and administrative expenses 3,662.5 3,455.5 207.0 6.0 34.9 34.5 Provision for restructured operations --- 552.6 (552.6) (100.0) 0.0 5.5 Other expense, net 112.6 115.3 (2.7) (2.3) 1.1 1.1 Interest expense, net of interest income of$41.2 and $36.7, respectively 236.9 246.5 (9.6) (3.9) 2.3 2.5 Income before income taxes$1,145.5 $436.2$709.3 162.6 10.9 4.3 Provision for income taxes 383.5 229.8 153.7 66.9 3.7 2.3 Net income $762.0$206.4 $555.6 269.2 7.3 2.1 Retained earnings, January 1 2,870.6 2,996.0 (125.4) (4.2) Total Dividends declared:$3,632.6 $3,202.4$430.2 13.4 Series B convertible preference stock, net of income taxes 25.1 25.3 (0.2) (0.8) Preferred stock 0.6 0.6 0.0 0.0 Common stock 329.8 305.9 23.9 7.8 Retained earnings, December 31 $3,277.1$2,870.6 \$406.5 14.2 *Dollars = (7) – (8); Per cent = (9)/(8)

Exhibit 134: Comparative statements of income and retained earnings

Having completed the horizontal analysis and vertical analysis of Synotech's balance sheet and statement of income and retained earnings, you are ready to study trend percentages and ratio analysis. The last section in this chapter discusses some final considerations in financial statement analysis. Professional financial statement analysts use several tools and techniques to determine the solvency and profitability of companies.

The horizontal analysis shows that sales increased a total of USD 469.0 million, an increase of 4.7 per cent. Since cost of goods sold increased by a much smaller amount (USD 117.6 million), gross profit increased by USD 351.4, or 7.3 per cent. The USD 552.6 million expense in 2009 was the result of a provision for restructured operations. Although this is not a recurring expense, it does not classify as an extraordinary expense and is treated as part of income from continuing operations.

Now look at Columns (11) and (12) to see the vertical analysis that would be performed. Columns (11) and (12) express the dollar amount of each item in Columns (7) and (8) as a percentage of net sales. Even though cost of goods sold increased in 2010, it remained a fairly constant percentage of net sales. Therefore, gross profit as a percentage of net sales increased only slightly. The percentage of expenses to net sales decreased somewhat, thus yielding an increase in income before income taxes as a percentage of net sales.