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Case Study: Financial Analysis

Author: Sophia
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what's covered
This tutorial will cover the topic of financial analysis in the context of a case study, by performing financial analysis for a subject company. Specifically, this lesson will cover:

Table of Contents

1. Case Study: Legacy Clothing

Our subject company, Legacy Clothing, is a sole proprietorship, which is a type of company that is owned by a single individual, and where that individual and the business are legally treated as the same.

The purpose of Legacy Clothing as a business is to own and operate clothing/merchandise stores. It is similar to a department store chain, selling men's, women's, and children's clothing and other related items.

Legacy Clothing has locations throughout Washington, DC, and they have a staff of 50 people employed in their stores.

Legacy Clothing
Type of company Sole proprietorship
Business purpose Own and operate clothing/merchandise stores
Business location(s) Washington, D.C.
Staff of 50 people

To evaluate the financial health of the business, Legacy clothing will perform several types of financial analyses. The first analysis Legacy will carry out is called a vertical analysis. A vertical analysis uses the income statement accounts and highlights the relationship between the individual accounts and overall revenue (net sales). A balance sheet vertical analysis compares all accounts to the total assets account.

Another way Legacy will analyze their financial statements is by conducing horizontal analyses. A horizontal analysis shows how different accounts have changed over time. Horizontal analyses will be performed on both the income statement and the balance sheet and are calculated by subtracting the least current year from the most current year then diving by the least current year. The result shows the percentage increase or decrease in an individual account.

Finally, several ratio analyses will be performed. Ratio analyses are performed to inform a business of its operating efficiency or how its business is performing in the sector.

Essentially, all three of these types of financial analysis are needed in order for Legacy Clothing to truly understand the state of their business, how it's performing and changing.

Using financial analysis, Legacy Clothing can do a comparison of changes within the company, as well as compare itself to other companies and against industry standards. In this manner, they have a better picture of their business and where they fit within the greater context of the competitive and industry landscape.

In today's lesson, we're going to look at our case study company in performing financial analysis, exploring examples of performing vertical analysis, horizontal analysis, and ratio analysis.

2. Case Study: Vertical Analysis

The first analysis Legacy Clothing will perform is a vertical analysis of its income statement.

2a. Income Statement

The income statements from both 2021 and 2022 are provided. Our base amount for the vertical analysis is net sales. We will determine the relationships of all of the income statement accounts to net sales. These relationships will give us the percentage of sales each item accounts for, which we can use to understand the impact of the income statement accounts.

Table titled Vertical Analysis for Legacy Clothing, Income Statement, for the period ending December 31, 2022. There are two columns each named amount and percent for 2021 and 2022; the percent column is blank. The items and amounts are as follows:
Sales: 2021 $1,000,000, 2022 $1,100,000;
Sales returns and allowances: 2021 $50,000, 2022 $55,000;
Sales discounts: 2021 $25,000, 2022 $20,000;
Net sales: 2021 $925,000, 2022 $1,025,000; Cost of goods sold: 2021 $450,000, 2022 $475,000;
Gross profit: 2021 $475,000, 2022 $550,000;
Salaries expense: 2021 $150,000, 2022 $175,000;
Advertising expense: 2021 $30,000, 2022 $32,000,
Rent expense: 2021 $10,000, 2022 $11,000;
Insurance expense: 2021 $2,500, 2022 $2,500;
Supplies expense: 2021 $5,000, 2022 $5,000; Depreciation expense—buildings: 2021 $15,000, 2022 $15,000;
Total operating expenses: 2021 $212,500, 2022 $240,500;
Income from operations: 2021 $262,500, 2022 $309,500;

Other revenue (expenses), Interest expense: 2021 $5,000, 2022 $5,500;
Net income: 2021 $257,500, 2022 $304,000.
View this spreadsheet in Google Sheets

Next, we take the dollar figures on our income statement and convert them to a percentage of our base amount, for both years. In this manner, we can understand how these individual financial statement line items relate to our base amount, net sales.

For Legacy Clothing, salary expense was 16.2% of net sales in 2021, but in the following year, salary expense represented 17.1% of net sales. This allows us to see its changing composition over time.

Another example is sales, where 2021 sales represented 108.1% of net income while in 2022, sales decreased to 107.3% of net income.

Table titled Vertical Analysis for Legacy Clothing, Income Statement, for the period ending December 31, 2022. There are two columns each named amount and percent for 2021 and 2022; the percent column is blank. The items and amounts are as follows:
Sales: 2021 108.1%, 2022 107.3%;
Sales returns and allowances: 2021 5.4%, 2022 5.4%;
Sales discounts: 2021 2.7%, 2022 2.0%;
Net sales: 2021 100%, 2022 100%; Cost of goods sold: 2021 48.6%, 2022 46.3%;
Gross profit: 2021 51.4%, 2022 53.7%;
Salaries expense: 2021 16.2%, 2022 17.1%;
Advertising expense: 2021 3.2%, 2022 3.1%,
Rent expense: 2021 1.1%, 2022 1.1%;
Insurance expense: 2021 0.3%, 2022 0.2%;
Supplies expense: 2021 0.5%, 2022 0.5%; Depreciation expense—buildings: 2021 1.6%, 2022 1.5%;
Total operating expenses: 2021 23%, 2022 23.5%;
Income from operations: 2021 28.4%, 2022 30.2%;

Other revenue (expenses), Interest expense: 2021 0.5%, 2022 0.5%;
Net income: 2021 27.8%, 2022 29.7%.
View this spreadsheet in Google Sheets

2b. Balance Sheet

Now we can perform our vertical analysis for Legacy Clothing's balance sheet, performing the same type of exercise as we did with the income statement.

Once again, we're going to express these individual accounts, or financial statement line items, as a percentage of a base amount. In the case of the balance sheet, the base amount is our total assets.

Table titled Vertical Analysis for Legacy Clothing, Balance Sheet, As of December 31, 2022. There are two columns each named amount and percent for 2021 and 2022; the percent column is blank. The items and amounts are as follows:
Assets, Cash: 2021 $125,000, 2022 $200,000;
Accounts receivable, 2021 $150,000, 2022 $100,000;
Merchandise inventory, 2021 $200,000, 2022 $250,000;
Supplies, 2021 $15,000, 2022 $20,000;
Prepaid insurance, 2021 $10,000, 2022 $10,000;
Land, 2021 $50,000, 2022 $50,000;
Buildings (net), 2021 $375,000, 2022 $350,000;
Total assets, 2021 $925,000, 2022 $980,000; Liabilities,
Accounts payable, 2021 $85,000, 2022 $75,000;
Sales tax payable, 2021 $50,000, 2022 $55,000;
Unearned revenue, 2021 $30,000, 2022 $25,000;
Notes payable, 2021 $325,000, 2022 $300,000;
Total liabilities, 2021 $490,000, 2022 $455,000;

Equity
Owner’s capital, 2021 $435,000, 2022 $525,000; Total liabilities and equity, 2021 $925,000, 2022 $980,000.
View this spreadsheet in Google Sheets

We express each line item as a percentage of that base amount. Note that total assets is 100%.

By expressing each line item as a percentage of the base amount, we can understand the composition of these line items, as well as any changes over time.

For example, in 2021, our merchandise inventory represented 21.6% of total assets, whereas in 2022, it represented 25.5%. In another instance, notes payable represented 35.1% of total assets in 2021 and 30.6% in 2022; therefore, notes payble is decreasing.

Table titled Vertical Analysis for Legacy Clothing, Balance Sheet, As of December 31, 2022. There are two columns each named amount and percent for 2021 and 2022. The items and amounts are as follows:
Assets, Cash: 2021 13.5%, 2022 20.4%;
Accounts receivable, 2021 16.2%, 2022 10.2%;
Merchandise inventory, 2021 21.6%, 2022 25.5%;
Supplies, 2021 1.6%, 2022 2.0%;
Prepaid insurance, 2021 1.1%, 2022 1.0%;
Land, 2021 5.4%, 2022 5.1%;
Buildings (net), 2021 40.5%, 2022 35.7%;
Total assets, 2021 100%, 2022 100%; Liabilities,
Accounts payable, 2021 9.2%, 2022 7.7%;
Sales tax payable, 2021 5.4%, 2022 5.6%;
Unearned revenue, 2021 3.2%, 2022 2.6%;
Notes payable, 2021 35.1%, 2022 30.6%;
Total liabilities, 2021 53%, 2022 46.4%;

Equity
Owner’s capital, 2021 47%, 2022 53.6%; Total liabilities and equity, 2021 100%, 2022 100%.
View this spreadsheet in Google Sheets

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3. Case Study: Horizontal Analysis

Now we're going to turn our attention to our horizontal analysis, which will help us understand trends in the individual financial statement line items and how they change over time.

3a. Income Statement

Again, we're going to start with the income statement for our Legacy Clothing.

Table titled Horizontal Analysis for Example Company, Income Statement, for the period ending December 31, 2022. The analysis has four columns, namely 2021, 2022, increase or decrease amount, and increase or decrease percent. The increase or decrease amount and percent columns are blank. The rest of the items in the table are as follows:
Sales, 2022 $1,100,000, 2021 $1,00,000;
Sales returns and allowances, 2022 $55,000, 2021 $50,000;
Sales discounts, 2022 $20,000, 2021 $25,000;
Net sales, 2022 $1,025,000, 2021 $925,000;
Cost of goods sold, 2022 $475,000, 2021 $450,000;
Gross profit, 2022 $550,000, 2021 $475,000;
Salaries expense, 2022 $175,000, 2021 $150,000;
Advertising expense, 2022 $32,000, 2021 $30,000;
Rent expense, 2022 $11,000, 2021 $10,000;
Insurance expense, 2022 $2,500, 2021 $2,500;
Supplies expense, 2022 $5,000, 2021 $5,000;
Depreciation expense—buildings, 2022 $15,000, 2021 $15,000;
Total operating expenses, 2022 $240,500, 2021 $212,500;
Income from operations, 2022 $309,500, 2021 $262,500;
Other revenue (expenses), Interest expense, 2022 $5,500, 2021 $5,000;
Net income, 2022 $304,000, 2021 $257,500.
View this spreadsheet in Google Sheets

First, we express the changes from 2021 to 2022 in dollar amounts for each of these individual financial statement line items.

Table titled Horizontal Analysis for Example Company, Income Statement, for the period ending December 31, 2022. The analysis has four columns, namely 2021, 2022, increase or decrease amount, and increase or decrease percent. The increase or decrease percent column is blank. The rest of the items in the table are as follows:
Sales, increase $100,000; Sales returns and allowances, increase $5,000; Sales discounts, decrease $5,000;
Net sales increase $100,000;
Cost of goods sold increase $25,000;
Gross profit increase $75,000; Salaries expense increase $25,000;
Advertising expense increase $2,000; Rent expense increase $1,000;
Insurance expense no increase or decrease; Supplies expense no increase or decrease; Depreciation expense—buildings no increase or decrease; Total operating expenses increase $28,000;
Income from operations increase $47,000;

Other revenue (expenses), Interest expense increase $500;
Net income increase $46,500.
View this spreadsheet in Google Sheets

Now, once we have this information, we can convert those amounts to a percentage increase or decrease, so that we can understand how these individual lines are changing.

In this case, we can see that sales have increased by 10%, year over year. However, sales discounts actually decreased by 20%, which means we are issuing less discounts. Also, we can see that our salaries have increased 16.7% from 2021 to 2022.

Table titled Horizontal Analysis for Example Company, Income Statement, for the period ending December 31, 2022. The analysis has four columns, namely 2021, 2022, increase or decrease amount, and increase or decrease percent. The rest of the items in the table are as follows:
Sales increase 10%; Sales returns and allowances increase 10%;
Sales discounts decrease 20%;
Net sales increase 10.8%;
Cost of goods sold increase 5.6%;
Gross profit increase 15.8%;

Salaries expense increase 16.7%;
Advertising expense increase 6.7%;
Rent expense increase 10%;
Insurance expense 0.0%;
Supplies expense 0.0%;
Depreciation expense—buildings 0.0%;
Total operating expenses increase 13.2%;
Income from operations increase 17.9%;
Other revenue (expenses), 
Interest expense increase 10%;
Net income increase 18.1%.
View this spreadsheet in Google Sheets

3b. Balance Sheet

Next, Legacy Clothing will perform a horizontal analysis on its balance sheet.

Once again, we will evaluate the individual financial statement line items on the balance sheet to see how they have changed from one year to the next.

Table titled Horizontal Analysis for Example Company, Balance Sheet, As of December 31, 2022. There are four columns named 2021, 2022, increase or decrease amount, and increase or decrease percent. The increase or decrease amount and percent columns are blank. The rest of the items in the table are as follows:
Assets,
Cash, 2022 $200,000, 2021 $125,000;
Accounts receivable, 2022 $100,000, 2021 $150,000;
Merchandise inventory, 2022 $250,000, 2021 $200,000;
Supplies, 2022 $20,000, 2021 $15,000;
Prepaid insurance, 2022 $10,000, 2021 $10,000;
Land, 2022 $50,000, 2021 $50,000;
Buildings (net), 2022 $350,000, 2021 $375,000;
Total assets, 2022 $980,000, 2021 $925,000;
Liabilities,
Accounts payable, 2022 $75,000, 2021 $85,000;
Sales tax payable, 2022 $55,000, 2021 $50,000;
Unearned revenue, 2022 $25,000, 2021 $30,000;
Notes payable, 2022 $300,000, 2021 $325,000;
Total liabilities, 2022 $455,000, 2021 $490,000;
Equity
Owner’s capital, 2022 $525,000, 2021 $435,000;
Total liabilities and equity, 2022 $980,000, 2021 $925,000.
View this spreadsheet in Google Sheets

The first thing we do is to express that change in dollars, whether an increase or decrease, for each of these individual financial statement line items.

Table titled Horizontal Analysis for Example Company, Balance Sheet, As of December 31, 2022. There are four columns named 2021, 2022, increase or decrease amount, and increase or decrease percent. The increase or decrease percent column is blank. The rest of the items in the table are as follows:
Assets,
Cash increase $75,000; Accounts receivable decrease $50,000;
Merchandise inventory increase $50,000;
Supplies increase $5,000;
Prepaid insurance no increase or decrease; Land no increase or decrease; Buildings (net) decrease $25,000; Total assets increase $55,000;
Liabilities,
Accounts payable decrease $10,000;
Sales tax payable increase $5,000;
Unearned revenue decrease $5,000;
Notes payable decrease $25,000; Total liabilities decrease $35,000;
Equity
Owner’s capital increase $90,000;
Total liabilities and equity increase $55,000.
View this spreadsheet in Google Sheets

Next, we convert that dollar amount change to a percentage, to show us the percentage change of these individual financial statement line items. As you can see, cash increased by 60% and merchandise inventory increased 25%. However, accounts payable decreased by 11.8%, which tells us that we are paying down our short-term debt.

Table titled Horizontal Analysis for Example Company, Balance Sheet, As of December 31, 2022. There are four columns named 2021, 2022, increase or decrease amount, and increase or decrease percent. The items in the table are as follows:
Assets,
Cash increase 60%;
Accounts receivable decrease 33.3%;
Merchandise inventory increase 25%;
Supplies increase 33.3%;
Prepaid insurance 0%;
Land 0%;
Buildings (net) decrease 6.7%;
Total assets increase 5.9%;

Liabilities,
Accounts payable decrease 11.8%; Sales tax payable increase 10%;
Unearned revenue decrease 16.7%; Notes payable decrease 7.7%;
Total liabilities decrease 7.1%;
Equity,
Owner’s capital increase 20.7%;

Total liabilities and equity increase 5.9%.
View this spreadsheet in Google Sheets

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4. Case Study: Ratio Analysis

The last type of analysis that Legacy Clothing will perform today is ratio analysis.

4a. Profitability Ratios

Let's start with profitability ratios, which measure the operating performance of the company.

We will calculate three different profitability ratios: rate of return on sales, return on total assets, and asset turnover.

So, let's look at rate of return on sales, which is net income divided by net sales, and input our figures for Legacy Clothing from the income statement, where net income is $304,000 and net sales is $1,025,000. We can see that Legacy’s rate of return on sales is 29.7%. This means that 29.7% of every dollar Legacy generates in net sales, becomes its profit.

formula to know
Rate of Return on Sales
Rate space of space Return space on space Sales equals fraction numerator Net space Income over denominator Net space Sales end fraction

Rate space of space Return space on space Sales equals fraction numerator 304 comma 000 over denominator 1 comma 025 comma 000 end fraction equals 0.297 equals 29.7 percent sign

Return on total assets measures how effectively Legacy Clothing uses its assets, expressed as income before interest expense and taxes, divided by total assets. Plug in Legacy Clothing's information, which is $309,500 for income before interest and expense taxes from the income statement, and $980,000 for total assets from the balance sheet. The return on total assets for Legacy Clothing is 31.6%. A high asset turnover means a company is running efficiently, where a low asset turnover means there is room for improvement.

formula to know
Return on Total Assets
Return space on space Total space Assets equals fraction numerator Income space Before space Interest space Expense space and space Taxes over denominator Total space Assets end fraction

Return space on space Total space Assets equals fraction numerator 309 comma 500 over denominator 980 comma 000 end fraction equals 0.316 equals 31.6 percent sign

Asset turnover measures the use of assets to make sales, calculated by taking net sales divided by total assets. In this case, net sales is $1,025,000 from the income statement and total assets is $980,000 from the balance sheet. So the asset turnover is 1.0 times. Regarding the asset turnover ratio, the larger the better.

formula to know
Asset Turnover
Asset space Turnover equals fraction numerator Net space Sales over denominator Total space Assets end fraction

Asset space Turnover equals fraction numerator 1 comma 025 comma 000 over denominator 980 comma 000 end fraction equals 1.0 space times

4b. Liquidity Ratios

Finally, Legacy will look at its liquidity ratios. Liquidity ratios measure the ability of our company to pay their debts, when they are due.

Legacy will calculate both the current ratio as well as inventory turnover.

The current ratio shows how much in current assets we have to pay off our current liabilities, or short-term debt obligations. Plug in the information from Legacy Clothing, current assets divided by current liabilities. Looking at the balance sheet, we can see that current assets (cash, accounts receivable, merchandise inventory, supplies, and prepaid insurance) add to $580,000, while current liabilities (accounts payable, sales tax payable, and unearned revenue) add to $155,000. Using the formula, the current ratio is 3.74. As we can see, Legacy’s current assets far exceed its currently liabilities.

formula to know
Current Ratio
Current space Ratio equals fraction numerator Current space Assets over denominator Current space Liabilities end fraction

Current space Ratio equals fraction numerator 580 comma 000 over denominator 155 comma 000 end fraction equals 3.74

Inventory turnover tells us the number of times inventory is sold and replaced during the period, expressed as cost of goods sold divided by average inventory. The more times the inventory turns over, the more efficient the company is at managing its stock of goods. Legacy inputs the $475,000 for cost of goods sold from the income statement and $225,000 for average inventory from the balance sheet, to calculate its inventory turnover and finds it is 2.1 times.

formula to know
Inventory Turnover
Inventory space Turnover equals fraction numerator Cost space of space Goods space Sold over denominator Average space Inventory end fraction

Inventory space Turnover equals fraction numerator 475 comma 000 over denominator 225 comma 000 end fraction equals 2.1 space times

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summary
Today we introduced our case study company called Legacy Clothing, a department store selling men's, women's, and children's clothing and other related items. We learned how to perform financial analysis for our subject company, including vertical analysis and horizontal analysis on Legacy Clothing's income statement and balance sheet. We also performed ratio analysis, calculating profitability ratios and liquidity ratios.

Source: THIS TUTORIAL WAS AUTHORED BY EVAN MCLAUGHLIN FOR SOPHIA LEARNING. PLEASE SEE OUR TERMS OF USE.

Formulas to Know
Asset Turnover

Asset space Turnover equals fraction numerator Net space Sales over denominator Total space Assets end fraction

Current Ratio

Current space Ratio equals fraction numerator Current space Assets over denominator Current space Liabilities end fraction

Inventory Turnover

Inventory space Turnover equals fraction numerator Cost space of space Goods space Sold over denominator Average space Inventory end fraction

Rate of Return on Sales

Rate space of space Return space on space Sales equals fraction numerator Net space Income over denominator Net space Sales end fraction

Return on Total Assets

Return space on space Total space Assets equals fraction numerator Income space Before space Interest space Expense space and space Taxes over denominator Total space Assets end fraction

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