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Case Study: Financial Analysis

Author: Sophia
PDF Version

Financial Accounting 4.3.5

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 2011 and 2012 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.

This table titled “vertical analysis” for an example company shows the income statement for the period ending December 31, 2012. There are two columns each named amount and percent for 2011 and 2012; the percent column is blank. The items and amounts are as follows:
Sales, 2011 amount 1,000,000, 2012 amount 1,100,000
Sales returns and allowances, 2011 amount 50,000, 2012 amount 55,000
Sales discounts, 2011 amount 25,000, 2012 amount 20,000
Net sales, 2011 amount 925,000, 2012 amount 1,025,000
The amounts for the entry “Net Sales” are highlighted in the income statement.
Cost of goods sold, 2011 amount 450,000, 2012 amount 475,000
Gross profit, 2011 amount 475,000, 2012 amount 550,000

Salaries expense, 2011 amount 150,000, 2012 amount 175,000
Advertising expense, 2011 amount 30,000, 2012 amount 32,000
Rent expense, 2011 amount 5,000, 2012 amount 11,000
Insurance expense, 2011 amount 2,500, 2012 amount 2,500
Supplies expense, 2011 amount 5,000, 2012 amount 5,000
Depreciation expense—buildings, 2011 amount 15,000, 2012 amount 15,000
Total operating expenses, 2011 amount 212,500, 2012 amount 240,500
Income from operations, 2011 amount 262,500, 2012 amount 309,500

Other revenue (expenses) 
Interest expense, 2011 amount 5,000, 2012 amount 5,500

Net income, 2011 amount 257,500, 2012 amount 304,000

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.

This table titled “vertical analysis” for an example company shows the income statement for the period ending December 31, 2012. There are two columns each named amount and percent for 2011 and 2012. The items are as follows:
Sales, 2011 amount 1,000,000, percent 108.1%, 2012 amount 1,100,000, percent 107.3%
Sales returns and allowances, 2011 amount 50,000, percent 5.4%, 2012 amount 55,000, percent 5.4%
The row for “Sales” is highlighted in the income statement.
Sales discounts, 2011 amount 25,000, percent 2.7%, 2012 amount 20,000, percent 2.0%
Net sales, 2011 amount 925,000, percent 100.0%, 2012 amount 1,025,000, percent 100.0%
The amounts for the entry “Net Sales” are highlighted in the income statement.
Cost of goods sold, 2011 amount 450,000, percent 48.6%, 2012 amount 475,000, percent 46.3%
Gross profit, 2011 amount 475,000, percent 51.4%, 2012 amount 550,000, percent 53.7%

Salaries expense, 2011 amount 150,000, percent 16.2%, 2012 amount 175,000, percent 17.1%
The row for “Salaries Expense” is highlighted in the income statement.
Advertising expense, 2011 amount 30,000, percent 3.2%, 2012 amount 32,000, percent 3.1%
Rent expense, 2011 amount 5,000, percent 1.1%, 2012 amount 11,000, percent 1.1%
Insurance expense, 2011 amount 2,500, percent 0.3%, 2012 amount 2,500, percent 0.2%
Supplies expense, 2011 amount 5,000, percent 0.5%, 2012 amount 5,000, percent 0.5%
Depreciation expense—buildings, 2011 amount 15,000, percent 1.6%, 2012 amount 15,000, percent 1.5%
Total operating expenses, 2011 amount 212,500, percent 23.0%, 2012 amount 240,500, percent 23.5%
Income from operations, 2011 amount 262,500, percent 28.4%, 2012 amount 309,500, percent 30.2%

Other revenue (expenses) 
Interest expense, 2011 amount 5,000, percent 0.5%, 2012 amount 5,500, percent 0.5%

Net income, 2011 amount 257,500, percent 27.8%, 2012 amount 304,000, percent 29.7%

For Legacy Clothing, salary expense was 16.2% of net sales in 2011, 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 2011 sales represented 108.1% of net income while in 2012, sales decreased to 107.3% of net income.

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.

This table titled “vertical analysis” for an Legacy Clothing shows the balance sheet as of December 31, 2012. There are two columns each named amount and percent for 2011 and 2012; the percent column is blank. The items and amounts are as follows:
Assets
Cash, 2011 amount 125,000, 2012 amount 200,000
Accounts receivable, 2011 amount 150,000, 2012 amount 100,000
Merchandise inventory, 2011 amount 200,000, 2012 amount 250,000
Supplies, 2011 amount 15,000, 2012 amount 20,000
Prepaid insurance, 2011 amount 10,000, 2012 amount 10,000
Land, 2011 amount 50,000, 2012 amount 50,000
Buildings (net), 2011 amount 375,000, 2012 amount 375,000
Total assets, 2011 amount 925,000, 2012 amount 980,000
The row for “Total Assets” is highlighted in the income statement.

Liabilities
Accounts payable, 2011 amount 85,000, 2012 amount 75,000
Sales tax payable, 2011 amount 50,000, 2012 amount 55,000
Unearned revenue, 2011 amount 30,000, 2012 amount 25,000
Notes payable, 2011 amount 325,000, 2012 amount 300,000
Total liabilities, 2011 amount 490,000, 2012 amount 455,000

Equity
Owner’s capital, 2011 amount 435,000, 2012 amount 525,500

Total liabilities and equity, 2011 amount 925,000, 2012 amount 980,000

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.

This table titled “vertical analysis” for Legacy Clothing shows the balance sheet as of December 31, 2012. There are two columns each named amount and percent for 2011 and 2012. The items, amounts, and percentages are as follows:
Assets
Cash, 2011 amount 125,000, percent 13.5%, 2012 amount 200,000, percent 20.4%
Accounts receivable, 2011 amount 150,000, percent 16.2%, 2012 amount 100,000, percent 10.2%
Merchandise inventory, 2011 amount 200,000, percent 21.6%, 2012 amount 250,000, percent 25.5%
The row for “Merchandise inventory” is highlighted in the income statement.
Supplies, 2011 amount 15,000, percent 1.6%, 2012 amount 20,000, percent 2.0%
Prepaid insurance, 2011 amount 10,000, percent 1.1%, 2012 amount 10,000, percent 1.0%
Land, 2011 amount 50,000, percent 5.4%, 2012 amount 50,000, percent 5.1%
Buildings (net), 2011 amount 375,000, percent 40.5%, 2012 amount 375,000, percent 35.7%
Total assets, 2011 amount 925,000, percent 100.0%, 2012 amount 980,000, percent 100.0%
The row for “Total Assets” is highlighted in the income statement.

Liabilities
Accounts payable, 2011 amount 85,000, percent 9.2%, 2012 amount 75,000, percent 7.7%
Sales tax payable, 2011 amount 50,000, percent 5.4%, 2012 amount 55,000, percent 5.6%
Unearned revenue, 2011 amount 30,000, percent 3.2%, 2012 amount 25,000, percent 2.6%
Notes payable, 2011 amount 325,000, percent 35.1%, 2012 amount 300,000, percent 30.6%
The row for “Notes payable” is highlighted in the income statement.
Total liabilities, 2011 amount 490,000, percent 53.0%, 2012 amount 455,000, percent 46.4%

Equity
Owner’s capital, 2011 amount 435,000, percent 47.0%, 2012 amount 525,500, percent 53.6%

Total liabilities and equity, 2011 amount 925,000, percent 100.0%, 2012 amount 980,000, percent 100.0%

For example, in 2011, our merchandise inventory represented 21.7% of total assets, whereas in 2012, it represented 16.9%.

In another instance, notes payable represented 35.3% of total assets in 2011 and 42.3% in 2012; therefore, notes payable is increasing.

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.

This horizontal analysis shows the income statement for Legacy Clothing for the period ending December 31, 2012. The analysis has four columns, namely 2011, 2012, 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, 2012 1,100,000, 2011 1,000,000
Sales returns and allowances, 2012 55,000, 2011 50,000
Sales discounts, 2012 20,000, 2011 25,000
Net sales, 2012 1,025,000, 2011 925,000
Cost of goods sold, 2012 475,000, 2011 450,000
Gross profit, 2012 550,000, 2011 475,000

Salaries expense, 2012 175,000, 2011 150,000
Advertising expense, 2012 32,000, 2011 30,000
Rent expense, 2012 11,000, 2011 10,000
Insurance expense, 2012 2,500, 2011 2,500
Supplies expense, 2012 5,000, 2011 5,000
Depreciation expense—buildings, 2012 15,000, 2011 15,000
Total operating expenses, 2012 240,500, 2011 212,500
Income from operations, 2012 309,500, 2011 262,500

Other revenue (expenses) 
Interest expense, 2012 5,500, 2011 5,000

Net income, 2012 304,000, 2011 275,500

First, we express the changes from 2011 to 2012 in dollar amounts for each of these individual financial statement line items.

This horizontal analysis shows the income statement for Legacy Clothing for the period ending December 31, 2012. The analysis has four columns, namely 2011, 2012, 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, 2012 1,100,000, 2011 1,000,000, increase or decrease amount 100,000
Sales returns and allowances, 2012 55,000, 2011 50,000, increase or decrease amount 5,000
Sales discounts, 2012 20,000, 2011 25,000, increase or decrease amount 5,000
Net sales, 2012 1,025,000, 2011 925,000, increase or decrease amount 100,000
Cost of goods sold, 2012 475,000, 2011 450,000, increase or decrease amount 25,000
Gross profit, 2012 550,000, 2011 475,000, increase or decrease amount 75,000

Salaries expense, 2012 175,000, 2011 150,000, increase or decrease amount 25,000
Advertising expense, 2012 32,000, 2011 30,000, increase or decrease amount 2,000
Rent expense, 2012 11,000, 2011 10,000, increase or decrease amount 1,000
Insurance expense, 2012 2,500, 2011 2,500
Supplies expense, 2012 5,000, 2011 5,000
Depreciation expense—buildings, 2012 15,000, 2011 15,000
Total operating expenses, 2012 240,500, 2011 212,500, increase or decrease amount 28,000
Income from operations, 2012 309,500, 2011 262,500, increase or decrease amount 47,000

Other revenue (expenses) 
Interest expense, 2012 5,500, 2011 5,000, increase or decrease amount 500

Net income, 2012 304,000, 2011 275,500, increase or decrease amount 46,500

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.

This horizontal analysis shows the income statement for Legacy Clothing for the period ending December 31, 2012. The analysis has four columns, namely 2011, 2012, increase or decrease amount, and increase or decrease percent. The items in the table are as follows:
Sales, 2012 1,100,000, 2011 1,000,000, increase or decrease amount 100,000, increase or decrease percent 10.0%
The row for “Sales” is highlighted in the income statement.
Sales returns and allowances, 2012 55,000, 2011 50,000, increase or decrease amount 5,000, increase or decrease percent 10.0%
Sales discounts, 2012 20,000, 2011 25,000, increase or decrease amount 5,000, increase or decrease percent negative 20.0%
The row for “Sales discounts” is highlighted in the income statement.
Net sales, 2012 1,025,000, 2011 925,000, increase or decrease amount 100,000, increase or decrease percent 10.8%
Cost of goods sold, 2012 475,000, 2011 450,000, increase or decrease amount 25,000, increase or decrease percent 5.6%
Gross profit, 2012 550,000, 2011 475,000, increase or decrease amount 75,000, increase or decrease percent 15.8%

Salaries expense, 2012 175,000, 2011 150,000, increase or decrease amount 25,000, increase or decrease percent 16.7%
The row for “Salaries expense” is highlighted in the income statement.
Advertising expense, 2012 32,000, 2011 30,000, increase or decrease amount 2,000, increase or decrease percent 6.7%
Rent expense, 2012 11,000, 2011 10,000, increase or decrease amount 1,000, increase or decrease percent 10.0%
Insurance expense, 2012 2,500, 2011 2,500, increase or decrease percent 0.0%
Supplies expense, 2012 5,000, 2011 5,000, increase or decrease percent 0.0%
Depreciation expense—buildings, 2012 15,000, 2011 15,000, increase or decrease percent 0.0%
Total operating expenses, 2012 240,500, 2011 212,500, increase or decrease amount 28,000, increase or decrease percent 13.2%
Income from operations, 2012 309,500, 2011 262,500, increase or decrease amount 47,000, increase or decrease percent 17.9%

Other revenue (expenses) 
Interest expense, 2012 5,500, 2011 5,000, increase or decrease amount 500, increase or decrease percent 10.0%

Net income, 2012 304,000, 2011 275,500, increase or decrease amount 46,500, increase or decrease percent 18.1%

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 2011 to 2012.

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.

This table titled “horizontal analysis” for Legacy Clothing shows the balance sheet as of December 31, 2012. There are four columns named 2012, 2011, 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, 2012 200,000, 2011 125,000
Accounts receivable, 2012 100,000, 2011 150,000
Merchandise inventory, 2012 250,000, 2011 200,000
Supplies, 2012 20,000, 2011 15,000
Prepaid insurance, 2012 10,000, 2011 10,000
Land, 2012 50,000, 2011 50,000
Buildings (net), 2012 350,000, 2011 375,000
Total assets, 2012 980,000, 2011 925,000

Liabilities
Accounts payable, 2012 75,000, 2011 85,000
Sales tax payable, 2012 55,000, 2011 50,000
Unearned revenue, 2012 25,000, 2011 30,000
Notes payable, 2012 300,000, 2011 325,000
Total liabilities, 2012 455,000, 2011 490,000

Equity
Owner’s capital, 2012 525,500, 2011 435,000

Total liabilities and equity, 2012 980,000, 2011 925,000

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.

This table titled “horizontal analysis” for Legacy Clothing shows the balance sheet as of December 31, 2012. There are four columns named 2012, 2011, 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, 2012 200,000, 2011 125,000, increase or decrease amount 75,000
Accounts receivable, 2012 100,000, 2011 150,000, increase or decrease amount 50,000
Merchandise inventory, 2012 250,000, 2011 200,000, increase or decrease amount 50,000
Supplies, 2012 20,000, 2011 15,000, increase or decrease amount 5,000
Prepaid insurance, 2012 10,000, 2011 10,000
Land, 2012 50,000, 2011 50,000
Buildings (net), 2012 350,000, 2011 375,000, increase or decrease amount 25,000
Total assets, 2012 980,000, 2011 925,000, increase or decrease amount 55,000

Liabilities
Accounts payable, 2012 75,000, 2011 85,000, increase or decrease amount 10,000
Sales tax payable, 2012 55,000, 2011 50,000, increase or decrease amount 5,000
Unearned revenue, 2012 25,000, 2011 30,000, increase or decrease amount 5,000
Notes payable, 2012 300,000, 2011 325,000, increase or decrease amount 25,000
Total liabilities, 2012 455,000, 2011 490,000, increase or decrease amount 35,000

Equity
Owner’s capital, 2012 525,500, 2011 435,000, increase or decrease amount 90,000

Total liabilities and equity, 2012 980,000, 2011 925,000, increase or decrease amount 55,000

Next, we convert that dollar amount change to a percentage, to show us the percentage change of these individual financial statement line items.

This table titled “horizontal analysis” for Legacy Clothing shows the balance sheet as of December 31, 2012. There are four columns named 2012, 2011, increase or decrease amount, and increase or decrease percent. The items in the table are as follows:
Assets
Cash, 2012 200,000, 2011 125,000, increase or decrease amount 75,000, increase or decrease percent 60.0%
The row for “Cash” is highlighted in the balance sheet.
Accounts receivable, 2012 100,000, 2011 150,000, increase or decrease amount 50,000, increase or decrease percent negative 33.3%
Merchandise inventory, 2012 250,000, 2011 200,000, increase or decrease amount 50,000, increase or decrease percent 25.0%
The row for “Merchandise inventory” is highlighted in the balance sheet.
Supplies, 2012 20,000, 2011 15,000, increase or decrease amount 5,000, increase or decrease percent 33.3%
Prepaid insurance, 2012 10,000, 2011 10,000, increase or decrease percent 0.0%
Land, 2012 50,000, 2011 50,000, increase or decrease percent 0.0%
Buildings (net), 2012 350,000, 2011 375,000, increase or decrease amount 25,000, increase or decrease percent negative 6.7%
Total assets, 2012 980,000, 2011 925,000, increase or decrease amount 55,000, increase or decrease percent 5.9%

Liabilities
Accounts payable, 2012 75,000, 2011 85,000, increase or decrease amount 10,000, increase or decrease percent negative 11.8%
Sales tax payable, 2012 55,000, 2011 50,000, increase or decrease amount 5,000, increase or decrease percent 10.0%
Unearned revenue, 2012 25,000, 2011 30,000, increase or decrease amount 5,000, increase or decrease percent negative 16.7%
Notes payable, 2012 300,000, 2011 325,000, increase or decrease amount 25,000, increase or decrease percent negative 7.7%
The row for “Notes payable” is highlighted in the balance sheet.
Total liabilities, 2012 455,000, 2011 490,000, increase or decrease amount 35,000, increase or decrease percent negative 7.1%

Equity
Owner’s capital, 2012 525,500, 2011 435,000, increase or decrease amount 90,000, increase or decrease percent 20.7%

Total liabilities and equity, 2012 980,000, 2011 925,000, increase or decrease amount 55,000, increase or decrease percent 5.9%

As you can see, cash increased by 170% and merchandise inventory increased 25%. However, accounts payable decreased by 11.8%, which tells us that we are paying down our short-term debt.

4. 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.



Rate of Return on Sales
So, if we look at rate of return on sales—net income divided by net sales—and input our figures for Legacy Clothing, 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.

To calculate rate of return on sales, 304,000 is divided by 1,025,000 to get 29.7%.

Return on Total Assets
Return on total assets measures how effectively Legacy Clothing uses its assets, expressed as income before interest expense and taxes, divided by total assets. Plugging in our information, our return on total assets for Legacy Clothing is 20.9%. A high asset turnover means a company is running efficiently, where a low asset turnover means there is room for improvement.

To calculate return on total assets, 309,500 is divided by 1,479,000 to get 20.9%.

Asset Turnover
Asset turnover measures the use of assets to make sales, calculated by taking net sales divided by total assets. In this case, the asset turnover is 0.69 times. Regarding the asset turnover ratio, the larger the better.

To calculate asset turnover, 1,025,000 is divided by 1,479,000 to get 0.69 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.



Current Ratio
The current ratio shows how much in current assets we have to pay off our current liabilities, or short-term debt obligations. Plugging in the information from Legacy Clothing—current assets divided by current liabilities—we can see that the current ratio is 4.54. As we can see, Legacy’s current assets far exceed its currently liabilities.

To calculate current ratio, 704,000 is divided by 155,000 to get 4.54.

Inventory Turnover
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 information to calculate its inventory turnover and finds it is 2.11 times.

To calculate inventory turnover, 475 ,000 is divided by 225,000 to get 2.1 times.

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: Adapted from Sophia instructor Evan McLaughlinTHIS TUTORIAL WAS AUTHORED BY EVAN MCLAUGHLIN FOR SOPHIA LEARNING. PLEASE SEE OUR TERMS OF USE.

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