Deitz J.E., Southam J.L. Contemporary Business Mathematics for Colleges
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Financial statements provide information that allows owners, managers, and others
interested in a business to evaluate its current condition and past operating results.
Two important financial statements are the balance sheet and income statement. The
balance sheet shows the current condition of a business at a definite point in time. It
lists what a business owns (assets), how much it owes (liabilities), and the difference
between the two (net worth), usually referred to as owners’ or shareholders’ equity.
The income statement shows the past operating results for a given period of time. It
lists the revenues, the expenses, and the net income or loss for the period.
Financial statement data are typically analyzed three ways. The first, called horizontal
analysis, is a comparison of data from year to year. This analysis shows the dollar amount
of change and the percent of change for each item on the statement from one year to the
next. The second, called vertical analysis, compares all other data on a statement with
one figure for that same year. On the balance sheet, for example, each asset, liability, and
equity amount is calculated as a percent of total assets (or total liabilities and owners’
equity). The third type of analysis compares selected related data for the year such as
current assets to current liabilities. These analyses are used by managers, owners, inves-
tors, creditors, and others to help them analyze data and make decisions concerning the
business.
384 Part 5 Business Applications
Analyzing Balance Sheets
THE SKI CHALET
Balance Sheet as of December 31, 2008 and 2007
2008 2008 2007 2007 Increase/Decrease
Amount Percent Amount Percent Amount Percent
ASSETS
Current assets:
Cash $ 90,000 12.64% $ 86,000 13.15% $ 4,000 4.65%
Accounts receivable 134,000 18.82% 98,000 14.98% 36,000 36.73%
Notes receivable 28,000 3.93% 32,000 4.89% (4,000) 212.50%
Merchandise inventory 180,000 25.28% 148,000 22.63% 32,000 21.62%
Total current assets $432,000 60.67% $364,000 55.66% $ 68,000 18.68%
Fixed assets:
Equipment $220,000 30.90% $190,000 29.05% $ 30,000 15.79%
Less depreciation (60,000) 28.43% (50,000) 27.65% (10,000) 20.00%
Equipment net $160,000 22.47% $140,000 21.41% $ 20,000 14.29%
Buildings 300,000 42.13% 300,000 45.87% — 0.00%
Less depreciation (180,000) 225.28% (150,000) 222.94% (30,000) 220.00%
Buildings net $120,000 16.85% $150,000 22.94% $(30,000) 220.00%
Total fixed assets $280,000 39.33% $290,000 44.34% $(10,000) 23.45%
TOTAL ASSETS $712,000 100.00% $654,000 100.00% $ 58,000 8.87%
Figure 19-1 Balance Sheet
19.1 On the balance sheet,current as-
sets are cash and those readily salable
securities,short-term receivables,and
inventory that are expected to be con-
verted into cash or used up within1
year of the balance sheet date.Current
liabilities are those payment obliga-
tions that are expected to be paid off
within 1 year of the balance sheet
date.
1
Learning Objective
Analyze balance sheets, comparing
items and periods.
On a balance sheet, total assets must always equal total liabilities plus owners’ or
shareholders’ equity. Balance sheets are analyzed to compare individual items with other
items and with the same item on different dates, usually 1 year apart. Many businesses
use the form of balance sheet illustrated in Figure 19-1.
Chapter 19 Financial Statements 385
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2008 2008 2007 2007 Increase/Decrease
Amount Percent Amount Percent Amount Percent
LIABILITIES AND
SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable $ 18,000 2.53% $ 24,000 3.67% $ (6,000) 225.00%
Accrued payroll 38,000 5.34% 30,000 4.59% 8,000 26.67%
Payroll taxes payable 6,000 0.84% 4,000 0.61% 2,000 50.00%
Notes payable 42,000 5.90% 48,000 7.34% (6,000) 212.50%
Total current liabilities $104,000 14.61% $106,000 16.21% $ (2,000) 21.89%
Long-term liabilities:
Mortgage payable $ 90,000 12.64% $120,000 18.35% $(30,000) 225.00%
Notes payable (over 1 year) 36,000 5.06% 30,000 4.59% 6,000 20.00%
Total long-term liabilities $126,000 17.70% $150,000 22.94% $(24,000) 216.00%
Total liabilities $230,000 32.30% $256,000 39.14% $(26,000) 210.16%
Shareholders’ equity:
Common stock $359,000 50.42% $359,000 54.89% — 0.00%
Retained earnings 123,000 17.28% 39,000 5.96% 84,000 215.38%
Total shareholders’ equity $482,000 67.70% $398,000 60.86% $ 84,000 21.11%
TOTAL LIABILITIES AND
SHAREHOLDERS’ EQUITY $712,000 100.00% $654,000 100.00% $ 58,000 8.87%
Figure 19-1 Balance Sheet (continued)
In Figure 19-1, the amounts for various items such as cash and accounts payable are
compared to total assets and total liabilities and shareholders’ equity. Also, the amounts
for 2008 are compared to the corresponding amounts for 2007, and the amounts and
percents of increase or decrease are shown. When two statements are compared, the
earlier period, usually the prior year, is always used as the base. The changes in balance
sheet items between two periods measure the growth or decline of the business.
The first step in analyzing a balance sheet is to compute the percent each item is
of the total assets or of the total liabilities and shareholders’ equity (net worth). For
example, the percent of cash for 2008 is calculated by dividing the amount of cash for
2008 by the total assets for 2008 and then converting the resulting decimal answer to a
percent ($90,000 4 $712,000 5 0.1264 5 12.64%).
The second step is to compute the amount and percent of change between the two
dates being compared. The amount of change in cash from 2007 to 2008 is calculated by
subtracting the cash amounts for the two years ($90,000 2 $86,000 5 $4,000 increase).
Increases are shown as positive numbers. Decreases, negative changes, are shown in
parentheses. The percent of change in cash is calculated by dividing the amount of
change by the prior year’s amount ($4,000 4 $86,000 5 0.0465 5 4.65%).
Note three facts:
1. The totals for assets equal the totals for liabilities and shareholders’ equity.
2. The percent listed for each item under assets is of the total assets; the percent listed
for each item under liabilities and shareholders’ equity is of the total liabilities and
shareholders’ equity.
3. The percent of increase or decrease between the two years is based on 2007, the earlier
year.
The income statement shows revenue, expenses, and the difference between the two, or
net income. Income statements are analyzed by comparing all other statement items
with the net revenue, which is total revenue less any returns and allowances. Net revenue
(frequently called net sales) is always 100%. All other items on the income statement are
reported as a percent of net revenue/sales. The resulting percents are extremely impor-
tant for all businesspeople. They are compared to budgeted amounts, to percents for
competing businesses, and to percents for past periods.
Figure 19-2 shows a typical income statement for 1 year, in which dollar amounts are
converted to percents based on net sales. Percents are rounded to two decimal places,
and dollar amounts are rounded to the nearest whole dollar. Cents are seldom used in
reporting annual figures.
386 Part 5 Business Applications
✔
CONCEPT CHECK 19.1
In its next year, 2009, The Ski Chalet had total assets of $720,000, total liabilities of $245,000,
cash of $123,000, and mortgage payable of $60,000. Determine the following amounts and
percents:
a. What was its total shareholders’ equity in 2009?
$720,000 2 $245,000 5 $475,000
b. What was its balance sheet percent of cash?
$123,000 4 $720,000 5 17.08%
c. What was its balance sheet percent of mortgage payable?
$60,000 4 $720,000 5 8.33%
d. What was its percent of increase in cash?
($123,000 2 $90,000) 4 $90,000 5 36.67%
e. What was its percent of decrease in mortgage payable?
($90,000 2 $60,000) 4 $90,000 5 33.33%
Analyzing Income Statements
THE SKI CHALET
Income Statement for Year Ended
December 31, 2008
2008 2008
Amount Percent
Revenue from sales:
Sales $988,900 101.43%
Less returns 13,900 1.43%
NET SALES $975,000 100.00%
Figure 19-2 Income Statement
2
Learning Objective
Analyze income statements,
comparing items and periods.
19.2 The income statement is
commonly referred to as the profit
and loss statement or the P&L.
19.3 Often,companies in the same
trade or industry (or trade associa-
tions) compile and distribute industry-
average percentage figures,which
allow individual companies to
compare their own percents with
the industry averages.Almost all
companies that have many branches
derive percentage figures and compare
each branch against all others.
Most businesses want to compare the operations of the current year with those of the
preceding year. The statement shown in Figure 19-3 has information for both the current
year and the preceding year. It also shows the amount and percent of increase or decrease
from the preceding year.
Chapter 19 Financial Statements 387
THE SKI CHALET
Income Statement for the Years Ended
December 31, 2008 and 2007
2008 2008 2007 2007 Difference
Amount Percent Amount Percent Amount Percent
Revenue from sales:
Sales $988,900 101.43% $850,000 104.81% $138,900 16.34%
Less returns 13,900 1.43% 39,000 4.81% (25,100) 264.36%
NET SALES $975,000 100.00% $811,000 100.00% $164,000 20.22%
Cost of goods sold:
Inventory, January 1 $148,000 15.18% $152,000 18.74% $ (4,000) 22.63%
Purchases 440,000 45.13% 379,000 46.73% 61,000 16.09%
Available for sale $588,000 60.31% $531,000 65.47% $ 57,000 10.73%
Inventory, December 31 180,000 18.46% 148,000 18.25% 32,000 21.62%
Cost of goods sold $408,000 41.85% $383,000 47.23% $ 25,000 6.53%
Gross profit on sales $567,000 58.15% $428,000 52.77% $139,000 32.48%
Figure 19-3 Comparative Income Statement
2008 2008
Amount Percent
Cost of goods sold:
Inventory, January 1 $148,000 15.18%
Purchases 440,000 45.13%
Available for sale $588,000 60.31%
Inventory, December 31 180,000 18.46%
Cost of goods sold $408,000 41.85%
Gross profit on sales $567,000 58.15%
Operating expenses:
Salary and benefits $290,000 29.74%
Rent and utilities 62,000 6.36%
Advertising 32,400 3.32%
Depreciation 40,000 4.10%
Equipment and supplies 15,800 1.62%
Administrative 12,500 1.28%
Total operating expense $452,700 46.43%
Income before tax $114,300 11.72%
Income tax 30,300 3.11%
NET INCOME $ 84,000 8.62%
Figure 19-2 Income Statement (continued)
388 Part 5 Business Applications
2008 2008 2007 2007 Difference
Amount Percent Amount Percent Amount Percent
Operating expenses:
Salary and benefits $290,000 29.74% $242,000 29.84% $ 48,000 19.83%
Rent and utilities 62,000 6.36% 61,400 7.57% 600 0.98%
Advertising 32,400 3.32% 25,700 3.17% 6,700 26.07%
Depreciation 40,000 4.10% 32,000 3.95% 8,000 25.00%
Equipment and supplies 15,800 1.62% 10,300 1.27% 5,500 53.40%
Administrative 12,500 1.28% 14,200 1.75% (1,700) 211.97%
Total operating expense $452,700 46.43% $385,600 47.55% $ 67,100 17.40%
Income before tax $114,300 11.72% $42,400 5.23% $ 71,900 169.58%
Income tax 30,300 3.11% 24,400 3.01% 5,900 24.18%
NET INCOME $ 84,000 8.62% $18,000 2.22% $ 66,000 366.67%
Figure 19-3 Comparative Income Statement (continued)
Another analysis carried out by many businesses is a comparison between actual
results and budgeted figures. Owners and managers note differences between budgeted
and actual amounts and make adjustments where necessary. Most businesses and virtu-
ally all government entities use monthly and annual budgets to guide and monitor their
operations. Figure 19-4 illustrates a monthly and year-to-date budget comparison at the
end of June, the sixth month of the year.
To find the percent change, the budgeted amount is subtracted from the actual
amount and the difference is divided by the budgeted amount.
THE SKI CHALET
Income Statement for the Month and the
Six-Month Period Ended June 30, 2008
June 2008 Six Months Year-to-Date
Amount Percent Amount Percent
Budget Actual Difference Difference Budget Actual Difference Difference
Revenue from sales:
Sales $85,000 $86,500 $ 1,500 1.76% $510,000 $480,000 $(30,000) 25.88%
Sales returns 5,000 3,500 (1,500) 230.00% 10,000 6,000 (4,000) 240.00%
NET SALES $80,000 $83,000 $ 3,000 3.75% $500,000 $474,000 $(26,000) 25.20%
Cost of goods sold 35,000 38,000 3,000 8.57% 225,000 230,000 5,000 2.22%
Gross profit $45,000 $45,000 $ — 0.00% $275,000 $244,000 $(31,000) 211.27%
Operating expenses 31,000 39,000 8,000 25.81% 185,000 196,000 11,000 5.95%
Income before tax $14,000 $ 6,000 $(8,000) 257.14% $ 90,000 $ 48,000 $(42,000) 246.67%
Income tax 6,000 1,000 (5,000) 283.33% 40,000 16,000 (24,000) 260.00%
NET INCOME $ 8,000 $ 5,000 $(3,000) 237.50% $ 50,000 $ 32,000 $(18,000) 236.00%
Figure 19-4 Monthly/Year-to-Date Budget Comparison
19.4 Charitable,nonprofit,and
government agencies also use budgets
for planning and monitoring.Many
of these budgets closely follow the
sections and sequences of the business
income statement.
In addition to comparing dollar amounts and percents on financial statements, business
managers and owners frequently want to study relationships between various items on
their income statements and balance sheets. These relationships generally are expressed
by ratios. A ratio is the relation of one amount to another. Thus the ratio of one dollar
to one quarter, or $1 to $0.25, is a ratio of 4 to 1, or 4:1, showing that a dollar is 4 times
the value of a quarter.
In analyzing financial statements, six important financial analysis ratios are com-
monly used: the working capital ratio, the acid test ratio, the ratio of accounts receivable
to net sales, the inventory turnover rate, the relation of net income to net sales, and the
rate of return on investment (equity).
WORKING CAPITAL RATIO
Working capital and the working capital ratio come from the balance sheet. Wo r king
capital is the amount of current assets less current liabilities. It tells the amount of
current assets that would remain if all the company’s current liabilities were paid imme-
diately. The working capital ratio shows the relationship between current assets and
current liabilities. It calculates the amount of current assets per dollar of current liabili-
ties. The working capital ratio helps the reader of the balance sheet understand how well
the company is able to pay its current debts.
Working capital ratio 5 Total current assets 4 Total current liabilities
Chapter 19 Financial Statements 389
In its next year, 2009,The Ski Chalet had total sales of $1,480,000, net sales of $1,320,000, gross
profit of $710,000, and advertising expense of $45,000. In 2009,the company budgeted gross
profit of $800,000. Determine the following amounts and percents:
a. Amount of sales returns in 2009
$1,480,000 2 $1,320,000 5 $160,000
b. Amount of cost of goods sold in 2009
$1,320,000 2 $710,000 5 $610,000
c. Percent of net sales increase from 2008 to 2009
($1,320,000 2 $975,000) 4 $975,000 5 35.38%
d. Percent of advertising expense in 2009
$45,000 4 $1,320,000 5 3.41%
e. Difference between percent gross profit and 2009 budgeted amount
($710,000 2 $800,000) 4 $800,000 5211.25%
✔
CONCEPT CHECK 19.2
Compute commonly used business
operating ratios.
3
Learning Objective
Computing Business Operating Ratios
EXAMPLE A
The working capital ratio for The Ski Chalet for 2008 from Figure 19-1 is
$432,000 4 $104,000 5 4.2 5 4.2:1
The ratio 4.2 to 1, or 4.2:1, means that the business has $4.20 in current assets to pay
for each $1 in current liabilities.
390 Part 5 Business Applications
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ACID TEST RATIO
The acid test ratio is used to determine the relationship between assets that can be
quickly turned into cash and current liabilities. Usually, these assets are cash and ac-
counts receivable. Accounts receivable are amounts owed to a business for services
performed or goods delivered.
Acid test ratio 5 (Total of cash 1 Accounts receivable) 4 Total current liabilities
EXAMPLE B
The acid test ratio for The Ski Chalet for 2008 from Figure 19-1 is computed as follows:
Cash $ 90,000
Accounts receivable 1134,000
Total cash and receivables $224,000
$224,000 4 $104,000 5 2.2 5 2.2:1
RATIO OF ACCOUNTS RECEIVABLE TO NET SALES
When businesses sell on credit, they need to be alert to the amount and quality of their
accounts receivable. They need to compare the amount of their current receivables to the
amounts for prior years and compare the extent of their receivables to those of similar
companies. By computing the ratio of accounts receivable to net sales every year, man-
agement and investors can keep track of the percent of sales that have not yet been paid
for by customers. An increasing ratio over the years can indicate problems with collect-
ing payments and should be investigated.
Ratio of accounts receivable to net sales 5 Accounts receivable 4 Net sales
EXAMPLE C
The Ski Chalet ratio for 2008 is
Figure 19-1 Figure 19-3
$134,000 4 $975,000 5 0.137 5 0.14:1
RELATIONSHIP OF NET INCOME TO NET SALES
An increase in total sales volume doesn’t necessarily mean that a business is improving
because expenses may be increasing at an equal or greater rate than revenues. Thus,
looking at the relationship of net income to net sales is important. The relationship is
given as a percentage.
Relationship of net income to net sales 5 Net income 4 Net sales
Chapter 19 Financial Statements 391
INVENTORY TURNOVER
In retail stores, the cost of inventory often is very high. One way to control inventory
costs and increase profit is to maintain a high level of inventory turnover. Recall from
Chapter 17 that inventory turnover lets management and others know the number of
times average inventory is sold during the year. The higher the turnover number, the
better is the movement of inventory. Recall also that average inventory, found by averag-
ing monthly, quarterly, or yearly inventory amounts, must be computed first. Inventory
turnover is given as the number of times instead of as a ratio to 1.
Average inventory 5 (Beginning inventory 1 Ending inventory) 4 2 (annual)
Inventory turnover 5 Cost of goods sold 4 Average inventory
EXAMPLE D
Based on the information given in Figures 19-3 and 19-1, the 2008 inventory turnover
for The Ski Chalet is found as follows:
01-Jan 31-Dec
($148,000 1 $180,000) 4 2 5 $328,000 4 2 5 $164,000 average inventory
$408,000 cost of merchandise sold 4 $164,000 5 2.5 times inventory turnover rate
EXAMPLE E
Based on information from Figure 19-3, The Ski Chalet’s 2008 relationship of net in-
come to net sales is $84,000 4 $975,000 5 8.6%. Comparison with the relationship for
2007 of 2.2% ($18,000 4 $811,000) indicates an improvement.
RATE OF RETURN ON INVESTMENT
Shareholders and owners want a reasonable return on their investment (equity). A ratio
that measures the rate of return on investment is the ratio of net income to sharehold-
ers’/owners’ equity. The rate is given as a percentage.
Rate of return on investment 5 Net income 4 Shareholders’/owners’ equity
EXAMPLE F
Based on Figures 19-3 and 19-1, the rate of return on the shareholders’ investment for
The Ski Chalet for 2008 is
$84,000 4 $482,000 5 0.1742 5 17.4% rate of return
392 Part 5 Business Applications
Boswell Designs’financial statements showed the following:
Cash $ 85,000 Current liabilities $320,000 Net sales $950,000
Accounts receivable 260,000 Total liabilities 560,000 Inventory 1/1/2008 240,000
Total current assets 580,000 Net income 80,000 Inventory 12/31/2008 200,000
Total assets 990,000 Shareholders’ equity 430,000 Purchases for 2008 630,000
Using the above numbers, compute the following ratios:
a. Working capital ratio $580,000 4 $320,000 5 1.81:1
b. Acid test ratio ($85,000 1 $260,000) 4 $320,000 5 1.08:1
c. Average inventory ($240,000 1 $200,000) 4 2 5 $220,000
d. Inventory turnover $240,000 1 $630,000 2 $200,000 5 $670,000
$670,000 4 $220,000 5 3.05 turnovers
e. Net income to net sales ratio $80,000 4 $950,000 5 0.084, or 8.4%
f. Rate of return on investment $80,000 4 $430,000 5 0.186, or 18.6%
COMPLETE ASSIGNMENTS 19.1, 19.2, AND 19.3.
✔
CONCEPT CHECK 19.3
accounts receivable
acid test ratio
assets
balance sheet
financial statements
income statement
liabilities
net revenue
net worth
rate of return on investment
ratio
ratio of accounts receivable to net
sales
relationship of net income to net
sales
working capital
working capital ratio
Chapter Terms for Review
THE BOTTOM LINE
Chapter 19 Financial Statements 393
Summary of chapter learning objectives:
Learning Objective
19.1
Analyze balance sheets, comparing items and periods.
Example
1. A modified balance sheet for The Ski Chalet for December 2008
and 2007 is shown. Compute the percents for 2008 and the percents
of increase/decrease between 2008 and 2007.
THE SKI CHALET
Balance Sheet as of
December 31, 2008 and 2007
2008 2008 2007 2007 Increase/Decrease
Amount Percent Amount Percent Amount Percent
ASSETS
Current assets:
Cash $ 90,000 $ 86,000 15.03% $ 4,000
Accounts receivable 134,000 98,000 17.13% 36,000
Merchandise inventory 180,000 148,000 25.87% 32,000
Total current assets $404,000 $332,000 58.04% $ 72,000
Fixed assets:
Equipment $220,000 $190,000 33.22% $ 30,000
Less depreciation (60,000) (50,000) 28.74% (10,000)
Equipment net $160,000 $140,000 24.48% $ 20,000
Buildings 100,000 100,000 17.48% —
Total fixed assets $260,000 $240,000 41.96% $ 20,000
TOTAL ASSETS $664,000 $572,000 100.00% $ 92,000
LIABILITIES AND
SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable $ 18,000 $ 24,000 4.20% $ (6,000)
Accrued payroll 38,000 30,000 5.24% 8,000
Payroll taxes payable 6,000 4,000 0.70% 2,000
Total current liabilities $ 62,000 $ 58,000 10.14% $ 4,000
Long-term liabilities:
Mortgage payable 90,000 120,000 20.98% (30,000)
Total liabilities $152,000 $178,000 31.12% $ (26,000)
Shareholders’ equity:
Common stock $359,000 $359,000 62.76% —
Retained earnings 153,000 35,000 6.12% 18,000
Total shareholders’ equity $512,000 $394,000 68.88% $118,000
TOTAL LIABILITIES AND
SHAREHOLDERS’ EQUITY $664,000 $572,000 100.00% $ 92,000
Answers: 1. 2008 percent: 13.55%; 20.18%; 27.11%; 60.84%; 33.13%; 29.04%; 24.10%; 15.06%; 39.16%;
100.00%; 2.71%; 5.72%; 0.90%; 9.34%; 13.55%; 22.89%; 54.07%; 7.98%; 77.11%; 100.00%. Increase/decrease
percent: 4.65%; 36.73%; 21.62%; 21.69%; 15.79%; 20.00%; 14.29%; 0%; 8.33%; 16.08%; 225.00%; 26.67%;
50.00%; 6.90%; 225.00%; 214.61%; 0%; 51.43%; 29.95%; 16.08%