 Hello and welcome to this session in which you would look at tools for financial statement analysis. This is part two of seven of financial statement analysis series. Specifically in this session, we're going to be looking at horizontal analysis, vertical analysis, and common size financial statement. In section one, we looked at why do we prepare financial statement analysis, who benefits, and we overall looked at the tools and we looked at what should you do when you have the numbers. Obviously you should compare them to certain standards. In this session specifically, we're going to be looking at horizontal analysis, which is comparing the figures across time, the figures of financial statement across time, vertical analysis, comparing a figure to a number to a base in the financial statement, and we'll see how this works today, and common size financial statements, how the figures are changing in relative importance on the financial statement. Now those are the definitions. The best way to illustrate those definitions is to actually show you actual financial statement and we will perform horizontal analysis, financial statement, vertical analysis, and common size financial statements. Okay, so we're going to be dealing with this balance sheet. We have a two-year worth of data, x1 and x2. And by the way, this financial statement can be found. This excel sheet can be found on my website, farhatlectures.com, and we're going to be looking at also two years of income statement, two years of income statement. Starting with the balance sheet, we are going to be performing horizontal analysis. Now, before we prefer horizontal analysis, the investor, the creditor, and specifically the auditor, what they would do, and I was an auditor myself, or somebody who was preparing financial statement, for example, if you are doing a review or a compilation, not necessarily in a compilation, but when you're doing a review, you start by computing the difference in the dollar amount. So first, you find the difference from year to year in the dollar amount. Then in addition to the difference in the dollar amount, you find the percentage change. How big, how large was the change? So you need to compute two things. And usually the auditor or somebody who is preparing the financial statement, they will have a predetermined dollar amount and a percentage. And for example, you would say any change, depending on the size of the company, I'm just going to give an example, any change that is more the absolute value more than 20%. And the reason I say absolute value, it means it could be plus 20,000 or minus 20,000 and represent. So it has to have two conditions. Usually it has to have two conditions. For example, we say an absolute value change of 20,000 plus represent an 8% change. So what we do is this, we look at all the changes. And if these changes represent $20,000 difference and that difference is 8%, then we consider it significant. It means we have to look a little bit more into this account. I just, these amounts are arbitrary. I can choose 10% and 10,000 and 10%. I can choose 8,006%. The point is you will base this based on your experience with the company, based on the industry and based on other factors. But the point is first you determine what numbers, what figures are significant that if they are, if they change that much, then I have to look at them. For example, I can say for this illustration, I would say the change, it has to be 20,000 and it has to be 20%. I just arbitrarily looked at this number. Now I would run the numbers. I will find the difference between year two and year one by taking the difference 62,500 minus 42,000. First you want to make sure you know how to do this manually. So basically finding the difference. So this is the difference in the dollar amount in the cash account. And then you find the percentage difference, which you will take the change and you will divide it by the original amount, the year one, the base year and the change is 48.8. So notice here immediately, I would flag cash and cash equivalent. Why? Because cash and cash equivalent was more than 20,000 and more than 20%. So it meets both criteria. I would say, well, there are some major changes in cash and cash equivalent from the prior year. Now what are we assuming here? We are assuming that the prior year is audited. So we're assuming this year is correct. Now we're saying that there was a large increase in cash. We really need to take a look at why. So this is the starting point. Let's look at the trading securities. They are reported at fair value. They went down by 8,750 and it's a decrease of 11%. Well, not it's everything is important, but it doesn't meet my criteria, but I have to know why. I mean, that's why like why did the why did their trading securities went down? Did their investment went down in value or did they sell the investments or what's going on? So it's either the value of the investment went down or they sold some investments. That could be either or. I would look at a count receivable. Wow, $85,000 change. The difference is $85,000, but that represent only 16.7. Well, again, it doesn't meet both criteria because look, the dollar amount is large, but the size of it, it doesn't meet my criteria. Now, if I lower my criteria at the 10%, then account receivable will be a relevant number. In other words, not relevant. It means I have to look a little bit more into it. But this is what we're saying. What does that mean? It means it's either you sold less or you collected more on account. Now, what you should do next here and under those circumstances, you could pick real quick to the income statement and notice incomes on the income statement, we saw that sales went up. So it doesn't mean we sold less. It appears that we collected more cash. Now it's starting to make sense, maybe because account receivable went down. It means we are collecting more cash. We're not sure, but the point I'm trying to show you in this exercise is to help you use this information to think on a larger picture, to think on a larger picture. And the larger picture is what? Look at the change and see what does it affect. If I have less receivable, if I'm making more sales, but I have less receivable, it means I'm collecting more cash. That's why my receivable went down. Again, I can take a look at my allowance. The change is 1,000. Notice the change is small and the percentage is small. Never the less, never the less, this is an estimate. And once you have estimate, you have to always question the estimate. So I'm just telling you, although the number may not be large, but where is it coming from? It's important. Inventory went from 281 to 321. Inventory went up more than 20%, but it's less, sorry, went up more than 20,000, but less than 20%. And it's maybe I want to take a look at, see what happened. I want to ask them, why did inventory go up? Why did inventory go up? Okay. And they might have an explanation, but the point is it increased substantially by 14%. Prepaid is went from 7,200 to 3,000. It went down by 4,200. The dollar amount is small. The percentage is large. I won't worry about this. I won't worry about the prepaid. It's a small number, but nevertheless, you want to see why it's a small number. Overall, current assets went down by 4%. And you will do the same thing for the other account. And this is what horizontal analysis is. You're looking horizontally between the numbers. You're looking at property, plant, and equipment. It went up. It means we purchase more property, plant, and equipment by 10%. Depreciation went up by 25%, because accumulated depreciation changed by 25%. Again, we want to make sure that that's a good number. Goodwill and intangible asset went down by 4,500. Somehow we either write down goodwill or we sold some of our intangibles. We don't know, but that's something you want to look at. The amount is not large, dollar amount or percentage wise. And you will do the same thing for the liabilities. Now, again, what you can do when you're doing this, for example, if you are in the real world, either when the software does it, you can ask it to highlight certain numbers, or you can do what's called conditional formatting. If you know how to do conditional formatting, and you can tell it to highlight any changes, you can color scale it, highlight the large changes or something to the effect of conditional formatting. I'm just telling you there are more options, but again, I cannot spend time on this. This is basically a data analytics course, but something you want to be aware of that you could have those features involved to help you in your analysis, so conditional formatting. Now, here what I did is the negatives are in red. For example, note spable went down. Note spable went down by 30,000, 30,750. It's a small decrease. We have a lot of notes spable, but nevertheless it went down. Bond spable went down, but again, it's small. We have a small decrease in our liabilities. Accrued liabilities went up, and that could explain why we have more cash. We are operating using accrued liabilities. That could be it. Our account spable went up, but our notes spable went down. It means we pay off some notes. So we have to explain what happened to cash. Notice common stock, nothing changes in common stock, nothing changes in additional paid in capital. That's good. Now also, as an auditor, you would say, okay, I want to take a look at the board of directors minute to see if there's any stocks were issued and compare this, but it looks like there's no stocks. Before we proceed, I would like to remind you whether you are an accounting student or a CPA candidate to take a look at my website farhatlectures.com. My motto is saving CPA exam candidates and accounting student one at a time, helping you focus on your accounting career so you could move on with your life. I don't replace your CPA review course. If you are using one, you should be using one, by the way. I'm a useful addition to your CPA review course. I provide you with additional resources, lectures, multiple choice, true, false, that's going to help you understand the concept better. This is a list of all my course catalog that includes intermediate accounting, managerial accounting costs, governmental taxation, so advanced, so on and so forth. My CPA supplemental resources are aligned with your Becker, Roger, Gleam and Wiley. So it's very easy to go back and forth between my material and your CPA review course. I also provide you with the 1500 previously released AICPA questions with detailed solution. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation, like this recording, share it with other, connect with me on Instagram, Facebook, Twitter and Reddit. Now you will do the same thing, however, for the income statement. Again, going from year to year, it's as simple as taking the difference between the numbers, sales, and notice sales went up by 210,000. Again, we might have a different figures for the income statement. For the income statement could be anything above 150, any change, 150, and 5% difference. It has to be 150 and 5%, or any number. I'm just telling you, it doesn't matter what you choose, but the point is you plan ahead. Notice sales went up by 10.9%. Now, cost of goods sold also went up by 122, which is also 10.8%. And this should be logical. Why? Because if sales goes up, cost of goods sold is generally considered a variable, varies with sales. And now usually it varies in direct proportion, usually unless there's a reason not to. Here it looks like it's varying in the right proportion, 10% in sales, approximately 10.2 versus 10.82. So cost of goods sold is growing a little bit faster than sales, that could be normal. But you have to know more about the industry. If you know that this industry, somehow the cost of goods sold went up faster, let's assume this industry uses oil. And you know that the cost of oil increased substantially. But you also know that the company cannot increase their sales. So if sales goes up by 10%, well, cost of goods sold should go up higher than 10%, because the cost of their goods went up. But assuming, again, this is when you draw analytical procedure, relationship between the accounts, assuming it's stable, that looks normal. Gross profit went up by 9.65. That's also normal because the gross profit percentage change increased by 88,000 or 9.65% is the difference. Selling in general went up, their expenses went from 172 to 180. That makes sense. You're dealing with payroll and from year to year due to inflation, you increase prices. It doesn't look anything unusual. It's by 4.65. But also here you want to know if they hired more people or if they lay off people. If they lay off people selling general and administrative, why is it going up? But if they are stable, it looks here, they did not really overall, it's a minor increase. Maybe the increase wages a little bit for the overall employees. Research and development, this is worrying a little bit. It's a 40,000 decrease and 20%. And if this company is in technology or in pharmaceutical, that's alarming. Why is R&D went down? Why did you cut down on research and development by 20%? So this is what the horizontal analysis shown us. Pinpointing certain numbers that are important. Maybe we made a mistake. Maybe some of the costs here, maybe some of the costs and costs of goods sold should be down here or some of the costs in selling that 8,000 should have been, we don't know, should have been there. But the point is we need to ask questions or it could be the case that they cut down on research and development. Depreciation expense, this should be easy to see. It went up by 45,000. Again, also the balance sheet shows this, but we want to know why it went up 150%. They did buy a new asset. Are they switching to a new depreciation method? What's going on? Interest expense is what? 62,000, now it's 65,000. Practically stable went up a little. Now interest expense is also an easy number to kind of see what's going on with interest expense because what do we do? When we have interest expense, you have to draw the connection to the debt and we look at their debt. They have for year two, 419,000 in notes payable short-term, 700,000 approximately in long-term debt, approximately all in all just to estimate $1.1 million. And we would know what's their average interest rate. So if we see their average interest rate is 6%, that should be around 60,000. If that's the case, it looks like interest expense is fairly stated. But again, this is just an initial figure. But this is how they help. It looks like around 60,000, that looks good. But if their average interest rate is 10%, then this should be 100,000 or more than around 100,000. What I'm saying, average interest rate on all the loans. Then income before taxes, 733,000. Then we pay taxes and we're assuming the taxes here are, let's see, 21%. I believe I used, let's use 21%. I'm going to assume a tax rate, a tax of 21%. And overall, net income increased by 16.63%. So here's what we can say. We can say that sales only increased by 10%. Net income increased by 16.6%. You want to try to understand why it could be they cut down on research and development. That could be a reason. That could be a reason why, or you just have to understand what's going on in this picture. But that's the point that we're trying to make from horizontal analysis is finding the change, the dollar change, and the size of it, the percentage change. So this is vertical analysis. This is horizontal analysis. The next thing we're going to do is we're going to look at vertical analysis for the balance sheet. And what's vertical analysis? And I'm going to show you the balance sheet, the current, the asset section. Here, what we're doing is we're looking vertically. And for the balance sheet, we use the total asset as the base, the total asset as the base. And what we're doing is this, we're looking to see how much does cash represent of the total assets in year one, and how much the cash represent of the total asset of year two. What we see, we see that in year one, if we take 42,000 divided by 2,898,875, I'm just going to round it to 2.9 million, and this is, I'm going to say, 3 million. So if we take 42,000 divided by 2.9 million, it's going to give us 1.45. It means cash represented 1.45 of your assets in year one. In year two, cash represented 2.6%. Yes, notice cash is relatively, it's taken a larger, a larger, a larger percentage of your asset. And that's a huge increase, by the way, from 1.45 to 2.6. If we look at trading securities, they were 78, they were 2.69, and now they're 69 or 2.29. Again, we don't know whether they sold the shares or the value of those stocks went down. Account receivable used to represent 510,000 gross, now it's 425, it used to be 17%, now it's 14. It could be, again, we collected some receivable and that's why our cash went up, we don't know. Inventory was 281,000, now it's 321, it's approximately 10%. It looks that stable, approximately 10% of our assets is tied up in inventory. Prepaid, again, as I told you, the prepaid is not important, and notice it's a very small percentage of our asset. And that's why I told you it's not important. And notice here, when we did the, when we are performing the vertical analysis, it just shows you the size of it is very small. Property, plant, and equipment represent 75, 78, 74, and 78. I would say we need to investigate more on this account, make sure those accounts are fairly stated. Why? Because they represent a large portion of our assets. And the good news is it's easy to audit property, plant, and equipment. And, you know, you'll go to the auditing property, plant, and equipment, and you'll see how we do this. But the point is it's easy to audit property, plant, and equipment. Goodwill and intangible asset, I combine those two together, although they should be, each one should be separate. They represent 1.45 and 1.24, not that important in the grand scheme of things unless we are a technology company. It looks here that we are, we are in a business where we need a lot of property, plant, and equipment, and some inventory, maybe we're in retail, you know, some sort of a light retail. So this is how we perform what's called a horizontal analysis for the, sorry, vertical analysis for the balance sheet. Now, let's take a look at a vertical analysis when it comes to the income statement. On the income statement, we are comparing everything to sales, because sales drives everything. So sales is set at 100%. Now, first, we have to know manually how we, how we compute the vertical analysis. So we're going to take cost of goods sold and divided by sales. All the numbers will be divided by sales. And notice here, cost of goods sold represent 55.29% of sales, which is, which is we don't know until we go to year two and it represent 55.56. And if we have several years, it will be better. It seems that cost of goods sold, and as I told you earlier, when we talked about cost of goods sold and sales, there's a direct relationship, they move together. And in most companies they do, in most companies, it doesn't mean an all. And if they don't, there should be an explanation why they don't. Okay, now we'll do the same thing with margin. It seems our gross margin is 44.71 and 44.44. Again, these are all related to sales and cost of goods sold. If we look at our selling general and administrative, they represent approximately 8 to 8.5% of sales. Is this reasonable? Well, depending on how large is the company, depending on if we have previous another two years, then we have a better idea. Research and development used to represent 10% of sales, now at 7.8. Definitely, we are cutting down on research and development. And that's alarming. We need to know why. Depreciation was 1.4.7 of expenses, now it's 3.3. And depreciation is important because it's a non-cash, so it's going to affect our cash position. Interest expense was 62 and 65, representing approximately 3% of our expenses. A small percentage of our expenses is interest expense. Then our taxes, 90,000 and 106,050. Again, our taxes represent as percentage of sales, 4.46% of sales. And at the end, we look at this important number, which is the net profit margin. It's approximately between 17 and 18%. 16.7 and 17.73. 17 to 18% we can say overall. So what we did here is we looked at a vertical, comparing everything to sales to see how things are the importance of them relative to that sales number. Also, what we can do, we can look at a trend analysis, looking at what's happening over several years. Because as I told you, the more years you have, the better off you are. But when we're doing to illustrate horizontal and vertical, we can only use two years. But this is called the trend analysis. And what we're doing here is we're looking sales over a period of five years, cost of goods sold gross profit and gross margin. And when we graph them, we notice that sales and cost of goods sold in a sense, they're both going up in the same direction. They're both going up in the same direction, which is good. That's we especially we want sales to go up. If anything, we want them to deviate, deviate in what sense we want cost of goods sold to head down sales to go up. So we want over the years to be able to be more efficient as we become more efficient, cost of goods sold goes up down a little bit, try to bring it down, basically make the make the size between them grow larger and larger with sales going up, of course. Now, if we look at the gross profit percentage, notice here, if we look at the percentage, it looks like it's, it's fluctuating more. It is fluctuating because your gross profit percentage, although it's like 43.92, it's only you would say it's 1%. You'd say, you know, it's only 1% difference. Yes, it is 1% difference. But when for a company like Walmart, when you are talking about 500 billion or 400 billion in sales and 1% difference, that's a lot of millions or company like Amazon. So you might think, well, it's only 1%. But that's huge for most companies. So the gross profit percentage is important. Also, the gross profit percentage is important because you can compare the gross profit percentage to other companies to see how your gross profit percentage, assuming it's comparable, how well you are doing to other companies. So that's why it's very important. And notice it went, but it's fluctuating between 40, 44, it's at the 44 to the 45%. It went up at some point, 44.93. So we want to know what happened in 2009 that the gross profit percentage was almost 45. Then it went down to 40, 42. Was this an odd year? Then it went up to 47.2. Then it went down. It's fluctuating between 40 and 45 or 43.9 and 44.49. So those are the two extremes, the two extremes, year 08 and 09. So this is basically how you look at the financial statements and perform what's called a vertical and horizontal analysis. Again, how do you use this? You would use this when you are auditing the company or when you are analyzing the company, if you want to buy their stock, Durban's, should go to farhatlectures.com and answer multiple choice questions about this topic. At the end of this recording, I'm going to remind you to invest in yourself. Go to Farhat Lectures, subscribe. Your accounting career is important. It's going to pay you dividend for years. You have to pass your CPA exam once, have strong accounting education, pass the exam. It's going to pay you dividend for years. Study hard.