Chapter 3

Analyzing Financial
Statements

Copyright © 2007 by John Wiley

& Sons, Inc. All rights reserved
 Chapter Overview
• Readers of Financial Statements
• Types of Financial Analysis
• Management Decision Making
• Financial Tricks
Readers of Financial Analysis

Owners Track and evaluate management’s performance

Lenders Determine the risk of the business defaulting on its loan

Managers Compare actual and budgeted results

Government Ensure that taxes have been paid

Readers of Financial Analysis cont.

Suppliers Evaluate the company’s ability to pay its obligations

Investment
Evaluate the company’s performance
Analysts

Mergers and Highlight financial strengths, upside potential, and future

Acquisitions value
 Types of Analysis
• Vertical Analysis
– Used to analyze variable expenses
– All accounts are sized using either:
• Total revenue or
• Departmental revenue
– Variable expenses should increase or
decrease with the level of sales
 Sample Vertical Analysis
Shae's

Income Statement
• Accounts are divided by total
For the month ended June 30, 2008 revenues
Revenues: Amount Percent
– $1,138,100
Food $ 890,000 78.20

Beverage 220,000 19.33

Others 28,100 2.47 • Cost of Sales is divided by its

Total Revenues $ 1,138,100 100.00 respective revenue amount
Cost of Sales:
– EX: Food
Food $ 320,400 36.00 – $320,400 / $890,000 = 36%
Beverage 48,400 22.00

Others 15,455 55.00

Total Cost of Sales $ 384,255 33.76

Gross Profit:

Food $ 569,600 50.05

Beverage 171,600 15.08

Others 12,645 1.11

Total Gross Profit $ 753,845 66.24

 Sample Vertical Analysis cont.
Operating (Controllable) Expenses: Amount Percent

Salaries and Wages $ 352,811 31.00

• Accounts are divided by total
Employee Benefits 105,843 9.30 revenues
Total Labor Cost 458,654 40.30

Direct Operating Expenses 68,286 6.00

– $1,138,100
Marketing 39,834 3.50

Utilities 44,386 3.90

Administration & General 28,453 2.50

Repairs and Maintenance 25,038 2.20

Music and Entertainment 31,867 2.80

Total Operating Expenses $ 696,517 61.20

Operating Income $ 57,328 5.04

Other (Non-controllable) Expenses:

Rent $ 8,000 0.70

Depreciation 20,470 1.80

Interest 4,500 0.40

Total Non-controllable Expenses $ 32,970 2.90

Income Before Income Taxes $ 24,358 2.14

 Types of Analysis
• Horizontal Analysis
– Tracks and Analyzes:
• Income Statement
• Balance Sheet
– Focuses on both $$ and % changes
– Analyzes changes over time
• Month to Month
• Year to Year
 Sample Horizontal Analysis
Danforth Hotels
Horizontal Analysis for the Balance Sheets
As of December 31
(in millions)

2007 2008 $ change

Cash $ 82 $ 298 $ 216

Accounts Receivable 288 269 (19)

Marketable Securities 100 112 12

Inventory 193 158 (35)

Other current assets 64 90 26

Total Current Assets 727 927 200

Furniture, Fixture & Equipment, net 3,641 3,520 (121)

Management and Franchise Contracts, net 383 347 (36)

Goodwill 1,230 1,230 -

Long term Investments 568 599 31

Other long term assets 260 328 68

Long Term Assets 6,082 6,024 (58)

Total Assets $ 6,809 $ 6,951 $ 142

 Sample Horizontal Analysis cont.

2007 2008 $ change

Accounts Payable and Accrued Expenses $ 540 $ 601 $ 61

Current maturities of long-term debt 329 118 (211)

Accrued Taxes 4 4 -

Total Current Liabilities 873 723 (150)

Long Term Debt 3,709 3,560 (149)

Total Liabilities 4,582 4,283 (299)

Owner's Equity 1,807 1,998 191

Retained Earnings 420 670 250

Total Owner's Equity 2,227 2,668 441

Total Liabilities and Owner's Equity $ 6,809 $ 6,951 $ 142

 Types of Analysis
• Trend Analysis
– Calculations and data points
– Over a specified period of time
– Presented on line graphs and bar charts
– Examples
• RevPAR
• Food Cost
• Payroll Cost
 Types of Analysis
• Published Industry Averages
– Management can compare operating results
– Examples
• Smith Travel Research HOST Report
– Operating results
• Smith Travel Research STAR Report
– Occupancy, ADR, and RevPAR
 Types of Analysis
• Ratio Analysis
– Used to asses financial health
– Five categories:
• Liquidity
• Solvency
• Activity
• Operating
• Profitability
 Liquidity Ratios
• Measures ability to meet short-term
obligations
– Current Ratio
– Accounts Receivable Turnover
– Average Collection Period
– Operating Cash to Current Liabilities
 Solvency Ratios
• Measure ability to meet long-term
obligations
– Operating Cash Flow to Long-term Debt
– Long-term Debt to Total Capitalization
– Debt-to-equity Ratio
– Times Interest Earned (TIE)
– Fixed Charge Coverage
 Activity Ratios
• Gauge effectiveness of how assets are
managed
– Food Inventory Turnover
– Beverage Inventory Turnover
– Fixed Asset Turnover
 Operating Ratios
• Determine how efficient the operation is
– Food Cost Percentage
– Beverage Cost Percentage
– Labor Cost Percentage
 Profitability Ratios
• Effectiveness of achieving profit margins
and ROI goals
– Profit Margin
– Return on Assets
– Return on Investment
– Return on Equity
 Management Decision Making
• Employee Scheduling
– Based on:
• Accurate revenue forecasts
• Productivity goals
• Customer service goals
 Management Decision Making
• Food and Beverage Pricing
– Track sales of each menu item
– Calculate each items gross profitability
– Set menu prices
– Remove unprofitable items from the menu
 Management Decision Making
• Revenue Management
– Strategies
• Close lower levels of pricing during high demand
• Open all pricing levels during times of low demand
 Management Decision Making
• Profit Flexing
– Utilized when revenues fall behind budget
– Adjust pricing and reduce expenses
• Without impacting customer service
– Maximize remaining revenue opportunities
 Management Decision Making
• Cost-volume-profit Modeling
– Also known as Breakeven Analysis
– Target the amount of revenue required to reach the
owner’s goal
 Cost-volume-profit Equations

Fixed costs
Breakeven Volume of Sales =
(sale price – variable cost)

Rooms sold
Desired Occupancy % =
Rooms available for sale

Fixed Costs + Desired Profits

Desired Volume =
Sale Price – Variable Cost
 Breakeven Volume Example
• Sale price = $250 a night
• Fixed costs = $40,000 per month
• Variable cost = $35 per room
Fixed costs
Breakeven Volume of Sales =
(sale price – variable cost)

40,000
=
(250 - 35)

40,000
=
215

= 186 rooms
 Financial Tricks
• Window Dressing
– Making a company’s financial statements look
more favorable
– Example
• Company does not pay invoices
• Makes year-end balance sheet look better
 Financial Tricks
• Capitalize Current Operating Expenses
– Reduces current expenses
– Increases profits
 Financial Tricks
• Improper Revenue Recognition
– Revenues are recorded before they are
actually earned
– Violates matching principle