Financial Analysis- The Big Picture (Week

4)
Topics

 Sustainable income and discontinued operations

 Horizontal analysis
 Vertical analysis
 Introduction to ratio analysis

Sustainable income: a business’s income, less unusual (out-of-the-ordinary) revenues, expenses, gains,
and losses. Sustainable income is the most likely level of income to be earned by a company in the
future.

Discontinued operations:  disposal/termination of a significant component of a business, such as the

elimination of a major class of customers or an entire activity (ex. the UCW Bookstore could decide to
stop offering computer repairs/IT services).

The gain or loss from discontinued operations is usually made up of two parts:

1) The income or loss from operations

2) The gain or loss on disposal of the components

As an example, let’s assume that the bookstore actually did end its IT department last quarter. During
the quarter, the IT department earned service revenues of $13,000 and had associated expenses of
$7,000. As the quarter ended, the IT department sold all of its assets for $40,000. These assets’ updated
balance sheet values were as follows:

Inventory-replacement parts $3,500

Computer A 1,000
Accumulated Depreciation- Computer A (600)

Computer B 900
Accumulated Depreciation- Computer B (300)

Diagnostic and repair tools 45,000

Accumulated Depreciation- Diagnostic and repair tools (5,000)
 1) The income/loss from discontinued operations is:

2) The gain or loss from disposal of the equipment:

3) Net income/loss from the discontinued IT department:

Note that discontinued operations increased the company’s net income in this case. However, it can also
decrease net income. In either case, the future projections of the company should be based on the
income number net of discontinued operations. We can also take things further by including the impact
of taxes on the income of the discontinued department. Let’s assume the tax rate is 15%.

Horizontal analysis is also known as trend analysis. This is a technique for analyzing a company’s
numbers over time. This is done by calculating variances as dollar amounts or percentages.

Let’s look at the some of the UCW Bookstore’s 2024 and 2023 sales numbers:

Increase (decrease) during 2024

2024 2023 Amount Percentage

Sales Revenues $472,500 $460,000
Cost of Goods Sold 200,000 175,000
Gross Margin 272,500 285,000

Rent Expense 100,000 100,000

Salary Expense 300,000 275,000

Net Income $35,000 $20,000

We calculate the dollar amount by subtracting the 2023 items from the 2024 numbers. The percentage
change is calculated by:

2024 value – 2023 value

2023 value
Note the nominator is the same as the number in the amount column. Hence, to calculate percentage
change, we simply divide the dollar difference amount by the 2023 value.

Note that horizontal analysis for the items shown is tricky, since the bookstore has two major
departments- sales and service. When we compare key numbers from year-to-year, the big jump in net
income doesn’t really add up. For example, the gross margin is actually smaller in 2024 and there isn’t a
significant change in the major expenses (these include costs from the service side of the business).
Hence, we should suspect that the growth in income can be attributed to growth in the service
department. To confirm this, let’s do a similar comparison with service revenues:

Increase (decrease) during 2024

2024 2023 Amount Percentage

Service Revenues $253,500 $210,000

Net Income $35,000 $20,000

This confirms what we suspected. There was 20%-plus growth in service revenues (compared to about
3% in sales revenue), so the 75% jump in net income can be largely attributed to one department. Once
we derive some conclusions, we can consider improvements to the business going forward. Again, we
need to be careful since there are common costs between the departments (most items have
overlapping elements).

For instance, we might ponder questions such as:

 Why is the sales revenue growing at a low rate? Is it possible to boost the growth rate? If not,
what’s our strategy going forward?

 What are the factors behind the growth of the service department? Can we expect a similar
growth in coming years?

 How do we manage a growing service department? Are we keeping costs under control with
such rapid growth? If not, how do we achieve that?

To get better answers to the revenues questions, we should look at a longer stretch of time. Let’s look at
the past 5 years below:

2024 2023 2022 2021 2020

Sales Revenue $472,500 $460,000 $468,000 $473,250 $470,000
% change over base year

Service Revenue $253,500 $210,000 $188,750 $179,500 $175,000

% change over base year
For both sets of revenues, let’s set 2020 as the base year and calculate the percentage change on that
year. For example, 2024 Sales will be calculated as: ($472,500 - $470,000)/$470,000.

Now that we have a longer data set to look at, we can better identify trends with sales revenue and
service revenue. We conclude that sales revenue isn’t really growing at all (there are minor year-to-year
fluctuations), but there is a clear growth trend in the service revenue. Now, we can make business
decisions knowing that sales revenues are relatively constant from year to year and service revenues are
growing sharply.

Vertical analysis is also called common-size analysis. We complete this analysis by expressing items as a
percentage of a base amount. For example, we may use the net sales number as the base amount for
income statement items and the total assets number as the base amount for balance sheet items.

Let’s try this with part of the 2024 income statement. We will assume 40% of the bookstore’s total
operating expenses should be allocated to the service department, except for Cost of Goods Sold which
is 10%:

UCW Bookstore
Income Statement Item as a percent of
For the Year Ended Dec 31, 2024 Sales Revenue
Sales Revenue $472,500
Cost of Goods Sold 180,000
Gross Margin 292,500

Salary Expense 180,000

Rent Expense 60,000
Utilities expense 30,000
Amortization expense 9,600
Total Expenses 279,600

Net Income $12,900

Using Sales Revenue as the base number, let’s calculate the empty column.

After completing these calculations, we can see the real “weight” of everything on the income
statement. For example, the two biggest expenses, cost of goods sold and salary, are proportionally
equal in comparison with sales revenue. We can also see that net income is a relatively small portion of
sales. A major conclusion we might be able to draw from this analysis might be that higher prices with a
small dip in sales volume might boost profits (we may also be able to reduce expenses without hurting
sales revenue much).

Let’s now try the Dec 31, 2024 balance sheet (continued over 2 pages), using total assets as the base:

UCW Bookstore
Balance Sheet
December 31, 2024
Assets % of total assets
Current Assets:
Cash $200,000
Accounts receivable 5,000
Inventory 440,000
Total current assets 645,000

Fixed Assets:
Furniture 30,000
Accumulated Depreciation- Furniture (10,000)
Furniture, net 20,000
Equipment 50,000
Accumulated Depreciation- Equipment (20,000)
Equipment, net 30,000
Total Fixed Assets 50,000

Total Assets $695,000

Liabilities and Shareholders Equity % of total assets

Current Liabilities:
Accounts Payable 5,000
Long-Term Debt:
Bank Loan 232,000
Total Liabilities 237,000
 Shareholders' Equity
Common Shares 300,000
Retained Earnings 158,000
Total Shareholders' Equity 458,000

Total Liabilities and Shareholders' Equity $695,000

Now let’s try the 2023 balance sheet for comparative purposes:

UCW Bookstore
Balance Sheet
December 31, 2023
Assets % of total assets
Current Assets:
Cash $170,000
Accounts receivable 15,000
Inventory 430,000
Total current assets 615,000

Fixed Assets:
Furniture 30,000
Accumulated Depreciation- Furniture (8,000)
Furniture, net 22,000
Equipment 50,000
Accumulated Depreciation- Equipment (6,000)
Equipment, net 44,000
Total Fixed Assets 66,000

Total Assets $681,000

 Liabilities and Shareholders Equity % of total assets
Current Liabilities:
Accounts Payable 5,000
Long-Term Debt:
Bank Loan 246,000
Total Liabilities 251,000

Shareholders' Equity
Common Shares 300,000
Retained Earnings 130,000
Total Shareholders' Equity 430,000

Total Liabilities and Shareholders' Equity $681,000

Now, we can compare the percentages from year-to-year. There are not really any major fluctuations
from 2023 to 2024, but there are still some interesting items we can take a closer look at. For example,
the 2023 is Accounts Receivable balance is three times higher than 2024. Hence, we could look at why
things changed there (ex. more cash sales, better collection policy, more bad debts written off, etc).

On the liabilities side, we see that the bank loan has dropped (about 3%). This explanation is probably a
simple one- the bookstore has been generating extra cash and using it to pay down the bank loan.

Ratio Analysis
Price-to-Earnings ratio: This is a ratio used by value investors who may feel that a low P/E ratio
compared to a peer represents buying opportunity. However, a low P/E ratio may also tell an investor
that the market is not expecting the company to do well going forward (may not be able to keep the EPS
number up). The P/E ratio is calculated as:

P/E Ratio = Market Price Per Share

Earnings Per Share
Let’s calculate the P/E ratio for the UCW Bookstore, which is publicly traded with a current share price of
$20. The 2023 EPS for the bookstore was $3.50 per share.

Now let’s compare this to the 7.0x P/E ratio of the SFU Bookstore. Which bookstore would be
considered a better “bargain” by a value investor?

Now, let’s look at some turnover ratios. Typically, quicker inventory and receivables turnover is better,
since slowness can add to business costs. Recall that we calculate average by adding two year-end
balances together and dividing by two. The bookstore’s 2024 inventory turnover rate is:

Inventory Turnover = Cost of Goods Sold

Average Inventory

Days in inventory is an average of how long it takes to sell off products. Obviously, you want this to be
low, since storing inventory is costly. However, you also don’t want this to be too low because that is
putting you at risk of stock-outs, resulting in frustrated customers and lost business. These ratios vary
greatly between industries because of the nature of products. For example, a grocery store has much
higher inventory turnover and fewer days in inventory compared to a luxury car dealership. Let’s
calculate days in inventory for the bookstore:

Days in Inventory = 365 days

Inventory Turnover
The Accounts Receivable Turnover ratio measures how quickly accounts receivable balances are
converted to cash. Obviously, we want this ratio to be as high as possible. Let’s assume 10% of the
bookstore’s sales were on credit. The Accounts Receivable Turnover ratio is:

Accounts Receivable Turnover = Net Credit Sales

Average Net Accounts Receivable

Finally, we can express the same concept in days again:

Average Collection Period = 365 days

Accounts Receivable Turnover