Study: Analyzing a Comparative, Multi-Step Income Statement
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Slides 1-2 (1m:15s)
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Welcome to Introduction to Accounting for a User's Perspective
Analyzing a Comparative, Multi-Step Income Statement
As you learned in prior topics, Common-Size, Multi-Step Income Statements have many benefits. For example, the Common-Size Income Statement
Links to an external site. enables the user to perform a "vertical analysis" of all items on the Income Statement in relation to Sales Revenue. It is called a vertical analysis
Links to an external site. because numbers in the same vertical column are compared to another number (i.e. Sales Revenue) in the same column to compute a ratio such as Gross Margin / Sales Revenue = Gross Margin ratio. The Gross Margin ratio
Links to an external site. (also known as the Gross Profit ratio) comes from the math involved in a vertical analysis.
Another method of analyzing a Company's Income Statement is a "horizontal analysis Links to an external site." using a Comparative Income Statement as provided by Candy Store Co. below. In a horizontal analysis, users compare the account balance in one accounting period to the same account's balance in a prior period to highlight positive and negative trends.
Once users receive a Comparative Income Statement like the one here, they will often import the numbers into a spreadsheet, such as Microsoft Excel, to compute additional values, such as the $ change and the % change in the accounts.
Slides 3-4 (0m:51s)
Links to an external site.These additional computations simplify the process of recognizing positive and negative trends as noted below:
In addition, users have found that preparing a graph of each year's values helps to visually represent the trends that are occurring. As you can see the Sales Revenue line is steeper (increased at 35% from 20X1) than the Cost of Goods Sold
Links to an external site. line (increased only 27%). This is a positive sign because it indicates that not only is its total Gross Margin increasing but its Gross Margin ratio is increasing as well (from 70% ($70 COGS / $100 Sales Revenue) in 20X1 up to almost 72% ($97 COGS / $135 Sales Revenue) in 20X2).
Slides 5-6 (1m:40s)
Links to an external site.For this topic, we will analyze a simple Comparative, Multi-Step Income Statement for a three-year period. The company, Super Big Tech Company (SBTC) is fictitious but you can imagine that it competes in the same industry as Microsoft.
Please stop and take a moment to perform a horizontal scan of each of SBTC's accounts on its Comparative Income Statement to see what positive, negative and unusual patterns you can recognize.
Congratulations!!! You just performed a simple horizontal analysis of SBTC's Comparative Income Statement. Good job. What did you learn from it?
Maybe you learned that from 20X1 to 20X2, SBTC's Revenues and Gross Profits grew BUT its Operating Income declined. This is unusual. Then, from 20X2 to 20X3, its Revenues and Gross Profits grew again, BUT this time its Operating Income also grew.
What caused the Operating Income Links to an external site. decline in 20X2 and the increase in 20X3?
If you said that the major cause of the decline was a $1,923 M Goodwill Impairment in 20X2, you would be right. Had such Goodwill Impairment not been recognized in 20X2, its Operating Income would have actually increased (i.e. from $8,435 M in 20X1 up to a revised $8,682 M in 20X2) rather than decreased.
You probably also noticed that SBTC recognized no Goodwill Impairments Links to an external site. in 20X1 or in 20X3. Why did it only record a goodwill impairment in 20X2?
Slide 7 (0m:57s)
Links to an external site.What is Goodwill and when does Goodwill Impairment need to be recorded? Although we don't have time to fully answer these questions now, you should already know that Goodwill
Links to an external site.is an intangible asset
Links to an external site.. Goodwill represents the fact that SBTC paid (let's assume $17 B) to purchase another company, let's call it Acquired Tech Co (ATC), that had $10 B in net identifiable assets thus overpaying for the net identifiable assets by $7 B. This $7 B overpayment resulted in Goodwill. When SBTC later realized that its Goodwill had declined in value, it had to record a Goodwill Impairment in the amount of $1,923 M.
At any rate, I hope you see that by using SBTC's Comparative Income Statement you were able to quickly home in on the Goodwill Impairment which was one of the major causes of SBTC's declining Operating Income for 20X2.
Slides 8-9 (0m:42s)
Links to an external site.Let's not stop there. Let's continue to improve the usefulness of SBTC's Comparative Income Statement by presenting the dollar changes in each revenue and expense account from one year to the next. We can compute the dollar change of each account as follows:
Current period balance - Prior period balance = Change in balance
For example, SBTC's Revenues increased from 20X2 to 20X3 by $1,281 M as follows:
| 20X3 | 20X2 | Change | |
| Revenue | $24,177 | $22,895 | $1,281 |
Depending on your preference, you might present the same information as follows.
| 20X3 | Change | 20X2 | |
| Revenue | $24,177 | $1,281 | $22,895 |
Both formats are allowed, just make sure you use the format that your users want to see.
Slide 10 (2m:01s)
Links to an external site.I have included SBTC's Comparative Income Statement below and have included the computed dollar changes for each account. By visually providing the dollar changes in each account, users can more readily identify significant, and possibly unexpected, increases and decreases and related trends in various accounts.
Please stop and take a moment to perform a horizontal scan of the dollar changes noted in SBTC's Comparative Income Statement below to see what patterns you can recognize in its revenues and expenses over this three-year period.
Did you notice that SBTC's 20X3 Sales and Marketing increased by $441 M from 20X2 to 20X3, but they decreased by $26 M from 20X1 to 20X2? This change is almost 1/2 billion dollars. Hopefully, SBTC's additional Sales and Marketing helped increase its Revenues by at least 1/2 billion or more. Let's see how the increase in Revenue compares to the increase in Sales and Marketing below:
Change in Revenue $1,281 M / Change in Sales and Marketing $441 M = $2.90 of additional Revenue per each additional $ of Sales and Marketing
At a very basic level, it appears that for each additional dollar spent in 20X3 on Sales and Marketing, SBTC was able to earn an additional $2.90 of Revenue. To analyze this further, we would need to use some managerial accounting skills and regression analysis to help determine how much of SBTC's Sales and Marketing Expenses are fixed expenses (i.e. remain the same in total over the relevant range but decline on a per unit basis as more units are sold) and variable expenses (remain the same on a per unit base, such as a commission, but increase in total as more units are sold). For now though, we at least have a general feeling for the effectiveness of the additional Sales and Marketing expenditures during 20X3.
Slide 11 (0m:31s)
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Let's take our horizontal analysis another step forward and compute the % change in the dollar amounts from one year to the next using the following formula:
(Change from the prior period) / Prior period balance
Using the math above, I computed the % changes for Revenues and Sales and Marketing Expenses below:
(20X3 Revenue $24,177 M - 20X2 Revenue $22,895) / 20X2 Revenue $22,895 = .056 or 5.6%
(20X3 Sales and Marketing $4,744 M - 20X2 Sales and Marketing $4,303) / 20X2 Sales and Marketing $4,303 = .1025 or 10.25%
As you can see, Sales and Marketing increased by 10.25%, but Revenues only increased by 5.6%.
Slide 12 (0m:37s)
Links to an external site.Clearly a 1% increase in Sales and Marketing Expenses did not automatically result in a 1% increase in Revenues. This may be due to the fact that SBTC operates in a highly-competitive, saturated industry (i.e. computer software and hardware) in which it is becoming more and more expensive to convince the few remaining, undecided customers to choose its products and services rather than going with those of a competitor. It could also be due to a less effective Sales and Marketing strategy. To determine the cause, a user would need to dig deeper into SBTC's annual report as well as other company and industry information.
Slide 13 (0m:28s)
Links to an external site.Below is SBTC's full Comparative Income Statement including the % changes for each account from one year to the next.
Please stop and take a moment to perform a horizontal scan of the % changes noted in SBTC's Comparative Income Statement to see what patterns you can recognize in its revenues and expenses over this three-year period.
As described above, although its Revenue increased by 5.6% to 20X3, its Cost of Revenue increased by 15.5% during the same year. This is not a good trend because it will squeeze SBTC's Gross Profit ratio and its total Gross Profits Links to an external site.. This is something to watch out for because if a company's Cost of Revenue grows at a faster rate than its growth in Revenue, the rate at which Gross Profits increase will decline.
Slides 14-16 (1m:24s)
Links to an external site.If you were to graph SBTC's Revenue and Cost of Revenue for the three-year period ending 20X3, you would notice that its Cost of Revenue line is steeper, meaning its Cost of Revenue is rising more quickly each year, than its Revenue. In addition, you should notice that If this trend were to continue from 20X3 onward for the next 20 years, Gross Profit would become negative after only 15 years.
Having said that, SBTC's Gross Profits in 20X2 and 20X3 are very healthy as noted below.
20X3 Gross Profit ratio 74% (i.e. $17,888 Gross Profit / $24,177 Revenue)
20X2 Gross Profit ratio 76% (i.e. $17,451 Gross Profit / $22,895 Revenue)
At any rate, an analyst would want to understand the causes of the decline in SBTC's Gross Profit ratio. Why did it drop from 76% in 20X2 down to 74% in 20X3. Possibly it is experiencing increased competition, increased manufacturing costs, a maturing market, a saturated market, a poor economy, as well as other things.
In summary, a Comparative Income Statement provides account balance information for multiple years which users then analyze to determine the dollar and percentage changes in the accounts to recognize positive and negative trends as compared to itself and its competitors. Graphing of changes is a very effective visual tool to help users quickly recognize trends.
Good luck on the quiz.