Bennet Tchaikovsky: Hello and welcome to managerial accounting financial statement analysis. Overview Bennet Tchaikovsky: My disclaimer and copyright notice the information and opinions in this presentation are those of the author only and not be authors employers. Bennet Tchaikovsky: Or affiliated organizations, including but not limited to Irvine Valley College and the South. Orange County Community College District Bennet Tchaikovsky: The presentation is for educational purposes only and does not constitute any legal or accounting advice whatsoever. Bennet Tchaikovsky: This presentation is copyright 2008 to 2020 by Bennet Tchaikovsky all rights reserved any distribution is strictly prohibited. Bennet Tchaikovsky: Presentations from time to time we use information from third parties. The third party information third party information as a property of those respective copyright holders and the author does not make any claim to the third party information. Bennet Tchaikovsky: Okay, so when we're talking about financial statement analysis. One of the things that I like to kind of look at first is quantitative versus qualitative analysis. Bennet Tchaikovsky: So in financial accounting are our focus was on creating a financial statements.
So we've done that already. Bennet Tchaikovsky: Now what we want to do is we want to analyze those results so that we can see is like, okay, how can we make ourselves better for the future. Is there something that we can be learning from our past. Bennet Tchaikovsky: Is there a way we can go through and predict future results. So what I like to when I'm looking at analysis.
I like to look at it as qualitative versus quantitative because Bennet Tchaikovsky: The numbers aren't going to be telling us everything. There's also going to be some other factors in place. So quantitative is generally focusing exclusively on the numbers. Bennet Tchaikovsky: Qualitative is looking at more external factors. So here's a great example of qualitative versus quantitative Bennet Tchaikovsky: So a company has a decision to make in terms of how much to spend using the numbers exclusively what would you choose. Bennet Tchaikovsky: So I have two alternatives. I have alternative A which is 11 million units at $11 per unit Bennet Tchaikovsky: Or I have alternative B – Alternative B is made up of three different components you have 180 incidents at $200,000 per incident 180 minor incidents at $67,000 per minor incident and then you have placements at $700 per replacement Bennet Tchaikovsky: So if I was asked, just to go through and compute the cheaper alternative Bennet Tchaikovsky: Alternative A would cost me 121 million or this 11,000 units at $11 per unit. Alternative B if I multiply these through 180 incidents at 200,000 Bennet Tchaikovsky: 180 minor incidents and then the 2100 replacements is a total of $49.53 million so quantitatively.
Bennet Tchaikovsky: We would choose alternative B because that is actually better than alternative a because I'm spending less money. Bennet Tchaikovsky: So, and when I look at this, this is just on the numbers alone I'm wanting the numbers drive my decision. But now let's look at what I really pulled this example from so Bennet Tchaikovsky: For fun if you have a parent or a grandparent, ask them if they were living in the United States in the 1970s asked them about the Ford Pinto. And you should get a little fun story but Ford Motor Company was Bennet Tchaikovsky: They had a problem and their problem was when their car hit a certain speed that there was a problem with the car exploding.
So now we're going to be a YouTube video within a video. Just give me a moment here. Bennet Tchaikovsky: So this is a video that shows what happens when a Pinto is rear ended at around this is the Ford Pinto. So this is a car that's being rear ended at about Bennet Tchaikovsky: I think was like they said about 35 miles an hour and then there you see it. Okay, so what happened was is that Ford Motor Company knowingly sold a car that if it was hit at a certain mile per hour on impact. Then the car would explode.
Bennet Tchaikovsky: And so, Ford had dilemma. And they said to themselves and what exactly what exactly should Ford be doing. So let's go back and take a look at these numbers. So this is, this is the car. Bennet Tchaikovsky: So Ford said of themselves like okay, we can repair the 11 million vehicles that thats related to Bennet Tchaikovsky: A cost all up $11 per vehicle. We can spend 121 million or what we can say is we can say Burn Baby Burn, which is a famous disco song from the 1970s. Bennet Tchaikovsky: And you know what they said was, OK, we're going to look at highway statistics and how many people do we think, how many people would die as a result of owning this car. Bennet Tchaikovsky: And so what they did was they said, Okay, well, if we allow this product to go out into the marketplace. Bennet Tchaikovsky: we're predicting that 180 people will die.
And we'll have to pay them out $200,000 per person per death as back in the early 70s. So this is obviously different monies Bennet Tchaikovsky: 180 serious burn injuries, we would have to pay 67,000 per serious burn injury and then 2100 burnout vehicles have a cost us around $700 per vehicle. Bennet Tchaikovsky: So this is the way the Ford Motor Company thought they just thought, in terms of numbers and in this Pinto Memo. Bennet Tchaikovsky: It's cheaper to let them burn. And so this is the whole thing is that they chose to say Burn Baby Burn.
And so I'll share this link up here. It's a great little Bennet Tchaikovsky: Article or analysis up there. So when the Ford Motor Company, what their huge failing was in this particular instance is they they looked at the numbers exclusively Bennet Tchaikovsky: What the Ford Motor Company did not do was to take a step back from the situation and say, hmm. Bennet Tchaikovsky: Am I looking at this the right way and the real pain here is not the one thing that they did not factor into their quantitative analysis. Bennet Tchaikovsky: Especially as alternative to is what would happen as a result of the brand damage. So what was the brand damage to the Ford Motor Company. Bennet Tchaikovsky: As a result of offering the Pinto. And so this is really one of the huge takeaways, which was just.
We can't just look at the numbers themselves. Bennet Tchaikovsky: We have to look at the surrounding parts of it is that can we really put a dollar value on human life. Is that something that we should be going through and doing Bennet Tchaikovsky: So what I want to encourage you to be doing in this class is not only just to be coming up with Okay here is alternative one here is alternative two Bennet Tchaikovsky: But to take a step back from the situation and say to yourself, is there something that I'm kind of missing here. Is there something else that I'm not picking up here.
Bennet Tchaikovsky: So when we're looking at qualitative analysis what this is really kind of going through and and referring to is that going beyond these numbers. Bennet Tchaikovsky: What are the backgrounds. So if I'm dealing with a company who are the officers and directors or the investors who are involved with a company Bennet Tchaikovsky: What's the background of the other company investors and what is the industry that this company is operating in so just beyond the numbers because something looks really, really good. It doesn't mean that we want to be. Bennet Tchaikovsky: You know, going through and believing it or doing business with somebody, one of the major mistakes I made in my business career is I was referred by a colleague Bennet Tchaikovsky: To a firm and he said, out of these guys are great. They're going to do a great job for you. And had I spent $300 on a background check.
Prior to wiring the company's money. Bennet Tchaikovsky: What I've would have realized very quickly is that the person that I was dealing with was a complete scumbag. Bennet Tchaikovsky: And they were not a good person. They had bankruptcies. They were really terrible people so Bennet Tchaikovsky: What I want to encourage you to do is before you get into business with people is to really understand who you are, who you are dealing with. Bennet Tchaikovsky: Um, I've put up some links here before you use a stockbroker who going to look at FINRA and Bennet Tchaikovsky: I'll put these also in the bottom link of the video as well. But this is a way you can go see if I'm trusting somebody with my money, who is the person that I, who do I go through. Do I trust that person. Bennet Tchaikovsky: Over here is for attorneys in California. So anybody who's a licensee like over here. This is going to be for the California Board of Accountancy Bennet Tchaikovsky: How do I search up somebody's CPA license. So if you want to find out if somebody is a CPA or an attorney or find out what their background is, Bennet Tchaikovsky: These are great websites ago to renew.
So just don't. When you're in a business situation, the numbers are part of the answer. But that's not the full answer. You have to look beyond the numbers. Bennet Tchaikovsky: So when we're going now in terms of looking at quantitative analysis and is to say, all right, we have like these various be we have these numbers. How do we go through to analyze it and the thing I would be showing you over here. And I have a few separate videos on this, but Bennet Tchaikovsky: Right over here. Bennet Tchaikovsky: So one of the things we're going to be doing is in this chapter, we're going to be looking at ratios and I have separate videos that walk you through the various different ratios for liquidity and so I'm going to give you those links at the end of this presentation.
Bennet Tchaikovsky: But you go through and we'll be going through and doing, you know, ratio analysis. But before we do that, ratio analysis and Bennet Tchaikovsky: There are ratios for everything the ratios for accounts receivable how how liquid is it. There's her inventory, but before we do any type of ratio analysis. Bennet Tchaikovsky: What the first thing we want to go through and do is to create what we call common sized financial statements. Bennet Tchaikovsky: And what that means is we're going to be dividing all of our anything that's on the balance sheet by the total assets. Bennet Tchaikovsky: And then at the same time we're going to be taking anything that is on the income statement and be dividing this by total sales (revenues).
Bennet Tchaikovsky: Now the reason why we do this is because when I start when I'm going to analyze financial statements, where do I want to Bennet Tchaikovsky: Concentrate my time. I want to be concentrating my time on the areas that are the most relevant or significant to the company. Bennet Tchaikovsky: So for example, if I said to you. Well, would you want to use an accounts receivable turnover ratio or an inventory turnover ratio to analyze Home Depot. Bennet Tchaikovsky: I wouldn't want you just to say okay well I'm going to choose, you know, inventory or I'm just going to choose receivables Bennet Tchaikovsky: The answer is what I'm analyzing a company if I'm given a choice say Bennet, what is the best ratio to use for analyzing receivables or for inventories for Home Depot well Bennet Tchaikovsky: What I would say to myself as well.
What percent is merchandise inventory of my total assets and right here. This about 14.5 it's about 51 so the total inventory represents 29% Bennet Tchaikovsky: Approximately 29% of the total balance sheet for Home Depot. Now compare that to receivables, receivables as 2.1 billion. Bennet Tchaikovsky: And of the total $51 billion in assets. This is less than around. It's probably right around 4% Bennet Tchaikovsky: So what's really important to remember is that before we start going through and doing analysis and using ratios and everything else. Bennet Tchaikovsky: We need to get a sense of the company for what is, what are like their largest assets were, what is their operations. Bennet Tchaikovsky: Because what I will be giving you is I will be giving you a lot of different ratios. So over here, you'll see over here activity ratios inventory turnover.
Bennet Tchaikovsky: Accounts receivable turnover, you'll see a lot of different things. And I'll be providing these videos to you. So a our turnover an inventory turnover. Bennet Tchaikovsky: But before you go through and you just start saying, Okay, I'm going to use inventory turnover, you need to be asking yourself first is Bennet Tchaikovsky: Using inventory turnover to analyze the Home Depot. Would that give me something meaningful. The answer is probably yes because of how large Bennet Tchaikovsky: The inventory balances relative to the other items that are here. So this is why before we go through and do the comment before we go through and do a financial statement analysis. We don't want to be walking in blindly Bennet Tchaikovsky: We want to create common size financial statements so that we can understand how you know how significant are certain balances to this company. Bennet Tchaikovsky: The other why and what is common size we're just basically everything is going to be in a percentage and they'll see that on on later video.
Bennet Tchaikovsky: So, but we want to go through and do this just because we need to really understand is that when we're looking at the ratios. Am I selecting the proper ratios to really go through and analyze this company. Bennet Tchaikovsky: What a common size financial statement will also do is, and if I have over here. Bennet Tchaikovsky: Let's say I've got total assets of 51 billion. And we're going to say that merchandise inventories here for the Home Depot was about 14.5 billion. Bennet Tchaikovsky: Or roughly 29% if I use common size financial statements and I say, okay, well, Home Depot has 29% and I compare that to a Lowes, and let's take a look at Lowes, just for a moment.
Bennet Tchaikovsky: So these are the financial statements here of loves. And now let's take a look at their financial statements. So we can go over here to the financial statements and Bennet Tchaikovsky: So here they Lowes has total assets of about $39 billion and their merchandise inventory is about 13.1 billion. So if I took Bennet Tchaikovsky: 13.1 billion and I divided that by 39.4 billion, I will come up with about 33% so right over here by putting this as a percentage of total assets. Bennet Tchaikovsky: I can say that because Home Depot and Lowes are in a similar industry. Bennet Tchaikovsky: That you know they're they're on a common size basis in terms of a percentage of total assets their inventory amounts seem to be relatively in line. Bennet Tchaikovsky: That can also tell me other things, too, is that if I'm looking at similar industries, should they be having the same roughly the same amount of these various different balances, say for example for inventory Bennet Tchaikovsky: Now, I believe that the, the other part of the example that I gave you in that one is talking about a company like Facebook.
Let's take a look at Facebook, real quick. Bennet Tchaikovsky: If we notice here for Facebook. Facebook does not have inventory and they really wouldn't be a virtual inventory or they might have inventory in the form of Bennet Tchaikovsky: Our Instagram or Facebook accounts or WhatsApp, but here though for Facebook. They don't have inventory. So they're in because Facebook is not a retailer that it's not the kind of business that they're going through and operating Bennet Tchaikovsky: So again, when we're doing financial statement analysis. One of the other important parts is obviously we will be doing common size financial statements but Bennet Tchaikovsky: When you're comparing companies in order for the financial the ratios for the work we need to be comparing companies and similar industries. Bennet Tchaikovsky: So as I look it over here for Home Depot and then for. And then over here for Lowes, these are generally going to be comparable because they're in the same industry. Bennet Tchaikovsky: For a company like Facebook, who are they, closest to and you know that answer might be something like snap.
Bennet Tchaikovsky: Snap is significantly smaller than Facebook. But in any event, it's worth when you're looking what we're doing financial statement analysis, you really need to be comparing you know apples to apples is the same. Bennet Tchaikovsky: So, but, again, we're going to start with making common size financial statements and this is going to be before we're going through and looking at the ratios. Bennet Tchaikovsky: So another thing that will be seen and the homework questions is something called a horizontal or a trend analysis.
Bennet Tchaikovsky: And really what this is, is it gives us a way to look at companies key you know components, say something like that and column or sales. Bennet Tchaikovsky: And we're trying to determine what is the year over year growth. So, as we'll see, from your homework. What we're doing here is basically a horizontal or what we call a trend analysis. Bennet Tchaikovsky: Is we're taking the total amount of the net income work basically we create a base year okay so your base here is going to be the hundred percent level. Bennet Tchaikovsky: For that net income divided by that income right here. When I compare future years. I'm going to be doing that at the base here.
Bennet Tchaikovsky: So let's take a look, a year to year to this is here is 250,000. So in terms of a percentage. What percentage growth is this over a year one. Bennet Tchaikovsky: Well, the year one comparing this over here to the year one. It's basically it's grown by 25% or that 50,000 difference. So, but let's look at your three. Now, some of you might be saying, it's like, well, wait a second. Bennet Tchaikovsky: Year three was 230 that's the lesson here too, so should not be negative. And the answer is not necessarily Bennet Tchaikovsky: Because if we're doing a trend analysis and we're comparing your three tier one, it's actually going to be higher.
Bennet Tchaikovsky: Right, because if I'm, if I'm when I'm doing this horizontal or trend analysis. I'm doing this using against the base year right this is not a year over year. Bennet Tchaikovsky: Rather on going through and doing this at the base here. So I want to thank you for watching today. If you have any comments or questions, please send these to email@example.com. I will also be providing you links for the other videos on how to do financial statement analysis. Bennet Tchaikovsky: Also, how to go through and prepare common size financial statements, how to look up financial statement at www.sec.gov so that you can get a better context for this chapter, have a great one. And I'll see you on the next video..