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Hey, everyone. And welcome to today's video. Case study: financial analysis. So what is today's video about? Well, we're going to learn about a subject company called Legacy Clothing. And then we're going to look at financial analysis, and how our company uses and needs financial analysis. And then we're going to finish up with a case study of performing financial analysis for a subject company. But let's learn a little bit about that company.
So our case study company. What type of company is it? Well, it's a sole proprietorship. It's a type of company that is owned by a single individual, and where the individual and the business are legally treated as the same. What's the purpose of our business? Well, they own and operate clothing stores. So men's, women's, children's clothing, as well as other related merchandise items. Where's the business located? In Washington, DC, and they have a staff of 50 people.
So now our case study company. Does our company need to perform financial analysis? Do we need to do that? Well, of course we do. Well, why do we need to do that? Well, we need to perform vertical analysis because it helps us understand the relationship between individual accounts and overall revenue-- In the case of the income statement-- or total assets-- in the case of the balance sheet. We also need horizontal analysis because it helps us understand trends in individual accounts. So how our individual accounts changing over time? And then we also need ratio analysis to help us understand our business operating performance in the case of profitability, or our business position and ability to pay debts in the case of liquidity ratios . So all three of these really help us understand what's going on with our business and how it's changing and how it's performing.
So what we're going to do is an analysis or comparison of changes within the company. We can compare it to other companies and we can also compare ourselves against industry standards. So it helps us understand the business and where we fit in to our competitors and to our industry. So, now, let's look at our case study company in performing financial analysis. We're going to go ahead and look at examples of performing vertical analysis, horizontal analysis, and ratio analysis.
OK. So the first piece of analysis we're going to perform is vertical analysis. And we're going to start with a Legacy Clothing's income statement. So what we have here is income statement information from both 2012, which is this year, as well as 2011, which is last year. And what we're going to look at is the relationship of these individual financial statement line items to our base amount. And in the case of the income statement, the base amount is net sales. So we have our dollar figures here on our income statement. So what we're going to do is convert those to a percentage of our base amount. So we're going to do that for 2012 as well. So then we can understand how these individual financial statement line items relate to our base amount. So how they relate to our net sales. So, in this case, you'll see that salary expense is 16% of our net sales, and then you can also look at how this changes over time. So this changing composition. So we see in the following year, those salaries expense now represent 17% percent of our net sales. And we'll see here that in 2011, our sales represented 108%, and it looks like it's going down in 2012 to 107%. Now we can perform our vertical analysis for our subject company's balance sheet.
So we can go through the same type of exercise we went through on the income statement. We're going to be expressing these individual accounts, these individual financial statement line items, as a percentage of a base amount, which in the case of the balance sheet is going to be our total assets. So we express each line item as a percentage of that base amount. So you'll see total assets is 100%. So we can understand the composition of these line items, as well as any changes over time. So what you'll see here, you'll see in 2011 our merchandise inventory represented 21% of our total assets, whereas in 2012, it represents a little more than 25%. And then the other thing you can look at, down here, are notes payable. So you'll see that in 2011 it represented 35% of our total assets, and then in 2012 it represented 30%. So our notes payable is going down, which makes sense.
OK. So now we're going to turn our attention to our horizontal analysis. Again, we're going to start with the income statement for our subject company, but we're going to be performing horizontal analysis. So that's going to help us understand trends in these individual financial statement line items and how they're changing over time. So if we first express these changes from one year to the next. So the change from 2011 to 2012, in this example. We need to put a dollar value on that. So we need to see how much each of these individual financial statement line items is changing. Now, once we have that information, then we can convert that to a percentage increase so that we can understand how these individual lines are changing. So in this case, we can see that our sales are going up 10%. It looks like our sales discounts actually went down 20%, so we're issuing less discounts. And then we can see that our salaries have gone up from 2011 to 2012 16%. Let's stick with our horizontal analysis, but now let's take a look at the balance sheets. So now we're going to be performing horizontal analysis for our subject company balance sheet
OK. Again, so what we're looking at are the individual financial statement line items on the balance sheet and how they're changing from one year to the next. So the first thing we do is express that change in dollars. So what is the dollar increase all of these individual financial statement line items? And then we change that to a percentage. So what is the percentage change of these individual financial statement line items? So what we can see here is our cash position went up 60%, merchandise inventory increased 25%. And if you look down here at our notes payable-- our notes payable is going down. So it went down 7%. So that would tell us we're paying our notes payable down.
So the last piece of analysis that we're going to be performing today for our subject company is ratio analysis. We're going to start with our profitability ratios. So profitability ratios help us measure the operating performance of the company. So we have these three ratios: rate of return on sales, return on total assets, as well as asset turnover. So if we look at rate of return on sales-- net income divided by net sales. If we take our figures for our subject company-- so our net income and our net sales-- we would see that our rate of return on sales 29.7%. And if we turn our attention now to return on total assets, which measures the effective use of our assets-- so how effectively we're using our assets. Its income before interest expense and taxes divided by total assets. So if we take that information, we would see that our return on total assets for our subject company is 31.6%.
And, finally, asset turnover. That measures the use of assets to make sales so it's net sales divided by total assets. So for our subject company, the asset turnover is 1.0 times. The last piece of our ratio analysis is to look at our liquidity ratios for our subject company. Now our liquidity ratios help measure the ability of the company to pay our debts when they're due. So we're going to look at both the current ratio as well as inventory turnover. So the current ratio shows how much in current assets we have to pay off our current liabilities. So our short term debt obligations. So if we plug-in the information from our subject company's current assets divided by current liabilities, we'll see that current ratio is 3.74. Now if we go to our inventory turnover, which tells us the number of times inventory is sold and replaced during the period, it's cost of goods sold divided by average inventory. So plug-in the information for our subject company and we'll see their inventory turnover is 2.1 times.
Great. So now that we've seen how to perform financial analysis for our subject company, let's summarize what we talked about today. In a nutshell, what was today about? Well, we discussed case study company Legacy Clothing. We looked at performing financial analysis for this case study company. We looked at vertical analysis, horizontal analysis, as well as ratio analysis. I hope everybody enjoyed this video, and I hope to see you next time.
(00:00-00:35) Introduction and Overview
(00:36-02:12) Case Study Company and Financial Analysis
(02:13-04:35) Vertical Analysis
(04:36-06:23) Horizontal Analysis
(06:24-08:30) Ratio Analysis
(08:31-08:51) Wrap-up and Conclusion