Problem 29 - Accounting

Question

The following income statement data (in thousands) for Dell Computer Corporation and Gateway Inc. were taken from their recent annual reports: \begin{tabular}{lrr} & Dell & Gateway \\ \hline Net sales & \(\$ 35,404,000\) & \(\$ 4,171,325\) \\ Cost of goods sold (expense) & \((29,055,000)\) & \((3,605,120)\) \\ Operating expenses & \((3,505,000)\) & \((1,077,447)\) \\ Operating income (loss) & \(\$ 2,844,000\) & \(\$(511,242)\) \\ \hline \hline \end{tabular} a. Prepare a vertical analysis of the income statement for Dell. b. Prepare a vertical analysis of the income statement for Gateway. c. Based upon (a) and (b), how does Dell compare to Gateway?

Step-by-Step Solution

Answer

Dell is more efficient and profitable with lower costs and positive income compared to Gateway's higher expenses and negative income.

Step 1: Understanding Vertical Analysis

Vertical analysis involves expressing each item in a financial statement as a percentage of a base amount from the same statement. For income statements, net sales typically serve as the base amount.

Step 2: Calculate Dell's Vertical Analysis

For Dell: - Net sales is the base and equals 100%.- Cost of goods sold as a percentage of net sales = \(\frac{29,055,000}{35,404,000} \times 100 \approx 82.06\%\).- Operating expenses as a percentage of net sales = \(\frac{3,505,000}{35,404,000} \times 100 \approx 9.90\%\).- Operating income as a percentage of net sales = \(\frac{2,844,000}{35,404,000} \times 100 \approx 8.03\%\).

Step 3: Calculate Gateway's Vertical Analysis

For Gateway: - Net sales is again the base and equals 100%.- Cost of goods sold as a percentage of net sales = \(\frac{3,605,120}{4,171,325} \times 100 \approx 86.40\%\).- Operating expenses as a percentage of net sales = \(\frac{1,077,447}{4,171,325} \times 100 \approx 25.82\%\).- Operating income (loss) as a percentage of net sales = \(\frac{-511,242}{4,171,325} \times 100 \approx -12.25\%\).

Step 4: Comparison Between Dell and Gateway

Comparing both companies: - Dell has a lower cost of goods sold percentage (82.06%) compared to Gateway (86.40%). - Dell's operating expenses (9.90%) are significantly lower than Gateway's (25.82%). - Dell achieves positive operating income (8.03%), while Gateway incurs a negative operating income (-12.25%). Thus, Dell shows better operational efficiency and profitability relative to Gateway.

Key Concepts

Income Statement Analysis

Income statement analysis serves as a valuable tool in assessing a company's financial health by reviewing its income statement. The income statement records a company's revenues and expenses during a specific period, helping us understand its profitability.
Analyzing an income statement typically involves looking at several key components:

• Net sales - the revenue generated from products or services sold.
• Cost of goods sold (COGS) - the direct costs attributable to goods produced and sold by the company.
• Operating expenses - costs related to the day-to-day operations of a business.
• Operating income - the profit a company makes after deducting operating expenses from gross profit.

By reviewing these elements, we can derive insights into how efficiently a company operates and its overall financial performance.
Tools like vertical analysis further simplify the examination process, facilitating comparisons over time or between different companies.

Financial Statement Interpretation

Interpreting a financial statement requires a keen understanding of the numbers and what they represent. Through techniques such as vertical analysis, we can express each item on a financial statement as a percentage of a single item, often net sales for an income statement.
For example, in Dell's case, vertical analysis shows:

• Cost of goods sold is 82.06% of net sales.
• Operating expenses are 9.90% of net sales.
• Operating income is 8.03% of net sales.

This percentage-based approach helps to:

• Identify trends or changes over time.
• Understand how each segment contributes to the company's overall profitability.
• Effectively compare companies, even when they differ drastically in size.

Such interpretations help stakeholders, like investors, understand where a company excels or where potential risks may lie.

Operating Income Comparison

Operating income comparison is crucial when evaluating different companies or measuring progress over time within the same company. Operating income, derived after deducting all operating expenses from gross profit, reflects a company's basic operational efficiency.
By comparing Dell and Gateway, we observe that Dell's operating income as a percentage of net sales (8.03%) is healthier than Gateway's (-12.25%).
This information tells us that:

• Dell efficiently manages its costs and generates a significant profit from its core operations.
• Gateway, conversely, struggles with its cost structure, resulting in operating losses.

Evaluating these percentages enables stakeholders, such as analysts and investors, to make informed decisions. They can gauge which company might provide better returns or require strategic adjustments to improve profitability.