Chapter 5

Basics of Analysis

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duplicated, or posted to a publicly accessible website, in whole or in part.
 Ratio Analysis

• Liquidity
– Measures a firm’s ability to meet its current obligations

• Leverage (borrowing capacity)

– Measures the degree of protector for long-term creditors

• Profitability
– Measures the earning ability of a firm

• Investor-focused
• Cash flow
– Indicate liquidity,
borrowing
capacity, and
profitability
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Chapter 5, Slide #2
 Ratio Analysis

• Interpreted in comparison with

– Prior ratios
– Competitor ratios
– Industry ratios
– Predetermined standards

• Trend and variability of a ratio are important

considerations.

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #3
 Complexities and Context

• Use of average data from balance sheet

accounts
– Necessary when comparing against income
statement data
– Does not
• Eliminate cyclical or seasonal variations
• Capture changes that occur unevenly
throughout the year
• Analysis must be performed and understood
within the context of
– Native accounting principles
– Native business practices and culture
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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #4
 Common-Size Analysis

• The use of percentages is usually preferable to

the use of absolute amounts
• Vertical analysis
– All amounts of a year expressed as a percentage of
a base amount (e.g., net sales revenue, total
assets)
• Horizontal analysis
– Amounts for comparative years are expressed as a
percentage of the base year amount

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #5
 Vertical Analysis
Melcher Company
Income
Statement
For the Years Ended December 31 2007
Sales revenue $ 100.0% 2009 $ 100.0% $91,000 100.0%
100,000 95,000
Cost of goods sold 65,000 2008
65.0% 60,800 64.0% 56,420 62.0%
Gross profit 35,000 35.0% 34,200 36.0% 34,580 38.0%
Operating expenses:
Selling expense 14,000 14.0% 11,400 12.0% 10,000 11.0%
General expense 16,000 16.0% 15,200 16.0% 13,650 15.0%
Total operating expense 30,000 30.0% 26,600 28.0% 23,650 26.0%
Operating Income before taxes 5,000 5.0% 7,600 8.0% 10,930 12.0%
Taxes related to operations 1,500 1.5% 2,280 2.4% 3,279 3.6%
Net Income $ 3,500 3.5% $ 5,320 5.6% $ 7,651 8.4%

Each financial statement element is presented as

a percentage of a designated base which is
sales revenue on the Income Statement.
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duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 5, Slide #6
 Horizontal Analysis
Melcher Company
Income
Statement
2009 2008
For the Years Ended 2007 2009 2008 2007
Sales revenue $December 31
$ 95,000 $ 109.9% 104.4% 100.0%
100,000 91,000
Cost of goods sold 65,000 60,800 56,420 115.2% 107.8% 100.0%
Gross profit 35,000 34,200 34,580 101.2% 98.9% 100.0%
Operating expenses:
Selling expense 14,000 11,400 10,000 140.0% 114.0% 100.0%
General expense 16,000 15,200 13,650 117.2% 111.4% 100.0%
Total operating expense 30,000 26,600 23,650 126.8% 112.5% 100.0%
Operating Income before taxes 5,000 7,600 10,930 45.7% 69.5% 100.0%
Taxes related to operations 1,500 2,280 3,279 45.7% 69.5% 100.0%
Net Income $ 3,500 $ 5,320 $ 7,651 45.7% 69.5% 100.0%

Each financial statement element is presented as a

percentage of a base amount from a selected
year.
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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #7
 Year-to-Year Change Analysis

• Use both absolute and percentages

• Guidelines:
– When an item has value in the base year and none
in the next period, the decrease is 100%
– A meaningful percent change cannot be computed
when one number is positive and the other number
is negative
– A percent change is incomputable when there is no
figure for the base year.

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #8
 Industry Variations

• Financial components vary by type of industry

• Merchandising
– Inventory is a principal asset
– Sales may be primarily for cash or on credit
• Service
– Inventory is low or nonexistent
• Manufacturing
– Large inventory holdings
– Substantial investment in plant assets

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #9
 Descriptive Information

• Narrative data
– Annual report
– Trade periodicals
– Industry reviews

• Further explains the financial position of a firm

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #10
 Comparisons

• Provides context for analysis of ratios and financial

data

• Common types
– Trend analysis
– SIC: Standard Industrial Classification. The U.S.
Department of Labor provides website for searching for key
words ([Link]
– NAICS: North American Industry Classification System
– Industry averages; competitor comparisons

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #11
 Comparisons: Trend Analysis

• A study of the financial history of a firm

• Longitudinal ratio comparison
– Falling
– Rising
– Relatively constant
• Highlight
– Effective management
– Evidence of problems

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #12
 Comparisons: SIC

• Classifies business by industry

• Defines industries in accordance with the
composition and structure of the economy
• Coding structure
– Division
– Major group
– Industry group
– Industry
• Reported in SEC registrant filings
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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #13
 Comparisons: NAICS

• Joint creation of NAFTA partners: Canada,

U.S., and Mexico
• Industry is defined by similar production
processes
• Coding structure
– Sector, sub-sector, industry group, NAICS industry
and national industry

– U.S. Census Bureau provides website:

[Link] and under “business and
industry click on NAICS.
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Chapter 5, Slide #14
 Comparisons: Industry

• Industry comparison complicated by highly

diversified companies
• Financial services
– Base their analysis on industry placement
– Provide composite industry data

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #15
 Comparisons: Caution

Ratios are subject to variance from:

• Inconsistent formula construction
• Optional (elective) accounting treatment
• Different fiscal year-ends
• Varying financial policies
• Inconsistent basis (before or after tax)

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #16
 Relative Size of Firm

• Comparison of disparate size firms

– Capital market access
– Economy of scale (purchasing)
– Wider customer base
• Information
– Absolute: amplifies comparison difficulty
– Common-size: eliminates some of the difficulty
• Percent of market helps to define relative size

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Chapter 5, Slide #17
 Other Resources:
Ward’s Business Directory

• Domestic private and public companies

• Up to 20 items of information are provided for

each company listed

• Ward’s Business Directory went digital in 2007

under Gale Directory Library.

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #18
 Other Resources:
Standard & Poor’s Stock Reports

• Companies listed on various stock exchanges

• Alphabetical by exchange
– NYSE
– American Stock Exchange
– NASDAQ stock market
– Regional exchanges

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #19
 Other Resources:
Standard & Poor’s Register Of Corporations, Directors, And
Executives

• 2-volumes
– V1
Alphabetical by firm name
Industries in 7 subsections
– V2§2

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #20
 Other Resources:
Standard & Poor’s Analyst’s Handbook

• Selected income statement and balance sheet

items

• Related ratios

• Applicable to Standard & Poor’s industry group

stock price indexes

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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #21
 The Users of Financial Statements

• Management
– Analyze information from the perspective of both
investors and creditors
• Investors
– Analysis of past and present information to project
the future prospects of the entity
• Creditors
– Short-term: focus is on current resources
– Long-term: consider the future prospects of the
firm
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duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5, Slide #22