basics of analysis chapter 5 © 2011 cengage learning. all rights reserved. may not be scanned,...

Basics of Analysis

Chapter 5

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 5, Slide #2

• 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

Ratio Analysis


Chapter 5, Slide #3

Ratio Analysis

• Interpreted in comparison with– Prior ratios– Competitor ratios– Industry ratios– Predetermined standards

• Trend and variability of a ratio are important considerations.


Chapter 5, Slide #4

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


Chapter 5, Slide #5

• 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

Common-Size Analysis


Chapter 5, Slide #6

Vertical Analysis

Sales revenue 100,000$ 100.0% 95,000$ 100.0% 91,000$ 100.0%Cost of goods sold 65,000 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%

Melcher CompanyIncome Statement

2009 2008 2007For the Years Ended December 31

Each financial statement element is presented as a percentage of a designated base which is sales revenue on the Income Statement.


Chapter 5, Slide #7

Horizontal Analysis

2009 2008 2007 2009 2008 2007

Sales revenue 100,000$ 95,000$ 91,000$ 109.9% 104.4% 100.0%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%

Melcher CompanyIncome Statement

For the Years Ended December 31

Each financial statement element is presented as a percentage of a base amount from a selected year.


Chapter 5, Slide #8

• 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.

Year-to-Year Change Analysis


Chapter 5, Slide #9

• 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

Industry Variations


Chapter 5, Slide #10

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

• Further explains the financial position of a firm

Descriptive Information



• 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 (http://www.osha.gov/pls/imis/sksearch.html)

– NAICS: North American Industry Classification System– Industry averages; competitor comparisons

Comparisons



• A study of the financial history of a firm• Longitudinal ratio comparison

– Falling– Rising– Relatively constant

• Highlight– Effective management– Evidence of problems

Comparisons: Trend Analysis



• 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

Comparisons: SIC



• 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: www.census.gov and under “business and industry click on NAICS.

Comparisons: NAICS



• Industry comparison complicated by highly diversified companies

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

Comparisons: Industry



Financial Services’ Publications

Publication Service Coverage Data ClassificationThe Department of Commerce Financial Report

Economic Surveys Division, Bureau of the Census

Manufacturing, mining, and trade corporations

Income statement and balance sheet data and ratios

NAICS

Annual Statement Studies

Risk Management Association

Manufacturing, wholesaling, retailing, service, agriculture, and construction

Common-size financial statements and ratios

NAICS and SIC

Standard & Poor’s Industry Surveys

Standard & Poor’s

50 North American and global industries

Industry write-ups and statistics

NAICS

Almanac of Business and Industrial Financial Ratios

CCH, Inc. 192 industries Corporate tax return data

NAICS



Financial Services’ Publications (cont’d)

Publication Service Coverage Data ClassificationIndustry Norms and Key Business Ratios

Dun & Bradstreet 800 business lines; 5 segments

Condensed financial statements; ratios

SIC

[various] Value Line Investment Service

98 industries Longitudinal financial information



Comparisons: Caution

Ratios are subject to variance from:• Differing data• Inconsistent formula construction• Optional (elective) accounting treatment• Different fiscal year-ends• Varying financial policies• Inconsistent basis (before or after tax)



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



• 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.

Other Resources: Ward’s Business Directory



• Companies listed on various stock exchanges

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

Other Resources: Standard & Poor’s Stock Reports



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

Other Resources: Standard & Poor’s Register Of Corporations, Directors, And Executives



• Selected income statement and balance sheet items

• Related ratios

• Applicable to Standard & Poor’s industry group stock price indexes

Other Resources: Standard & Poor’s Analyst’s Handbook



• U.S. corporations– Background information– Detailed financial statistics

Standard & Poor’s Standard Corporation Descriptions



• Covers 5,300 common and preferred stocks. It contains:– Trading activity– Price range– Dividends

Other Resources: AQ1 Standard & Poor’s Security Owner’s Guide



• Industry statistics– Agriculture– Metals– Building– Transportation– etc.

Other Resources: Standard & Poor’s Statistical Service



• Available in may academic libraries

• Other publication available with Net Advantage– Standard & Poor’s stock reports– Standard & Poor’s Register of Corporations,

Directors and Executives– Stand and Poor’s Standard Corporation

Descriptions

AQ2 Standard & Poor’s Net Advantage



Mergent Dividend Record Standard & Poor’s Annual Dividend Record

• Provide a dividend record of payments on virtually all publicly owned American and some foreign companies.



• Companies must meet at least one of two inclusion requirements: - $9 million or more in sales volume - 180 or more employees if company is in single location, 900 or more if employees if company is a branch.

• Company listings– Alphabetical– Geographically– SIC

Other Resources: D&B® Million Dollar Directory®



• Corporate information– Divisions– Subsidiaries– Affiliates

• Indexes– Alphabetical– Geographical– SIC

Other Resources: Directory Of Corporate Affiliates



• Comprehensive reference– Products– Services– Company profiles– Catalog file

Other Resources: Thomas Register Of American Manufacturers



• Covers 2000 industrial corporations• New York and American Stock Exchanges

– History– Business– Properties– Subsidiaries– Financial statements– SIC codes

Other Resources: Mergent Industrial Manual and News Reports



• Principle corporate officers– Year of birth– Education– Military service– Present business position– Previous positions

Other Resources: D&B Reference Book of Corporate Managements



Other Resources: Compact Disclosure

• Database of textual and financial information• Annual and periodic reports filed with the SEC• Contents

– Major financial statements– Financial ratios– Institutional holdings– Insider ownership– President’s letter– Financial notes



• Accounting, legal, newspaper, and periodical information

• Financial statements from annual reports

Other Resources: Lexis-Nexis



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


basics of analysis chapter 5 © 2011 cengage learning. all rights reserved. may not be scanned,...

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