basics of analysis copyright ©2007 thomson south-western, a part of the thomson corporation....

Basics of Analysis

COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 5

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 5, Slide #2

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

• Cash flow– Indicate liquidity, borrowing capacity, and profitability


Ratio Analysis

• A ratio alone means nothing• Must compare ratios to other ratios such as:

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


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


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


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

2005 2004 2003For the Years Ended December 31

Each financial statement element is presented as a percentage of a designated base.


Horizontal Analysis

2005 2004 2003 2005 2004 2003

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.


Year-to-Year Change Analysis

• 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.


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


Comparisons

• Common types– Trend analysis– SIC: Standard Industrial Classification– NAICS: North American Industry Classification

System– Industry averages; competitor comparisons


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


SIC

• Classifies business by industry

• Defines industries in accordance with the composition and structure of the economy

• Reported in SEC registrant filings


NAICS

• Joint creation of NAFTA partners: Canada, U.S., and Mexico

• Industry is defined by similar production processes


Comparisons: Industry

• Industry comparison complicated by highly diversified companies

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


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)


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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