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Chapter 5 Basics of Analysis

Chapter 5, Slide #1

Ratio Analysis
Liquidity (Ch.6)
Measures a firms ability to meet its current obligations

Leverage (borrowing capacity) (Ch.7)


Measures the degree of protector for long-term creditors

Profitability (Ch. 8)
Measures the earning ability of a firm

Investor-focused (Ch. 9)

Cash flow (Ch. 10)


Indicate liquidity, borrowing capacity, and profitability

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Ratio Analysis
Interpreted in comparison with
Prior ratios Competitor ratios Industry ratios Predetermined standards

Chapter 5, Slide #3

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

Chapter 5, Slide #4

Complexities and Context


Use of average data from balance sheet accounts
Necessary when comparing against income statement data Does not

Analysis must be performed and understood within the context of


Native accounting principles

Eliminate cyclical or seasonal variations Capture changes that occur unevenly throughout the year

Chapter 5, Slide #5

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

Chapter 5, Slide #6

Vertical Analysis
Melcher Company Income Statement For the Years Ended December 31 2007 2006 Sales revenue Cost of goods sold Gross profit Operating expenses: Selling expense General expense Total operating expense Operating Income before taxes Taxes related to operations Net Income $ $ 100,000 65,000 35,000 14,000 16,000 30,000 5,000 1,500 3,500 100.0% 65.0% 35.0% 14.0% 16.0% 30.0% 5.0% 1.5% 3.5% $ 95,000 60,800 34,200 11,400 15,200 26,600 7,600 2,280 $ 5,320 100.0% 64.0% 36.0% 12.0% 16.0% 28.0% 8.0% 2.4% 5.6% 2005 $91,000 56,420 34,580 10,000 13,650 23,650 10,930 3,279 $ 7,651 100.0% 62.0% 38.0% 11.0% 15.0% 26.0% 12.0% 3.6% 8.4%

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


Chapter 5, Slide #7

Horizontal Analysis
Melcher Company Income Statement For the Years Ended December 31 2007 2006 2005 Sales revenue Cost of goods sold Gross profit Operating expenses: Selling expense General expense Total operating expense Operating Income before taxes Taxes related to operations Net Income $ $ 100,000 65,000 35,000 14,000 16,000 30,000 5,000 1,500 3,500 $ 95,000 60,800 34,200 11,400 15,200 26,600 7,600 2,280 $ 5,320 $ 91,000 56,420 34,580 10,000 13,650 23,650 10,930 3,279 $ 7,651 2007 109.9% 115.2% 101.2% 140.0% 117.2% 126.8% 45.7% 45.7% 45.7% 2006 104.4% 107.8% 98.9% 114.0% 111.4% 112.5% 69.5% 69.5% 69.5% 2005 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Each financial statement element is presented as a percentage of a base amount from a selected year.
Chapter 5, Slide #8

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.

Chapter 5, Slide #9

Industry Variations
Financial components vary by type of industry Merchandising (retail-wholesale)
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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Descriptive Information
Narrative data
Annual report Trade periodicals Industry reviews

Further explains the financial position of a firm Management Discussion & Analysis

Chapter 5, Slide #11

Comparisons
Provides context for analysis of ratios and financial data Common types
Trend analysis SIC: Standard Industrial Classification NAICS: North American Industry Classification System Industry averages; competitor comparisons

Chapter 5, Slide #12

Comparisons: Trend Analysis


A study of the financial history of a firm Longitudinal ratio comparison
Falling Rising Relatively constant
2011 Cash Accounts Receivable, net Sales $ 6,950 18,567 2010 $ 6,330 19,330 Increase/(De crease) $ 620 (763) Percent Change 9.8% (3.9%)

Highlight
Effective management Evidence of problems

129,000

103,000 0

26,000 10,000

25.2% N/M

Rent Expense 10,000

Net Income (Loss)

8,130

(1,400)

9,530

N/M

Chapter 5, Slide #13

2011
Cash

2010
$ 6,330 19,330

Increase/(D ecrease)
$ 620 (763)

Percent Change
9.8% (3.9%)

$ 6,950

Accounts 18,567 Receivable, net

Sales
Rent Expense Net Income (Loss)

129,000
10,000 8,130

103,000
0 (1,400)

26,000
10,000 9,530

25.2%
N/M N/M

Chapter 5, Slide #14

Classifies business by industry Defines industries in accordance with the composition and structure of the economy Coding structure
Division Major group Industry group Industry

Standard Industrial Classification (SIC)

Reported in SEC registrant filings

Chapter 5, Slide #15

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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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)
Chapter 5, Slide #17

Relative Size of Firm


Comparison of disparate size firms
Capital market access Economy of scale (purchasing) Wider customer base

Information to use?
Absolute: amplifies comparison difficulty as firm size differences increase Common-size: eliminates some of the difficulty, but comparisons are still subject to issues above
Chapter 5, Slide #18

Reference
Gibson, C.H. (2009). Financial Reporting & Analysis: Using Financial Accounting Information. 11th ed. Norwalk, Connecticut: South-Western Cengage Learning.

Chapter 5, Slide #19

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