Analysis of Financial Statements

Lecture 5Basics of Analysis

1

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

• Investor-focused

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

Chapter 5, Slide #3

Ratio Analysis

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

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

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

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.

Chapter 5, Slide #7

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.

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

– 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

Chapter 5, Slide #10

Descriptive Information

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

• Further explains the financial position of a firm

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

• Highlight– Effective management– Evidence of problems

Chapter 5, Slide #13

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

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

Chapter 5, Slide #15

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 #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

Chapter 5, Slide #17

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