Analysis of Financial Statements

Lecture 5
Basics of Analysis

1
 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 #2
 Ratio Analysis
• Interpreted in comparison with
– Prior ratios
– Competitor ratios
– Industry ratios
– Predetermined standards

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

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

Chapter 5, Slide #5
 Vertical Analysis
Melcher Company
Income Statement
For the Years Ended December 31
2005 2004 2003
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%

Each financial statement element is presented as a percentage of a

designated base.

Chapter 5, Slide #6
 Horizontal Analysis Melcher Company
Income Statement
For the Years Ended December 31
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%

Each financial statement element is presented as a percentage of a base amount

from a selected year.

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.

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

Chapter 5, Slide #9
 Descriptive Information
• Narrative data
– Annual report
– Trade periodicals
– Industry reviews
• Further explains the financial position of a
firm

Chapter 5, Slide #10

 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 #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

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

Chapter 5, Slide #13

 Comparisons: Industry
• Industry comparison complicated by highly
diversified companies
• Financial services
– Base their analysis on industry placement
– Provide composite industry data

Chapter 5, Slide #14

 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 #15

 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 #16

 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 #17