Chapter 5

Basics of Analysis

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 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

Chapter 5, Slide #2
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 Ratio Analysis

• A ratio alone means nothing

• Must compare ratios to other ratios such as:
– Prior ratios
– Competitor ratios
– Industry ratios
– Predetermined standards

Chapter 5, Slide #3
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 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

Chapter 5, Slide #4
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 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
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 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
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 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
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 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.

Chapter 5, Slide #8
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 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
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 Comparisons

• Common types
– Trend analysis
– SIC: Standard Industrial Classification
– NAICS: North American Industry Classification
System
– Industry averages; competitor comparisons

Chapter 5, Slide #10

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 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 #11

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 SIC

• Classifies business by industry

• Defines industries in accordance with the
composition and structure of the economy
• Reported in SEC registrant filings

Chapter 5, Slide #12

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 NAICS

• Joint creation of NAFTA partners: Canada,

U.S., and Mexico
• Industry is defined by similar production
processes

Chapter 5, Slide #13

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 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

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 Financial Services’ Publications
Publication Service Coverage Data Classification
The Department Economic Manufacturing, Income NAICS
of Commerce Surveys Division, mining, and trade statement and
Financial Report Bureau of the corporations balance sheet
Census data and
ratios
Annual Statement Risk Manufacturing, Common-size NAICS and SIC
Studies Management wholesaling, financial
Association retailing, service, statements
agriculture, and and ratios
construction
Standard & Standard & 50 North Industry write- NAICS
Poor’s Industry Poor’s American and ups and
Surveys global industries statistics
Almanac of CCH, Inc. 192 industries Corporate tax NAICS
Business and return data
Industrial
Financial Ratios
Chapter 5, Slide #15
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Financial Services’ Publications (cont’d)

Publication Service Coverage Data Classification

Industry Norms Dun & Bradstreet 800 business Condensed SIC
and Key Business lines; 5 segments financial
Ratios statements;
ratios
[various] Value Line 98 industries Longitudinal
Investment financial
Service information

Chapter 5, Slide #16

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 Comparisons: Caution

Ratios are subject to variance from:

• Inconsistent formula construction
• Optional (elective) accounting treatment
• Different fiscal year-ends
• Varying financial policies
• Inconsistent basis (before or after tax)

Chapter 5, Slide #17

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 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 #18

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