Ch05 - Basics of Analysis

© 2013 Cengage Learning. All Rights Reserved.
May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use.
Chapter
5
Basics of Analysis
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Ratio Analysis
• Liquidity ratios
– Measures a firm’s ability to meet its current
obligations
• Borrowing capacity (leverage) ratios
– Measures the degree of protection for long-term
creditors
• Profitability ratios
– Measures the earning ability of a firm
• Cash flow ratios
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for classroom use.
Ratio Analysis—Continued
• Interpreted in comparison with
– Prior ratios
– Competitor’s ratios
– Industry ratios
– Predetermined standards
• Trend and variability of a ratio are important
considerations
Complexities and Context
• Use of average data from balance sheet
– Necessary when comparing with income statement
data
– Does not
• Eliminate seasonal or cyclical variations
• Reflect 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
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 of the same year (e.g., net sales
revenue, total assets)
• Horizontal analysis
– Amounts for comparative years are expressed as a
percentage of the base year amount
Exhibit 5-1: Melcher Company—Vertical
Common Size
For the years ended December 31,
(Absolute dollars) 2018 2017 2016
Revenue from sales $100,000 $95,000 $91,000
Cost of products sold 65,000 60,800 56,420
Gross profit 35,000 34,200 34,580
Operating expenses
Selling expenses 14,000 11.400 10,000
General expenses 16,000 15,200 13,650
Total operating expenses 30,000 26,600 23,650
Operating income before income taxes 5,000 7,600 10,930
Taxes related to operations 1,500 2,280 3,279
Net income $3,500 $5,320 $7,651
Vertical Common Size

Revenue from sales 100.0% 100.0% 100.0%
Cost of products sold 65.0 64.0 62.0
Gross profit 35.0 36.0 38.0
Operating expenses
Selling expenses 14.0 12.0 11.0
General expenses 16.0 16.0 15.0
Total operating expenses 30.0 28.0 26.0
Operating income before income taxes 5.0 8.0 12.0
Taxes related to operations 1.5 2.4 3.6
Net income 3.5% 5.6% 8.4%
Each financial statement element is presented as a percentage of a designated base

which is sales revenue on the income statement
Exhibit 5-1: Melcher Company—
Horizontal Common Size
For the years ended December 31,
(Absolute dollars) 2018 2017 2016
Revenue from sales $100,000 $95,000 $91,000
Cost of products sold 65,000 60,800 56,420
Gross profit 35,000 34,200 34,580
Operating expenses
Selling expenses 14,000 11.400 10,000
General expenses 16,000 15,200 13,650
Total operating expenses 30,000 26,600 23,650
Operating income before income taxes 5,000 7,600 10,930
Taxes related to operations 1,500 2,280 3,279
Net income $3,500 $5,320 $7,651
Horizontal Common Size

Revenue from sales 109.9% 104.4% 100.0%
Cost of products sold 115.2 107.8 100.0
Gross profit 101.2 98.9 100.0
Operating expenses
Selling expenses 140.0 114.0 100.0
General expenses 117.2 111.4 100.0
Total operating expenses 126.8 112.5 100.0
Operating income before income taxes 45.7 69.5 100.0
Taxes related to operations 45.7 69.5 100.0
Net income 45.7 69.5 100.0
Each financial statement element is presented as a percentage of a base amount
fromLearning.
© 2013 Cengage a selected year
All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
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
– No percent change is computable 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
– Cost of sales often represents the major expense
Descriptive Information
• Narrative data
– Annual report
– Trade periodicals
– Industry reviews
• Further explains the financial position of a firm
• Management Discussion and Analysis (MD&A)
provides an overview of the previous year and of
future goals and new projects
Comparisons
• Provides context for analysis of ratios and
financial data
• Common types
– Trend analysis
– Standard Industrial Classification (SIC) Manual
• The U.S. Department of Labor provides Web site that details
the SIC manual
– North American Industry Classification System
(NAICS)
– Industry Averages and Comparison with Competitors
Comparisons: Trend Analysis
• A study of the financial history of a firm
• It reveals whether the ratio is
– Falling
– Rising
– Relatively constant
• Highlight
– Effective management
– Evidence of problems
Comparisons: SIC
• Classifies business by industry
• Defines industries in accordance with the
composition and structure of the economy
• Coding structure
– Two-digit major group number
– Three-digit industry group number
– Four-digit industry number
Comparisons: NAICS
• Jointly created by the U.S., Canada, and Mexico
• Industry is defined by similar production
processes
• U.S. Census Bureau provides a Web site (
www.census.gov) that that details the NAICS
manual. Go on this site and under “business and
economy” click on NAICS
Comparisons: Industry Averages
• Industry comparison complicated by highly
diversified companies
• Financial services
– Base their analysis on industry placement
– Provide composite industry data
Financial Services’ Publications
Publication Publisher(s) Coverage Data Classification
The Department Economic Manufacturing, Income NAICS
of Commerce Surveys mining, and statement
Financial Report Division, Bureau trade and balance
of the Census corporations sheet data
and ratios
Annual Risk Manufacturing, Common- NAICS or SIC
Statement Management wholesaling, size financial
Studies Association retailing, statements
service, and 16
agriculture, and selected
construction ratios
Standard & Standard & North American Industry NAICS
Poor’s Industry Poor’s and global write-ups
Surveys industries and statistics
Financial Services’ Publications—
Continued
Publication Publisher(s) Coverage Data Classification
Almanac of CCH, Inc. 200 industries Corporate NAICS
Business and tax return
Industrial data
Financial Ratios
Industry Norms Dun & 800 business Condensed SIC

and Key Bradstreet lines financial
Business Ratios statements;
ratios
Value Line The Standard 1 to 97 Longitudinal

Investment Edition and the industries; financial
Survey Small & 1 to 84 information
Mid-Cap Edition industries
Comparisons: Caution in Using Industry
Averages
• 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)
Relative Size of Firm
• Comparison of disparate size firms
– Capital market access
– Economy of scale (purchasing)
– Wider customer base
• Information
– Absolute numbers amplifies comparison difficulty
– Common-size analysis help to eliminate some of the
difficulty
• Percent of market helps to define relative size
Ward’s Business Directory
• Covers domestic private and public companies
• Up to 20 items of information are provided for
each company listed
• Went digital in 2007 under Gale Directory Library
Standard & Poor’s Stock Reports
• Companies listed on various stock exchanges
– New York Stock Exchange
– American Stock Exchange
– NASDAQ stock market
– Regional exchanges
• Arranged Alphabetically by stock exchanges
– Contains brief analysis of companies regularly traded
Standard & Poor’s Register Of Corp.,
Directors, And Executives
• Contains 2-volumes
– Volume 1
• Alphabetical list of approximately 75,000 corporations
– Volume 2
• Alphabetical list of over 70,000 individuals serving as
officers, directors, trustees, partners, and so on
• Brief biographical data
– Volume 3
• Indices by SIC, geography, and subsidiaries and divisions
Standard & Poor’s Analyst’s Handbook
• Selected income statement and balance sheet

items
• Related ratios
• Applicable to Standard & Poor’s industry group
stock price indexes
• Brief monthly updates for selected industries
supplement the annual editions of the handbook
Standard & Poor’s Standard Corporation
Descriptions
• U.S. corporations
– Background information
– Detailed financial statistics
• The contents and the index are updated
throughout the year
Standard & Poor’s Security Owner’s
Stock Guide
• Covers 5,300 common and preferred stocks
• It contains trading activity, price range,
dividends, and so on, for companies traded on
– New York Stock Exchange
– American Stock Exchange
– Over the Counter
– Regional Exchanges
Standard & Poor’s Statistical Service
• Industry statistics on industries such as
– Agriculture
– Metals
– Building
– Transportation
• Additional statistics are included such as price
indexes and daily highs, lows, and closes for
stock
Standard & Poor’s Net Advantage
• Available at many academic, public, and
corporate libraries, and information centers
• Other publication available with Net Advantage
– Standard & Poor’s Stock Reports
– Standard & Poor’s Register of Corporations, Directors
and Executives
– Stand and Poor’s Standard Corporation Descriptions
Mergent and Standard & Poor’s Dividend
Record
• Provide a dividend record of payments on
virtually all publicly owned American and some
foreign companies
D&B Million Dollar Directory
® ®
• Companies must meet size requirements to be

included in the directory (measured in minimal
sales volume or number of employees)
• Company listings in Volumes
– Alphabetical
– Geographically
– SIC
Directory Of Corporate Affiliates™
• Gives an in-depth view of companies and their
divisions, subsidiaries, and affiliates
• Contains an alphabetical index, geographical
index, and SIC classifications
• The parent company listing consists of address,
telephone number, stock ticker symbol, stock
exchange(s), approximate sales, number of
employees, type of business, and top corporate
officers
Thomas Register Of American
Manufacturers
• Comprehensive reference
– Products and services
– Company profiles
– Catalog file
Mergent Industrial Manual and News
Reports
• Published in two volumes
• Covers industrial corporations listed
– On New York and American Stock Exchanges and
other selected exchanges
• Provides information such as history, business,
properties, subsidiaries, financial statements,
and SIC codes
D&B Reference Book of Corporate
Managements
• Contains profile information on over 200,000
principal corporate officers in over 12,000
companies
• This information includes
– Year of birth
– Education
– Military service
– Present business position
– Previous positions
Compact Disclosure
• Database of textual and financial information on
public companies
• Taken from reports filed with the SEC
• Contents
– Major financial statements
– Financial ratios
– Institutional holdings
– Insider ownership
– President’s letter
– Financial notes
Lexis-Nexis
• Provides accounting, legal, newspaper, and
periodical information
• Includes financial statements from annual
reports for thousands of publicly traded
companies
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 creditor focus on current resources
– Long-term creditors consider the future prospects of
the firm

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© 2013 Cengage Learning. All Rights Reserved.

Vertical Common Size

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

Horizontal Common Size

Industry Norms Dun & 800 business Condensed SIC

Value Line The Standard 1 to 97 Longitudinal

• Selected income statement and balance sheet

• Companies must meet size requirements to be

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