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  1. 1. Basics of Analysis COPYRIGHT © 2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5
  2. 2. Ratio Analysis <ul><li>Liquidity </li></ul><ul><ul><li>Measures a firm’s ability to meet its current obligations </li></ul></ul><ul><li>Leverage (borrowing capacity) </li></ul><ul><ul><li>Measures the degree of protector for long-term creditors </li></ul></ul><ul><li>Profitability </li></ul><ul><ul><li>Measures the earning ability of a firm </li></ul></ul><ul><li>Cash flow </li></ul><ul><ul><li>Indicate liquidity, borrowing capacity, and profitability </li></ul></ul>
  3. 3. Ratio Analysis <ul><li>A ratio alone means nothing </li></ul><ul><li>Must compare ratios to other ratios such as: </li></ul><ul><ul><li>Prior ratios </li></ul></ul><ul><ul><li>Competitor ratios </li></ul></ul><ul><ul><li>Industry ratios </li></ul></ul><ul><ul><li>Predetermined standards </li></ul></ul>
  4. 4. Complexities and Context <ul><li>Use of average data from balance sheet accounts </li></ul><ul><ul><li>Necessary when comparing against income statement data </li></ul></ul><ul><ul><li>Does not </li></ul></ul><ul><ul><ul><li>Eliminate cyclical or seasonal variations </li></ul></ul></ul><ul><ul><ul><li>Capture changes that occur unevenly throughout the year </li></ul></ul></ul>
  5. 5. Common-Size Analysis <ul><li>The use of percentages is usually preferable to the use of absolute amounts </li></ul><ul><li>Vertical analysis </li></ul><ul><ul><li>All amounts of a year expressed as a percentage of a base amount (e.g., net sales revenue, total assets) </li></ul></ul><ul><li>Horizontal analysis </li></ul><ul><ul><li>Amounts for comparative years are expressed as a percentage of the base year amount </li></ul></ul>
  6. 6. Vertical Analysis Each financial statement element is presented as a percentage of a designated base.
  7. 7. Horizontal Analysis Each financial statement element is presented as a percentage of a base amount from a selected year.
  8. 8. Year-to-Year Change Analysis <ul><li>Guidelines: </li></ul><ul><ul><li>When an item has value in the base year and none in the next period, the decrease is 100% </li></ul></ul><ul><ul><li>A meaningful percent change cannot be computed when one number is positive and the other number is negative </li></ul></ul><ul><ul><li>A percent change is incomputable when there is no figure for the base year. </li></ul></ul>
  9. 9. Industry Variations <ul><li>Financial components vary by type of industry </li></ul><ul><li>Merchandising </li></ul><ul><ul><li>Inventory is a principal asset </li></ul></ul><ul><ul><li>Sales may be primarily for cash or on credit </li></ul></ul><ul><li>Service </li></ul><ul><ul><li>Inventory is low or nonexistent </li></ul></ul><ul><li>Manufacturing </li></ul><ul><ul><li>Large inventory holdings </li></ul></ul><ul><ul><li>Substantial investment in plant assets </li></ul></ul>
  10. 10. Comparisons <ul><li>Common types </li></ul><ul><ul><li>Trend analysis </li></ul></ul><ul><ul><li>SIC: Standard Industrial Classification </li></ul></ul><ul><ul><li>NAICS: North American Industry Classification System </li></ul></ul><ul><ul><li>Industry averages; competitor comparisons </li></ul></ul>
  11. 11. Comparisons: Trend Analysis <ul><li>A study of the financial history of a firm </li></ul><ul><li>Longitudinal ratio comparison </li></ul><ul><ul><li>Falling </li></ul></ul><ul><ul><li>Rising </li></ul></ul><ul><ul><li>Relatively constant </li></ul></ul><ul><li>Highlight </li></ul><ul><ul><li>Effective management </li></ul></ul><ul><ul><li>Evidence of problems </li></ul></ul>
  12. 12. SIC <ul><li>Classifies business by industry </li></ul><ul><li>Defines industries in accordance with the composition and structure of the economy </li></ul><ul><li>Reported in SEC registrant filings </li></ul>
  13. 13. NAICS <ul><li>Joint creation of NAFTA partners: Canada, U.S., and Mexico </li></ul><ul><li>Industry is defined by similar production processes </li></ul>
  14. 14. Comparisons: Industry <ul><li>Industry comparison complicated by highly diversified companies </li></ul><ul><li>Financial services </li></ul><ul><ul><li>Base their analysis on industry placement </li></ul></ul><ul><ul><li>Provide composite industry data </li></ul></ul>
  15. 15. Financial Services’ Publications Corporate tax return data Industry write-ups and statistics Common-size financial statements and ratios Income statement and balance sheet data and ratios Data Classification Coverage Service Publication NAICS 192 industries CCH, Inc. Almanac of Business and Industrial Financial Ratios NAICS 50 North American and global industries Standard & Poor’s Standard & Poor’s Industry Surveys NAICS and SIC Manufacturing, wholesaling, retailing, service, agriculture, and construction Risk Management Association Annual Statement Studies NAICS Manufacturing, mining, and trade corporations Economic Surveys Division, Bureau of the Census The Department of Commerce Financial Report
  16. 16. Financial Services’ Publications (cont’d) Longitudinal financial information Condensed financial statements; ratios Data Classification Coverage Service Publication 98 industries Value Line Investment Service [various] SIC 800 business lines; 5 segments Dun & Bradstreet Industry Norms and Key Business Ratios
  17. 17. Comparisons: Caution <ul><li>Ratios are subject to variance from: </li></ul><ul><li>Differing data </li></ul><ul><li>Inconsistent formula construction </li></ul><ul><li>Optional (elective) accounting treatment </li></ul><ul><li>Different fiscal year-ends </li></ul><ul><li>Varying financial policies </li></ul><ul><li>Inconsistent basis (before or after tax) </li></ul>
  18. 18. Users of Financial Statements <ul><li>Management </li></ul><ul><ul><li>Analyze information from the perspective of both investors and creditors </li></ul></ul><ul><li>Investors </li></ul><ul><ul><li>Analysis of past and present information to project the future prospects of the entity </li></ul></ul><ul><li>Creditors </li></ul><ul><ul><li>Short-term: focus is on current resources </li></ul></ul><ul><ul><li>Long-term: consider the future prospects of the firm </li></ul></ul>