The document discusses various topics related to financial statement analysis using ratios, including: - Types of ratios that measure liquidity, borrowing capacity, profitability, and cash flow - How ratios should be interpreted by comparing to prior periods, competitors, industry standards, and analyzing trends - Considerations for analysis such as accounting principles, business practices, and industry variations - Tools for comparisons including trend analysis, SIC and NAICS industry classifications, and industry average data sources

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Financial Statement
Analysis
CHARLES H. GIBSON

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classroom use.
Chapter
5
Basics of Analysis

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• 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
Ratio Analysis

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• Interpreted in comparison with
– Prior ratios
– Competitor’s ratios
– Industry ratios
– Predetermined standards
• Trend and variability of a ratio are important
considerations
Ratio Analysis—Continued

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• 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
Complexities and Context

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• 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
Common-Size Analysis

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Exhibit 5-1: Melcher Company—
Vertical Common Size
Each financial statement element is presented as a percentage of a
designated base which is sales revenue on the income statement

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Exhibit 5-1: Melcher Company—
Horizontal Common Size
Each financial statement element is presented as a percentage of a
base amount from a selected year

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• 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
Year-to-Year Change Analysis

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• 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
Industry Variations

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• 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
Descriptive Information

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• 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

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• 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: Trend Analysis

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• 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: SIC

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• 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
industry” click on NAICS
Comparisons: NAICS

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

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Publication Publisher(s) Coverage Data Classification
The Department
of Commerce
Financial Report
Economic
Surveys
Division, Bureau
of the Census
Manufacturing,
mining, and
trade
corporations
Income
statement
and balance
sheet data
and ratios
NAICS
Annual
Statement
Studies
Risk
Management
Association
Manufacturing,
wholesaling,
retailing,
service,
agriculture, and
construction
Common-
size financial
statements
and 16
selected
ratios
NAICS or SIC
Standard &
Poor’s Industry
Surveys
Standard &
Poor’s
North American
and global
industries
Industry
write-ups
and statistics
NAICS
Financial Services’ Publications

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product or service or otherwise on a password-protected website for classroom use.
Publication Publisher(s) Coverage Data Classification
Almanac of
Business and
Industrial
Financial Ratios
CCH, Inc. 200 industries Corporate
tax return
data
NAICS
Industry Norms
and Key
Business Ratios
Dun &
Bradstreet
800 business
lines
Condensed
financial
statements;
ratios
SIC
Value Line
Investment
Survey
The Standard
Edition and the
Small &
Mid-Cap Edition
1 to 97
industries;
1 to 84
industries
Longitudinal
financial
information
Financial Services’ Publications—
Continued

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• 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)
Comparisons: Caution in Using
Industry Averages

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product or service or otherwise on a password-protected website for classroom use.
• 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
Relative Size of Firm

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product or service or otherwise on a password-protected website for classroom use.
• 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
Ward’s Business Directory

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product or service or otherwise on a password-protected website for classroom use.
• 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 Stock Reports

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product or service or otherwise on a password-protected website for classroom use.
• Contains 2-volumes
– Volume 1
• Alphabetical list of approximately 75,000 corporations
– Volume 2,
• Section 1 contains an alphabetical list of over 70,000
individuals serving as officers, directors, trustees, partners,
and so on
• Section 2 is divided into seven subsections providing
additional details
Standard & Poor’s Register Of
Corp., Directors, And Executives

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product or service or otherwise on a password-protected website for classroom use.
• 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 Analyst’s
Handbook

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product or service or otherwise on a password-protected website for classroom use.
• U.S. corporations
– Background information
– Detailed financial statistics
• The contents and the index are updated
throughout the year
Standard & Poor’s Standard
Corporation Descriptions

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product or service or otherwise on a password-protected website for classroom use.
• 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 Security
Owner’s Stock Guide

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product or service or otherwise on a password-protected website for classroom use.
• 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 Statistical
Service

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product or service or otherwise on a password-protected website for classroom use.
• 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
Standard & Poor’s Net Advantage

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product or service or otherwise on a password-protected website for classroom use.
• Provide a dividend record of payments on
virtually all publicly owned American and some
foreign companies
Mergent and Standard & Poor’s
Dividend Record

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product or service or otherwise on a password-protected website for classroom use.
• Companies must meet at least one of two
inclusion requirements
– $9 million or more in sales volume
– 180 or more employees if company is a headquarters
single location, 900 or more if employees if company
is a branch
• Company listings in Volumes
– Alphabetical
– Geographically
– SIC
D&B® Million Dollar Directory®

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product or service or otherwise on a password-protected website for classroom use.
• 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
Directory Of Corporate Affiliates™

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product or service or otherwise on a password-protected website for classroom use.
• Comprehensive reference
– Products and services
– Company profiles
– Catalog file
Thomas Register Of American
Manufacturers

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product or service or otherwise on a password-protected website for classroom use.
• Published in two volumes
• Covers 2000 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
Mergent Industrial Manual and
News Reports

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product or service or otherwise on a password-protected website for classroom use.
• 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
D&B Reference Book of Corporate
Managements

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product or service or otherwise on a password-protected website for classroom use.
• Database of textual and financial information on
about 12,000 public companies
• Taken from reports filed with the SEC
• Contents
– Major financial statements
– Financial ratios
– Institutional holdings
– Insider ownership
– President’s letter
– Financial notes
Compact Disclosure

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product or service or otherwise on a password-protected website for classroom use.
• Provides accounting, legal, newspaper, and
periodical information
• Includes financial statements from annual
reports for thousands of publicly traded
companies
Lexis-Nexis

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product or service or otherwise on a password-protected website for classroom use.
• 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
The Users of Financial Statements