COM670 Chapter 5

 

Chapter 5 Basics of Analysis

Chapter 5, Slide #1

 

Ratio Analysis •

Liquidity (Ch.6)  –

•

Leverage Lever age (borrowing capacity) (Ch.7)  –

•

•

Measures the degree of protector protector for long-term creditor c reditorss

Profitability Profit ability (Ch. 8)  –

•

Measures a firm’s ability to meet its current obligations  

Measures the earning ability of a firm

Investor-focused (Ch. 9) Cash flow (Ch. 10)  –

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

 

The Users of Financial Statements •

Management  –

•

Investors  –

•

Analyze information from the perspective of both investors and creditors Analysis of past and present inf information ormation to project the future prospects of the entity

Creditors  –

 –

Short-term: focus is on current resources resources Long-term: consider the future prospects of the firm

Chapter 5, Slide #4

 

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

Chapter 5, Slide #5

 

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 percentag percentage e of a base amount (e.g., net sales revenue, tot total al assets)

Horizontal analysis  –

Amounts for comparative years are expressed as a percentage percent age of the base year amount

Chapter 5, Slide #6

 

Vertical Analysis Melcher Melc her Compan Company y Income Statement For the Years Ended December 31 2007

Sales revenue Cos t of goods s old

2006

2005

$ 100,000   65,000

100.0% 65. 0% 65

$ 95,000   60,800

100.0% 64.0% 64

$91,000  56,420

100.0% 62.0%

Gros s profit

  35,000

35. 0% 35

  34,200

36.0% 36

 34,580

38.0%

Operating expenses: Selling ex pens e General expens e

  14,000   16,000

14 1 4. 0% 16. 0% 16

  11,400   15,200

12 1 2.0% 16.0% 16

 10,000  13,650

11.0% 15.0%

Total operating ex pens e

  30,000

30. 0% 30

  26,600

28.0% 28

 23,650

26.0%

Operating Inco com me before ta tax xes Tax es related t o operat ions

   

5,000 1,500

5.. 0% 5 1. 5% 1.

  7,600   2,280

8.. 0% 8 2. 4% 2.

 10,930   3,279

12.0% 3.6%

$

3,500

3. 5%

$ 5,320

5. 6%

$ 7,651

8.4%

Net Income

Each financial statement element is presented as a percentage of a designated base. Chapter 5, Slide #7

 

Horizontal Analysis Melcher Compan Company y Income Statement For the Years Ended December 31 2007 2006 2005 Sales revenue Cost of goods sold

2007

2006

2005

$ 100,000   65,000

$ 95,000   60,800

$ 91,000   56,420

109.9% 115.2% 11

104.4% 107.8%

100.0% 100.0%

Gros s profit

  35,000

  34,200

  34,580

101.2% 10

98.9%

100.0%

Operating expenses: Selling expense General ex pens e

  14,000   16,000

  11,400   15,200

  10,000   13,650

14 1 40.0% 117.2% 11

114.0% 111.4%

100.0% 100.0%

Total operating ex pense

  30,000

  26,600

  23,650

126.8% 12

112.5%

100.0%

Operatin ting Inco com me before taxe xes s Tax es related to operations

   

5,000 1,500

  7,600   2,280

  10,930   3,279

45 4 5.7% 45.7% 45

69.5% 69.5%

100.0% 100.0%

$

3,500

$ 5,320

$ 7,651

45.7%

69.5%

100.0%

Net Inc ome

Each financial statement element is presented as a percentage of a base amount from a selected year. year. Chapter 5, Slide #8

 

Year-to-Year Change Analysis •

•

Use both absolute and percentages Guidelines:  –

 –

 –

When item has value in base year and none inanthe next period, thethe decrease is 100% A meaningful percent change cannot be computed when one number is positive and the other number is negativ negative e A percent change is incomputable when there is no figure for the base year.

Chapter 5, Slide #9

 

Industry Variations • •

•

Financial components vary by type of industry Merchandising (retail-wholesale)  –

Inventory Inven tory is a principal asset

 –

Sales may be primarily for cash or on credit

Service  –

Inventory is low or nonexistent

•

Manufacturing Large inventory inventory holdings  –

 –

Substantial Substan tial inv i nvestment estment in plant assets

Chapter 5, Slide #10

 

Descriptive Information •

Narrative data  –

 –

 –

Annual report Trade periodicals Industry reviews

•

Further explains the financial position of a

•

firm Management Discussion & Analysis

Chapter 5, Slide #11

 

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 #12

 

Comparisons: Trend Analysis •

•

A study of the financial history of a firm Longitudinal ratio comparison  –

 –

 –

Falling Rising Relatively constant

2011

2010

Increase/(De

Percent

crease)

Change

Cash

$ 6,950

$ 6,330

$ 620

9.8%

Accounts

18,567

19,330

(763)

(3.9%)

129,000

103,000

26,000

25.2%

0

10,000

N/M

(1,400)

9,530

N/M

Receivable, •

net

Highlight Effective management  –

 –

Evidence of problems

Sales

Rent Expense 10,000

Net Income (Loss)

8,130

Chapter 5, Slide #13

 

2011

2010

Increase/(D Increase/( D

Percent

ecrease)

Change

Cash

$ 6,950

$ 6,330

$ 620

9.8%

Accounts

18,567

19,330

(763)

(3.9%)

Sales

129,000

103,000

26,000

25.2%

Rent Expense

10,000

0

10,000

N/M

Net Income

8,130

(1,400)

9,530

N/M

Receivable, net

(Loss)

Chapter 5, Slide #14

 

Standard Standar d Industrial Classification (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 #15

 

Comparisons: Industry •

•

Industry comparison complicated by highly diversified companies Financial services  –

Base their analysis on industry placement

 –

Provide composite industry data

Chapter 5, Slide #16

 

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 #17

 

Relative Size of Firm •

Comparison of disparate size firms  –

 –

 –

•

Capital market access Economy of scale (purchasing) Economy Wider customer base

Information to use?  –

 –

Absolute: amplifies comparison difficulty as firm size differences increase Common-size: eliminates some of the difficulty, but comparisons are still subject to issues above Chapter 5, Slide #18

 

Reference •

Gibson, C.H. (2009). Financial Reporting &  Analysis: Using Using Financ Financial ial Accoun Accounting ting th

Information.  11  ed. Norwalk, Connecticut:

South-Western Cengage Learning.

Chapter 5, Slide #19