MODULE 9

ANALYZING THE FINANCIAL STATEMENTS

The views expressed in this paper are the views of the authors and do not necessarily
reflect the views or policies of the Asian Development Bank (ADB), or its Board of
Directors or the governments they represent. ADB makes no representation
concerning and does not guarantee the source, originality, accuracy, completeness or
reliability of any statement, information, data, finding, interpretation, advice, opinion, or
view presented.
MODULE NINE ANALYZING THE FINANCIAL STATEMENTS

Learning Objectives: The objectives of this module are to present some

of the fundamentals of financial statement analysis
to afford the non-accountant a very basic
understanding of how the investor and analysts use
financial statements in making investment
decisions and what should be necessary for the
company to report to the regulator in order to
provide the investor with the information needed.

CONTENTS Page

I Ratios 3

Profitability 3

Rate of Return 3
Return on Investment (ROI) 4
Return on Equity (ROE) 5
Dividend Yield 6
Dividend Payout Ratio 7

Liquidity 7

Working Capital 7
Current Ratio 8
Acid Test Ratio / Quick Ratio 8

Activity 8

Turnover 9
Days’ Sales in Accounts Receivable and
Days’ Sales in Inventory 10

Leverage 11

Debt Ratio and Debt/Equity Ratio 12

Times Interest Earned Ratio 13

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II Trend Analysis 13

Secular Trends 14
Cyclical Trends 15
Linear Trends 16

Moving Average 17

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NOTE: The learner might consider printing out each financial statement from
Module eight so that he or she may refer to it as the elements of each are
discussed. For this reason, each is displayed on a single screen. The
learner is encouraged to review the information in Module eight before
beginning this Module.

I RATIOS

A ratio is the relationship between two numbers. In most cases a single ratio does not
describe very much about the company. When these ratios are compared over time, a
trend will emerge which will indicate the direction that these ratios are taking and when
ratios are compared over time the process is known as trend analysis. Analysis and
investors use ratios and trend analysis as tools to interpret and evaluate the figures on a
financial statement.

Of course, consistency in financial reporting and in defining the ratio components is

crucial if either the ratio or the trend is to be meaningful.

The ratios and trends that are calculated can be categorized under the four areas of
profitability, liquidity, activity and leverage.

PROFITABILITY

Three of the most important measures of profitability are the return on investment (ROI)
and return on equity (ROE). Each of these measures, derived from the income
statement, relates net income to an element on the balance sheet.

RATE OF RETURN

Investors look at the rate of return of an investment to evaluate an individual investment

and to compare potential investments. If investment A is paying a return of $80 and
investment B is paying a return of $90, which investment should you buy? The answer
is not as easy as it may first appear. The amount of the return is not enough information
to make an informed decision. You also need to know how much each investment cost
and what is the time period that the investment takes to yield that return. If we assume
an annual rate of return, the formula for the rate of return is:

annual rate of return = amount of return = %

amount invested

The rate of return is calculated by dividing the amount of the return by the amount of the
investment. If the cost of the investment for each of the two options above is the same,
then investment B has the higher rate of return. For example, if both cost $1,000, then

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the amount of the return ($80for A, $90 for B) divided by the amount invested ($1,000)
would yield a return of 8% for A ($80 / $1,000) and 9% for B ($90 / $1,000)..

If the costs of the investments are different, the return on the investment must be
calculated. If investment A above costs $1,000, but investment B above costs $500 then
the amount of return of B ($90 divided by $500) would be 18% and the better
investment.

RETURN ON INVESTMENT

The return on investment (ROI) is used as an indication of the effectiveness of

management since it describes the rate of return that management was able to achieve
on the assets that it had available to use in operating the business. Before we get to
ROI, let’s first look at the rate of return. The return on investment (ROI) is the name for
the rate of return on the assets for a company and can be expressed by the formula:

ROI = net income = %

Average total assets

The income statement of ATC in Module eight reported that the net income was $18,000
and the total assets from the balance sheet were $284,000. An average of the total
assets for the current year and the total assets for the previous year is used after the
company’s first year of operation because the net income was earned over that one-year
period and therefore should relate to that one-year period. For ATC, the ROI was
approximately 6.3% ($18,000/$284,000).

If we assume that ATC had been in business the previous year and that the total assets
for that year were $194,000, the average total assets would be $239,000 ($194,000 plus
$284,000 divided by 2). The ROI in that case would be approximately 7.5% ($18,000 /
$239,000).
As mentioned in Module eight, the standards of accounting are not a codified set of rules
to be blindly followed. In accounting, consistency in the definition of terms is more
important than the definition itself. So it should come as no surprise that the above ROI
formula is not the only ROI formula that can be used.

The balance sheet element in the formula is average total assets. By now you should
have developed a healthy skepticism about the assumptions, methods and calculations
of these “average” amounts and how they relate, or don’t relate, to “true” rates of returns
based upon real economic profit and fair market values. Therefore, actual rates are
usually used instead of averages and again, the raw ratios are not as important as the
trend of these ratios.

Some financial analysts will use operating income and average operating assets in the
formula because they believe that excluding interest expense, income taxes, and assets
not used in operating the business results in a better measurement of the operating
results. That formula would be:

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 ROI = operating income / operating assets

Another popular approach to ROI is known as the DuPont model, because it was
developed by the financial analysts at E.I. DuPont de Nemours & Co. a large chemical
company in the Untied States. The significance of the DuPont model is that it has led
many managements to consider utilization of assets, including keeping investment in
asserts as low as feasible to be just as important to overall performance as generating
profit from sales. That formula is:

ROI = net income X sales

sales average total assets

Net income divided by sales is also called margin. Margin emphasizes that a portion of
every cash unit of sales revenue must appear in net income.

Sales divided by average total assets is asset turnover or turnover. Turnover relates to
the efficiency with which the company’s assets are used in generating revenue.
Therefore:

ROI = Margin x Turnover

RETURN ON EQUITY

Return on Equity (ROE) is the primary measure of a company’s profitability. It is the

percentage of net income divided by average owners’ equity for the fiscal period in which
the net income was earned.

ROE = net income / average owner’s equity

As with the formula for ROI, operating income, which excludes other income and
expense (mainly interest expense) and income taxes, is also frequently used in
calculating ROE because it is a more direct measure of the results of management’s
activities than is net income. Interest expense (included in net income) is a function of
the board of director’s decision about capital structure (debt and owner’s equity) and not
a function of the operating activities of the company. Income taxes are a function of the
tax laws and therefore also not under the control of management.

The other three most common profitability ratios are the P/E, dividend yield and the
dividend payout ratios.

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We previously discussed the price/earnings (P/E) ratio and said that is was:

P/E = price of a share of stock / earnings per share

The denominator of this equation is used extensively by investors and market analysts to
evaluate the market price of a stock against the market price as a whole. The P/E ratio
(or P/E) is also known as the earnings multiple of a stock. The term refers to the fact
that the market price of a stock is equal to the earnings per share multiplied by the P/E
ratio.

The P/E ratio, or earnings multiple, is one of the most important measures used by
investors and analysts to evaluate the market price of a share of common stock.
When the decision to buy a share of common stock is made, it is most often based upon
the fact that the buyer anticipates the company will pay dividends (usually cash but
maybe stock) based upon profits and the price of the stock will rise. So, in a very real
sense, the market price of a share of common stock is a reflection of investor
expectations of dividends. The greater the probability of increased earnings, the more
investors are willing to pay for the stock. For example, company A is trading at
HK$48.00 and company B is trading at HK$75.00. Which is the better investment? One
might be tempted to say company B because the stock is trading at a higher price and
therefore, it would be assumed, that company B is worth more than company A.
However, suppose we also knew that company A’s last quarter earnings per share were
HK$4.00 and company B’s last quarters earnings per share were HK$7.50. Now which
is the better investment? It still may look to some that company B is the better
investment due to higher price and higher earnings. Now, calculate the P/E ratio. Which
is the better investment? (Answer appears in the answers to the questions at the end of
this Module).
As your calculations reveal, investor’s are willing to pay more for the stock of company A
than for the stock of company B, because investors expect better future earnings and
growth from company A than they do from company B. This is the reason that stock
tables publish the P/E ratio. High P/E ratios indicate high investor expectations, low
multiples indicate low expectations.

Analysts will also use the expected earnings of a company and the current market price
to determine the future market price of a company’s stock. Other approaches are to use
the expected future earnings per share and the current (or expected future) earnings
multiple.

DIVIDEND YIELD

Another ratio used by investors and analysts is the dividend yield:

dividend yield = dividend per share / market price per share

The yields for different investments are compared to help investors and analysts
evaluate the extent to which the investment objectives are being met.

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 DIVIDEND PAYOUT RATIO

Another ratio involving the dividend is the dividend payout ratio which reflects the
company’s dividend policy is the dividend pay-out ratio.

dividend pay-out ratio = dividend per share / earnings per share

Most companies that pay dividends have a dividend pay-out policy of some specified
percentage. Knowing the dividend pay-out ratio permits the investor and analyst to
project future dividends from projected earnings as well as track the company’s ability to
earn profits consistently enough to pay or increase the dividend pay-out target. Again, a
trend here is more important than one static figure.

LIQUIDITY

Liquidity is the company’s ability to meet its current obligations. There are three
principal tests of liquidity. The figures are obtained from the balance sheet.

working capital = current asset – current liabilities

current ratio = current assets / current liabilities

acid test ratio = cash* + accounts receivable

current liabilities

*cash includes temporary cash investments

The acid test ratio is also known as the quick ratio and is a short-term measurement
because merchandise inventories are excluded from the computation. This is the ability
of the company to meet its current obligations without selling any of its inventory.

Working capital is not as significant as the current ratio and as we said earlier, it is the
trend of this ratio that is the most important information. The working capital
measurement merely reports a figure, without a reference this figure is not very
meaningful. If working capital is HK$3.2million, what does that tell you?

From the balance sheet of ATC set forth in Module eight, we found that the current
assets are $284,000 and the current liabilities are $67,000. Therefore, working capital is
$217,000 ($284,000-$67,000). Is that good or bad? Is our company liquid? How can
you tell?

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The current ratio is 4.2 ($284,000/$67,000) and the acid test ratio is 1.7. As a general
rule, a current ratio of 2 and an acid test ratio of 1 are considered indicative of
good liquidity. Now can you tell if ATC is liquid?

You will recall that it was stated in Module eight that the accounting standards were not
detailed proscriptions but rather general guidelines for operation that left choices in
assumptions, methods and calculations up to the accountant. Financial statement
analysis involves careful observation of those assumptions made by the accountant and
the methods chosen to account for the reporting. The analysis attempts an
understanding of the basis for the assumptions and methods used to acquire the figures
reported. It further attempts to work those figures into ratios that may be compared to
reveal relative standing and to discern trends in those ratios to determine direction of the
figures, the future of the company and therefore the direction of the stock price.

For example, let’s look at the effect of the inventory cost-flow assumption on the working
capital ratio. The value of inventory that is reported on the balance sheet will depend on
whether the weighted-average, FIFO (first in, first out), or LIFO (last in, first out)
assumption is used. In periods of rising prices, a company using FIFO will report a
relatively higher asset value for inventories than a similar firm using the LIFO cost-flow
assumption. Therefore, even though two companies may be similar in all other respects,
they will report different amounts of working capital and they will have a different current
ratio. Without analyzing the assumptions, the reader of the financial reports for these
two companies would not know that a direct comparison of current ratios cannot be
made because of the different inventory accounting methods used. The better
comparison to be made for these two companies would be the trend of the two ratios.

ACTIVITY

Physical measures of activity, rather than financial measures, are also frequently used.
For example, it may be more informative to know the number of units sold rather than
the sales value of those units. The amount will reflect inflation, deflation and currency
changes, unit numbers will not. The same is true for reporting the total number of
employees rather than the payroll costs of a company.

Many analysts combine the physical and financial measures to develop useful statistics
and plot trends in order to compare results over time of a company or the differences
between companies. Sales values per employee and operating income per employee
may be used as productivity measures. Plant operating expenses per square foot or
gross profit per square foot might also be used as a productivity measure.

When comparing the operating results of different sized companies, many analysts
convert the items on the balance sheets into percentages of total assets and the items
on the income statement into percentage of sales. This process results in common size
financial statements.

As is the case with the accounting standards themselves, there are no absolutes in
measurements and analysis. The goal is to look behind the figures and determine the
company’s objectives, procedures and methods and to develop measurements that are
meaningful when used in comparison with each other within the company, between

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companies and across sectors. It is often the case, that the trend of a ratio is more
informative than any single ratio.

TURNOVER

Activity measures the efficiency with which assets have been utilized to generate sales
revenue. Therefore, activity measures focus primarily on the relationship between asset
levels and sales (called turnover). The formula for calculating turnover is:

Turnover = sales / average assets

Remember that we said that financial statements were a snapshot of the financial
condition of a company at a given point in time. Because sales are generated over a
period of time, it is appropriate that the average asset investment over the same period
be used rather than the amount of assets at any single point in time, such as the balance
sheet amount reported at the end of a fiscal period.

Usually the average asset amount is determined by using the balance sheet amount
reported at the beginning and end of the period. However, if available, monthly and
quarterly balance sheet amounts can be used to calculate an average.

Turnover is usually calculated for:

Accounts receivable;

turnover = sales/average accounts receivable

Inventories; and

turnover = cost of goods sold* / average inventories

Plant and equipment;

turnover = sales / average plant and equipment**

*because inventories are reported at cost, it is possible to substitute the

cost of goods sold for the sales amount in the turnover formula.

**some analysts use the cost of plant and equipment rather than the net
book value (cost minus accumulated depreciation) when calculating plant
and equipment turnover. This removes the differences in depreciation
calculation methods. However, since the assets or each company are
reported at original cost and not current value or replacement cost, as
they are acquired over time, the cost data are not as likely to be
comparable.

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 DAYS’ SALES IN ACCOUNTS RECEIVABLE and

DAYS’ SALES IN INVENTORY

Two other activity measures that permit assessment of the efficiency of asset
management are made for receivables and for inventories.

Number of days’ sales in accounts receivable

days’ sales in accounts receivable =

accounts receivable / average day sales*

* average day sales = annual sales / 365 days

The sooner that accounts receivable can be collected, the sooner cash is
available to use in the business and the less cash that needs to be
borrowed to meet current liabilities.

Number of days’ sales in inventory

days’ sales in inventory = inventory / cost of goods

sold*

*average day cost of goods sold = annual cost of goods sold / 365
days

The lower that inventories can be maintained relative to sales, the less investment that
needs to be made in inventory and the less those inventories need to be financed with
debt or owner’s equity and the greater the return on investment. The risk of having
minimum inventories is that an unanticipated increase in demand or a delay in receiving
raw materials or finished products can result in an out-of-stock situation and perhaps
loss of business. The “just-in-time” system pioneered by Japanese companies is
designed to keep the investment in inventories at a minimum by forecasting needs and
having suppliers deliver components as they are needed.

Alternative inventory cost-flow assumptions and alternative depreciation calculation

methods will affect the comparability of turnover between companies. When
assumptions and methods of calculation differ between companies, the trend of the
turnover ratios is more informative than the ratios themselves when comparing two
companies.

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 LEVERAGE

Leverage is the use of debt to finance the acquisition of assets. Leverage ratios focus
on the financial leverage of the company. Financial leverage will magnify return on
equity relative to return on assets and will add risk to the operation of a company and the
securities of that company. If the company does not earn enough income to pay the
interest (paying the interest is also called servicing the debt), creditors may force the
company into liquidation or bankruptcy. Because the interest on debt is fixed, leverage
also magnifies the return to the owners relative to the return on assets.

For example, assume that Asia Trading Company (ATC) has no financial leverage:

Balance Sheet Income Statement

assets ………………….S$10,000 earnings before interest and taxes…..S$2,000

liabilities………………..S$ 0.00 interest…………………………………..S$ 0.00
owners’ equity…………S$10,000 earnings before taxes………………….S$2,000
total L + OE……………S$10,000 income taxes (40%)……………………S$ 800
net income………………………………S$1,200

then:

ROI (before taxes) = earnings before interest and taxes / total assets

= $2,000 / $10,000

= 20%

ROE (after taxes) = net income / owners’ equity

= $1,200 / $10,000

= 12%

But if ATC were leveraged:

Balance Sheet Income Statement

assets………………….S$10,000 earnings before interest and taxes………S$2,000

liabilities (9% interest)..S$ 4,000 interest………………………………………S$ 360
owners’ equity…………S$ 6,000 earnings before taxes……………………..S$1,640
total L + OE……………S$10,000 income taxes (40%)……………………….S$ 656
net income………………………………….S$ 984

ROI (before taxes) = earnings before interest and taxes / total assets

= $2,000 / $10,000

= 20%

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ROE (after taxes) = net income / owners’ equity

= $984 / $6,000

= 16.4%

The use of leverage has not affected the ROI since leverage refers to how assets are
financed, not how efficiently they are used by management to generate operating
income. The use of leverage, however, has caused the ROE to increase from 12% to
16.4% because ROI exceeds the cost of the debt used to finance a portion of the assets.

Borrowing money at an interest rate cost (9%) that is less than the rate of return that can
be earned on that money (20%) increases the return on owner’s equity. Of course, if the
return on investment were less than the cost of borrowing, the result would be a
reduction of the return on owners’ equity. This is the risk of leverage. The increase
works both ways.

DEBT RATIO and DEBT EQUITY RATIO

Highly leveraged company’s or individuals run the risk of losses if the return on
investment falls below the cost of borrowing. Most companies limit the amount of debt to
a stated percent (usually no more than 50%) of total capital (debt plus owner’s equity).
Two financial leverage ratios are used to determine the extent to which a company is
using leverage, the debt ratio and the debt/equity ratio.

debt ratio = total liabilities / total liabilities and owners’ equity

debt/equity ratio = total liability / total owners’ equity

Suppose ATC’s balance sheet listed liabilities at $40,000 and owners’ equity at $60,000.
The debt ratio would then be 40%:

debt ratio = S$40,000 / $100,000

= 40%

as mentioned, most companies will have a debt ratio below 50%.

The debt/equity ratio would be 66.7%:

debt/equity ratio = S$40,000 / S$60,000

= 66.7%

A debt ratio of 50% would yield a debt/equity ratio of 100% (frequently referred to as 1 or
1:1). Thus, the debt/equity ratio should be below 100% or 1 or not exceed 1:1. At these

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levels, there is one dollar of equity to cover each dollar of debt. In excess of these
levels, debt outweighs equity.

TIMES INTEREST EARNED RATIO

Holders of long-term debt frequently will be interested in the times interest earned ratio.
This ratio shows the relationship of earnings (before interest and taxes) to interest
expenses. The greater the ratio the more confident the debt holders can be that the
company will continue to earn enough income to cover the interest expense. In general
a ratio of 5 or more is considered to indicate a relatively low risk that a company will not
be able to make its future interest payments.

times interest earned = earnings before interest and taxes

interest expense

II TREND ANALYSIS

After the profitability, liquidity, activity and leverage ratios are obtained, or any other
ratios that seem relevant, they can be plotted on a graph over time and the direction of
the performance of a company and the company’s stock can be discovered. These
indicators can also be plotted for and compared between different companies within a
sector or industry.

Trend analysis can get as complicated and detailed as technical analysis and a full
discussion is beyond the scope of this course. What trend analysis does do, however,
and its greatest valued, is to eliminate the differences in the assumptions, methods,
calculations and reporting of the raw data and the determinations of the ratios. As we
have seen, there are several alternatives for calculating and reporting raw data used to
compute a ratio. ROI computed with net income will be very different than ROI
computed with operating income. Just looking at the ratio, how do you know what the
definition of net income was that the accountant used and how do you know which
formula was used? You don’t.

In trend analysis, the ratios are not compared on absolute values, but are looked at only
for the direction that they take. Even though the data used in the ratio may have been
developed under different financial accounting alternatives, internal consistency within
each of the trends can still permit a meaningful trend comparison.

In trend analysis a graph is produced. The horizontal axis is usually time (months,
quarters, years, etc.) and the vertical axis is the ratio that is being plotted (ROI, ROE,
dividend yield, turnover, etc). The choice of the alternatives with which the ratios were
computed doesn’t matter as long as the alternatives are consistent. When the ratios are
plotted on the graph, the trend will appear. And you can compare trends between the
ratios computed under the alternative choices.

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For example, suppose that your best friend in college told you that her grades for last
semester were 2.0. That number doesn’t mean very much to you unless you have more
information. First, you would probably want to know what scale the 2.0 is based on. A
2.0 on a scale of 5.0 isn’t as impressive as one based upon a 4.0 or even better, a 3.0
scale. And if the scale is 2.0, then you are very impressed with your friend’s grades.
That’s the same as asking what depreciation schedule is used in a company’s report, or
is a figure or ratio net of interest and taxes?

Also, the 2.0 is an average. You don’t know what makes up that average. On a four
point system, she could have had two As and two Fs; one A, two Ds and a C; one B, two
Cs and one D, …well, you get the point. Averages are designed to smooth out the raw
data and sometimes that’s very helpful and sometimes it eliminates important
information. If your friend is a math major and got an A in geometry and an A in
calculus, but an F in swimming and an F in art, don’t you judge her differently than if the
Fs were in geometry and calculus and the As were in swimming and art? If she were a
company selling stock, which would you choose to invest in?

Regardless of the scale, you still only know how your friend is doing in school at this
point in time. Her grades are only a snapshot, just like he balance sheet for a company.
You still don not know whether that 2.0 is either good or bad. If she had a 1.5 last
semester, she’s improving; if her grades last semester were 4.0, she’s not. If a company
reports net assets of $2m for the last fiscal year, you really don’t know whether that is
good or bad. Do you? But if you know that the company reported net assets of $4m the
previous year, now you have a basis for comparison. If you plot the net assets of the
company on a graph over five years, a trend will emerge.

The same is true between companies. If one company chooses very different accounting
alternatives from another company in reporting their financial information, the only
informative way that these two companies can be compared is to plot the ratios on a
graph and look for the direction of the trend. The picture will become clearer. Even if
the trend is hard to discern, or there is not a trend for one of the companies, the
conclusion can still be reached that the company with a clearer more favorable trend is
the better investment.

Trend analysis can be used not only to analyze the performance of a company or the
comparison between companies, but also for the comparison of a company against
certain benchmarks like the industry or sector as a whole.

Secular Trends

A secular trend is a long-term (more than one year, usually 5-10 years) direction of a
time series. A time series is a collection of data recorded over a period of time. A
secular trend may be either up, level (flat), or down.

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 14

13

12 Western

Cars (000)
Europe
11

10

9 Japan
8

7
1992 1993 1994 1995 1996
Year

Cyclical Trends

The general economy of any country is said to be cyclical. That is, that any country will
go through a series of cycles involving periods of prosperity, recession, depression and
recovery. Business is also said to be cyclical and therefore stock prices are thought to
be cyclical as well. Cycles are the rise and fall of the performance of what is being
measured over periods longer than one year. The amount of rise and fall of the
performance in a cycle is determined from the deviation from the long-term secular
trend.

73 Prosperity
Batteries Sold (000)

Recession

63

Recovery
Lone-term
53 Secular trend

Depression
43
1980 1985 1990 1995
Year
Linear Trend

While economies, business and stock prices are cyclical, it is thought that if their
performance would be plotted over a long enough time line, any trend would be a
straight line. This straight line is called a linear trend and is plotted to establish a basis
from which to measure the deviation of whatever data is being measured. This
“smoothing out over time” is much like taking the average of a series of numbers. The
linear trend would be the average and the raw numbers would be the data being
measured. The point of this approach is to be able to measure the deviation from the
hypothetical linear trend line. This linear trend is plotted by the equation:

Y’ = a + bt

Y’ (read Y prime) is the projected value of the variable being plotted

for a selected value of t.

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 a is the Y intercept. It is the estimated value of Y
when t = 0. Another way to look at this is that a is
the estimated value of Y where the line crosses the
Y axis when t is zero.

b is the slope of the line, or the average change in Y’

for each change of one unit (either an increase or
decrease ) in t.

t is any selected value of time.

24

20

(chart 18-3)
Sales ($ millions)

16
Trend
12
Sales
8

0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Years
1 2 3 4 5 6 7 8 9 Codes

This linear line theory is very subjective as is the method of calculation. There are
additional complicated formulas for computing the lines, such as the least squares
method that solves two equations simultaneously and from which this course will spare
you. Those who are interested in the mathematics of trend line analysis should seek
outside materials on the subject. There is one measurement, however, that is referred
to commonly in the financial media and needs the most cursory of coverage. It is called
the moving-average and is derived from the moving average method of smoothing out
a time series line.

MOVING AVERAGE

You may recall from Module five on Investing and Investors, that when we discussed the
technical analysis approach to stocks we also said that the various approaches or
theories could be broken down into four categories. One of those categories was trends.
Do you remember what the other three were? The answer is included in the answers to
the review questions at the end of this Module. At that time it was also mentioned that
the most well known and most followed of the trends was probably the moving average.
You will recall that an average is merely the sum of a series of numbers divided by the
number of entries. The moving average simply adds a new number to the series and
drops the oldest one. The moving average can be calculated and plotted for any period

16
of time. The moving average can be used as a comparison to the actual daily close
price of a stock or for any other computation that the analyst is interested in.

When calculating a moving average, the analyst first determines the length of time the
average will cover. (See table below). Let’s take 5 years. Next, we determine the five
year moving totals by adding up the first five stock price numbers on some specified
date, say 31 December, (assume 5 + 6 + 8 + 10 + 5 = 34). This total of $34 is divided by
5 to arrive at the arithmetic mean price per year over the five year period (34 / 5 = 6.8).
The total and mean are positioned opposite the middle year of the period range, which
for 5 is 3 and therefore 1985. Then the total price and average are determined for the
next five years (or simply subtract the price for the 1983 and add the price for 1988 since
the whole purpose of a rolling average is to continuously drop the oldest entry and add
the new entry). The new total and average are placed opposite the middle of the new
range, in our case 1986. The process is continued until all the numbers have been
used. Our tabulations look like this:

Year Price Total Average

31/12 $ 5 yr. 5 yr.__
1983 5
1984 6
1985 8 34 6.8
1986 10 32 6.4
1987 5 33 6.6
1988 3 35 7.0
1989 7 37 7.4
1990 10 43 8.6
1991 12 49 9.8
1992 11 55 11.0
1993 9 60 12.0
1994 13 66 13.2
1995 15 70 14.0
1996 18 72 14.4
1997 15 73 14.6
1998 11 75 15.0
1999 14 79 15.8
2000 17
2001 22

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The prices and the moving average are then plotted on a graph where the horizontal
axis represents time and the vertical axis represents price:

90

80 Price ($)
Total 5 Year
70
Average 5 Year
60(chart 18-6)
Production

50

40

30

20

10

0
1983 1988 1993 1998
Year

In actual practice, the moving average method to data does not result in a precise linear
line, but the line produced does indicate a trend and the trend is what the process is
used to discover.

There are also nonlinear trends which require the use of logarithmic equations and
which, you will be relieved to learn, are beyond the scope of this course.

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