Basics of Analysis

Ratio Analysis
Liquidity
Measures a firms ability to meet its current obligations

Leverage (borrowing capacity)

Measures the degree of protector for long-term creditors

Profitability
Measures the earning ability of a firm

Investor-focused Cash flow

Indicate liquidity, borrowing capacity, and profitability

Ratio Analysis
Interpreted in comparison with
Prior ratios Competitor ratios Industry ratios Predetermined standards

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 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 (e.g., net sales revenue, total assets)

Horizontal analysis
Amounts for comparative years are expressed as a percentage of the base year amount

Vertical Analysis
Melcher Company Income Statement For the Years Ended December 31 2005 2004 Sales revenue Cost of goods sold Gross profit Operating expenses: Selling expense General expense Total operating expense Operating Income before taxes Taxes related to operations Net Income $ $ 100,000 65,000 35,000 14,000 16,000 30,000 5,000 1,500 3,500 100.0% 65.0% 35.0% 14.0% 16.0% 30.0% 5.0% 1.5% 3.5% $ 95,000 60,800 34,200 11,400 15,200 26,600 7,600 2,280 $ 5,320 100.0% 64.0% 36.0% 12.0% 16.0% 28.0% 8.0% 2.4% 5.6% 2003 $91,000 56,420 34,580 10,000 13,650 23,650 10,930 3,279 $ 7,651 100.0% 62.0% 38.0% 11.0% 15.0% 26.0% 12.0% 3.6% 8.4%

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

Horizontal Analysis
Melcher Company Income Statement For the Years Ended December 31 2005 2004 2003 Sales revenue Cost of goods sold Gross profit Operating expenses: Selling expense General expense Total operating expense Operating Income before taxes Taxes related to operations Net Income $ $ 100,000 65,000 35,000 14,000 16,000 30,000 5,000 1,500 3,500 $ 95,000 60,800 34,200 11,400 15,200 26,600 7,600 2,280 $ 5,320 $ 91,000 56,420 34,580 10,000 13,650 23,650 10,930 3,279 $ 7,651 2005 109.9% 115.2% 101.2% 140.0% 117.2% 126.8% 45.7% 45.7% 45.7% 2004 104.4% 107.8% 98.9% 114.0% 111.4% 112.5% 69.5% 69.5% 69.5% 2003 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Each financial statement element is presented as a percentage of a base amount from a selected year.

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 A percent change is incomputable 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

Descriptive Information
Narrative data
Annual report Trade periodicals Industry reviews

Further explains the financial position of a firm

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

Comparisons: Trend Analysis

A study of the financial history of a firm Longitudinal ratio comparison
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
Division
Major group Industry group

Industry

Reported in SEC registrant filings

Comparisons: NAICS
Joint creation of NAFTA partners: Canada, U.S., and Mexico Industry is defined by similar production processes Coding structure
Sector Sub-sector Industry group NAICS industry National industry

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

Financial Services Publications

Publication
The Department of Commerce Financial Report

Service
Economic Surveys Division, Bureau of the Census
Risk Management Association

Coverage
Manufacturing, mining, and trade corporations

Data
Income statement and balance sheet data and ratios
Common-size financial statements and ratios

Classification
NAICS

Annual Statement Studies

Manufacturing, wholesaling, retailing, service, agriculture, and construction

NAICS and SIC

Standard & Poors Industry Surveys

Almanac of Business and Industrial Financial Ratios

Standard & Poors

CCH, Inc.

50 North American and global industries

192 industries

Industry writeups and statistics

Corporate tax return data

NAICS

NAICS

Financial Services Publications (contd)

Publication Service Coverage
800 business lines; 5 segments

Data
Condensed financial statements; ratios Longitudinal financial information

Classification
SIC

Industry Norms Dun & Bradstreet and Key Business Ratios [various] Value Line Investment Service

98 industries

Copright 2007 by Thomson South-Western, a

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)

Relative Size of Firm

Comparison of disparate size firms
Capital market access Economy of scale (purchasing) Wider customer base

Information
Absolute: amplifies comparison difficulty Common-size: eliminates some of the difficulty

Percent of market helps to define relative size

Other Resources: Wards Business Directory

Domestic and public companies 8-volume set
V1, 2, 3 V4 V5 V6-7 V8 Alphabetical listing State and ZIP code SIC code State then SIC code NAICS code then revenue

Other Resources: Standard & Poors Stock Reports

Companies listed on various stock exchanges Alphabetical by exchange
NYSE American Stock Exchange NASDAQ stock market Regional exchanges

Other Resources: Standard & Poors Register Of Corporations, Directors, And Executives

3-volumes
V1 V21 V22 Alphabetical by firm name Alphabetical listing of key individuals Industries in 7 subsections

Other Resources: Standard & Poors Analysts Handbook

Selected income statement and balance sheet items Related ratios Applicable to Standard & Poors industry group stock price indexes

Other Resources: Standard & Poors Corporation Records

U.S. corporations
Background information Detailed financial statistics

Other Resources: Americas Corporate Families: The Billion Dollar Directory

Corporate family listings

Alphabetical Geographical SIC

Cross-reference divisions, subsidiaries, and ultimate parent companies

Other Resources: D&B Million Dollar Directory

Company listings
Alphabetical Geographically SIC

Other Resources: Directory Of Corporate Affiliates

Corporate information
Divisions Subsidiaries Affiliates

Indexes
Alphabetical Geographical SIC

Chapter 5, 2007 by Thomson South-Western, a Copyright Slide #27

Other Resources: Thomas Register Of American Manufacturers

Comprehensive reference
Products Services Company profiles Catalog file

Chapter 5, 2007 by Thomson South-Western, a Copyright Slide #28

Other Resources: Mergent Industrial Manual

New York and American Stock Exchanges
History Business Properties Subsidiaries Financial statements SIC codes

Other Resources: Security Owners Stock Guide

Published by Standard & Poors Survey of 5,300 stocks
Trading activity Price range Dividends etc.

Other Resources: Standard & Poors Statistical Service

Industry statistics
Agriculture Metals Building Transportation etc.

Other Resources: Dividend Records

Mergent Dividend Record Standard & Poors Annual Dividend Record
Provide dividend records of virtually publicly owned American and some foreign companies

Other Resources: D&B Reference Book of Corporate Managements

Principle corporate officers
Year of birth Education Military service Present business position Previous positions

Other Resources: Compact Disclosure

Database of textual and financial information Annual and periodic reports filed with the SEC Contents
Major financial statements Financial ratios Institutional holdings Insider ownership Presidents letter Financial notes

Other Resources: Lexis-Nexis

Accounting, legal, newspaper, and periodical information Financial statements from annual reports

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