Lecture 3: Basics of Analysis

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ...

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Chapter 3 Basics of Analysis © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Ratio Analysis 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Ratio Analysis—Continued Interpreted in comparison with – Prior ratios – Competitor’s ratios – Industry ratios – Predetermined standards Trend and variability of a ratio are important considerations © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Complexities and Context 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 – No percent change is computable when there is no figure for the base year © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 – Cost of sales often represents the major expense © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Descriptive Information 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparisons 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparisons: Trend Analysis 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparisons: SIC 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparisons: NAICS 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparisons: Industry Averages Industry comparison complicated by highly diversified companies Financial services – Base their analysis on industry placement – Provide composite industry data © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparisons: Caution in Using Industry Averages 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Relative Size of Firm 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 creditor focus on current resources – Long-term creditors consider the future prospects of the firm © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.