Week

10-11

Basics of Analysis

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classroom use.
Ratio Analysis
• Financial ratios are usually expressed as a
percent or as times per period.
– Liquidity ratios measures a firm’s ability to meet its
current obligations (Week 12-13)
– Borrowing capacity (leverage) ratios measures the
degree of protection for long-term creditors (Week 14)
– Profitability ratios measures the earning ability of a
firm (Week 15)
– Investor ratios
– Cash flow ratios

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

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Ratio Analysis—Complexities and
Context
• Comparison of income statement and balance
sheet numbers, in the form of ratios, can create
difficulties due to the timing of the financial
statements.
– the income statement covers the entire fiscal period;
– the balance sheet applies to a single point in time i.e.
the end of the period

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Ratio Analysis—Complexities and
Context
• Use of average of the beginning and ending
balance sheet figures.
– 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

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Common-Size Analysis
• Expresses comparisons in percentages.
– Vertical analysis
• compares each amount with a base amount
selected from the same year e.g. net sales
(revenues), total assets

– Horizontal analysis
• compares each amount with a base amount for a
selected base year.

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 Example – Vertical Common Size
Analysis

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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 Example – Horizontal Common Size
Analysis

Each financial statement element is presented as a percentage of a

base amount from a selected year
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product or service or otherwise on a password-protected website for classroom use.
Year-to-Year Change Analysis
• Use both absolute amounts and percentages
• Rules to be followed
– 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

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Year-to-Year Change Analysis—
Continued

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Financial Statement Variation by Type
of Industry
• Components of FS 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
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Descriptive Information
• Founds in
– Annual report
– Trade periodicals
– Industry reviews
• Helps to understand 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

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Comparisons
• Provides context for analysis of ratios and
financial data
• Common types
– Trend analysis
– Standard Industrial Classification (SIC) Manual
– North American Industry Classification System
(NAICS)
– Industry Averages and Comparison with Competitors

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Comparisons: Trend Analysis
• A study of the financial history of a firm
• It reveals whether the ratio is
– Falling
– Rising
– Remains relatively constant
• Helps
– Detecting problem
– Observing good management

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Comparisons: Standard Industrial
Classification (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

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Comparisons: North American Industry
Classification System (NAICS)
• Jointly created by the U.S., Canada, and Mexico
• Industry is defined by similar production
processes
• provides enhanced industry comparability
among the three NAFTA trading partners.
• divides the economy into 20 sectors.
• United States adopted the NAICS in 1997

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Comparisons: Industry Averages and
Comparison with Competitors
• Analysis is more meaningful if the results are
compared with
– industry averages
– results of competitors.
• Industry comparison is complicated in highly
diversified companies
• Financial services
– Base their analysis on industry placement
– Provide composite industry data

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Comparisons: Caution in Using Industry
Averages
• Ratios are subject to variance from
– Differing data/figures
– Inconsistent industry ratio formulas
– Use of different accounting methods
– Different fiscal year-ends
– Varying financial policies
– Inconsistent basis (before or after tax)
• Ratios are not absolute norms
– to be combined with other methods in formulating an
evaluation of the financial condition of a firm.

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Relative Size of Firm
• Comparisons of different size firms is more
difficult than comparisons of equal size firms.
• Larger firms have
– Access to wider capital market
– Economy of scale (buying larger quantities)
– Wider customer base
• Differences in relative size can be seen by
looking at relative sales, assets, or profit sizes.
• Percent of market also helps to define relative
size
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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

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