Basics of Analysis COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #2 Ratio Analysis Liquidity –Measures a firm’s 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 Cash flow –Indicate liquidity, borrowing capacity, and profitability

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #3 Ratio Analysis A ratio alone means nothing Must compare ratios to other ratios such as: –Prior ratios –Competitor ratios –Industry ratios –Predetermined standards

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. 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 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #6 Vertical Analysis Each financial statement element is presented as a percentage of a designated base.

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #7 Horizontal Analysis Each financial statement element is presented as a percentage of a base amount from a selected year.

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #8 Year-to-Year Change Analysis 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.

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #9 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #10 Comparisons Common types –Trend analysis –SIC: Standard Industrial Classification –NAICS: North American Industry Classification System –Industry averages; competitor comparisons

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #11 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #12 SIC Classifies business by industry Defines industries in accordance with the composition and structure of the economy Reported in SEC registrant filings

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #13 NAICS Joint creation of NAFTA partners: Canada, U.S., and Mexico Industry is defined by similar production processes

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #14 Comparisons: Industry Industry comparison complicated by highly diversified companies Financial services –Base their analysis on industry placement –Provide composite industry data

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #15 Financial Services’ Publications PublicationServiceCoverageDataClassification The Department of Commerce Financial Report Economic Surveys Division, Bureau of the Census Manufacturing, mining, and trade corporations Income statement and balance sheet data and ratios NAICS Annual Statement Studies Risk Management Association Manufacturing, wholesaling, retailing, service, agriculture, and construction Common-size financial statements and ratios NAICS and SIC Standard & Poor’s Industry Surveys Standard & Poor’s 50 North American and global industries Industry write- ups and statistics NAICS Almanac of Business and Industrial Financial Ratios CCH, Inc.192 industriesCorporate tax return data NAICS

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #16 Financial Services’ Publications (cont’d) PublicationServiceCoverageDataClassification Industry Norms and Key Business Ratios Dun & Bradstreet800 business lines; 5 segments Condensed financial statements; ratios SIC [various]Value Line Investment Service 98 industriesLongitudinal financial information

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #17 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)

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #18 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