1. Financial Statement Analysis
Course Title:
Financial Statement Analysis
Course Code:
MGT-537
Course Instructor:
Dr. Hafiz Muhammad Ishaq
Total Lectures: 32

2. Previous Lecture Summary
Special Income Statement Items:
Unusual item disclosed separately,
Discontinued operations,
Extraordinary items,
Minority share of earnings
Earnings per share ,
Retained Earnings,
Dividends and stock splits

3. Today's Lecture Topics Basics of Analysis
Ratio Analysis, Common size analysis (Vertical and Horizontal),
Financial Statement Variations by type of Industry, Comparison,
Trend Analysis,

4. Ratio Analysis
Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency.
The trend of these ratios over time is studied to check whether they are improving or weakening.
Ratios are also compared across different companies in the same sector to see how they stack up, and to get an idea of comparative valuations. Ratio analysis is a cornerstone of fundamental analysis.
Liquidity
Measures a firm’s ability to meet its current obligations and Liquidity ratios are used to determine a company’s ability to meet its short-term debt obligations.
Leverage (borrowing capacity)
Measures the degree of protector for long-term creditors. A leverage ratio is meant to evaluate a company’s debt levels. The most common leverage ratios are the debt ratio and the debt-to-equity ratio.

5. Investor-focused Cash flow Profitability
Measures the earning ability of a firm.
Measures that indicate how well a firm is performing in terms of its ability to generate profit
Investor-focused
Cash flow
Indicate liquidity, borrowing capacity, and profitability

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

7. 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
Accounting principles differ around the world, and countries usually have their own, slightly different, versions of GAAP.
Native business practices and culture

8. Common-Size Analysis
The use of percentages is usually preferable to the use of absolute amounts and analysis expresses comparisons in percentages.
Vertical analysis
Compares each amount with a base amount selected from the same year.
All amounts of a year expressed as a percentage of a base amount (e.g., net sales revenue, total assets)
Horizontal analysis
Compares each amount with amounts for comparative years are expressed as a percentage of the base year amount

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

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

15. 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.

16. Industry Variations Financial components vary by type of industry
Merchandising
Inventory is a principal asset a large amount of sales may be for cash in this case receivables balance will be low.
Sales may be primarily for cash or on credit
Service
A service firm generates its revenue from the service provided in this case Inventory is low or nonexistent
Investment in property at equipment is low compare than to manufacturing firms.
Manufacturing
Large inventory holdings
Substantial investment in plant assets

17. Descriptive Information
Narrative data
Annual report
Trade periodicals
Industry reviews
Further explains the financial position of a firm

18. Comparisons
Absolute figures or ratios appear meaningless unless compared to other figures or ratio.
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

19. 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

20. 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

21. 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

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

23. Financial Services’ Publications
Coverage
Data
Classification
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
Almanac of Business and Industrial Financial Ratios
CCH, Inc.
192 industries
Corporate tax return data

24. Financial Services’ Publications (cont’d)
Coverage
Data
Classification
Industry Norms and Key Business Ratios
Dun & Bradstreet
800 business lines; 5 segments
Condensed financial statements; ratios
SIC
[various]
Value Line Investment Service
98 industries
Longitudinal financial information

25. 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)

26. Relative Size of Firm Comparison of disparate size firms Information
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

27. Other Resources: Ward’s Business Directory
Domestic and public companies
8-volume set
V1, 2, 3 Alphabetical listing
V4 State and ZIP code
V5 SIC code
V6-7 State then SIC code
V8 NAICS code then revenue

28. Other Resources: Standard & Poor’s Stock Reports
Companies listed on various stock exchanges
Alphabetical by exchange
NYSE
American Stock Exchange
NASDAQ stock market
Regional exchanges

29. 3-volumes V1 Alphabetical by firm name
Other Resources: Standard & Poor’s Register Of Corporations, Directors, And Executives
3-volumes
V1 Alphabetical by firm name
V2§1 Alphabetical listing of key individuals
V2§2 Industries in 7 subsections

30. Other Resources: Standard & Poor’s Analyst’s Handbook
Selected income statement and balance sheet items
Related ratios
Applicable to Standard & Poor’s industry group stock price indexes

31. Other Resources: Standard & Poor’s Corporation Records
U.S. corporations
Background information
Detailed financial statistics

32. Corporate family listings
Other Resources: America’s Corporate Families:® The Billion Dollar Directory®
Corporate family listings
Alphabetical
Geographical
SIC
Cross-reference divisions, subsidiaries, and ultimate parent companies

33. Other Resources: D&B® Million Dollar Directory®
Company listings
Alphabetical
Geographically
SIC

34. Other Resources: Directory Of Corporate Affiliates
Corporate information
Divisions
Subsidiaries
Affiliates
Indexes
Alphabetical
Geographical
SIC

35. Other Resources: Thomas Register Of American Manufacturers
Comprehensive reference
Products
Services
Company profiles
Catalog file

36. Other Resources: Mergent Industrial Manual
New York and American Stock Exchanges
History
Business
Properties
Subsidiaries
Financial statements
SIC codes

37. Other Resources: Security Owner’s Stock Guide
Published by Standard & Poor’s
Survey of 5,300 stocks
Trading activity
Price range
Dividends
etc.

38. Other Resources: Standard & Poor’s Statistical Service
Industry statistics
Agriculture
Metals
Building
Transportation
etc.

39. Other Resources: Dividend Records
Mergent Dividend Record
Standard & Poor’s Annual Dividend Record
Provide dividend records of virtually publicly owned American and some foreign companies

40. Other Resources: D&B Reference Book of Corporate Managements
Principle corporate officers
Year of birth
Education
Military service
Present business position
Previous positions

41. 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
President’s letter
Financial notes

42. Other Resources: Lexis-Nexis
Accounting, legal, newspaper, and periodical information
Financial statements from annual reports

43. 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

44. Practical Exercise
Tic-Tac Homes has had the following balance sheet statements the past four years (in thousands):

47. In the last three years, the company has increased its receivables and inventories rather dramatically. While net fixed assets jumped in 20X4, changes were only modest in 20X2 and 20X3.
The basic problem is that retained earnings have grown at only a very slow rate, almost all of which occurred in 20X3. This is due to inadequate profitability, excessive dividends, or both.
While the company increased its long-term debt in 20X2, it has not done so since. The burden of financing has fallen on accounts payable and accruals, together with drawing down the cash position and $50,000 in increased short-term borrowings (notes payable).
The question would be whether payables are past due and whether employees are being paid on time. It is clear that the company cannot continue to expand its assets without increasing its equity base in a significant way.

48. Lecture Summary Basics of Analysis
Ratio Analysis, Common size analysis (Vertical and Horizontal),
Financial Statement Variations by type of Industry, Comparison,
Trend Analysis,