Chapter 5:

Basics of
Analysis
_Financial Analysis_
 Outline

• Ratio Analysis
• Common-size analysis
• Study of differences in components of financial statements among industries
• Review of descriptive material
• Comparisons of results with other types of data
The Users of Financial Statements

• Management
• Analyse 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
5.1. 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
• 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 unevenlt throughout the year

• Analysis must ben performed and understood within the context of

• Native accounting principles
• Native business practices and culture
Using Financial Ratios:
Interested Parties

• Ratio analysis involves methods of calculating and interpreting financial ratios to

analyze and monitor the firm’s performance.
• Current and prospective shareholders are interested in the firm’s current and future
level of risk and return, which directly affect share price.
• Creditors are interested in the short-term liquidity of the company and its ability to
make interest and principal payments.
• Management is concerned with all aspects of the firm’s financial situation, and it
attempts to produce financial ratios that will be considered favorable by both owners
and creditors.
Using Financial Ratios:
Types of Ratio Comparisons

• Cross-sectional analysis is the comparison of different firms’ financial ratios at

the same point in time; involves comparing the firm’s ratios to those of other
firms in its industry or to industry averages
• Benchmarking is a type of cross-sectional analysis in which the firm’s ratio
values are compared to those of a key competitor or group of competitors that it
wishes to emulate.
• Comparison to industry averages is also popular, as in the following example.
 Using Financial Ratios:
Types of Ratio Comparisons (cont.)

•Caldwell Manufacturing’s calculated inventory turnover for 2012 and the

average inventory turnover were as follows:

Inventory turnover, 2012

Caldwell Manufacturing 14.8
Industry average 9.7
Financial Ratios for Select Firms and Their Industry Median Values
 Using Financial Ratios:
Types of Ratio Comparisons (cont.)

• Time-series analysis is the evaluation of the firm’s financial

performance over time using financial ratio analysis
• Comparison of current to past performance, using ratios, enables
analysts to assess the firm’s progress.
• Developing trends can be seen by using multiyear comparisons.
• The most informative approach to ratio analysis combines cross-
sectional and time-series analyses.
Combined Analysis
Using Financial Ratios:
Cautions about Using Ratio Analysis

1. Ratios that reveal large deviations from the norm merely indicate the possibility of a
problem.
2. A single ratio does not generally provide sufficient information from which to judge
the overall performance of the firm.
3. The ratios being compared should be calculated using financial statements dated at
the same point in time during the year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have been developed in the same way.
6. Results can be distorted by inflation.
Ratio Analysis Example

We will illustrate the use of financial ratios for analyzing financial

statements using the Bartlett Company Income Statements and
Balance Sheets.
Bartlett Company Income Statements ($000)
Bartlett Company Balance Sheets ($000)
Bartlett Company Balance Sheets ($000)
Ratio Analysis

• Liquidity Ratios

Current ratio = Current assets ÷ Current liabilities

The current ratio for Bartlett Company in 2012 is:

$1,223,000 ÷ $620,000 = 1.97

Matter of Fact

• Determinants of liquidity needs

• Large enterprises generally have well established relationships with banks that can provide
lines of credit and other short-term loan products in the event that the firm has a need for
liquidity.
• Smaller firms may not have the same access to credit, and therefore they tend to operate
with more liquidity.
Personal Finance Example

• The personal liquidity ratio is calculated by dividing total liquid

assets by total current debt. It indicates the percent of annual debt
obligations that an individual can meet using current liquid assets.
• Calculate Jan and Jon Smith’s liquidity ratio for calendar year 2012:
• Liquidity ratio = ($2,225/$21,539) = 0.1033, or 10.3%
• That ratio indicates that the Smiths can cover only about 10 percent
of their existing 1-year debt obligations with their current liquid
assets.
Ratio Analysis (cont.)

• Liquidity Ratios

The quick ratio for Bartlett Company in 2012 is:

Matter of Fact

• The importance of inventories:

Company Current ratio Quick ratio
• From Table 3.5:
Dell 1.3 1.2
Home Depot 1.3 0.4
Lowes 1.3 0.2

• All three firms have current ratios of 1.3. However, the quick ratios for
Home Depot and Lowes are dramatically lower than their current ratios, but
for Dell the two ratios are nearly the same. Why?
Ratio Analysis (cont.)

• Activity Ratios

Inventory turnover = Cost of goods sold ÷ Inventory

Applying this relationship to Bartlett Company in 2012 yields:

$2,088,000 ÷ $289,000 = 7.2

Ratio Analysis (cont.)

• Activity Ratios

Average Age of Inventory = 365 ÷ Inventory turnover

For Bartlett Company, the average age of inventory in 2012 is:

365 ÷ 7.2 = 50.7 days

Ratio Analysis (cont.)

• Activity Ratios

The average collection period for Bartlett Company in 2012 is:

Matter of Fact

• Who gets credit?

• Notice in Table 3.5 the vast differences across industries in the average
collection periods.
• Companies in the building materials, grocery, and merchandise store
industries collect in just a few days, whereas firms in the computer industry
take roughly two months to collect on their sales.
• The difference is primarily due to the fact that these industries serve very
different customers.
Ratio Analysis (cont.)

• Activity Ratios

If we assume that Bartlett Company’s purchases equaled 70 percent of its

cost of goods sold in 2012, its average payment period is:
Ratio Analysis (cont.)

• Activity Ratios

Total asset turnover = Sales ÷ Total assets

The value of Bartlett Company’s total asset turnover in 2012 is:

$3,074,000 ÷ $3,597,000 = 0.85

Matter of Fact

• Sell it fast
• Observe in Table 3.5 that the grocery business turns over assets faster than
any of the other industries listed.
• That makes sense because inventory is among the most valuable assets held
by these firms, and grocery stores have to sell baked goods, dairy products,
and produce quickly or throw them away when they spoil.
• On average, a grocery stores has to replace its entire inventory in just a few
days or weeks, and that contributes to the rapid turnover of the firms total
assets.
Table 3.6 Financial Statements
Associated with Patty’s Alternatives
Ratio Analysis (cont.)

• Debt Ratios

Debt ratio = Total liabilities ÷ Total assets

The debt ratio for Bartlett Company in 2012 is

$1,643,000 ÷ $3,597,000 = 0.457 = 45.7%

 Ratio Analysis (cont.)

• Debt Ratios
Times interest earned ratio = EBIT ÷ taxes
• The figure for earnings before interest and taxes (EBIT) is the same as that for
operating profits shown in the income statement.
• Applying this ratio to Bartlett Company yields the following 2012 value:
$418,000 ÷ $93,000 = 4.5
Ratio Analysis (cont.)
• Debt Ratios
Fixed-Payment coverage Ratio (FPCR)

Applying the formula to Bartlett Company’s 2012 data yields:

Table 3.7 Bartlett Company
Common-Size Income Statements
Ratio Analysis (cont.)

• Profitability Ratios

Bartlett Company’s gross profit margin for 2012 is:

Ratio Analysis (cont.)

• Profitability Ratios

Operating profit margin = Operating profits ÷ sales

Bartlett Company’s operating profit margin for 2012 is:

$418,000 ÷ $3,074,000 = 13.6%

Ratio Analysis (cont.)

• Profitability Ratios
Net profit margin = Earnings available for common stockholders ÷ Sales
• Bartlett Company’s net profit margin for 2012 is:
$221,000 ÷ $3,074,000 = 0.072 = 7.2%
Ratio Analysis (cont.)

• Profitability Ratios

Bartlett Company’s earnings per share (EPS) in 2012 is:

$221,000 ÷ 76,262 = $2.90

 Ratio Analysis (cont.)

• Profitability Ratios
Return on total assets (ROA) = Earnings available for common stockholders ÷ Total assets
• Bartlett Company’s return on total assets in 2012 is:
$221,000 ÷ $3,597,000 = 0.061 = 6.1%
 Ratio Analysis (cont.)

• Profitability Ratios
Return on Equity (ROE) = Earnings available for common stockholders ÷ Common stock equity
• This ratio for Bartlett Company in 2012 is:
$221,000 ÷ $1,754,000 = 0.126 = 12.6%
Ratio Analysis (cont.)

• Market Ratios
Price Earnings (P/E) Ratio = Market price per share of common stock ÷ Earnings
per share
• If Bartlett Company’s common stock at the end of 2012 was selling
at $32.25, using the EPS of $2.90, the P/E ratio at year-end 2012 is:
$32.25 ÷ $2.90 = 11.1
Ratio Analysis (cont.)

• Market Ratios

where,
 Ratio Analysis (cont.)

•Substituting the appropriate values for Bartlett Company from its 2012 balance sheet, we get:

•Substituting Bartlett Company’s end of 2012 common stock price of $32.25 and its $23.00 book
value per share of common stock (calculated above) into the M/B ratio formula, we get:
$32.25 ÷ $23.00 = 1.40
Summary of Bartlett Company Ratios
Summary of Bartlett Company Ratios
5.2. Common-size analysis

• The use of percentages is usually preferable to the use of absolute

amounts
• Vertical analysis
• All amount of a year expressed as a percentage of a base amount (e.g., net
sales revenue, total assets)

• Horizontal analysis
• Amounts of comparative years are expressed as a percentage of the base year
amount
Vertical Analysis

• Each financial statement element is presented as a percentage of a

designated base.
Vertical Analysis

• Vertical analysis focuses on the relationships among financial statement items at a

given point in time. A common-size financial statement is a vertical analysis in which
each financial statement item is expressed as a percentage.
• In income statements, all items are usually expressed as a percentage of sales.
• Managers often pay close attention to the gross margin percentage, which is
computed as shown on the next slide.
• In balance sheets, all items are usually expressed as a percentage of total assets.
Gross Margin Percentage

Gross Margin Gross Margin

=
Percentage Sales

This measure indicates how much

of each sales dollar is left after
deducting the cost of goods sold to
cover expenses and provide a profit.
Common-Size Statements
Wendy's McDonald's
(dollars in millions) Dollars Percentage Dollars Percentage
2002 Net income $ 219 8.00% $ 893 5.80%

Common-size financial statements are

particularly useful when comparing
data from different companies.
Common-Size Statements

Example

Let’s take another look at the information from the

comparative income statements of Clover Corporation
for 2005 and 2004.
Let’s prepare common-size statements.
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005 2004 2005 2004
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000 Sales is
Operating expenses 128,600 126,000 usually the
Net operating income 31,400 39,000 base and is
Interest expense 6,400 7,000 expressed
Net income before taxes 25,000 32,000
as 100%.
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005 2004 2005 2004
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
2005 Cost
Net operating ÷ 2005 Sales
income 31,400× 100%
39,000
( $360,000
Interest expense ÷ $520,000 ) × 100%
6,400 = 69.2%
7,000
Net income before taxes 25,000 32,000
Less income 2004 Cost ÷ 2004
taxes (30%) 7,500 Sales × 100%
9,600
Net income ( $315,000 $÷17,500 $480,000 ) × 100% = 65.6%
$ 22,400
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
What conclusions can we draw? Percentages
2005 2004 2005 2004
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000 30.8 34.4
Operating expenses 128,600 126,000 24.8 26.2
Net operating income 31,400 39,000 6.0 8.2
Interest expense 6,400 7,000 1.2 1.5
Net income before taxes 25,000 32,000 4.8 6.7
Less income taxes (30%) 7,500 9,600 1.4 2.0
Net income $ 17,500 $ 22,400 3.4 4.7
Horizontal analysis

• Each financial statement element is presented as a percentage of a

base amount from a selected year.
Horizontal Analysis

Example

The following slides illustrate a horizontal analysis of

Clover Corporation’s December 31, 2005 and 2004,
comparative balance sheets and comparative income
statements.
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
Horizontal Analysis
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

The dollar
amounts for
2004 become
the “base” year
figures.
Horizontal Analysis
Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $12,000 –155,000
$23,500164,700
= $(11,500)
Property and equipment:
Land 40,000 40,000
($11,500
Buildings and equipment, net ÷ $23,500)
120,000 × 100% = 48.9%
85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
5.3. 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
positve and the other number is negative
• A percentage change is incomputable when there is no figure for the base year
5.4. 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 invesrment in plant assets
5.5. Descriptive Information

• Narrative data
• Annual report
• Trade periodicals
• Industry reviews

• Further explains the financial position of a firm

5.6. 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
eonomy
• 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
Comparisons: Caution

• Ratios are subject to variance from:

• Different 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

Quiz

1. Statements in which all items are expressed only in relative terms

(percentages of a base) are termed:
a. Vertical Statements
b. Horizontal Statements
c. Funds Statements
d. Common Size Statements
e. none of the answers are correct
2. In financial statement analysis, ratios are:
a. the only type of analysis where industry data are available
b. absolute numbers converted to a common base
c. fractions usually expressed in percent or times
d. the only indication of the financial position of the firm
e. none of the answers are correct
3. Denver Dynamics has net income of $2,000,000. Oakland Enterprises has net
income of $2,500,000. Which of the following best compares the profitability of
Denver and Oakland?
a. Oakland Enterprises is 25% more profitable than Denver Dynamics.
b. Oakland Enterprises is more profitable than Denver Dynamics, but the comparison
can't be quantified.
c. Oakland Enterprises is only more profitable if it is smaller than Denver Dynamics.
d. Further information is needed for a reasonable comparison.
e. Oakland Enterprises is more profitable if it is a larger firm than Denver Dynamics
4. Which of the following can offer a type of comparison in financial
statement analysis?
a. past ratios and figures
b. industry averages
c. statistics of competitors
d. all of the answers are correct
e. none of the answers are correct
5. Which of the following is not a source of industry statistics?
a. Annual Statement Studies
b. Mergent Dividend Record
c. Value Line
d. Standard and Poor's Industry Surveys
e. The Department of Commerce Financial Report