Basics Of Financial Statement Analysis_session 4
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Introduction to Finance PGDM 2009 – 2011 Batch Session 4 – Financial Statement Analysis
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
Chapter 5, Slide #2 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Ratio Analysis • Interpreted in comparison with – – – –
Prior ratios Competitor ratios Industry ratios Predetermined standards
Chapter 5, Slide #3 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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 Chapter 5, Slide #4 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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 – Native business practices and culture Chapter 5, Slide #5 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #6 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Vertical Analysis Melcher Company Income Statement For the Years Ended December 31 2005 2004 Sales revenue Cost of goods sold
2003
$ 100,000 65,000
100.0% 65.0%
$ 95,000 60,800
100.0% 64.0%
$91,000 56,420
100.0% 62.0%
Gross profit
35,000
35.0%
34,200
36.0%
34,580
38.0%
Operating expenses: Selling expense General expense
14,000 16,000
14.0% 16.0%
11,400 15,200
12.0% 16.0%
10,000 13,650
11.0% 15.0%
Total operating expense
30,000
30.0%
26,600
28.0%
23,650
26.0%
5,000 1,500
5.0% 1.5%
7,600 2,280
8.0% 2.4%
10,930 3,279
12.0% 3.6%
3,500
3.5%
$ 5,320
5.6%
$ 7,651
8.4%
Operating Income before taxes Taxes related to operations Net Income
$
Each financial statement element is presented as a percentage of a designated base. Chapter 5, Slide #7 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Horizontal Analysis Melcher Company Income Statement For the Years Ended December 31 2005 2004 2003
2004
2003
$ 100,000 65,000
$ 95,000 60,800
$ 91,000 56,420
109.9% 115.2%
104.4% 107.8%
100.0% 100.0%
Gross profit
35,000
34,200
34,580
101.2%
98.9%
100.0%
Operating expenses: Selling expense General expense
14,000 16,000
11,400 15,200
10,000 13,650
140.0% 117.2%
114.0% 111.4%
100.0% 100.0%
Total operating expense
30,000
26,600
23,650
126.8%
112.5%
100.0%
5,000 1,500
7,600 2,280
10,930 3,279
45.7% 45.7%
69.5% 69.5%
100.0% 100.0%
3,500
$ 5,320
$ 7,651
45.7%
69.5%
100.0%
Sales revenue Cost of goods sold
Operating Income before taxes Taxes related to operations Net Income
$
2005
Each financial statement element is presented as a percentage of a base amount from a selected year. Chapter 5, Slide #8 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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.
Chapter 5, Slide #9 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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 Chapter 5, Slide #10 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Descriptive Information • Narrative data – Annual report – Trade periodicals – Industry reviews
• Further explains the financial position of a firm
Chapter 5, Slide #11 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #12 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #13 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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)
Chapter 5, Slide #14 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #2 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Ratio Analysis • Interpreted in comparison with – – – –
Prior ratios Competitor ratios Industry ratios Predetermined standards
Chapter 5, Slide #3 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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 Chapter 5, Slide #4 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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 – Native business practices and culture Chapter 5, Slide #5 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #6 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Vertical Analysis Melcher Company Income Statement For the Years Ended December 31 2005 2004 Sales revenue Cost of goods sold
2003
$ 100,000 65,000
100.0% 65.0%
$ 95,000 60,800
100.0% 64.0%
$91,000 56,420
100.0% 62.0%
Gross profit
35,000
35.0%
34,200
36.0%
34,580
38.0%
Operating expenses: Selling expense General expense
14,000 16,000
14.0% 16.0%
11,400 15,200
12.0% 16.0%
10,000 13,650
11.0% 15.0%
Total operating expense
30,000
30.0%
26,600
28.0%
23,650
26.0%
5,000 1,500
5.0% 1.5%
7,600 2,280
8.0% 2.4%
10,930 3,279
12.0% 3.6%
3,500
3.5%
$ 5,320
5.6%
$ 7,651
8.4%
Operating Income before taxes Taxes related to operations Net Income
$
Each financial statement element is presented as a percentage of a designated base. Chapter 5, Slide #7 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Horizontal Analysis Melcher Company Income Statement For the Years Ended December 31 2005 2004 2003
2004
2003
$ 100,000 65,000
$ 95,000 60,800
$ 91,000 56,420
109.9% 115.2%
104.4% 107.8%
100.0% 100.0%
Gross profit
35,000
34,200
34,580
101.2%
98.9%
100.0%
Operating expenses: Selling expense General expense
14,000 16,000
11,400 15,200
10,000 13,650
140.0% 117.2%
114.0% 111.4%
100.0% 100.0%
Total operating expense
30,000
26,600
23,650
126.8%
112.5%
100.0%
5,000 1,500
7,600 2,280
10,930 3,279
45.7% 45.7%
69.5% 69.5%
100.0% 100.0%
3,500
$ 5,320
$ 7,651
45.7%
69.5%
100.0%
Sales revenue Cost of goods sold
Operating Income before taxes Taxes related to operations Net Income
$
2005
Each financial statement element is presented as a percentage of a base amount from a selected year. Chapter 5, Slide #8 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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.
Chapter 5, Slide #9 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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 Chapter 5, Slide #10 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Descriptive Information • Narrative data – Annual report – Trade periodicals – Industry reviews
• Further explains the financial position of a firm
Chapter 5, Slide #11 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #12 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 5, Slide #13 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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)
Chapter 5, Slide #14 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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