91814 Basics of Analysis

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Basics of Analysis


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Ratio Analysis

Liquidity Measures a firms 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


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Ratio Analysis

Interpreted in comparison with Prior ratios Competitor ratios Industry ratios

Predetermined standards


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Complexities and Context

Use of average data from balance sheetaccounts 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


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Common-Size Analysis

The use of percentages is usually preferable tothe use of absolute amounts

Vertical analysis

All amounts of a year expressed as a percentage ofa base amount (e.g., net sales revenue, totalassets)

Horizontal analysis

Amounts for comparative years are expressed as apercentage of the base year amount


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Vertical Analysis

Sales revenue 100,000$ 100.0% 95,000$ 100.0% 91,000$ 100.0%

Cost of goods sold 65,000 65.0% 60,800 64.0% 56,420 62.0%

Gross profit 35,000 35.0% 34,200 36.0% 34,580 38.0%

Operating expenses:

Selling expense 14,000 14.0% 11,400 12.0% 10,000 11.0%General expense 16,000 16.0% 15,200 16.0% 13,650 15.0%

Total operating expense 30,000 30.0% 26,600 28.0% 23,650 26.0%

Operating Income before taxes 5,000 5.0% 7,600 8.0% 10,930 12.0%

Taxes related to operations 1,500 1.5% 2,280 2.4% 3,279 3.6%

Net Income 3,500$ 3.5% 5,320$ 5.6% 7,651$ 8.4%

Melcher Company

Income Statement

2005 2004 2003

For the Years Ended December 31

Each financial statement element is presented asa percentage of a designated base.


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Horizontal Analysis

2005 2004 2003 2005 2004 2003

Sales revenue 100,000$ 95,000$ 91,000$ 109.9% 104.4% 100.0%

Cost of goods sold 65,000 60,800 56,420 115.2% 107.8% 100.0%

Gross profit 35,000 34,200 34,580 101.2% 98.9% 100.0%

Operating expenses:

Selling expense 14,000 11,400 10,000 140.0% 114.0% 100.0%General expense 16,000 15,200 13,650 117.2% 111.4% 100.0%

Total operating expense 30,000 26,600 23,650 126.8% 112.5% 100.0%

Operating Income before taxes 5,000 7,600 10,930 45.7% 69.5% 100.0%

Taxes related to operations 1,500 2,280 3,279 45.7% 69.5% 100.0%

Net Income 3,500$ 5,320$ 7,651$ 45.7% 69.5% 100.0%

Melcher Company

Income StatementFor the Years Ended December 31

Each financial statement element is presented as apercentage of a base amount from a selected year.


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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 numberis negative

A percent change is incomputable when there is nofigure for the base year.


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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


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Descriptive Information

Narrative data

Annual report

Trade periodicals

Industry reviews Further explains the financial position of a firm


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Comparisons

Provides context for analysis of ratios andfinancial data

Common types

Trend analysis SIC: Standard Industrial Classification

NAICS: North American Industry ClassificationSystem

Industry averages; competitor comparisons


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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


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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


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Comparisons: NAICS

Joint creation of NAFTA partners: Canada,U.S., and Mexico

Industry is defined by similar productionprocesses

Coding structure

Sector

Sub-sector

Industry group NAICS industry

National industry


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Comparisons: Industry

Industry comparison complicated by highlydiversified companies

Financial services

Base their analysis on industry placement Provide composite industry data


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Financial Services Publications

Publication Service Coverage Data ClassificationThe Departmentof CommerceFinancial Report

EconomicSurveys Division,Bureau of theCensus

Manufacturing,mining, and tradecorporations

Incomestatement andbalance sheetdata andratios

NAICS

Annual StatementStudies

RiskManagementAssociation

Manufacturing,wholesaling,retailing, service,agriculture, andconstruction

Common-sizefinancialstatementsand ratios

NAICS and SIC

Standard &

Poors IndustrySurveys

Standard &

Poors

50 North

American andglobal industries

Industry write-

ups andstatistics

NAICS

Almanac ofBusiness andIndustrialFinancial Ratios

CCH, Inc. 192 industries Corporate taxreturn data

NAICS


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Financial Services Publications (contd)

Publication Service Coverage Data ClassificationIndustry Normsand Key BusinessRatios

Dun & Bradstreet 800 businesslines; 5 segments

Condensedfinancialstatements;ratios

SIC

[various] Value Line

InvestmentService

98 industries Longitudinal

financialinformation


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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)


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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

O h R


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Other Resources:Wards 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

Oth R


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Other Resources:Standard & Poors Stock Reports

Companies listed on various stock exchanges

Alphabetical by exchange

NYSE

American Stock Exchange NASDAQ stock market

Regional exchanges


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Other Resources:Standard & Poors Register Of Corporations, Directors, And Executives

3-volumes

V1 Alphabetical by firm name

V21 Alphabetical listing of key individuals

V22 Industries in 7 subsections

Oth R


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Other Resources:Standard & Poors Analysts Handbook

Selected income statement and balance sheetitems

Related ratios

Applicable to Standard & Poors industry groupstock price indexes

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Other Resources:Standard & Poors Corporation Records

U.S. corporations

Background information

Detailed financial statistics


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Other Resources:Americas Corporate Families:The Billion Dollar Directory

Corporate family listings

Alphabetical

Geographical

SIC Cross-reference divisions, subsidiaries, and

ultimate parent companies

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Other Resources:D&BMillion Dollar Directory

Company listings

Alphabetical

Geographically

SIC

Other Reso rces


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Other Resources:Directory Of Corporate Affiliates

Corporate information

Divisions

Subsidiaries

Affiliates Indexes

Alphabetical

Geographical

SIC

Oth R


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Other Resources:Thomas Register Of American Manufacturers

Comprehensive reference

Products

Services

Company profiles Catalog file

Other Resources:


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Other Resources:Mergent Industrial Manual

New York and American Stock Exchanges

History

Business

Properties Subsidiaries

Financial statements

SIC codes

Other Resources:


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Other Resources:Security Owners Stock Guide

Published by Standard & Poors

Survey of 5,300 stocks

Trading activity

Price range Dividends

etc.

Other Resources:


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Other Resources:Standard & Poors Statistical Service

Industry statistics

Agriculture

Metals

Building Transportation

etc.


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Other Resources: Dividend Records

Mergent Dividend Record

Standard & Poors Annual Dividend Record

Provide dividend records of virtually publicly ownedAmerican and some foreign companies

Oth R


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Other Resources:D&B Reference Book of Corporate Managements

Principle corporate officers

Year of birth

Education

Military service

Present business position

Previous positions

Other Resources:


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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

Presidents letter Financial notes

Other Resources:


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Other Resources:Lexis-Nexis

Accounting, legal, newspaper, and periodicalinformation

Financial statements from annual reports


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The Users of Financial Statements

Management

Analyze information from the perspective of bothinvestors 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

91814 Basics of Analysis

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