AGibson 12e Ch05

Chapter 5
Basics of Analysis
COPYRIGHT ©2011 South-Western, a part of Cengage Learning.

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
Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 5, Slide #2
Ratio Analysis
• Interpreted in comparison with

– Prior ratios
– Competitor ratios
– Industry ratios
– Predetermined standards
• Trend and variability of a ratio are important

considerations.
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
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
Vertical Analysis
Melcher Company
Income Statement
For the Years Ended December 31
2009 2008 2007
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%
Each financial statement element is presented as

a percentage of a designated base which is sales
revenue on the Income Statement.
Horizontal Analysis
Melcher Company
Income Statement
For the Years Ended December 31
2009 2008 2007 2009 2008 2007
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%
Each financial statement element is presented as a

percentage of a base amount from a selected year.
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.
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
Descriptive Information
• Narrative data
– Annual report
– Trade periodicals
– Industry reviews
• Further explains the financial position of a firm
Comparisons
• Provides context for analysis of ratios and financial

data
• Common types
– Trend analysis
– SIC: Standard Industrial Classification. The U.S. Department
of Labor provides website for searching for key words
(http://www.osha.gov/pls/imis/sksearch.html)
– 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 economy
• 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 and
national industry
– U.S. Census Bureau provides website:
www.census.gov and under “business and industry
click on NAICS.
Comparisons: Industry
• Industry comparison complicated by highly

diversified companies
• Financial services
– Base their analysis on industry placement
– Provide composite industry data
Financial Services’ Publications
Publication Service Coverage Data Classification
The Department Economic Manufacturing, Income NAICS
of Commerce Surveys Division, mining, and trade statement and
Financial Report Bureau of the corporations balance sheet
Census data and
ratios
Annual Statement Risk Manufacturing, Common-size NAICS and SIC
Studies Management wholesaling, financial
Association retailing, service, statements
agriculture, and and ratios
construction
Standard & Standard & 50 North Industry write- NAICS
Poor’s Industry Poor’s American and ups and
Surveys global industries statistics
Almanac of CCH, Inc. 192 industries Corporate tax NAICS
Business and return data
Industrial
Financial Ratios
Financial Services’ Publications (cont’d)
Publication Service Coverage Data Classification

Industry Norms Dun & Bradstreet 800 business Condensed SIC
and Key Business lines; 5 segments financial
Ratios statements;
ratios
[various] Value Line 98 industries Longitudinal
Investment financial
Service information
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)
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
Other Resources:
Ward’s Business Directory
• Domestic private and public companies
• Up to 20 items of information are provided for

each company listed
• Ward’s Business Directory went digital in 2007

under Gale Directory Library.
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
Other Resources:
Standard & Poor’s Register Of Corporations, Directors, And Executives
• 2-volumes
– V1 Alphabetical by firm name
– V2§2 Industries in 7 subsections
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
Standard & Poor’s
Standard Corporation Descriptions
• U.S. corporations
– Background information
– Detailed financial statistics
Other Resources:
AQ1 Standard & Poor’s Security Owner’s Guide
• Covers 5,300 common and preferred stocks.

It contains:
– Trading activity
– Price range
– Dividends
Other Resources:
Standard & Poor’s Statistical Service
• Industry statistics
– Agriculture
– Metals
– Building
– Transportation
– etc.
AQ2 Standard & Poor’s Net Advantage
• Available in may academic libraries
• Other publication available with Net Advantage

– Standard & Poor’s stock reports
– Standard & Poor’s Register of Corporations,
Directors and Executives
– Stand and Poor’s Standard Corporation
Descriptions
Mergent Dividend Record Standard & Poor’s
Annual Dividend Record
• Provide a dividend record of payments on

virtually all publicly owned American and
some foreign companies.
Other Resources:
D&B® Million Dollar Directory®
• Companies must meet at least one of two inclusion

requirements:
- $9 million or more in sales volume
- 180 or more employees if company is in single
location, 900 or more if employees if company is a
branch.
• Company listings
– Alphabetical
– Geographically
– SIC
Other Resources:
Directory Of Corporate Affiliates
• Corporate information
– Divisions
– Subsidiaries
– Affiliates
• Indexes
– Alphabetical
– Geographical
– SIC
Other Resources:
Thomas Register Of American Manufacturers
• Comprehensive reference
– Products
– Services
– Company profiles
– Catalog file
Other Resources:
Mergent Industrial Manual and News Reports
• Covers 2000 industrial corporations

• New York and American Stock Exchanges
– History
– Business
– Properties
– Subsidiaries
– Financial statements
– SIC codes
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:
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
Other Resources:
Lexis-Nexis
• Accounting, legal, newspaper, and periodical

information
• Financial statements from annual reports
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

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Chapter 5

COPYRIGHT ©2011 South-Western, a part of Cengage Learning.

• Interpreted in comparison with

• Trend and variability of a ratio are important

• Use of average data from balance sheet

• The use of percentages is usually preferable to

Each financial statement element is presented as

Each financial statement element is presented as a

• Use both absolute and percentages

• Financial components vary by type of industry

• Further explains the financial position of a firm

• Provides context for analysis of ratios and financial

• A study of the financial history of a firm

• Classifies business by industry

• Joint creation of NAFTA partners: Canada, U.S.,

• Industry comparison complicated by highly

Publication Service Coverage Data Classification

Ratios are subject to variance from:

• Comparison of disparate size firms

• Domestic private and public companies

• Up to 20 items of information are provided for

• Ward’s Business Directory went digital in 2007

• Companies listed on various stock exchanges

• Selected income statement and balance sheet

• Applicable to Standard & Poor’s industry group

• Covers 5,300 common and preferred stocks.

• Available in may academic libraries

• Other publication available with Net Advantage

• Provide a dividend record of payments on

• Companies must meet at least one of two inclusion

• Covers 2000 industrial corporations

• Principle corporate officers

• Database of textual and financial information

• Accounting, legal, newspaper, and periodical

• Financial statements from annual reports

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