Basics of Analysis COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 5

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #2 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 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #3 Ratio Analysis Interpreted in comparison with –Prior ratios –Competitor ratios –Industry ratios –Predetermined standards

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #4 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #5 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #6 Vertical Analysis Each financial statement element is presented as a percentage of a designated base.

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #7 Horizontal Analysis Each financial statement element is presented as a percentage of a base amount from a selected year.

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #8 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.

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #9 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #10 Descriptive Information Narrative data –Annual report –Trade periodicals –Industry reviews Further explains the financial position of a firm

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #11 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #12 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #13 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #14 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #15 Comparisons: Industry Industry comparison complicated by highly diversified companies Financial services –Base their analysis on industry placement –Provide composite industry data

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #16 Financial Services’ Publications PublicationServiceCoverageDataClassification 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 NAICS Almanac of Business and Industrial Financial Ratios CCH, Inc.192 industriesCorporate tax return data NAICS

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #17 Financial Services’ Publications (cont’d) PublicationServiceCoverageDataClassification Industry Norms and Key Business Ratios Dun & Bradstreet800 business lines; 5 segments Condensed financial statements; ratios SIC [various]Value Line Investment Service 98 industriesLongitudinal financial information

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #18 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)

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #19 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #20 Other Resources: Ward’s Business Directory Domestic and public companies 8-volume set –V1, 2, 3Alphabetical listing –V4State and ZIP code –V5SIC code –V6-7State then SIC code –V8NAICS code then revenue

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #21 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #22 Other Resources: Standard & Poor’s Register Of Corporations, Directors, And Executives 3-volumes –V1Alphabetical by firm name –V2§1Alphabetical listing of key individuals –V2§2Industries in 7 subsections

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #23 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #24 Other Resources: Standard & Poor’s Corporation Records U.S. corporations –Background information –Detailed financial statistics

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #25 Other Resources: America’s Corporate Families: ® The Billion Dollar Directory ® Corporate family listings –Alphabetical –Geographical –SIC Cross-reference divisions, subsidiaries, and ultimate parent companies

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #26 Other Resources: D&B ® Million Dollar Directory ® Company listings –Alphabetical –Geographically –SIC

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #27 Other Resources: Directory Of Corporate Affiliates Corporate information –Divisions –Subsidiaries –Affiliates Indexes –Alphabetical –Geographical –SIC

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #28 Other Resources: Thomas Register Of American Manufacturers Comprehensive reference –Products –Services –Company profiles –Catalog file

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #29 Other Resources: Mergent Industrial Manual New York and American Stock Exchanges –History –Business –Properties –Subsidiaries –Financial statements –SIC codes

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #30 Other Resources: Security Owner’s Stock Guide Published by Standard & Poor’s Survey of 5,300 stocks –Trading activity –Price range –Dividends –etc.

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #31 Other Resources: Standard & Poor’s Statistical Service Industry statistics –Agriculture –Metals –Building –Transportation –etc.

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #32 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #33 Other Resources: D&B Reference Book of Corporate Managements Principle corporate officers –Year of birth –Education –Military service –Present business position –Previous positions

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #34 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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #35 Other Resources: Lexis-Nexis Accounting, legal, newspaper, and periodical information Financial statements from annual reports

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 5, Slide #36 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