HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Chapter 5 Basics Analysis DR. AZIZ JAAFAR

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

Ratio Analysis Liquidity Leverage (borrowing capacity) Profitability 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 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 Each financial statement element is presented as a percentage of a designated base.

Horizontal Analysis 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 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: 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: 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 Information 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