Financial Statement Analysis Course Title: Financial Statement Analysis Course Code: MGT-537 Course Instructor: Dr. Hafiz Muhammad Ishaq Total Lectures: 32

Previous Lecture Summary Special Income Statement Items: Unusual item disclosed separately, Discontinued operations, Extraordinary items, Minority share of earnings Earnings per share , Retained Earnings, Dividends and stock splits

Today's Lecture Topics Basics of Analysis Ratio Analysis, Common size analysis (Vertical and Horizontal), Financial Statement Variations by type of Industry, Comparison, Trend Analysis,

Ratio Analysis Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency. The trend of these ratios over time is studied to check whether they are improving or weakening. Ratios are also compared across different companies in the same sector to see how they stack up, and to get an idea of comparative valuations. Ratio analysis is a cornerstone of fundamental analysis. Liquidity Measures a firm’s ability to meet its current obligations and Liquidity ratios are used to determine a company’s ability to meet its short-term debt obligations. Leverage (borrowing capacity) Measures the degree of protector for long-term creditors. A leverage ratio is meant to evaluate a company’s debt levels. The most common leverage ratios are the debt ratio and the debt-to-equity ratio.

Investor-focused Cash flow Profitability Measures the earning ability of a firm. Measures that indicate how well a firm is performing in terms of its ability to generate profit 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 Accounting principles differ around the world, and countries usually have their own, slightly different, versions of GAAP. Native business practices and culture

Common-Size Analysis The use of percentages is usually preferable to the use of absolute amounts and analysis expresses comparisons in percentages. Vertical analysis Compares each amount with a base amount selected from the same year. All amounts of a year expressed as a percentage of a base amount (e.g., net sales revenue, total assets) Horizontal analysis Compares each amount with 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 a large amount of sales may be for cash in this case receivables balance will be low. Sales may be primarily for cash or on credit Service A service firm generates its revenue from the service provided in this case Inventory is low or nonexistent Investment in property at equipment is low compare than to manufacturing firms. 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 Absolute figures or ratios appear meaningless unless compared to other figures or ratio. 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: 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

Comparisons: Industry Industry comparison complicated by highly diversified companies Financial services Base their analysis on industry placement Provide composite industry data

Financial Services’ Publications Coverage Data Classification 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 Almanac of Business and Industrial Financial Ratios CCH, Inc. 192 industries Corporate tax return data

Financial Services’ Publications (cont’d) Coverage Data Classification Industry Norms and Key Business Ratios Dun & Bradstreet 800 business lines; 5 segments Condensed financial statements; ratios SIC [various] Value Line Investment Service 98 industries Longitudinal financial 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 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

Other Resources: Ward’s 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

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

3-volumes V1 Alphabetical by firm name Other Resources: Standard & Poor’s Register Of Corporations, Directors, And Executives 3-volumes V1 Alphabetical by firm name V2§1 Alphabetical listing of key individuals 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

Other Resources: Standard & Poor’s Corporation Records U.S. corporations Background information Detailed financial statistics

Corporate family listings Other Resources: America’s Corporate Families:® The Billion Dollar Directory® Corporate family listings Alphabetical Geographical SIC Cross-reference divisions, subsidiaries, and ultimate parent companies

Other Resources: D&B® Million Dollar Directory® 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 New York and American Stock Exchanges History Business Properties Subsidiaries Financial statements SIC codes

Other Resources: Security Owner’s Stock Guide Published by Standard & Poor’s Survey of 5,300 stocks Trading activity Price range Dividends etc.

Other Resources: Standard & Poor’s Statistical Service Industry statistics Agriculture Metals Building Transportation etc.

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

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

Practical Exercise Tic-Tac Homes has had the following balance sheet statements the past four years (in thousands):

In the last three years, the company has increased its receivables and inventories rather dramatically. While net fixed assets jumped in 20X4, changes were only modest in 20X2 and 20X3. The basic problem is that retained earnings have grown at only a very slow rate, almost all of which occurred in 20X3. This is due to inadequate profitability, excessive dividends, or both. While the company increased its long-term debt in 20X2, it has not done so since. The burden of financing has fallen on accounts payable and accruals, together with drawing down the cash position and $50,000 in increased short-term borrowings (notes payable). The question would be whether payables are past due and whether employees are being paid on time. It is clear that the company cannot continue to expand its assets without increasing its equity base in a significant way.

Lecture Summary Basics of Analysis Ratio Analysis, Common size analysis (Vertical and Horizontal), Financial Statement Variations by type of Industry, Comparison, Trend Analysis,