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

2. 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

3. 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

4. Ratio Analysis Interpreted in comparison with Prior ratios
Competitor ratios
Industry ratios
Predetermined standards .

5. 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

6. 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 .

7. Vertical Analysis
Each financial statement element is presented as a percentage of a designated base.

8. Horizontal Analysis
Each financial statement element is presented as a percentage of a base amount from a selected year.

9. 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.

10. 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

11. Descriptive Information
Narrative data
Annual report
Trade periodicals
Industry reviews
Further explains the financial position of a firm

12. 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

13. 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

14. 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

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

16. 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)

17. 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