Financial Statement

Analysis
CHARLES H. GIBSON

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 Chapter
5

Basics of Analysis

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Ratio Analysis
• Liquidity ratios
– Measures a firm’s ability to meet its current
obligations
• Borrowing capacity (leverage) ratios
– Measures the degree of protection for long-term
creditors
• Profitability ratios
– Measures the earning ability of a firm
• Cash flow ratios

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Ratio Analysis—Continued
• Interpreted in comparison with
– Prior ratios
– Competitor’s ratios
– Industry ratios
– Predetermined standards
• Trend and variability of a ratio are important
considerations

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Complexities and Context
• Use of average data from balance sheet
– Necessary when comparing with income statement
data
– Does not
• Eliminate seasonal or cyclical variations
• Reflect 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

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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 of the same year (e.g., net sales
revenue, total assets)
• Horizontal analysis
– Amounts for comparative years are expressed as a
percentage of the base year amount

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Exhibit 5-1: Melcher Company—Vertical
Common Size

Each financial statement element is presented as a percentage of a

designated base which is sales revenue on the income statement
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Exhibit 5-1: Melcher Company—
Horizontal Common Size

Each financial statement element is presented as a percentage of a

base amount from a selected year
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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
– No percent change is computable when there is no
figure for the base year

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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
– Cost of sales often represents the major expense
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Descriptive Information
• Narrative data
– Annual report
– Trade periodicals
– Industry reviews
• Further explains the financial position of a firm
• Management Discussion and Analysis (MD&A)
provides an overview of the previous year and of
future goals and new projects

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Comparisons
• Provides context for analysis of ratios and
financial data
• Common types
– Trend analysis
– Standard Industrial Classification (SIC) Manual
• The U.S. Department of Labor provides Web site that details
the SIC manual
– North American Industry Classification System
(NAICS)
– Industry Averages and Comparison with Competitors

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Comparisons: Trend Analysis
• A study of the financial history of a firm
• It reveals whether the ratio is
– Falling
– Rising
– Relatively constant
• Highlight
– Effective management
– Evidence of problems

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Comparisons: SIC
• Classifies business by industry
• Defines industries in accordance with the
composition and structure of the economy
• Coding structure
– Two-digit major group number
– Three-digit industry group number
– Four-digit industry number

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Comparisons: NAICS
• Jointly created by the U.S., Canada, and Mexico
• Industry is defined by similar production
processes
• U.S. Census Bureau provides a Web site (
www.census.gov) that that details the NAICS
manual. Go on this site and under “business and
industry” click on NAICS

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

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Financial Services’ Publications
Publication Publisher(s) Coverage Data Classification
The Department Economic Manufacturing, Income NAICS
of Commerce Surveys mining, and statement
Financial Report Division, Bureau trade and balance
of the Census corporations sheet data
and ratios
Annual Risk Manufacturing, Common- NAICS or SIC
Statement Management wholesaling, size financial
Studies Association retailing, statements
service, and 16
agriculture, and selected
construction ratios
Standard & Standard & North American Industry NAICS
Poor’s Industry Poor’s and global write-ups
Surveys industries and statistics

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Financial Services’ Publications—
Continued
Publication Publisher(s) Coverage Data Classification
Almanac of CCH, Inc. 200 industries Corporate NAICS
Business and tax return
Industrial data
Financial Ratios

Industry Norms Dun & 800 business Condensed SIC

and Key Bradstreet lines financial
Business Ratios statements;
ratios

Value Line The Standard 1 to 97 Longitudinal

Investment Edition and the industries; financial
Survey Small & 1 to 84 information
Mid-Cap Edition industries

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Comparisons: Caution in Using Industry
Averages
• 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)

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Relative Size of Firm
• Comparison of disparate size firms
– Capital market access
– Economy of scale (purchasing)
– Wider customer base
• Information
– Absolute numbers amplifies comparison difficulty
– Common-size analysis help to eliminate some of the
difficulty
• Percent of market helps to define relative size

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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 creditor focus on current resources
– Long-term creditors consider the future prospects of
the firm

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product or service or otherwise on a password-protected website for classroom use.