Lesson #2 Analysis Tools

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Lesson #2

Analysis Tools

Università degli Studi di Trieste 27

D.E.A.M.S.

Paolo Altin

Advanced Accounting AY 2021/2022

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Components of Business Analysis

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Business Activities

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Analysis Tools

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1. Comparative financial statement analysis (or horizontal analysis)

2. Common-size financial statement analysis (or vertical analysis)

3. Ratio Analysis

4. Cash flow analysis

Università degli Studi di Trieste D.E.A.M.S.

Paolo Altin

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Horizontal and Vertical Analysis

• Three main ways to analyze financial statements

• Horizontal analysis

• Year-to-year comparison

• Vertical analysis

• Compare different companies

• Using industry averages

• Compare company’s performance against the industry averages

D.E.A.M.S.

Paolo Altin

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Horizontal Analysis

• This analysis is conducted by reviewing consecutive balance sheets, income statements, or statements of cash flows from period to period.

• The most important information revealed is trend.

• Two techniques are popular: year-to-year change analysis and index-number trend analysis.

D.E.A.M.S.

Paolo Altin

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Year-to-Year Change Analysis

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1) When a negative amount appears in the base and a positive amount in the next period (or vice versa), we cannot compute a meaningful percentage change.

2) When there is no amount for the base period, no percentage change is computable.

3) When the base period amount is small, a percentage change can be computed but the number must be interpreted with caution. This is because it can signal a large change merely because of the small base amount used in computing the change.

4) When an item has a value in the base period and none in the next period, the decrease is 100%.

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Year-to-Year Change Analysis

• The study of percentage changes in comparative statements

• Compute dollar changes

• Compute percentage changes

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Example: Income Statement

• Step 1

• Step 2 ³⁵

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Example: Balance Sheet (partial)

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Exercise: Horizontal Analysis - Income Statement

1. Prepare a horizontal analysis of the comparative income statement of

Mariner Designs, Inc. Round percentage changes to one decimal place. ³⁷ MARINER DESIGNS, INC.

Comparative Income Statement

Years Ended December 31, 2012 and 2011

2012 2011

Net sales revenue $ 431,000 $ 372,350

Expenses:

Cost of goods sold ^{$ 200,000} $ 187,550

Selling and general expenses ^99,000 91,050

Other expense ^8,350 6,850

Total expenses ^{$ 307,350} $ 285,450

Net income ^{$ 123,650} $ 86,900

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Exercise: Horizontal Analysis - Income Statement

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MARINER DESIGNS, INC.

Comparative Income Statement

Years Ended December 31, 2012 and 2011

Increase (Decrease)

2012 2011 Amount Percent

Net sales revenue $ 431,000 $ 372,350 $ 58,650 15.8 % Expenses:

Cost of goods sold $ 200,000 $ 187,550 $ 12,450 6.6 % Selling and general

expenses 99,000 91,050 7,950 8.7 %

Other expense 8,350 6,850 1,500 21.9 %

Total expenses $ 307,350 $ 285,450 21,900 7.7 %

Net income $ 123,650 $ 86,900 $ 36,750 42.3 %

Why did 2012 net income increase by a higher percentage than net sales revenue?

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Colgate

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Something to smile about?

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Colgate’s Comparative Income Statements

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2011 2010 Change % Change

Net sales 16.734 15.564

Cost of sales 7.144 6.360

Gross profit 9.590 9.204

SG&A expenses 5.758 5.414 Other (income) expense - 9 301 Operating profit 3.841 3.489 Interest expense, net 52 59 Income before income taxes 3.789 3.430 Provisions for income taxes 1.235 1.117 Net income including non controlling interests 2.554 2.313 Less: Net income attributable to noncontrolling int.123 110 Net income attributable to Colgate-Palmolive 2.431 2.203

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Colgate’s Comparative Income Statements

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Index-Number Trend Analysis

• Form of horizontal analysis

• Indicates business direction

• How have things changed over the years?

• Select a period of three to five years

• Base year is the earliest year and a normal year;

• Base year is selected and set equal to 100%;

• Subsequent years expressed as a percentage of the base period.

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Colgate’s Index Number Trend

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Vertical Analysis

• Is also referred to as common-size financial statement analysis.

• Shows relationship of each item to a base amount on financial statements;

• Income statement: each item expressed as percentage of net sales

• Balance sheet: each item expressed as percentage of total assets or total liabilities and equity.

• Remember total assets = total liabilities and equity

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Vertical Analysis

• Useful in understanding the internal makeup of financial statements;

• In analyzing a balance sheet, it stresses two factors:

1) Source of financing 2) Composition of assets

• Especially useful for intercompany comparisons.

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Example: Income Statement

• Base amount

• Percentage of the base amount

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Example: Balance Sheet

• Base amount

• Percentage of base

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Vertical Analysis – Short Exercise

Tri-State Optical Company reported the following amounts on its balance sheet at December 31, 2012 and 2011:

Prepare a vertical analysis of Tri-State assets for 2012 and 2011.

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2012 2011

Cash and receivables $ 54,530 $ 46,860

Inventory 42,435 32,670

Property, plant, and equipment, net 108,035 85,470

Total assets $ 205,000 $ 165,000

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Tri-State Optical Company reported the following amounts on its balance sheet at December 31, 2012 and 2011:

Prepare a vertical analysis of Tri-State assets for 2012 and 2011.

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2012 2011

Inventory 42,435 32,670

Total assets $ 205,000 $ 165,000

2012 % of total

2011 % of total

Inventory 42,435 32,670

Total assets $ 205,000 $ 165,000

26.6 20.7 52.7 100.0

28.4 19.8 51.8 100.0

Vertical Analysis – Short Exercise

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Colgate’s Common-Size Income Statements

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Colgate’s Common-Size Balance Sheet

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Colgate’s Common-Size Balance Sheet

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Colgate’s Common-Size Balance Sheet

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Common-Size Statements

• Common-size statements compare one company to another

• Report only percentages (same as vertical analysis)

• Remove dollar/euro value bias

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Common-Size Statements

• Common-size statements compare one company to another

• Report only percentages (same as vertical analysis)

• Remove dollar value bias

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Benchmarking

• Comparing a company with another leading companies

• Two main types:

• Against a key competitor

• Against the industry average

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Common-Size Income Statement – Short Exercise

Data for Martinez, Inc., and Rosado, Corp., follow:

1. Prepare common-size income statements.

Martinez Rosado

Net sales $ 10,600 $ 18,600

Cost of goods sold 6,455 13,522

Other expenses 3,541 4,185

Net income $ 604 $ 893

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Data for Martinez, Inc., and Rosado, Corp., follow:

1. Prepare common-size income statements.

Martinez Rosado

Net sales $ 10,600 $ 18,600

Cost of goods sold 6,455 13,522

Other expenses 3,541 4,185

Net income $ 604 $ 893

Martinez Rosado

Net sales 100 % 100 %

Cost of goods sold 60.9 % 72.7 %

Other expenses 33.4 % 22.5 %

Net income 5.7 % 4.8 %

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Common-Size Income Statement – Short Exercise

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The analysis – short recap

• The goal of analyzing a financial statement is essentially to determine if the story it tells is good, bad or indifferent.

• In other words, to evaluate the financial health of a business.

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WHY?

Make an investment in a company (or not) Extend (or not) credit

Know about the performance (as competitor, customer, etc.)

Compute the value of a company (acquiring or selling)

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The analysis – short recap

• The analyst studies as first the context the company is working in (industry, geographical markets, competition, etc.), and the strategies adopted to compete, than draws a few initial conditions, and puts the financial statement into that context:

• by comparing it with statements of earlier periods (past results)

• by comparing it with statements of other companies.

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The analysis - short recap

• Comparative Financial Analysis

It provides a comparison of a company ‘s financial performance over multiple periods (year-to-year analysis). It is possible to determine trends.

• Common-size Statement Financial Analysis

It helps to compare different companies and to provide a benchmark analysis.

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Ratio Analysis

• Ratio analysis is among the most popular and widely used tools of financial analysis.

• Provide a quick and (relatively) simple means of evaluating the financial health of a business (company).

• Computation of a ratio is a simple arithmetic operation, its interpretation is more complex.

• A ratio must refer to an economically important relation, to be meaningful.

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Ratio Analysis

• Ratios relate one figure appearing in the financial statement to some other figures appearing there (e.g., operating profit in relation to capital employed or in relation to assets) or to some other resources of the business (e.g., net profit for employee, sales revenue per square metre of selling space, etc.).

• Ratios are very helpful when comparing different businesses, even if involved in different scale of operations (e.g. expressing operating profit in relation to capital employed).

• They are one of the starting points of the analysis, not an

end point! ⁶³

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Factors affecting ratios

• Economic events

• Industry factors

• Managament policies

• Accounting methods

• Reliability of the numbers

• Skillful of analyst in application and interpretation

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Any limitation in accounting measurements impact the

effectiveness of ratios.

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Interpretation of ratios

• It is not necessary to compute all possible ratios to analyze a situation.

• Ratios, like most techniques in financial analysis, are not relevant in isolation.

• They are usefully interpreted in comparison with (benchmarks):

• Corresponding ratio for the prior period for the same company (time series)

• Predicted ratio for the period

• Predetermined standards

• Corresponding ratio for similar companies in the same period (cross sectional)

• Average or median ratio for comparable companies across time.

• The variability of a ratio across time is often as important as its trend.

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Cash Flow Analysis

• It is primarily used as a tool to evaluate the sources and uses of funds.

• It provides insights into how a company is obtaining its financing and deploying its resources.

• It also is used in cash flow forecasting and as part of liquidity analysis.

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Colgate’s Cash Flow Statement

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Colgate’s Cash Flow Statement

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Analysis Resources

• http://edgar.sec.gov/edgar/searchedgar/webusers.htm

• www.finviz.com

• www.adr.com

• www.bigcharts.com

• www.bridge.com

• www.cbsmarketwatch.com

• www.financenter.com

• www.freeedgar.com

• www.ipomaven.com

• www.marketguide.com

• www.morningstar.com

• www.nasdaq.com

• www.quote.com

• www.businessweek.com

• www.10kwizard.com

• www.wallstreecity.com

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