Chapter No.

Basics of
Analysis

Dr. Salman Masood Sheikh

PhD, M.Phil, M.Com, MBA,
FCMA, FPFA, ACPA, CA (Int.)
Director Quality Assurance
Superior University Lahore
Key Concepts and Skills
Understand sources and uses of cash and the
Statement of Cash Flows

Know how to standardize financial statements for

comparison purposes

Know how to compute and interpret important

financial ratios

Understand the problems and pitfalls in financial

statement analysis
Chapter Outline
Cash Flow and Financial Statements: A

Closer Look

Standardized Financial Statements

Ratio Analysis

Using Financial Statement Information

Standardized Financial Statements

Common-Size Balance Sheets

Compute all accounts as a percent of total assets
Common-Size Income Statements
Compute all line items as a percent of sales
Standardized statements make it easier to compare
financial information, particularly as the company
grows
They are also useful for comparing companies of
different sizes, particularly within the same industry
Methods of
Financial Statement Analysis
Horizontal Analysis
Vertical Analysis
Common-Size Statements
Trend Percentages
Ratio Analysis
Horizontal Analysis

Using comparative financial

statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
Vertical Analysis

For a single financial statement, each item

is expressed as a percentage of a
significant total,
e.g., all income statement items are
expressed as a percentage of sales
Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial information
of several years)
Common-Size Statements

Financial statements that show only

percentages and no absolute dollar
amounts
Ratio Analysis
Expression of logical relationships
between items in a financial statement of
a single period
(e.g., percentage relationship between
revenue and net income)
Horizontal Analysis Example
The management of Clover Company
provides you with comparative balance
sheets of the years ended December 31,
1999 and 1998. Management asks you to
prepare a horizontal analysis on the
information.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
I
1999 1998
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
Horizontal Analysis Example
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

Change = Figure Figure
Horizontal Analysis Example
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

Change = Figure Figure

Since we are measuring the amount of the change

between 1998 and 1999, the dollar amounts for
1998 become the base year figures.
Horizontal Analysis Example
Calculating Change as a Percentage

Percentage Dollar Change

Change = Base Year Figure 100%
 Horizontal Analysis Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $12,000 $23,500
155,000= $(11,500)
164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
 Horizontal Analysis Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets ($11,500 $23,500) 100%164,700
155,000 = 48.9%
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
 Horizontal Analysis Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
Horizontal Analysis Example
Lets apply the same
procedures to the
liability and stockholders
equity sections of the
balance sheet.
 CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
Horizontal Analysis Example
Now, lets apply the
procedures to the

income statement.
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
 CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
InterestSales
expense
increased by 8.3% while6,400
net income 7,000 (600) (8.6)
decreased
Net income by taxes
before 21.9%. 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
 There were increases in both cost of goods sold (14.3%) and
operating expenses (2.1%). These increased costs more than
offset the increase in sales, yielding an overall decrease in net
income. CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
Vertical Analysis Example
The management of Sample Company
asks you to prepare a vertical analysis
for the comparative balance sheets of
the company.
 Vertical Analysis Example
Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
 Vertical Analysis Example
Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
$82,000 $483,000 = 17% rounded
Land 101,000 90,000 21% 23%
$30,000 $387,000
Equipment 110,000
= 8% rounded 23%
100,000 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
 Vertical Analysis Example
Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Acts. Payable $ 76,000 $ 60,000 16% 16%
Wages Payable 33,000 17,000 7% 4%
Notes Payable
$76,000 $483,000 50,000 50,000
= 16% rounded 10% 13%
Common Stock 170,000 160,000 35% 41%
Retained Earnings 154,000 100,000 32% 26%
Total $ 483,000 $ 387,000 100% 100%
 Trend Percentages Example
Wheeler, Inc. provides you with the following
operating data and asks that you prepare a
trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119
 Trend Percentages Example
Wheeler, Inc. provides you with the following
operating data and asks that you prepare a
trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119

$1,991 - $1,820 = $171

 Trend Percentages Example
Using 1995 as the base year, we develop the
following percentage relationships.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 132% 123% 116% 109% 100%
Expenses 120% 116% 110% 106% 100%
Net income 313% 234% 203% 158% 100%

$1,991 - $1,820 = $171

$171 $1,820 = 9% rounded
 140
Trend line
130 for Sales
% of 100 Base

120

110

100

90
1995 1996 1997 1998 1999
Sales
Years
Expenses
Ratio Analysis
Ratios also allow for better comparison
through time or between companies
As we look at each ratio, ask yourself what
the ratio is trying to measure and why that
information is important
Ratios are used both internally and
externally
Categories of Financial Ratios
Short-term solvency or liquidity ratios

Long-term solvency Ratios

Asset management or turnover ratios

Profitability ratios

Market value ratios

Why Evaluate Financial Statements?

Internal uses
Performance evaluation compensation and
comparison between divisions
Planning for the future guide in estimating
future cash flows
External uses
Creditors
Suppliers
Customers
Stockholders
Benchmarking
Ratios are not very helpful by themselves;
they need to be compared to something

Time-Trend Analysis
Used to see how the firms performance is
changing through time
Internal and external uses

Peer Group Analysis

Compare to similar companies or within
industries
Potential Problems

There is no underlying theory, so there is no way

to know which ratios are most relevant
Benchmarking is difficult for diversified firms
Globalization and international competition
makes comparison more difficult because of
differences in accounting regulations
Varying accounting procedures, i.e. FIFO vs.
LIFO
Different fiscal years
Extraordinary events
Work the Web Example
The Internet makes ratio analysis much
easier than it has been in the past

Click on the web surfer to go to

www.investor.reuters.com
Choose a company and enter its ticker symbol
Click on Ratios and then Financial Condition and
see what information is available
RATIO ANALYSIS YET TO COME
Financial ratios are usually expressed as a percent or as times per
period. The ratio listed below will be discussed fully in future
chapters.
Liquidity ratios measure a firms ability to meet its current
obligations. They may include ratios that measure the efficiency
of the use of current assets. (Chapter 7)
Borrowing capacity (leverage ) ratios measure the degree of
protection of suppliers of long term funds (Chapter 8)
Profitability ratios measure the earning ability of a firm.
Discussion will include measures of the use of assets in general
(Chapter 9)
Investors are interested in a special group of ratios, in addition to
liquidity debt, and profitability ratios (Chapter 10)
Cash flow ratios can indicate liquidity, borrowing capacity or
profitability (Chapter 11)
Accounting oriented Home Pages
SEC Edgar Database
Address:
http://sec.gov/edgarhp.html
Rutgers Accounting web
Address:
http//www.rutgers.edu/Accounting/raw.htm
Accounting resources on internet
Address:
http://www.rutgers.edu.pk/accounting/raw/internet /internet.htm
ANet-The Accounting Network-Southern cross University
Address:
http://anet.scu.edu.au/anet
Summa Project-Chartered Accountants of England
Address:
http://www.ex.ac.uk/BjSpaul/1CAEW/1CAEW.html
 Yanceys Home Page
Address:
http://zeta.is.teu.edu/~yancey
www virtual Library- Finance
Address:
http://www.cob.ohio-stae.edu/dept/fin/overview.htm
Financial markets-stock information
a. Exchange: American Stock Exchange
Address: http://www.amex.com
b. Exchange: Chicago mercantile exchange
Address: http://www.cme.com
c. Exchange: NASDAQ Stock Market
Address: http://www.nasdaq.com
d. Exchange: New York Stock Exchange
Address: http://www.nyse.com
SUMMARY
Financial analysis consists of the quantitative and
qualitative aspects of measuring the relative
financial position among firms and among
industries. Analysis can be done in different ways,
depending on the type of firm or industry and the
specific needs of the user. Financial statements will
vary by size of firm and among industries. These
basics of analysis will be extensively illustrated.
Chapter 6 presents an actual set of set of financial
statements for Cooper Tire & Rubber Company.
Financial analysis is applied to the firm in chapters
7 through 12.
Chapter No.5

End of Chapter

Thank You for

being with Me