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There are three primary ways to analyze financial information: horizontal analysis, vertical analysis, and ratio analysis.
Horizontal analysis
Horizontal analysis is a technique for evaluating a financial statement item over a period of time. The purpose of a horizontal analysis is to express the change in a financial statement item in percentages rather than in dollars. Financial statement users can spot trends more easily with horizontal analysis than by simply looking at the raw numbers. Consider the cash flows for Wal-Mart. According to its past six statements of cash flows, Wal-Mart made the following cash expenditures for property, plant, and equipment.
Wal-Mart capital Expenditures
For fiscal years ended on January 31, 2001-2006
(in millions of dollars)
|
2006 |
2005 |
2004 |
2003 |
2002 |
2001 |
|
$14,583 |
12,893 |
10,308 |
9,245 |
8,285 |
8,042 |
Often, the analyst selects one of the years as the reference point. It is called the base year, and the amounts reported for the other years are expressed as a percentage of the chosen base year. The difference between the amount of the financial statement item each year and the base year is expressed as a percentage of the base year.
Suppose we choose 2001 as the base year. Then, we subtract the 2001 capital expenditures ($8,042) from 2002 capital expenditures ($8,285) and divide by the base year number ($8,042).
Our calculation shows that during the fiscal year ended January 31, 2002, Wal-Mart increased capital expenditures by just 3.02 % of the base year's capital expenditures. The calculation is done the same way for each year. The percentage change from the base year to 2003 is calculated as follows:
Wal-Mart
Capital Expenditures Comparison-Base year 2001
(dollars in millions)
|
|
2006 |
2005 |
2004 |
2003 |
2002 |
2001 |
|
Capital expenditures |
$14,583 |
12.893 |
10,308 |
9,245 |
8,285 |
8,042
|
|
% change |
81.3% |
60.3% |
28.2% |
15.0% |
3.0% |
100% |
There is more than one way to do a horizontal analysis. Frequently, the analysis is done by comparing one year with the next, rather than using a fixed base year.
It is usually difficult to understand the significance of a single item such as capital expenditures when viewing the raw numbers. To make trends more apparent, it may be useful to express the changes in spending in percentage form. A horizontal analysis makes it clear that Wal-Mart continues to make a significant investment in its property, plant, and equipment.
Vertical Analysis
Vertical analysis is similar to horizontal analysis, but the analysis involves items on a single year's financial statement. Each item on a financial statement is expressed as a percentage of a selected base amount. For example, a vertical analysis of an income statement almost always uses sales as the base a mount because almost all of a firm's expenditures depend on the level of sales. Each amount on the statement i s expressed as a percentage of sales. This type of analysis can point out areas in which the costs might be too large or growing without an obvious cause. For example, if managers at Wal-Mart see that employee salaries, as a percentage of sales, are increasing, they can investigate the increase and, if necessary, take action to reduce the firm's salaries expense. Vertical analysis also allows the meaningful comparison of companies of different sizes. Exhibit 1 shows a vertical analysis for Wal-Mart's income statements for the years ended January 31, 2006, and January 31, 2005.
Ratio Analysis
Throughout this book, you have learned that ratio analysis uses information in the financial statements to formulate specific values that determine some measure of a company's financial position. We will review all the ratios you have learned and then look at an additional category of ratios.
A Review of All Ratios
There are four general categories of ratios, named for what they attempt to measure:
· Liquidity ratios: These ratios measure a company's ability to pay its current bills and operating costs-obligations coming due in the next fiscal year.
· Solvency ratios: These ratios measure a company's ability to meet its long-term obligations, such as its long-term debt (bank loans), and to survive over a long period of time.
· Profitability ratios: These ratios measure the operating or income performance of a company. Remember the goal of a business is to make a profit, so this type of ratio examines how well a company is meeting that goal.
· Market indicators: These ratios relate the current market price of the company's stock to earnings or dividends.
Market Indicator Ratios
The market price of a share of stock is what an investor is willing to pay for the stock. There are two ratios that use the current market price of a share of stock to help potential investors predict what they might earn by purchasing that stock. One ratio is the price-earnings (P/E) ratio. This ratio is defined by its name: It is the price of a share of stock divided by the company's current earnings per share.
P/E ratio = Market price per share
Earnings per share
Investors and financial analysts believe the P/E ratio indicates future earnings potential. A high P/E ratio indicates that the company has the potential for significant growth. When a new firm has no earnings, the P/E ratio has no meaning because the denominator is zero. For the first several years of business, Amazon.com had no earnings but a rising stock price. Analysts have varying opinions about the information contained in the P/E ratio.
The other market indicator ratio is the dividend yield ratio. This ratio is the dividend per share divided by the market price per share. You may find that the values for the dividend yield ratio are quite low compared to the return an investor would expect on an investment. Investors are willing to accept a low dividend yield when they anticipate an increase in the price of the stock.
Stocks with low growth potential, however, may need to offer a higher dividend yield to attract investors.
Dividend yield ratio = Dividend per share
Market price per share
Exhibit 3 shows the earnings per share, the dividends per share, and the market price per share for Google Inc. and for General Mills. Which stock would be a better buy for long term growth? Which would be best if you needed regular dividend income?
The types of stock that will appeal to an investor depend on the investors' preferences for income and growth. A young investor, for example, will not need dividends from retirement funds invested in stocks. These long-term investors would prefer to invest in companies with high growth potential, no matter what the dividend yield. Google might be more attractive, with its high P/E ratio of 64.05, than General Mills, with its lower P/E ratio of 16.98. A retiree who needs a dividend income for living expenses will be more concerned with the size of the dividend yield of an investment and less concerned with the investment's long-term growth. General Mills would be better than Google for dividends.
These two market-related ratios are very important to management and to investors because analysts and investors use them in evaluating stocks. If you examine a company's annual report, you are likely to see these ratios reported, usually for the most recent 2 or 3 years.
Understanding Ratios
A ratio by itself does not give much information. To be useful, a ratio must be compared to the same ratios from previous periods, ratios of other companies in the industry, or industry averages. Keep in mind that, with the exception of earnings per share, the calculations to arrive at a specific ratio may vary from company to company. There are no standard or required formulas to calculate a ratio. One company may calculate a debt ratio as debt to equity, whereas another company may calculate a debt ratio as debt to debt plus equity. When interpreting and using any company's ratios, be sure you know how those ratios have been computed. When you are computing ratios, be sure to be consistent in your calculations so you can make meaningful comparisons among them.
Even though the only ratio that must be calculated and presented as part of the financial statements is EPS, managers typically include in their company's annual report many of the ratios we have discussed in this chapter. When these ratios are not shown as part of the financial statements, they may be included in other parts of the annual report, often in graphs depicting ratio trends over several years.
Any valuable financial statement analysis requires more than a cursory review of ratios. The analyst must look at trends, components of the values that are part of the ratios, and other information about the company that may not even be contained in the financial statements.
Using Ratio Analysis
We will compute some of the ratios shown in Exhibit 2a, Exhibit 2b for J&J Snack Foods Corp. using the company's 2005 annual report. Exhibit 4 shows the income statements for 3 years, and Exhibit 5 shows the balance sheets for 2 years.
Other information needed for the analysis:
· Market price per share at the close of fiscal year: approximately $55 per share at September 24, 2005 and $42 per share at September 25, 2004.
· No dividends were paid by J&J Snack Foods corp. during the fiscal year ended September 25, 2004. However, J&J Snack Foods Corp. paid dividends of $0.05 per share during the fiscal year ended September 24, 2005.
All the ratios shown in Exhibit 6a, Exhibit 6b are calculated for J&J Snack Foods Corp. for the fiscal years ended September 24, 2005, and September 25, 2004. Even though 2 years of ratios do not give us enough information for making decisions, use this as an opportunity to practice how to calculate the ratios. Exhibit 6 shows the computations.
Source: "Financial Accounting " Pennsylvania State University Edition
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