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Discussion Assignments 5-8 [removed] [removed]

Financial Ratio Analysis Guidelines

For use in Discussion Assignments 5-8

The discussion assignments for Weeks 5-8 will be devoted to financial ratio analysis. Ratios are used to evaluate a firm’s financial health and are used by stockholders, lenders, and the firm’s management to evaluate the firm’s financial performance and status.

You will be evaluating the financial strength of the company using both trend and comparative analysis. Trend analysis involves assessing a company’s performance over time. Comparative analysis involves comparing a company’s financial ratios to the industry norm or average.

Because many firms are conglomerates, owning more-or-less unrelated lines of business, comparative analysis presents its own unique challenges. In addition, major competitors in an industry may be scattered around the world and the existence of different standards and procedures sometimes makes it difficult to compare financial statements across national borders. In some cases, industry norms may not be a good fit.

Recommended Resources for the remaining discussion assignments: 

  • 10-K Reports
  • The RMA database: located on the Stafford Library website

Calculating Financial Ratios

The best practice is to calculate all ratios using the company’s balance sheets and income statements contained in the 10-K report. Although it can be a time-consuming and, at times, frustrating approach, it is the most accurate one. In spite of GAAP, companies have a fair amount of discretion when it comes to constructing their financial statements. As a result, the line items on the balance sheet and income statement may be labeled differently than the balance sheets and income statements found in the text.

From the company’s 10-K reports, you will need to locate the company’s balance sheet and income statement for the last 3 years. You will likely need to access the company’s previous 10-K report, the one filed two years ago, in order to find balance sheets for all 3 years. If your company has subsidiaries, take care to use the consolidated statements.

I recommend you use the Motley Fool’s document titled  "Roses by Other Names" which is posted in the module for this week. It will help in understanding how to calculate the ratios when company financial statements do not match-up with the financial statements presented in the textbook.

Although many financial research websites contain financial ratio data, the ratios provided on these sites tends to be far less reliable than calculating the ratios yourself and is therefore strongly discouraged as a source.

Locating and Using Industry Averages

To locate a company’s industry norms, you must first determine the company’s NAICS codes. The NAICS code is a U.S. government code used to classify firms by their type of business. The eStatement Studies database of RMA (Robert Morris & Associates) industry norms located on the Stafford Library website will be your source for industry average data. Although you may find industry norms on other financial research websites, the industry analysis data provided on these sites tends to be far less reliable than the ones included in the eStatement Studies database. Please use only the eStatement Studies database to report industry norms.

To find the NAICS Codes:

  • Using the Stafford Library website, select the Databases option from the tabbed menu.
  • Select Business, Management and Finance Databases from the category options.
  • Select the Business Source Complete database.
  • Click on the Company Information link in the blue banner near the top of the page.
  • Enter the company ticker symbol in the search box and set the box to the left as “ticker symbol.”
  • Open the company record and click on the Industry link. Take note of the NAICS codes on the screen that follows. The first code listed reflects the company’s primary industry. Companies with operations in different industries will have multiple NAICS codes.

A sample document showing the NAICS codes from the Business Source Complete database is posted in this week's module.

To find Industry Averages:

  • Return to the Business, Management and Finance Databases on the Stafford Library Website.
  • Select the eStatement Studies database.
  • Using the NAICS code that you found in the above steps, type it in the third search box, the one identified as “Search for an industry by keyword or code.”
  • Click on “Search” to the right of this search box.
  • A little farther down the screen you will see your NAICS code as a hyperlink along with the industry title. Click on the link for the NAICS code.
  • Click on the “Annual Statement Studies” link in the left column.
  • Click on the FRB Sales tab in the main right section of the screen.
  • Since it is recommended to print a copy of the pages that follow since you will be using them in each of the remaining weeks, click on the black print button. Choose to open it with Adobe Reader and click “OK.” Print the PDF that appears.
  • You next need to locate the column of data that you will use in your analysis. Data is categorized by the amount of annual company sales; data for most large corporations is under the column labeled $25MM. (Note: “M” stands for ….” )
  • If you are viewing the table online, look for the column labeled “25MM and Over.”
  • If you are looking at the pages you have printed out, consult the second page that has a set of columns for “Current Data Sorted by Sales.” Find the “25MM & Over” column there.

On the FRB Sales, the first thing you must do is to locate the column of data that you will use in your analysis. Data is categorized by the amount of annual company sales; data for most large corporations is under the column labeled $25MM. (Note:"M" stands for thousands of dollars, "MM" stands for millions of dollars.)

For most ratios, three numbers are listed, breaking the results into quartiles. Presenting the data in this form offers the user a broader perspective than a single average would provide. Using quartiled data offers the user a broader perspective when interpreting the results. For example, if a company’s ratio is a bit below the median, you might be tempted to conclude that the company is not doing well. However, you should also note that the company’s ratio falls between the top and bottom figures, putting the company among 50% of all companies reporting.

Use the following breakdown when evaluating the company’s ratio against the industry average:

  • The middle number of the three ratios is the median, not the average.
  • 50% of the companies reporting have a ratio between the top and bottom number.
  • 25% of the companies have a ratio that would be above the top number.
  • 25% of the companies have a ratio that would be between the top and middle number.
  • 25% of the companies have a ratio that would be between the middle and bottom number.
  • 25% of the companies have a ratio that would be below the bottom number.

To better understand and interpret the data, hover over the green mega-navigation bar area labeled eStatement Studies. Click on About eStatement Studies, then select the green button to the left labeled Financial Ratio Benchmarks Data in the left column. Review the links for ratios that follow.

Review the marked-up sample document in this module to locate the relevant data for Discussions 5-8.

Interpreting Financial Ratios

Chapter 3 in the text offers a good overview of financial ratios and how they are used to assess financial performance.

Investopedia’s website offers additional explanations for how specific ratios are used. Use the search box on the site to find more information.

Keep in mind that ratio analysis involves the evaluation of imperfect data. Nonetheless, financial analysis must use the data, however flawed, to make informed decisions.

Overall guidelines for Weeks 1-8 can be found in the Discussions Overview.

FINC 350: Business Finance

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