Financial Accounting:
Tools for Business Decision Making
Kimmel, Weygandt, Kieso
Chapter
14
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Chapter 14
Financial Analysis:
The Big Picture
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After studying Chapter 14, you should be
able to:
Understand the concept of earning power and indicate
how irregular items are presented.
Discuss the need for comparative analysis and identify
the tools of financial statement analysis.
Explain and apply horizontal analysis.
Describe and apply vertical analysis.
Identify and compute ratios and describe their purpose
and use in analyzing a firm's liquidity, solvency, and
profitability.
3
Discuss the limitations of financial statement analysis.
Earning Power
The value of a company is a
function of its future cash flows.
4
Earning Power
The most likely level of income to be
obtained in the future
- that is, to the extent this year’s net
income is a good predictor of future
years’ net income.
5
Earning Power
 Earning power differs from actual net
income by the amount of irregular revenues,
expenses, gains, and losses included in this
year's net income.
 Users are interested in earning power
because it helps them derive an estimate of
future earnings without the "noise" of
irregular items.
6
Irregular Items
Three types of irregular items are
reported - (all net of taxes):
 discontinued operations
 extraordinary items
 changes in accounting principle
7
Discontinued Operations
Refers to the disposal of a significant
segment of a business
 the elimination of a major class of
customers or an entire activity
8
Discontinued Operations
 Assume Rozek Inc. has revenues of $2.5 million
and expenses of $1.7 million or net income of
$800,000 from continuing operations in 1998.
 During 1998 the company discontinued and sold
its unprofitable chemical division. The loss in
1998 from chemical operations (net of $60,000
taxes) was $140,000, and the loss on disposal of
the chemical division (net $30,000 taxes) was
$70,000.
9
Page 649 in book
Discontinued Operations
Assuming a 30% tax rate on the income.
Rozek Inc.
Partial Income Statement
For the Year Ended December 31, 1998
Income before income taxes
$800,000
Income tax expense
240,000
Income from continuing operations
560,000
Discontinued operations
Loss from operations of chemical division,
net of $60,000 income tax saving
$140,000
Loss from disposal of chemical division,
net $30,000 income tax saving
70,000 210,000
Net income
$350,000
10
Extraordinary Items
Events and
transactions that
meet two
conditions:
 Unusual in
nature
 Infrequent in
occurrence
Extraordinary Items
 To be considered unusual, the item should be
abnormal and only incidentally related to
customary activities of the entity.
 To be regarded as infrequent, the event or
transaction should not be reasonably expected
to recur in the foreseeable future.
 Both criteria must be evaluated in terms of the
environment in which the entity operates.
12
Extraordinary Items
Page 651 in book
Ordinary Items
Page 651 in book
Extraordinary Items
 In 1998 a revolutionary foreign
government expropriated property
held as an investment by Rozek
Inc.
 If the loss is $70,000 before
applicable income taxes of
$21,000, the income statement
presentation will show a deduction
of $49,000.
15
Page 651 in book
Rozek Inc.
Partial Income Statement
For the Year Ended December 31, 1998
Income before income taxes
$800,000
Income tax expense
- 240,000
Income from continuing operations
560,000
Discontinued operations
Loss from operations of chemical division,
net of $60,000 income tax saving
$140,000
Loss from disposal of chemical
division, net $30,000 income tax
saving
70,000 210,000
Net income before extraordinary item
350,000
Extraordinary item
Expropriation of investment, net of
$21,000 income tax saving
49,000
Net income
$301,000
16
Changes in
Accounting Principle
 For ease of comparison, financial statements are
expected to be prepared on a basis consistent
with that used for the preceding period.
 When a choice of principles is available, the
principal initially chosen should be applied
consistently from period to period.
 A change in accounting principle occurs when the
principle used in the current year is different
from the one used in the preceding year.
17
Changes in
Accounting Principle
 A change is permitted, when
 management can show that the new
principle is preferable to the old;
 the effects of the change are clearly disclosed
in the income statement.
 Examples:
 a change in depreciation methods (such as
declining-balance to straight-line)
 a change in inventory costing methods (such
as FIFO to average cost)
18
Changes in
Accounting Principle
A change in accounting principle
affects reporting in two ways:
 The new principle should be used in
reporting the results of operations of the
current year.
 The cumulative effect of the change on all
prior-year income statements should be
disclosed net of applicable taxes in a special
section immediately preceding Net Income.
19
Changes in
Accounting Principle
 Rozek Inc. changes from the straight-line method
to the declining-balance method for equipment
purchased on January 1, 1995.
 The cumulative effect on prior-year income
statements (statements for 1995-1997) is to
increase depreciation expense and decrease
income before income taxes by $24,000.
 If there is a 30% tax rate, the net-of-tax effect of
the change is $16,800 ($24,000 x 70%).
20
Page 653 in book
Rozek Inc.
Partial Income Statement
For the Year Ended December 31, 1998
Income before income taxes
$800,000
Income tax expense
240,000
Income from continuing operations
560,000
Discontinued operations
Loss from operations of chemical division,
net of $60,000 income tax saving
$140,000
Loss from disposal of chemical
division, net $30,000 income tax saving
70,000 210,000
Net income before extraordinary item
350,000
Extraordinary item
Expropriation of investment, net of
$21,000 income tax saving
49,000
Cumulative effect of change in
accounting principle
Effect on prior years of change in
depreciation method, net of $ 7,200 tax
16,800
Net Income
284,200
Changes in
Accounting Principle
 Although most revenues, expenses, gains, and
losses recognized during the period are
included in net income, specific exceptions to
this practice have developed.
 Certain items such as unrealized gains and
losses on available-for-sale securities, now
bypass income and are reported directly in
stockholders' equity.
22
Changes in
Accounting Principle
Unrealized gains and losses on available-forsale securities are excluded from net income
because disclosing them separately:
 reduces the volatility of net income due to
fluctuations in fair value, yet
 informs the financial statement user of the gain
or loss that would be incurred if the securities
were sold at fair value.
23
Changes in
Accounting Principle
 Analysts have expressed concern that the
number of items bypassing the income
statement has increased significantly.
 The FASB now requires that, in addition to
reporting net income, a company must also
report comprehensive income.
24
Comprehensive Income
Includes all changes in stockholders'
equity during a period except those
resulting from investments by
stockholders and distributions to
stockholders.
25
Comparative Analysis
 Any item reported in a financial statement
has significance:
 Its inclusion indicates that the item exists at a
given time and in a certain quantity.
 For example, when Kellogg Company
reports $243.8 million on its balance sheet
as cash, we know that Kellogg did have
cash and that the quantity was $243.8
million.
26
Comparative Analysis
 Whether the amount represents an
increase over prior years, or whether it
is adequate in relation to the company's
needs, cannot be determined from the
amount alone.
 The amount must be compared with
other financial data to provide more
information.
27
Comparative Analysis
There are three types of comparisons to
provide decision usefulness of financial
information:
 Intracompany basis
 Intercompany basis
 Industry averages
28
Intracompany Basis
 Comparisons within a company are often
useful to detect changes in financial
relationships and significant trends.
 A comparison of Kellogg's current year's cash
amount with the prior year's cash amount
shows either an increase or a decrease.
 Likewise, a comparison of Kellogg's year-end
cash amount with the amount of total assets at
year-end shows the proportion of total assets in
the form of cash.
29
Intercompany Basis
 Comparisons with other companies provide
insight into a company's competitive
position.
 Kellogg's total sales for the year can be
compared with the total sales of its
competitors such as Quaker Oats and
General Mills.
30
Industry Averages
 Comparisons with industry averages
provide information about a company's
relative position within the industry.
 Kellogg's financial data can be compared
with the averages for its industry compiled
by financial ratings organizations such as
Dun & Bradstreet, Moody's, and Standard
& Poor's.
31
Financial Statement Analysis
Three basic tools are used in
financial statement analysis :
1. Horizontal analysis
2. Vertical analysis
3. Ratio analysis
Horizontal Analysis
 Horizontal analysis is a technique for
evaluating a series of financial statement
data over a period of time.
 The purpose of horizontal analysis is to
determine whether an increase or decrease
has taken place.
 The increase or decrease can be expressed as
either an amount or a percentage.
33
Page 656 in book
Horizontal Analysis
KELLOGG COMPANY
Net Sales (in millions)
Base Period 1992
1996
1995
1994
1993
1992
6,676.6 7,003.7 6,562.0 6,295.4 6,190.6
34
Page 656 in book
Horizontal Analysis
 If we assume that 1992 is the base year, we can
measure all percentage increases or decreases from
this base-period amount with the following formula:
CURRENT-YEAR AMOUNT – BASE-YEAR AMOUNT
BASE-YEAR AMOUNT
 We can determine that net sales for Kellogg
company increased approximately 1.7% [($6,295.4 –
$6,190.6)/$6,190.6] from 1992 to 1993.
35
Page 656 in book
Percentage Change in Sales
The percentage change in sales for each of the 5
years, assuming 1992 as the base period is:
1996
1995
6,676.6 7,003.7
107.8% 113.1%
1994
1993
1992
6,562.0 6,295.4 6,190.6
106.0%
100.2%
100%
36
Horizontal Analysis
of a Balance Sheet
Page 657 in book
The financial statements of Kellogg Company are used to
illustrate horizontal analysis:
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Increase (Decrease)
during 1996
1996
1995
Amount Percent
Assets
Current Assets $1,528.6 $1,428.8 $ 99.8
7.0%
Plant assets
2,932.9 2,784.8 148.1
5.3
Other assets
588 .5
201.0 387.5
192.8
Total assets
5,050.0 4,414.6 635.4
14.4%
Horizontal Analysis
of a Balance Sheet
Page 657 in book
1996
Liabilities and
Stockholders' Equity
Current liabilities
$2,199.0
Long-term liabilities
1,568.6
Total liabilities
3,767.6
Stockholders' equity
Common stock
201.8
Retained earnings
and other
3,984.0
Treasury stock
(2,903.4)
Total stockholders'
equity
1,282.4
Total liabilities and
stockholders' equity $5,050.0
Increase (Decrease)
during 1996
1995
Amount Percent
$1,265.4
1,558.3
2,823.7
$933.6
10.3
943.9
183.0
18.8
10.3
3,769.1
(2,361.2)
214.9
542.2
5.7
23.0
1,590.9
(308.5)
$4,414.6
$635.4
73.8%
.7
33.4%
(19.4)
14.4%
Horizontal Analysis
of an Income Statement
Page 657 in book
The following is a 2-year comparative income statement of
Kellogg Company for 1996 and 1995 (in condensed format):
KELLOGG COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
Net sales
Cost of goods sold
Gross profit
Increase (Decrease)
during 1996
Amount Percent
1996
1995
$6,676.6
$7.003.7
($327.1)
3,122.9
3,177.7
(54.8)
(1.7)
3,826.0
(272.3)
(7.1)
3,553.7
(4.7%)
Horizontal Analysis
of an Income Statement
Page 657 in book
1996
3,553.7
Gross profit
Selling and administrative
expenses
2,458.7
Nonrecurring charges
136.1
Income from operations
958.9
Interest expense
65.6
Other income
(expense), net
(33.4)
Income before
income taxes
859.9
Income tax expense
328.9
Net income
$531.0
Increase (Decrease)
during 1996
1995
Amount Percent
3,826.0
(272.3)
(7.1)
2,566.7
421.8
837.5
62.6
(108.0)
285.7
121.4
3.0
(4.2)
(67.7)
14.5
4.8
21.1
54.5
n/a
796.0
305.7
$490.3
63.9
32.2
$40.7
8.0%
7.6
8.3%
Horizontal Analysis
of an Income Statement
Horizontal analysis of the income statements
on Page 657shows these changes:
 Net sales decreased $327.1, or 4.7% ($327.1
÷ $7,003.7).
 Cost of goods sold increased $54.8, or 1.7%
($54.8 ÷ $3,177.7).
 Selling and administrative expenses
decreased $108.0, or 4.2% ($108.0 ÷
$2,566.7).
41
Horizontal Analysis
of an Income Statement
 Although gross profit decreased by
7.2%, net income increased by 8.3%.
 The increase in net income can be
attributed almost entirely to the
decrease in nonrecurring charges due
to the restructuring of the company.
42
Vertical Analysis
 Vertical analysis is a technique for
evaluating financial statement data that
expresses each item in a financial
statement as a percent of a base amount.
 Total assets is always the base amount in
vertical analysis of a balance sheet.
 Net sales is always the base amount in
vertical analysis of an income statement.
43
Vertical Analysis of a
Balance Sheet
Page 659 in book
Presented below is the comparative balance sheet
of Kellogg for 1996 and 1995, analyzed vertically.
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
1996
Assets
Current Assets
1995
Amount
Percent
Amount
Percent
$1,528.6
30.3%
$1,428.8
32.4%
Plant assets (net) 2,932.9
58.1
2,784.8
63.1
Other assets
588.5
11.7
201.0
4.6
Total assets
$5,050.0
100.0%
$4,414.6
100.0%
44
Vertical Analysis of a
Balance Sheet
Page 659 in book
1996
1995
Amount
Percent
Amount
$2,199.0
43.5%
$1,265.4
Percent
Liabilities and
Stockholders' Equity
Current liabilities
28.7%
Long-term
liabilities
Total liabilities
1,568.6
31.1
1,558.3
35.3
3,767.6
74.6
2,823.7
64.0
45
Vertical Analysis of a
Balance Sheet
Page 659 in book
Amount
3,767.6
Total liabilities
Stockholders' equity
Common stock
201.8
Retained earnings
and other
3,984.0
Treasury stock
(2,903.4)
Total stockholders'
equity
1,282.4
Total liabilities and
stockholders'
equity
$5,050.0
1996
Percent
74.6
4.0
Amount
2,823.7
1995
183.0
Percent
64.0
4.1
78.9
57.5
3,769.1
(2,361.2)
85.4
53.5
25.4
1,590.9
36.0
100.0% $4,414.6
100.0%
46
Vertical Analysis of a
Balance Sheet
 In addition to showing the relative size of each
category on the balance sheet, vertical analysis
may show the percentage change in the
individual asset, liability, and stockholders'
equity items.
 Although, Kellogg's current assets increased
$99.8 million from 1995 to 1996, they decreased
from 32.4% to 30.3% of total assets.
47
Vertical Analysis of a
Balance Sheet
 Plant assets decreased from
63.1% to 58.1% of total assets.
 Current liabilities increased by
$933.6 million, going from
28.7% to 43.5% of total
liabilities and stockholders'
equity.
Page 660 in book
Vertical Analysis of
an Income Statement
KELLOGG COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
1996
Amount
Percent
Net sales
$6,676.6
Cost of goods sold 3,122.9
Gross profit
3,553.7
Selling and administrative
expenses
2,458.7
Nonrecurring
charges
136.1
Income from
operations
958.9
100.0%
46.8
53.2
1995
Amount
Percent
$7,003.7
3,177.7
3,826.0
100.0%
45.4
54.6
36.8
2,566.7
36.6
2.0
421.8
6.0
14.4
837.5
12.0
Page 660 in book
Vertical Analysis of
an Income Statement
1996
Amount
Income from
operations
958.9
Interest expense
65.6
Other income
(expense),net
(33.4)
Income before
income taxes
859.9
Income tax expense 328.9
Net income
$531.0
1995
Percent
Amount
Percent
14.4
1.0
837.5
62.6
12.0
.9
.5
21.1
.3
12.9
4.9
8.0%
796.0
305.7
$490.3
11.4
43.6
7.0%
Vertical Analysis of
an Income Statement
 Vertical analysis of the comparative income
statements of Kellogg reveals that cost of goods
sold as a percentage of net sales increased 1.4%
(from 45.5% to 46.8%) and selling and
administrative expenses increased 0.2% (from
36.6% to 36.8%).
 Net income as a percent of net sales increased
from 7.0% to 8.0% attributed almost entirely to
the decline in nonrecurring charges which
decreased from 6% to 2% of sales.
51
Intercompany Comparison
by Vertical Analysis
Page 660 in book
 Vertical analysis enables you to compare companies
of different sizes.
 Shown below is a comparison of the income
statements of Kellogg and Quaker Oats:
CONDENSED INCOME STATEMENTS
For the Year Ended December 31, 1996
(In millions)
The Quaker
Kellogg Company, Inc.
Oats Company
Net sales
Cost of goods sold
Gross profit
Amount
$6,676.6
3,122.9
3,553.7
Percent
100.0%
46.8
53.2
Amount Percent
$5,199.0 100.0%
2,807.5 54.0
2,391.5 46.0
Intercompany Comparison
by Vertical Analysis
Kellogg Company, Inc.
Amount
Gross profit
3,553.7
Selling and administrative
expenses
2,458.7
Nonrecurring charges
136.1
Income from operations
958.9
Other expenses and
revenues (including
income taxes)
427.9
Net income
$531.0
The Quaker
Oats Company
Percent
53.2
Amount
2,391.5
Percent
46.0
36.8
2.0
14.4
1,981.0
113.4
415.6
38.1
2.2
8.0
6.4
8.0%
167.7
$247.9
3.2
4.8%
53
Intercompany Comparison
by Vertical Analysis
 Although Kellogg's net sales are 28% greater
than the net sales of Quaker Oats, vertical
analysis facilitates a comparison.
 Kellogg's income from operations as a
percentage of sales is 14.4% compared to
8.0% for Quaker Oats.
 Kellogg's higher percentage income from
operations is attributed to its superior gross
profit margin rate of 53.2%.
54
Ratio Analysis
Ratio Analysis
Ratios can be classified into three types:
 Liquidity ratios - measures of the short-term
ability of the enterprise to pay its maturing
obligations an to meet unexpected needs for cash
 Solvency ratios - measures of the ability of the
enterprise to survive over a long period of time
 Profitability ratios - measures of the income or
operating success of an enterprise for a given
period of time
56
Ratio Analysis
 As a tool of analysis, ratios can provide
clues to underlying conditions that
may not be apparent from an
inspection of the individual
components of a particular ratio.
 A single ratio by itself is not very
meaningful.
57
Liquidity Ratios
 Liquidity ratios measure the
short-term ability of the
enterprise to pay its maturing
obligations and to meet
unexpected needs for cash.
 Short-term creditors such as
bankers and suppliers are
particularly interested in
assessing liquidity.
58
Liquidity Ratios







Current ratio
Acid-test ratio
Current cash debt coverage ratio
Receivables turnover ratio
Average collection period
Inventory turnover
Average days in inventory
59
Current Ratio
 The current ratio is widely used for
evaluating a company's liquidity and shortterm debt-paying ability.
 The current ratio does not take into account
the composition of the current assets.
 A satisfactory current ratio does not disclose
that portion of the current assets that may
be tied up in slow-moving inventory.
60
Current Ratio
Indicates short-term debt-paying
ability
Current Assets
Current Ratio =
Current Liabilities
61
Acid-Test Ratio
 The acid-test ratio or quick ratio is a measure of
a company's immediate short-term liquidity.
 The acid-test ratio is computed by dividing the
sum of cash, marketable securities, and net
receivables by current liabilities.
 The ratio does not include inventory or prepaid
expenses.
 Cash, marketable securities, and receivables are
highly liquid compared with inventory and
prepaid expenses.
62
Acid-Test Ratio
Indicates immediate short-term debtpaying ability.
Cash,Marketable
Acid-Test Securities, Net Receivables
Ratio = Current Liabilities
63
Current Cash Debt
Coverage Ratio
Indicates short-term debt-paying
ability on the cash basis.
Cash provided by operations
Average current liabilities
64
Receivables Turnover Ratio
 Indicates liquidity of receivables by
determining how quickly receivables can
be converted to cash.
 The receivables turnover ratio measures
the number of times, on average,
receivables are collected during the
period.
65
Receivables Turnover Ratio =
a measure of the liquidity
of receivables
Net Credit Sales
Average Net Receivables
66
Average Collection Period
 The average collection period is a popular
variant of the receivables turnover ratio.
 The average collection period converts the
receivables turnover into an average
collection period expressed in days.
 The general rule is that the collection period
should not greatly exceed the credit term
period.
67
Average Collection Period =
the average amount of time that a
receivable is outstanding.
365 days
Receivables Ratio Turnover
68
Inventory Turnover Ratio
 The inventory turnover ratio measures
the number of times on average the
inventory is sold during the period.
 Indicates the liquidity of the inventory
69
Inventory Turnover Ratio =
Cost of Goods Sold
Average Inventory
70
Average Days in Inventory
 Is a variant of the inventory turnover
ratio.
 Measures the average number of days
it takes to sell the inventory.
71
Average Days in Inventory =
365 days
Inventory Turnover Ratio
72
Solvency Ratios
 Measure the ability of the enterprise to
survive over a long period of time
 Long-term creditors and stockholders are
interested in a company's long-run
solvency, particularly its ability to pay
interest as it comes due and to repay the
face value of the debt at maturity.
73
Solvency Ratios
 Debt to total assets ratio
 Times interest earned ratio
 Cash debt coverage ratio
 Free cash flow
74
Debt to Total Assets Ratio
Indicates % of total assets provided
by creditors.
Total Debt
Total Assets
Times Interest Earned Ratio
Indicates a company’s ability to meet
interest payments as they come due.
Interest Before Interest Expense & Income Tax
Interest Expense
76
Cash Debt Coverage Ratio
Indicates: Long-term debt-paying ability on
the cash basis.
Cash provided by operations
Average total liabilities
77
Free Cash Flow
Indicates cash available for paying
dividends or expanding operations.
Cash Provided By Operations
-
Capital Expenditures
-
Dividends Paid
Free Cash Flow
78
Profitability Ratios
 Measures the income or operating
success of an enterprise for a given
period of time
 These are important because a
company's income, or lack of it, affects
its ability to obtain debt and equity
financing, its liquidity position, and its
ability to grow.
79
Profitability Ratios










Return on common stockholders’ equity ratio
Return on assets ratio
Profit margin ratio
Assets turnover ratio
Gross profit rate
Operating expenses to sales ratio
Cash return on sales ratio
Earnings per share (EPS)
Price-earnings ratio
Payout ratio
80
Relationships Among
Profitability Measures
Page 668 in book
Return on Common
Stockholders’ Equity Ratio
Measures the profitability from the
stockholders’ point of view
Net income - Preferred stock dividends
Average common stockholders’ equity
82
Return on Assets Ratio
Reveals the amount of net income
generated by each dollar invested
Net income
Return on Assets Ratio =
Average assets
Higher value suggests favorable
efficiency.
83
Profit Margin Ratio
Indicates the percentage of each dollar of
sales that results in net income.
Net income
Profit Margin Ratio =
Net sales
Higher value suggests favorable
return on each dollar of sales.
84
Asset Turnover Ratio
Indicates how efficiently assets are
used to generate sales.
Net sales
Average total assets
85
Gross Profit Rate
Indicates margin between selling price
and cost of good sold.
Gross profit
Net sales
86
Operating Expenses to
Sales Ratio
Indicates the cost incurred to
support each dollar of sales.
Operating expenses
Net sales
87
Cash Return on Sales Ratio
 The cash return on sales ratio indicates
the company's ability to turn sales into
dollars for the firm.
 A low cash return on sales ratio should
be investigated because it might
indicate the firm is recognizing sales
that are not really sales - that is, sales it
will never collect.
88
Limitations Of
Financial Analysis
 Horizontal, vertical, and ratio analysis
are frequently used in making significant
business decisions.
 One should be aware of
the limitations of these
tools and the financial
statements.
89
Estimates
 Financial statements are based on
estimates.




allowance for uncollectible accounts
depreciation
costs of warranties
contingent losses
To the extent that these estimates are
inaccurate, the financial ratios and
percentages are also inaccurate.
90
Costs
 Traditional financial statements are based on
historical cost and are not adjusted for price level
changes.
 Comparisons of unadjusted financial data from
different periods may be rendered invalid by
significant inflation or deflation.
 Some assets such as property, plant, and
equipment may be many years old. The cost at
which they are shown on the balance sheet might
be significantly lower than current market value.
91
Alternative Accounting
Methods
 One company may use the FIFO method,
while another company in the same industry
may use LIFO.
 If the inventory is significant for both
companies, it is unlikely that their current
ratios are comparable.
 In addition to differences in inventory costing
methods, differences also exist in reporting
such items as depreciation, depletion, and
amortization.
92
Atypical Data
Fiscal year-end data may not be
typical of a company's financial
condition during the year.
93
Diversification
 Diversification in American industry
also limits the usefulness of financial
analysis.
 Many firms are so diverse they cannot
be classified by industry.
94
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95