If you are a business analyst this article is not for you. If you are not, and you are interested in developing some knowledge about financial tools that can help you understand how companies perform, than this might help. There are three tools that you can use, and in this post you have an overview.
Common Size, Trend, and Ratio Analysis
So, if you are familiar with a lot of different companies in each industry but you are not sure how to compare them at least from a financial perspective, these are the tools that can help:
- common size analysis
- trend analysis and
- ratio analysis
Each of these tools can be used to analyze a company’s historical performance, to make comparisons between firms and to predict future results, and all these tools rely on the financial statements. The income statement, the balance sheet and the statement of cash flows will give you all the necessary information.
Common size analysis
This analysis involves taking all the absolute figures on the company’s financial statements and converting them to percentages. In a common size income statement we simply compare all line items to sales or revenues.
After this is done, the results can be compared within industry and for different years. But, be aware, this common size analysis, while an extremely useful tool, is usually just a starting point for even greater analysis and inquiry. It just gives some hints on where to look first.
The other thing common size analysis tells us about is something known as operating leverage, which refers to an entity’s cost structure and whether it mostly consists of fixed costs costs that don’t change with increases in sales volume or variable costs meaning they change proportionately as sales volume increases.
Common size analysis – an example
P&G reported 2013 revenues of $84.2 billion. we will set that equal to 100%. The income statement also shows that the company’s 2013 cost of goods sold was $42.4 billion.
If we divide the $42.4 billion of cost of goods sold by the $84.2 billion of revenues, we get a cost of good sold percentage of 50.4%. Thus P&G’s 2013 gross profit percentage was 49.6% which is the difference between 100% and 50.4%.
We continue with the same exercise all the way down the entire income statement dividing each figure into total revenues and calculating the related percentages. For example P&G’s net income as a percentage of revenues was 13.4% which is something known as the net margin.
With trend analysis we first choose a particular base year, generally from the last few years and set every single figure in that year’s financial statements equal to 100%. And then we look at subsequent years comparing each individual line in the financial statements to the base year dividing one by the other to see how the financial statement lines are trending.
Sometime we have the same sort of trends with respect to the net income, which means that operating leverage was negative as increases in revenues did not translate to higher profits. Sales revenue might have increased, albeit modestly, but our trend analysis reveals that the company’s profitability is not keeping pace with the increases in revenues, because costs grew faster than sales revenue.
Trend analysis – an example
In 2011 P&G reported sales revenues of $81.1 billion. If we set this $81.1 billion equal to 100%, we can then compare the 2012 and 2013 sales revenue to the 2011 figures and evaluate the resulting trends. For example P&G reported 2012 and 2013 revenues of $83.7 and $84.2 billion respectively. If we divide these revenues by our base revenue of $81.1 billion, we see that revenues grew by 3.2% from 2011 to 2012 but that the recent trend is much lower as 2013 revenues grew only 3.8% as compared to 2011.
If we move on the income statement and continue our calculations, we find that 2012 operating income was less than 86% of 2011 levels and the 2013 operating income was 93.5% of 2011 levels better than 2012 the trend is still down over the past couple of years. Seeing these results, you would probably not be surprised to learn that P&G made substantial changes in 2013 replacing the company’s CEO among other changes in key personnel.
More uses for common-size and trend analysis
The approach to common size and trend analysis for both the balance sheet and statement of cash flows are very similar to that of the income statement. We first need to select the base year which should be the same year as that set for the income statement trend analysis and compare that year to later years on the balance sheet or statement of cash flows.
Again, remember that the base year is the year for which we are going to set all financial statement figures equal to 100%, so that we can then compare future results to the base year numbers. Whenever using common size analysis on the balance sheet or cash flow statement we first need to decide what will be the denominator or the particular line that we set equal to 100%.
For the balance sheet common size analysis we use total assets as our denominator. We then compare each and every other balance sheet line item to this figure putting results in percentage terms. To perform a common size analysis for the statement of cash flows the typical approach is to compare each of the line items to total sales revenue which is drawn from the income statement.
More uses for common-size and trend analysis – an example
At the end of 2013 P&G reported that total assets were $139.3 billion. Total long-term debt for P&G in 2013 was $19.1 billion. Divide that number by $139.3 million and you see that long-term debt was 13.7% of total assets.
Once again, we can use these results to compare 2013 to prior years or to competitors. For example in 2012 total long-term debt was closer to 16% of total assets. By one measure P&G has reduced its overall financial leverage in 2013. They, therefore, have less debt for every dollar of assets in 2013 than they did just a couple of years ago.
Also, to take this one step forward, in 2011 P&G’s net income was $11.9 billion this was equal to about 90% of the operating cash flows that they reported that year, which approximated $13.3 billion. But, in 2013 that 90% figure declined to less than 77%. Again, the company’s net income declined as a percentage of operating cash flows for about 90% to 77% in two years.
The ratio analysis is actually a set of tools which we can use to analyze many aspects of a company’s financial performance. In each case the objective of computing these ratios is to compare results over time and to competitors. All ratios involve relatively simple math thank goodness dividing one financial statement figure by another.
There are five categories of ratios that we should consider:
- liquidity ratios which help us assess how liquid is an organization is and whether it should be able to meet its shorter-term obligations.
- profitability ratios which focus on determining how profitable an organization is
- efficiency or activity ratios as they are sometimes called which measure how efficient an organization is in managing its working capital, it’s receivables, inventories, payables and other current assets and liabilities. These are also sometimes referred to as the turnover ratios.
- leverage or solvency ratios which tell us something about the overall riskiness of an organization in its ability to service its longer-term obligations and
- market ratios which serve as a link between certain accounting disclosures and valuation, a link between accounting and finance.
The most common ratio to measure organizational liquidity is to divide the total current assets by the current liabilities at any balance sheet date. That gives us something called the current ratio. Again go to the balance sheet and find the total current assets.
Remember those are assets that are very liquid like cash and marketable securities and others that can generally be convertible into cash at a reasonable period of time, like accounts receivable and inventories. Then you divide the total current assets by the total amount of current liabilities those liabilities that an organization expects to pay during the next 12 months.
So what is the minimal current ratio we would like to see? Generally we want to see current ratios of at least 1, indicating that current assets at least cover current liabilities. A rule of thumb is that we really want to see current ratios of at least two so that current assets are at least twice that of current liabilities. A higher figure indicates a firm is more liquid.
Organizational liquidity – an example
In 2013 Procter & Gamble had current assets about $24 billion and in current liabilities about $30 billion. If we divide P&G’s current liabilities into its current assets you find that P&G’s current ratio at the end of 2013 was about .8, less than 1.0.
At first glance it might be very concerning that the company’s current assets are actually less than their current liabilities. However upon further analysis about 40% of the current liabilities are represented by the current portion of the company’s long-term debt meaning that the current portion of the long-term debt the current ratio is closer to 1.4.
The efficiency ratio
One example is the accounts receivable turnover ratio which measures how quickly on average accompanies able to collect its receivables from customers. Obviously companies want to collect the amounts they are owed as quickly as they can. The formula for the accounts receivable turnover ratio is to take the sales revenue the company generates during a period divided by the average accounts receivable outstanding during that same period.
To find the average accounts receivable we go to the balance sheet and add the balance of receivables at the start of the. In the balance at the end of the period and then we divide the sum by two. Once we divide revenues by this average balance we can identify how many times on average the company collects its receivables during a particular period of time.
Accounts receivable turnover ratio – an example
You will recall that the company’s 2013 sales revenue was $84.2 billion. At the start of 2013 the company’s accounts receivable balance was about $6.1 billion and the ending balance was $6.5 billion. So the average accounts receivable balance was about $6.3 billion.
Dividing the $6.3 billion in the $84.2 million equals about 13.4, meaning that Procter & Gamble collects its receivables about 13.4 times each year. Now, if you divide 13.4 with the 365 days you get 27.3 days. In other words when Procter & Gamble sells products to customers the likes of Walmart, Costco, Sears and Kroger it gets paid on average in less than 28 days.
The inventory and payable turnover ratio
The inventory turnover ratio similar to the accounts receivable turnover ratio measures how quickly a company is turning over or selling its inventory. The formula is very similar to the accounts receivable turnover ratio except instead of sales revenue in the numerator we use cost of goods sold dividing the cost of goods sold by the average inventory balance during the period.
Again using the figures from P&G’s 2013 financial statements we see that the cost of goods sold was $42.4 billion and the average inventory about $6.82 billion resulting in inventory turnover of 6.23. Meaning that they current over their entire inventory 6.23 times each year. Divide 6.23 and 365 days and you find it takes about 59 days on average for P&G to turn over it’s inventory.
You can compute the accounts payable turnover ratio using the same exact approach. Dividing cost of goods sold by the average accounts payable balance. For P&G the accounts payable turnover ratio is about 5.1 which equates to just shy of 72 days. So P&G pays its own suppliers or vendors in 72 days or more than two months and yet is able to collect its receivables in less than a month.
Profitability ratios are designed to assess how profitable an organization may or may not be. The gross and net margin percentages that we derive from our common size analysis are some examples. The other set of profitability ratios are return on investment metrics known as ROI for short. They include return on assets known as ROA and return on equity or ROE.
ROA is calculated by taking a company’s net income and dividing it by the average total assets the company has outstanding during that same period of time. If we look again at P&G and compute the company’s 2013 ROA, the net income being $11.3 billion for the year while the average total assets approximated $135.8 billion the result is about 8.3%. In other words for every dollar of assets P&G owned in 2013 it earned about 8.3 ¢ during the year.
Return on equity (ROE) calculated by dividing net income by average shareholders equity. For 2013 P&G’s ROE was about 17% computed by dividing net income of $11.3 billion by the company’s average shareholders equity of 66.4 billion. In other words every dollar of shareholder capital or equity invested in P&G earned 17% on average, which is certainly not bad at all.
Leverage or solvency ratios
Leverage ratio is the interest coverage ratio which is computed by dividing operating income by interest expense. That is, we take the operating income from the income statement and divided it by the amount of interest expense the company reports.
A higher figure means the company is better able to cover the cost of its debt. To stay with our example, for P&G operating income is 22 times its interest expense. Clearly therefore P&G is a solid company and the risk of insolvency low.
Market ratios allow us to bridge accounting disclosures and market valuation. Common examples include the price earnings ratio is where we divide a company’s stock price by its earnings-per-share. Others include dividing a company’s total stock market value by total revenues something known as the price to sales ratio.
And with this we conclude the short presentation of these three extremely useful tools used to analyze financial trends and performance. All of which should be in our toolkits.