Chapter 5
How to Conduct a Financial Statement Analysis

Learning objectives

  • Identify the appropriate steps to conduct a financial statement analysis.
  • Identify the importance of time series and industry comparisons.
  • Recognize the various sources of industry data.

Introduction

The purpose of this section is to provide general guidance on how to conduct a financial statement analysis and to discuss the importance of both time series and industry comparisons as critical components of that analysis. The success of that analysis is also dependent on the analyst’s awareness of the various sources of industry data as well as the problems inherent in the use of that data.

How to conduct an analysis of financial statements

  • Determine what problems exist by comparing the company’s effect ratios to similar ratios for the company’s industry and to the same ratios for previous years.
  • Take a cursory look at the causal ratios, comparing them to previous years and to industry averages.
  • Determine which of the causal ratios are at fault by looking back at the balance sheet and income statement. Remember, the causal ratios can affect each other, so try to determine which one(s) is (are) at fault.
  • Take corrective action by attacking the cause of the problem, not the symptom.

Industry and time series analysis

There are two ways to compare ratios. The first is an industry comparison. Different industries behave differently and have different financial characteristics. To compare a ratio to some preconceived notion of what it should be does not make good economic sense. The analyst should compare a company’s ratios to similar companies. This task can be done two ways. The first is comparing the company ratios to an industry average. This lets the analyst know how the company’s financial condition compares to the average company in the industry. The second type of industry analysis is the comparison of company ratios to those of an industry leader. The company can then try to emulate the leader when possible.

A time series analysis of financial ratios compares the company’s current ratios to those of previous years. The purpose is to understand how the company’s financial condition is changing over time.

A complete analysis of a company should include both an industry and a time series comparison.

Knowledge check

  1. A(n) _______ analysis lets the analyst know how a company compares to similar companies during the most recent time period.
    1. Time series.
    2. Industry.
    3. Ratio.
    4. Time series and an industry.
  2. Select the statement that is most true.
    1. A complete analysis of a company can be accomplished by comparing company ratios to industry averages.
    2. A complete analysis of a company can be accomplished by examining a company’s current year ratios to past years.
    3. A complete analysis of a company should include both an industry and time series comparison.
    4. None of the above.

Sources of industry averages

Primary sources

  • Industry Norms and Key Business Ratios – 900 lines of business – 14 ratios by industry – provided by quartiles – common-sized financial statements. Dun’s Analytical Service, Dun & Bradstreet, One Diamond Hill Road, Murray Hill, NJ, 07974-0027, 1-800-223-0141.
  • Risk Management Associates Annual Statement Studies – 350 lines of business – 16 ratios – common-sized financial statements – size breakdown. Robert Morris Associates, One Liberty Place, Philadelphia, PA, 19103-7398.
  • Financial Studies of the Small Business, for companies with total capitalization less than $1,000,000. Data provided by 1500 CPA firms. Ratios provided by industry size for 69 industries. Provides 16 ratios and common-sized income statement. Financial Research Associates, 510 Ave J, S.E., Winterhaven, FL, 33880.
  • The Almanac of Business and Industrial Financial Ratios – 10 ratios by industry and asset size – also 12 items as a percent of sales. Prentice-Hall, Business and Professional Division, Englewood Cliffs, NJ, 07632.

Other sources

  • BusinessWeek Quarterly Corporate Scoreboard – Provides a lot of sales and stock market data by industry.
  • Value Line Investment Surveys – Provides a lot of detail on large industries.
  • Various publications of Moody’s and Standard and Poor’s.
  • Trade journals – Your clients may subscribe. There is a fairly comprehensive list of these in the back of RMA.

Knowledge check

  1. Of the sources of industry data presented in the manual, the two sources that not only provide the industry averages, but also provide a “size” breakdown of the averages are
    1. “Risk Management and Associates Annual Statement Studies” and “The Almanac of Business and Industrial Financial Ratios.”
    2. “Industry Norms and Key Business Ratios” and “Financial Studies of the Small Business.”
    3. Business Week and Moody’s.
    4. None of the sources provide a size breakdown.

Problems with using industry data

While it is very important to use industry ratios, there are many problems associated with the practice, including the following:

  • Averages are not goals; they are just averages.
  • Conglomerates—Which industry?
  • Accounting differences within industry.
  • Small sample of firms in industry.
  • Size differences in the industry.
  • Alternate calculations of ratios.
  • Delay (at least eight months) in publication of industry ratios.

Knowledge check

  1. A company with ratios that match the industry average is in _______ shape.
    1. Poor.
    2. Average.
    3. Great.
    4. Impossible to tell.
  2. Which is not generally a problem with using industry averages?
    1. A company may be a conglomerate.
    2. The company may use different accounting procedures than the industry.
    3. Industry data is not available at year-end.
    4. All of the above.

An example of computing industry statistics from risk management associates (formerly Robert Morris) data

Assets Percent
Cash 4.1
Marketable securities 1.3
Receivables, net 38.9
Inventory, net 20.7
All other current assets 2.5
Total current assets 67.5
Fixed assets, net 26.8
All other noncurrent assets 5.7
  100.0*
Liabilities and owners equity
Notes payable, short-term 12.9
Account payables 16.5
Income taxes payable 3.2
Current maturities of long-term debt 2.6
All other current liabilities 8.7
Total current liabilities 43.9
Noncurrent debt, unsubordinated 11.0
Total unsubordinated debt 54.9
Subordinated debt 1.7
Tangible net worth 43.4
  100.0

The key to using a common-sized balance sheet provided with industry averages is to use the percentages as if they were dollar figures. So, you can use these numbers to find the industry average for, say, the current ratio. It would be 67.5% ÷ 43.9% = 1.5x. A word of caution is in order, however, as most providers of industry averages use the median when reporting the average, On the other hand, the common-sized financial statements are means. Means and medians will not be the same unless the distribution of ratios is symmetrical (for example, normal distribution). So the current ratio you computed here will not necessarily match the industry average of provided by Risk Management Associates.

An example of computing industry statistics from Dun and Bradstreet data

Net sales to net worth 3.8 times
Current debt to equity 75.1%
Current ratio 1.9 times
Collection period 60 days

Compute receivables to working capital from the four ratios provided by Dun and Bradstreet by following these eight simple steps:

  1. Assume that net worth is $1,000,000.
  2. Sales then are $3,800,000, since net worth turns 3.8 times per year.
  3. Dividing $3,800,000 annual sales by 365, we find average daily sales to be $10,411.
  4. Multiplying $10,411 by the 60-day collection period, we arrive at a receivables figure of $624,660.
  5. Current debt is 75.1 percent of net worth ($1,000,000) or $751,000.
  6. Current assets are 1.9 times current debt (as shown by the current ratio) or $1,426,900.
  7. Subtracting $751,000 current debt from $1,426,900 current assets, we can establish that working capital is $675,900.
  8. Dividing $624,660 receivables by $675,900, the working capital, we find that the ratio of trade receivables to working capital is 92.4 percent.

Illustrative problem

How would your answer change if the current ratio is 2.5 instead of 1.89?

Group exercise

Suppose that for this industry, the inventory turnover (net sales/inventory) is 4x. Compute the ratio of inventory to working capital and the quick ratio.

Guidelines to use in applying ratio analysis

  • Ignore isolated figures; financial balance is relative.
  • Compare likes; ratios of a company under study must be related to averages for the line of business in which the particular concern is engaged.
  • Study any substantial deviation from normal, either high or low.
  • Avoid concentration on astronomically high percentages or spectacular variances; the significant ratios may be less sensational in appearance.
  • Remember that a ratio measures both components, the numerator and denominator.
  • Recognize the seasonal factor and make appropriate allowance for it.
  • Watch for trends.
  • Be alert to compensating advantages—offsetting strengths in other financial areas.

Knowledge check

  1. When conducting an analysis of financial statements, it is important to take corrective action by attacking the
    1. Underlying cause of the problems.
    2. Symptoms of the problem as indicated by the effect ratios.
    3. Profit ratios first and foremost.
    4. Bankers.

Review questions

  1. What is the major advantage of the cause-and-effect ratio system?

     

     

     

  2. What is the purpose of an industry analysis?