Imagine we were given balance sheets for the last 10 years for some company and we were trying to investigate trends in the firm’s pattern of operations. Does the firm use more or less debt? Has the firm grown more or less liquid? A useful way of standardizing financial statements in this case is to choose a base year and then express each item relative to the base amount. We will call the resulting statements common-base year statements.
For example, from 2014 to 2015, Prufrock’s inventory rose from $393 to $422. If we pick 2014 as our base year, then we would set inventory equal to 1.00 for that year. For the next year, we would calculate inventory relative to the base year as $422/393 = 1.07. In this case, we could say inventory grew by about 7 percent during the year. If we had multiple years, we would just divide the inventory figure for each one by $393. The resulting series is easy to plot, and it is then easy to compare companies. Table 3.7 summarizes these calculations for the asset side of the balance sheet.
COMBINED COMMON-SIZE AND BASE YEAR ANALYSIS
The trend analysis we have been discussing can be combined with the common-size analysis discussed earlier. The reason for doing this is that as total assets grow, most of the other accounts must grow as well. By first forming the common-size statements, we eliminate the effect of this overall growth.
For example, looking at Table 3.7, we see that Prufrock’s accounts receivable were $165, or 4.9 percent of total assets, in 2014. In 2015, they had risen to $188, which was 5.2 percent of total assets. If we do our analysis in terms of dollars, then the 2015 figure would be $188/165 = 1.14, representing a 14 percent increase in receivables. However, if we work with the common-size statements, then the 2015 figure would be 5.2%/4.9% = 1.06. This tells us accounts receivable, as a percentage of total assets, grew by 6 percent. Roughly speaking, what we see is that of the 14 percent total increase, about 8 percent (= 14% – 6%) is attributable simply to growth in total assets.
common-base year statement A standardized financial statement presenting all items relative to a certain base year amount.
Page 57TABLE 3.7
NOTE: The common-size numbers are calculated by dividing each item by total assets for that year. For example, the 2014 common-size cash amount is $84/3,373 = 2.5%. The common-base year numbers are calculated by dividing each 2015 item by the base year (2014) dollar amount. The common-base cash is thus $98/84 = 1.17, representing a 17 percent increase. The combined common-size and base year figures are calculated by dividing each common-size amount by the base year (2014) common-size amount. The cash figure is therefore 2.7%/2.5% = 1.08, representing an 8 percent increase in cash holdings as a percentage of total assets. Columns may not total precisely due to rounding.
3.2a Why is it often necessary to standardize financial statements?
3.2b Name two types of standardized statements and describe how each is formed.
3.3 Ratio Analysis
Another way of avoiding the problems involved in comparing companies of different sizes is to calculate and compare financial ratios. Such ratios are ways of comparing and investigating the relationships between different pieces of financial information. Using ratios eliminates the size problem because the size effectively divides out. We’re then left with percentages, multiples, or time periods.
There is a problem in discussing financial ratios. Because a ratio is simply one number divided by another, and because there are so many accounting numbers out there, we could examine a huge number of possible ratios. Everybody has a favorite. We will restrict ourselves to a representative sampling.
In this section, we only want to introduce you to some commonly used financial ratios. These are not necessarily the ones we think are the best. In fact, some of them may strike you as illogical or not as useful as some alternatives. If they do, don’t be concerned. As a financial analyst, you can always decide how to compute your own ratios.
What you do need to worry about is the fact that different people and different sources seldom compute these ratios in exactly the same way, and this leads to much confusion. The specific definitions we use here may or may not be the same as ones you have seen or will see elsewhere. If you are ever using ratios as a tool for analysis, you should be careful to document how you calculate each one. And if you are comparing your numbers to numbers from another source, be sure you know how those numbers are computed.
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financial ratios Relationships determined from a firm’s financial information and used for comparison purposes.
Page 58We will defer much of our discussion of how ratios are used and some problems that come up with using them until later in the chapter. For now, for each of the ratios we discuss, we consider several questions:
1. How is it computed?
2. What is it intended to measure, and why might we be interested?
3. What is the unit of measurement?
4. What might a high or low value tell us? How might such values be misleading?
5. How could this measure be improved?
Financial ratios are traditionally grouped into the following categories:
1. Short-term solvency, or liquidity, ratios.
2. Long-term solvency, or financial leverage, ratios.
3. Asset management, or turnover, ratios.
4. Profitability ratios.
5. Market value ratios.
We will consider each of these in turn. In calculating these numbers for Prufrock, we will use the ending balance sheet (2015) figures unless we say otherwise. Also notice that the various ratios are color keyed to indicate which numbers come from the income statement and which come from the balance sheet.