As we have discussed, the primary reason for looking at accounting information is that we don’t have, and can’t reasonably expect to get, market value information. We stress that whenever we have market information, we will use it instead of accounting data. Also, if there is a conflict between accounting and market data, market data should be given precedence.
Financial statement analysis is essentially an application of “management by exception.” In many cases, such analysis will boil down to comparing ratios for one business with average or representative ratios. Those ratios that seem to differ the most from the averages are tagged for further study.
Internal Uses Financial statement information has a variety of uses within a firm. Among the most important of these is performance evaluation. For example, managers are frequently evaluated and compensated on the basis of accounting measures of performance such as profit margin and return on equity. Also, firms with multiple divisions frequently compare the performance of those divisions using financial statement information.
Another important internal use we will explore in the next chapter is planning for the future. As we will see, historical financial statement information is useful for generating projections about the future and for checking the realism of assumptions made in those projections.
External Uses Financial statements are useful to parties outside the firm, including short-term and long-term creditors and potential investors. For example, we would find such information quite useful in deciding whether to grant credit to a new customer.
We would also use this information to evaluate suppliers, and suppliers would review our statements before deciding to extend credit to us. Large customers use this information to decide if we are likely to be around in the future. Credit-rating agencies rely on financial statements in assessing a firm’s overall creditworthiness. The common theme here is that financial statements are a prime source of information about a firm’s financial health.
We would also find such information useful in evaluating our main competitors. We might be thinking of launching a new product. A prime concern would be whether the competition would jump in shortly thereafter. In this case, we would be interested in learning about our competitors’ financial strength to see if they could afford the necessary development.
Finally, we might be thinking of acquiring another firm. Financial statement information would be essential in identifying potential targets and deciding what to offer.
Page 74CHOOSING A BENCHMARK
Given that we want to evaluate a division or a firm based on its financial statements, a basic problem immediately comes up. How do we choose a benchmark, or a standard of comparison? We describe some ways of getting started in this section.
Time Trend Analysis One standard we could use is history. Suppose we found that the current ratio for a particular firm is 2.4 based on the most recent financial statement information. Looking back over the last 10 years, we might find that this ratio had declined fairly steadily over that period.
Based on this, we might wonder if the liquidity position of the firm has deteriorated. It could be, of course, that the firm has made changes that allow it to more efficiently use its current assets, the nature of the firm’s business has changed, or business practices have changed. If we investigate, we might find any of these possible explanations behind the decline. This is an example of what we mean by management by exception—a deteriorating time trend may not be bad, but it does merit investigation.
Peer Group Analysis The second means of establishing a benchmark is to identify firms similar in the sense that they compete in the same markets, have similar assets, and operate in similar ways. In other words, we need to identify a peer group. There are obvious problems with doing this because no two companies are identical. Ultimately the choice of which companies to use as a basis for comparison is subjective.
One common way of identifying potential peers is based on Standard Industrial Classification (SIC) codes. These are four-digit codes established by the U.S. government for statistical reporting. Firms with the same SIC code are frequently assumed to be similar.
The first digit in an SIC code establishes the general type of business. For example, firms engaged in finance, insurance, and real estate have SIC codes beginning with 6. Each additional digit narrows down the industry. So, companies with SIC codes beginning with 60 are mostly banks and banklike businesses; those with codes beginning with 602 are mostly commercial banks; and SIC code 6025 is assigned to national banks that are members of the Federal Reserve system. Table 3.11 lists selected two-digit codes (the first two digits of the four-digit SIC codes) and the industries they represent.
Standard Industrial Classification (SIC) code A U.S. government code used to classify a firm by its type of business operations.
TABLE 3.11 Selected Two-Digit SIC Codes
Page 75SIC codes are far from perfect. For example, suppose you were examining financial statements for Walmart, the largest retailer in the United States. The relevant two-digit SIC code is 53, General Merchandise Stores. In a quick scan of the nearest financial database, you would find about 20 large, publicly owned corporations with a similar SIC code, but you might not be comfortable with some of them. Target would seem to be a reasonable peer, but Neiman Marcus also carries the same industry code. Are Walmart and Neiman Marcus really comparable?
As this example illustrates, it is probably not appropriate to blindly use SIC code–based averages. Instead, analysts often identify a set of primary competitors and then compute a set of averages based on just this group. Also, we may be more concerned with a group of the top firms in an industry, not the average firm. Such a group is called an aspirant group because we aspire to be like its members. In this case, a financial statement analysis reveals how far we have to go.
Beginning in 1997, a new industry classification system was initiated. Specifically, the North American Industry Classification System (NAICS, pronounced “nakes”) is intended to replace the older SIC codes, and it will eventually. Currently, however, SIC codes are still widely used.
With these caveats about industry codes in mind, we can now take a look at a specific industry. Suppose we are in the retail hardware business. Table 3.12 contains some condensed common-size financial statements for this industry from the Risk Management Association (RMA, formerly known as Robert Morris Associates), one of many sources of such information. Table 3.13 contains selected ratios from the same source.
There is a large amount of information here, most of which is self-explanatory. On the right in Table 3.12, we have current information reported for different groups based on sales. Within each sales group, common-size information is reported. For example, firms with sales in the $10 million to $25 million range have cash and equivalents equal to 6.7 percent of total assets. There are 33 companies in this group, out of 337 in all.
On the left, we have three years’ worth of summary historical information for the entire group. For example, operating profit fell from 2.3 percent of sales to 1.7 percent over that time.
Table 3.13 contains some selected ratios, again reported by sales groups on the right and time period on the left. To see how we might use this information, suppose our firm has a current ratio of 2. Based on these ratios, is this value unusual?
Looking at the current ratio for the overall group for the most recent year (third column from the left in Table 3.13), we see that three numbers are reported. The one in the middle, 2.8, is the median, meaning that half of the 337 firms had current ratios that were lower and half had bigger current ratios. The other two numbers are the upper and lower quartiles. So, 25 percent of the firms had a current ratio larger than 4.9 and 25 percent had a current ratio smaller than 1.6. Our value of 2 falls comfortably within these bounds, so it doesn’t appear too unusual. This comparison illustrates how knowledge of the range of ratios is important in addition to knowledge of the average. Notice how stable the current ratio has been for the last three years.
EXAMPLE 3.5 More Ratios
Take a look at the most recent numbers reported for Sales/Receivables and EBIT/Interest in Table 3.13. What are the overall median values? What are these ratios?
If you look back at our discussion, you will see that these are the receivables turnover and the times interest earned, or TIE, ratios. The median value for receivables turnover for the entire group is 36.7 times. So, the days in receivables would be 365/36.7 = 10, which is the boldfaced number reported. The median for the TIE is 2.6 times. The number in parentheses indicates that the calculation is meaningful for, and therefore based on, only 295 of the 337 companies. In this case, the reason is that only 295 companies paid any significant amount of interest.
Page 76TABLE 3.12 Selected Financial Statement Information
Page 77TABLE 3.13 Selected Ratios
M = $ thousand; MM = $ million.
© 2011 by RMA All rights reserved. No part of this table may be reproduced or utilized in any form or by any means, eletronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without permission in writing from RMA.
There are many sources of ratio information in addition to the one we examine here. Our nearby Work the Web box shows how to get this information for just about any company, along with some useful benchmarking information. Be sure to look it over and then benchmark your favorite company.