In this article, I will discuss some background skills that you will need to know when you conduct a financial statement analysis.
What is the Common Size Method?
The main key to financial statement analysis lies incomparing the different items in the financial statement and quantifying their size relative to the total.
For example, when analyzing an income statement, most analysts would compare the company’s expenses with its revenue.
In this hypothetical example, company A has a revenue of 1,000 Million and an operating expense of 700 Million and company B has a revenue of 2,000 Million and an operating expense 1,000 Million.
How would we know which company is better?
In this case, we should divide operating expense by revenue to see how big the company’s operating expense is relative to their revenue. So for our example, company A has 70% (700/1000) and Company B has 50% (1,000/2,000) of revenue in operating expenses.
As you can see, company B is considered more efficient than company A because company B’s operating expense is smaller as a percentage of sales relative to company A.
As you will see later on, you will be doing this type of math frequently (dividing one category with another category and making company comparisons).
Aside from comparing companies, investors can also use common size methods to make multi year comparisons.
For example, Coca Cola’s operating expenses (% of Revenue) has been in ranges of 37-40%% for the last five years. Since the range is so small, we can say that Coca Cola has been doing a good job in controlling their cost. On the other hand, MGM Grand’s operating expenses (% of revenue) range from 8-55% in the last five years. This creates more unpredictability with MGM’s management’s ability to control cost, which should be worrisome for many investors.
About Financial Ratios
For some investors, ratio analysis is like a dirty secret that is used to find a good company. However, despite the usefulness of ratio analysis, it can be disastrous for an investor if it is not used properly.
Ratios are commonly used by stock pickers to find relationships in the quantitative data within a financial statement.
For example, a stated company’s assets of 10 million are meaningless unless we can compare it with other quantitative data on the company’s balance sheet.
What an investor could do is divide the total assets with the company’s total debts. Say the total debts are equal to 5 million. Now an investor can divide the total assets by total debt, which results in a ratio of 2 (10 million / 5million = 2). An asset/debt ratio of 2 would indicate that the company is holding 2 dollars of assets for every 1 dollar of debt and by using this ratio, the investor can now see a clearer picture than just looking at the assets itself.
Comparing Ratios with Industry Standards
Most often, a ratio itself does not tell an investor everything. Instead, it is rather used as a standard of comparison between similar companies of the same industry.
For example, an asset/debt ratio of 2 might seem strong to the common eye, since the assets are two times the debt. However, what if the industry average has an average asset/debt ratio of 4? Then an asset/debt of 2 might indicate a company’s weakness to hold true to industry standards.
In conclusion, it is always important to compare the ratios of a company relative to its industries. Otherwise, the ratio will be misleading or meaningless.
Rate of Change
In addition, you should also know how to analyze certain items of a financial statement by calculating the year to year percentage change of a specific category. By doing so, you can see the historical trend of a specific category and compare it with other companies as well as with other categories in the financial statements.
How to calculate percentage change?
(New number – old number) ÷ old number x 100% OR [(New Number Old Number) -1 ]x 100%
Company ABC has a reported revenue of 100 million in 2009 and 80 Million in 2008. If I want to know how much revenue has changed in that time period, I would use the percentage method formula as follows:
(100 million – 80 million) ÷ 80 million x 100% OR [(100 million ÷ 80 million) – 1] x 100%
Through the use of the formula, I now know that revenue increased by 25% from 2008 to 2009.