FINANCIAL FINANCIAL STATEMENT STATEMENT COMPARABILITYCOMPARABILITY

Chapter 4Chapter 4

CHAPTER 4 OBJECTIVESCHAPTER 4 OBJECTIVES

Explain the advantage of common size Explain the advantage of common size financial statements compared to those financial statements compared to those disclosed on a monetary basis. disclosed on a monetary basis.

Compute vertical and horizontal common Compute vertical and horizontal common size income statements and balance size income statements and balance sheets.sheets.

Calculate compound annual growth rates Calculate compound annual growth rates and explain why this method provides and explain why this method provides better information than alternative better information than alternative methods of horizontal analysis.methods of horizontal analysis.

CHAPTER 4 OBJECTIVES CHAPTER 4 OBJECTIVES (CONT.)(CONT.)

Determine financial statement Determine financial statement vertical profiles and moving vertical profiles and moving averages.averages.

Use good judgment when reconciling Use good judgment when reconciling financial statement inconsistencies, financial statement inconsistencies, rounding numbers, computing ratios, rounding numbers, computing ratios, scaling numerical amounts and scaling numerical amounts and making qualitative assessments.making qualitative assessments.

BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONSCONSIDERATIONS

Enables valid comparisons over Enables valid comparisons over time or against competitiontime or against competition

BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)

Vertical common size financial Vertical common size financial statementsstatements

Disclosures are a percentage of another Disclosures are a percentage of another account in the same reporting periodaccount in the same reporting period Income statement: accounts reported as a Income statement: accounts reported as a

percentage of revenues (revenues = 100%)percentage of revenues (revenues = 100%) Balance sheet: accounts reported as a Balance sheet: accounts reported as a

percentage of total assets (or liabilities plus percentage of total assets (or liabilities plus shareholders’ equity)shareholders’ equity)

VERTICAL COMMON SIZE VERTICAL COMMON SIZE EXAMPLEEXAMPLE

eXTREMESTUFF.com, Inc.Income StatementsVertical Common Size 2003 2002 2001 2000Sales revenues 100.0% 100.0% 100.0% 100.0%Cost of goods sold 61.1% 58.0% 55.0% 60.0%Gross profit 38.9% 42.0% 45.0% 40.0%Selling expenses 27.1% 25.2% 29.3% 25.0%Administrative expenses 11.5% 12.1% 11.1% 8.5%Income from continuing operations 0.4% 4.8% 4.6% 6.5%Financial expenses 1.5% 1.6% 1.7% 1.0%Pretax income -1.1% 3.1% 2.9% 5.5%Income tax expense / benefit -0.5% 1.3% 1.2% 2.2%Net income -0.7% 1.9% 1.8% 3.3%

BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)

Horizontal common size financial Horizontal common size financial statementsstatements

Disclosures are a percentage of the Disclosures are a percentage of the same account from a previous reporting same account from a previous reporting period period Income statement: e.g., this year’s revenues Income statement: e.g., this year’s revenues

as a percentage of last year’s revenuesas a percentage of last year’s revenues Balance sheet: e.g., this year’s cash balance Balance sheet: e.g., this year’s cash balance

as a percentage of last year’s cash balanceas a percentage of last year’s cash balance

BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)

Alternative disclosures of Alternative disclosures of horizontal analysishorizontal analysis

AnchoringAnchoring Uses the earliest year’s data as the Uses the earliest year’s data as the

base year (100%)base year (100%) Subsequent observations are a Subsequent observations are a

percentage of the base year’s amountpercentage of the base year’s amount

HORIZONTAL COMMON HORIZONTAL COMMON SIZE EXAMPLESIZE EXAMPLE

eXTREMESTUFF.com, Inc.Income StatementsHorizontal Common Size-Base Year 2003 2002 2001 2000Sales revenues 131.0% 124.0% 120.0% 100.0%Cost of goods sold 133.3% 119.8% 110.0% 100.0%Gross profit 127.5% 130.3% 135.0% 100.0%Selling expenses 142.0% 124.8% 140.8% 100.0%Administrative expenses 176.5% 176.5% 156.5% 100.0%Income from continuing operations 7.7% 90.8% 84.6% 100.0%Financial expenses 200.0% 200.0% 200.0% 100.0%Pretax income -27.3% 70.9% 63.6% 100.0%Income tax expense / benefit -27.3% 72.7% 63.6% 100.0%Net income -27.3% 69.7% 63.6% 100.0%

BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)

Alternative disclosures of Alternative disclosures of horizontal analysishorizontal analysis

Rolling forwardRolling forward Uses the previous year’s observation Uses the previous year’s observation

as 100%as 100% Subsequent year’s observations are a Subsequent year’s observations are a

percentage of the previous year’s percentage of the previous year’s base amountbase amount

HORIZONTAL COMMON HORIZONTAL COMMON SIZE EXAMPLESIZE EXAMPLE

eXTREMESTUFF.com, Inc.Income StatementsRolling Forward 2003 2002 2001 2000Sales revenues 105.6% 103.3% 120.0% 100.0%Cost of goods sold 111.3% 108.9% 110.0% 100.0%Gross profit 97.9% 96.5% 135.0% 100.0%Selling expenses 113.8% 88.6% 140.8% 100.0%Administrative expenses 100.0% 112.8% 156.5% 100.0%Income from continuing operations 8.5% 107.3% 84.6% 100.0%Financial expenses 100.0% 100.0% 200.0% 100.0%Pretax income -38.5% 111.4% 63.6% 100.0%Income tax expense / benefit -37.5% 114.3% 63.6% 100.0%Net income -39.1% 109.5% 63.6% 100.0%

BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)

Types of disclosures: reported as aTypes of disclosures: reported as a Percentage of the base year amountPercentage of the base year amount Percentage change from the base Percentage change from the base

year amountyear amount Illustrated in Exhibit 4-4 (p. 88)Illustrated in Exhibit 4-4 (p. 88)

BASIC COMMON SIZE BASIC COMMON SIZE CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)

Mathematical properties of Mathematical properties of common size statementscommon size statements Vertical common sizing is appropriate Vertical common sizing is appropriate

for intraperiod benchmarksfor intraperiod benchmarks Horizontal common sizing is Horizontal common sizing is

appropriate for interperiod appropriate for interperiod benchmarksbenchmarks

Illustrated in Exhibit 4-5 (p. 89)Illustrated in Exhibit 4-5 (p. 89)

COMMON SIZE COMMON SIZE EXTENSIONSEXTENSIONS

Compound annual growth rates—Compound annual growth rates— better method of horizontal analysis than better method of horizontal analysis than

anchoring or rolling the data forwardanchoring or rolling the data forward Mathematically valid: considers the affect of Mathematically valid: considers the affect of

percentage changes on previous periods’ percentage changes on previous periods’ numbersnumbers

Superiority illustrated in Exhibit 4-6 (p. 90) Superiority illustrated in Exhibit 4-6 (p. 90) Internal rate of return command on Internal rate of return command on

spreadsheet application facilitates spreadsheet application facilitates computationscomputations

COMPOUND ANNUAL COMPOUND ANNUAL GROWTH RATE EXAMPLEGROWTH RATE EXAMPLE

eXTREMESTUFF.com, Inc.Income StatementsCompound Annual Growth 2000 2002 2001 2003 GrowthSales revenues (1000.00) 0 0 1310.00 9.4%Cost of goods sold (600.00) 0 0 800.00 10.1%Gross profit (400.00) 0 0 510.00 8.4%Selling expenses (250.00) 0 0 355.00 12.4%Administrative expenses (85.00) 0 0 150.00 20.8%Income from continuing operations (65.00) 0 0 5.00Financial expenses (10.00) 0 0 20.00 26.0%Pretax income (55.00) 0 0 (15.00)Income tax expense / benefit (22.00) 0 0 (6.00)Net income (33.00) 0 0 (9.00)

COMMON SIZE COMMON SIZE EXTENSIONS (CONT.)EXTENSIONS (CONT.)

Financial statement profilesFinancial statement profiles Condenses a vertical common size Condenses a vertical common size

statement into one “average” statement into one “average” reporting periodreporting period

Measures variability over timeMeasures variability over time See Exhibit 4-7 (p. 91)See Exhibit 4-7 (p. 91)

COMMON SIZE COMMON SIZE EXTENSIONS (CONT.)EXTENSIONS (CONT.)

Moving averagesMoving averages Condenses three, five, or seven year Condenses three, five, or seven year

vertical common size statements into vertical common size statements into an average for that period of timean average for that period of time

Moves the average period forward by Moves the average period forward by dropping the earliest observation and dropping the earliest observation and replacing with the most recent replacing with the most recent period’s dataperiod’s data

See Exhibit 4-8 (p. 93)See Exhibit 4-8 (p. 93)

DATA CONSIDERATIONS DATA CONSIDERATIONS

Observation quantityObservation quantity Analyzing sufficient reporting Analyzing sufficient reporting

disclosures to reach valid conclusionsdisclosures to reach valid conclusions Usually between five and 10 years of Usually between five and 10 years of

data sufficedata suffice

DATA CONSIDERATIONS DATA CONSIDERATIONS (CONT.)(CONT.)

Financial statement Financial statement inconsistenciesinconsistencies Format of reported data change over Format of reported data change over

time and differ among companiestime and differ among companies Use judgment to reduce differences in Use judgment to reduce differences in

disclosure setsdisclosure sets Use most recent data available if Use most recent data available if

options existoptions exist

DATA CONSIDERATIONS DATA CONSIDERATIONS (CONT.)(CONT.)

Scaling disclosuresScaling disclosures Companies report financial Companies report financial

statements in thousands or millions of statements in thousands or millions of dollarsdollars

Be aware of the scale or you will fail Be aware of the scale or you will fail to grasp the entity’s sizeto grasp the entity’s size

DATA CONSIDERATIONS DATA CONSIDERATIONS (CONT.)(CONT.)

Numerical roundingNumerical rounding Done to avoid insignificant data Done to avoid insignificant data

disclosuresdisclosures Reduces “clutter” of data disclosures Reduces “clutter” of data disclosures Should only be done when it does not Should only be done when it does not

alter analysts’ decisionsalter analysts’ decisions

DATA CONSIDERATIONS DATA CONSIDERATIONS (CONT.)(CONT.)

Qualitative statementsQualitative statements Analysts’ Analysts’ opinionsopinions about data (e.g. about data (e.g.

one company has a better profit one company has a better profit margin than another) should be made margin than another) should be made with care and after sufficient analysiswith care and after sufficient analysis