12.4 Financial Statement Analysis

Vertical Percentage Analysis

What does this statement tell us about your second year in business? Some things look good and some don’t. Your sales went up from $500,000 to $600,000 (a 20 percent increase—not bad). But your profit was down—from $30,000 to $18,000 (a bad sign). As you stare at the statement, you’re asking yourself the question: Why did my profit go down even though my sales went up? Does this result make sense? Is there some way of comparing two income statements that will give me a more helpful view of my company’s financial health? One way is called vertical percentage analysis. It’s useful because it reveals the relationship of each item on the income statement to a specified base—generally sales—by expressing each item as a percentage of that base.

Figure 12.20 “Comparative Income Statement Using Vertical Percentage Analysis” shows what comparative income statements look like when you use vertical percentage analysis showing each item as a percentage of sales. Let’s see if this helps clarify things. What do you think accounted for the company’s drop in income even though The College Shop sales went up?

The percentages help you to analyze changes in the income statement items over time, but it might be easier if you think of the percentages as pennies. In year 1, for example, for every $1.00 of sales, $0.55 went to pay for the goods that you sold, leaving $0.45 to cover your other costs and leave you a profit. Operating expenses (salaries, rent, advertising, and so forth) used up $0.35 of every $1.00 of sales, while interest and taxes took up $0.02 each. After you covered all your costs, you had $0.06 profit for every $1.00 of sales.

Asking the Right Questions

Now, compare these figures to those for year 2. Where is the major discrepancy? It’s in Cost of goods sold. Instead of using $0.55 of every $1.00 of sales to buy the goods you sold, you used $0.64. As a result, you had $0.09 less ($0.64 – $0.55) to cover other costs. This is the major reason why you weren’t as profitable in year 2 as you were in year 1: your Gross profit as a percentage of sales was lower in year 2 than it was in year 1. Though this information doesn’t give you all the answers you’d like to have, it does, however, raise some interesting questions. Why was there a change in the relationship between Sales and Cost of goods sold? Did you have to pay more to buy goods for resale and, if so, were you unable to increase your selling price to cover the additional cost? Did you have to reduce prices to move goods that weren’t selling well? (If your costs stay the same but your selling price goes down, you make less on each item sold.) Answers to these questions require further analysis, but at least you know what the useful questions are.

Profit Margin Ratios

We’ve already determined the two most common profit margin ratios—gross profit margin and net profit margin—when we used vertical percentage analysis to determine the relationship to Sales of each item on The College Shop’s income statement. We were examining gross profit when we found that Gross profit for year 1 was 45 percent of Sales and that, in year 2, it had declined to 36 percent. We can express the same relationships as ratios:

[latex]Gross\;profit\;margin=\frac{Gross profit}{Sales}[/latex]
[latex]Year\;1: \;\frac{\$225,000}{\$500,000}=45\%[/latex]
[latex]Year\;2: \;\frac{\$213,000}{\$600,000}=36\%(rounded)[/latex]

We can see that gross profit margin declined (a situation that, as we learned earlier, probably isn’t good). But how can you tell whether your gross profit margin for year 2 is appropriate for your company? For one thing, we can use it to compare The College Shop’s results to those of its industry. When we make this comparison, we find that the specialized retail industry (in which your company operates) reports an average gross profit margin of 41 percent. For year 1, therefore, we had a higher ratio than the industry; in year 2, though we had a lower ratio, we were still in the proverbial ballpark.

It’s worthwhile to track gross profit margin, whether for your company or for companies that you might invest in or lend money to. In particular, you’ll gain some insight into changes that might be occurring in a business. For instance, what if you discover that a firm’s gross profit margin has declined? Is it because it’s costing more for the company to buy or make its products, or is it because its competition is forcing it to lower its prices?

Net Profit Margin

Net profit is the money that a company earns after paying all its expenses, including the costs of buying or making its products, running its operations, and paying interest and taxes. Look again at Figure 12.20 “Comparative Income Statement Using Vertical Percentage Analysis”. Using vertical percentage analysis, we found that for The College Shop, net profit as a percentage of sales was 6 percent in year 1 but declined to 3 percent in year 2. Expressed as ratios, these relationships would look like this:

[latex]Net\;profit\;margin=\frac{Net\;profit}{Sales}[/latex]
[latex]Year\;1: \;\frac{\$30,000}{\$500,000}=6\%[/latex]
[latex]Year\;2: \;\frac{\$18,000}{\$600,000}=3\%(rounded)[/latex]

You realize that a declining net profit margin isn’t good, but you wonder how you compare with your industry. A little research informs you that average net profit margin in the industry is 7 percent. You performed nearly as well as the industry in year 1 but fell further from your target in year 2. What does this information tell you? That a goal for year 3 should be trying to increase your net profit margin.

Management Efficiency Ratios

These ratios reveal the way in which assets (shown on the balance sheet) are being used to generate income (shown on the income statement). To compute this group of ratios, therefore, you must look at both statements. In Figure 12.19 “Comparative Income Statement for The College Shop”, we produced a comparative income statement for The College Shop’s first two years. Figure 12.21 “Comparative Balance Sheet for The College Shop” is a comparative balance sheet for the same period.

As you can see from Figure 12.21 “Comparative Balance Sheet for The College Shop”, running even a small business entails a substantial investment in assets. Even if you rent space, for example, you must still buy furniture and equipment. To have products on hand to sell, you need to tie up money in inventory. And once you’ve sold them, you may have money tied up in accounts receivable while you’re waiting for customers to pay you. Thus, investing in assets is a normal part of doing business. Managing your assets efficiently is a basic requirement of business success. Let’s look at a representative management efficiency ratio. The inventory turnover ratio measures a firm’s efficiency in selling its inventory.

You don’t make money from unsold inventory. You make money when you sell inventory, and the faster you sell it, the more money you make. To determine how fast your inventory is “turning,” you need to examine the relationship between sales and inventory¹. Let’s see how well The College Shop is doing in moving its inventory:

[latex]Inventory\;turnover=\frac{Sales}{Inventory}[/latex]
[latex]Year\;1: \;\frac{\$500,000}{\$80,000}=6.25times[/latex]
[latex]Year\;2: \;\frac{\$600,000}{\$110,000}=5.45times[/latex]

For year 1, The College Shop converted its inventory into sales 6.25 times: on average, your entire inventory was sold and replaced 6.25 times during the year. For year 2, however, inventory was converted into sales only 5.45 times. The industry did better, averaging turnover of 6.58 times. Before we discuss possible reasons for the drop in The College Shop’s inventory turnover ratio, let’s look at an alternative way of describing this ratio. Simply convert this ratio into the average number of days that you held an item in inventory. In other words, divide 365 days by your turnover ratio:

[latex]Year\;1:\;365/6.25=58\;days[/latex]
[latex]Year\;2:\;365/5.45=67\;days[/latex]
[latex]Industry:365/6.58=55\;days[/latex]

The College Shop was doing fine in year 1 (relative to the industry), but something happened in year 2 to break your stride. Holding onto inventory for an extra 9 days (67 days for year 2 minus 58 days for year 1) is costly. What happened? Perhaps inventory levels were too high because you overstocked. It’s good to have products available for customers, but stocking too much inventory is costly. Maybe some of your inventory takes a long time to sell because it’s not as appealing to customers as you thought. If this is the case, you may have a problem for the next year because you’ll have to cut prices (and reduce profitability) in order to sell the same slow-moving inventory.

Optimal inventory turnover varies by industry and even by company. A supermarket, for example, will have a high inventory turnover because many of its products are perishable and because it makes money by selling a high volume of goods (making only pennies on each sale). A company that builds expensive sailboats, by contrast, will have a low inventory turnover: it sells few boats but makes a hefty profit on each one. Some companies, such as Dell Computer, are known for keeping extremely low inventory levels. Because computers are made to order, Dell maintains only minimal inventory and so enjoys a very high ratio of sales to inventory.

Management Effectiveness Ratios

“It takes money to make money,” goes the old saying, and it’s true. Even the smallest business uses money to grow. Management effectiveness ratios address the question: how well is a company performing with the money that owners and others have invested in it?

These ratios are widely regarded as the best measure of corporate performance. You can give a firm high marks for posting good profit margins or for turning over its inventory quickly, but the final grade depends on how much profit it generates with the money invested by owners and creditors. Or, to put it another way, that grade depends on the answer to the question: is the company making a sufficiently high return on its assets?

Like management efficiency ratios, management effectiveness ratios examine the relationship between items on the income statement and items on the balance sheet. From the income statement you always need to know the “bottom line”—net profit. The information that you need from the balance sheet varies according to the ratio that you’re trying to calculate, but it’s always some measure of the amount of capital used in the business. Common measures of capital investment include total equity, total assets, or a combination of equity and long-term debt. Let’s see whether The College Shop made the grade. Did it generate a reasonable profit on the assets invested in the company?

[latex]Return\;on\;assets=\frac{Net\;Profit}{Total\;assets}[/latex]
[latex]Year\;1: \;\frac{\$30,000}{\$360,000}=8.3\%[/latex]
[latex]Year\;2: \;\frac{\$18,000}{\$368,000}=4.9\%[/latex]

Because the industry average return on assets is 7.9 percent, The College Shop gets an “A” for its first year’s performance. It slipped in the second year but is probably still in the “B” range.

Financial Condition Ratios

Financial condition ratios measure the financial strength of a company. They assess its ability to pay its current bills; and to determine whether its debt load is reasonable, they examine the proportion of its debt to its equity.