Importance of Analyzing Financial Success

In this lesson, you’re expected to learn about:
– the need for analyzing the financial success of a company
– how to use common-size comparisons
– performance comparatives

You can analyze an organization’s finances in many ways – by looking at its cash flows, equity, debt, assets etc. but one important consideration worth knowing is whether or not the company you’re looking at is financially successful.

Understanding the extent of a particular company’s financial success is crucial, whether you’re an investor, manager, regulator, employee, supplier, partner or even a competitor.

Determining how financially successful a business is provides a lot more information about the company than simply how well it manages money.

The ultimate goal of a company is to generate wealth for its shareholders and so every element of the company’s activities is assessed in financial terms.

The nature of money combined with the objective of companies to maximize shareholder wealth make finance the ideal medium to assess how successful the company is, what activities are contributing to or detracting from that success and how the business compares to others in the market – as well as how it compares to itself over time.

A significant number of people are paid based on the financial performance of whatever they’re responsible for managing. For example:

1) Corporate executives 
Often paid bonuses based on the financial performance of the company.

2) Hedge fund managers 
Typically paid based on how the portfolio they’re managing compares to the market.

2) Investment bankers, Account managers, M&A consultants 
Paid based on the success of the transactions made or sales closed.

In addition, everyone else in society relies on companies to be financially successful, because when they’re not, firms go bust, forcing people to lose their jobs. This failure contributes to more unemployment, more people struggling to find new jobs and a stagnating economy.

If an organization isn’t operating efficiently, it’s wasting resources that can be better allocated to a more competitive firm.

Analyzing the financial performance of a company is how you determine whether it’s competitive.

What are Common-Size Comparisons?

Common-Size Comparisons (analyses used to do data comparisons) are some of the most valuable tools in assessing the financial performance of a company.

They come in two forms – vertical and horizontal, which provides a unique series of detailed information regarding each of the three primary financial statements:
– Balance sheet
– Cash flow statement
– P&L account

Common-Size Comparison analyses are used to determine how effectively the value of an organization is being managed and whether or not trends are improving. These comparisons are unique because everything in them is broken down to a percentage value of a single reference point, allowing you to account for change and proportions of a company’s finances.

– Vertical analyses reference the sum of the value of the company and track how a company is using its assets as a proportion of the total assets available.

– Horizontal analyses track changes over time as a proportion of a specific date used as a reference to determine how a company has improved (or not).

1) Vertical common-size comparisons 

Each vertical common-size comparison uses a single financial statement from a single year.

These comparisons are intended to calculate the allocation and usage of value within the organization by measuring the proportion of total value that’s being distributed in each entry of the financial statement. They’re called vertical comparisons because the items you’re comparing on P&L accounts appear in a vertical list, instead of next to each other.

Let’s look at an example to see how this process works.

Start at the top of the P&L account with turnover (also called sales or revenue) – the total amount of money the company brings in during that period. From here, you can break down any other part of the P&L account as a percentage of turnover.

So if your sales are £100,000 and COS are £65,000, 65% of all sales are going into the cost of production, leaving 35% (gross profit) to pay for other expenses. From the table below, you can see that if EBIT is 5%, administrative costs take up 30% of sales, leaving only 5% to be taxed on. By the end, the net profit is 1%.

By doing this analysis, you can easily compare items in the P&L account as a proportion of total profit. The same can be done with a balance sheet or cash flow statement.
2) Horizontal common-size comparisons

Horizontal common-size comparisons are a bit different from their vertical counterparts. They also use only one type of financial statement at a time, but instead of using that statement from just one year, they use several consecutive years’ worth of the same type of financial statement.

Doing extended analyses to measure long-term trends and searching for patterns or cycles in the company’s performance is very common.

For the sake of consistency, we’ll use the P&L account as an example to illustrate how the horizontal common-size analysis works.

The reference year is always considered 100% and the following years are measured as a proportion of that 100% value. For a horizontal analysis, you only need to be concerned with how values are changing over time.

So the percentages shown are a percentage of a single reference year. Turnover, for example, is £100,000 in the first year, and then changed in the following two years, referencing the first year rather than the year before.

This analysis allows you to track changes in financial management over time to determine whether the company’s financial management is getting better or worse, as well as where the changes are being experienced. As you can see from the table below, turnover increased over a three-year period.

Note: However, the horizontal analysis tells you how things are changing only in a nominal sense, which isn’t entirely useful.

Cross Comparisons

The horizontal common-size comparison does a lot to help you understand changes in a company’s finances over time by comparing financial reports from several consecutive years.

vertical comparison, by contrast, tells you how efficiently corporate value is being allocated and used.

But you can get the best of both methods, because two types of comparisons use data from both these analyses, producing cross comparisons. There are two types of cross comparisons:
– ‘rate-of-change’ cross comparison
– ‘time-distribution’ cross comparison

1) Rate-of-change cross comparison 

Before you can perform a rate-of-change cross comparison, you first need to do vertical common-size comparisons for several consecutive years.

After the vertical comparisons are done, you can measure the amount that each comparison has changed over time. In other words, you measure the rate of change of each proportion. If COS increases from 10% of turnover in 2012 to 20% of turnover in 2013, you can say that COS has increased as a proportion of sales by 100% in one year. This is clearly a bad situation for a company to be in.

You’re doing a horizontal comparison of several vertical comparisons. The reference year to which other years are being compared is adjusted to 100%, and then the following years are a percentage change of the different vertical comparison proportions.

The result tells you whether the asset use and allocation is improving over time, which is a very important indicator of changes in corporate financial efficiency and trends in corporate financial management.

2) Time-distribution cross comparison 

This cross comparison is similar to the preceding one except in reverse. You start by doing horizontal cross-comparison analyses, but pick only two of them — the one for the first year of the period you’re analyzing and the one for the last year of the period you’re analyzing.

Realistically, you can do them for every year in between as well, but you’re only carrying out this exercise two years at a time. So, for this example, you’re doing a horizontal comparison for the years 2012 and 2013.

After you finish the horizontal comparisons, you’re left with a series of percentages showing how 2013 changed from 2012. Now you move onto the vertical analysis. Remember that, unlike a standard vertical analysis, these percentages don’t add up to 100% of turnover.

But you’re still setting turnover (or total assets or total cash flows) to 100% and then comparing all other entries in the analysis to that. By doing so, you’re collecting information on the degree to which each changed relative to turnover. So, if COS is 101% of turnover in your cross comparison, COS increased by 1% more than turnover.

The goal is to measure how much each entry changes relative to a reference point. This process allows you to understand better how allocations are changing over time and whether they’re becoming more or less efficient.
Performance Comparatives
Each of the financial calculations we discuss is valuable in its own right, but, like financial statements, each is limited in the information it provides without some sort of context (a bit like a ratio: on its own it’s useless without something to compare it to).

What you really want is to take each of those calculations and work out how it compares to some reference point; otherwise, it doesn’t have much meaning. It’s just an abstract number that tells you about the company, but you have no idea whether the number attributed to the company is good or bad.

For example, a company may have an asset turnover of 3, which provides some information about the company but not whether the number is a good or a bad thing. To understand that, you have to analyze performance comparatives, which is the process by which you add context to your calculations by comparing them to some other standard.

Such calculations are commonly compared against two standards:
– the same company in a different year, or
– other companies in the same year.

We look at both in the following section. 

1) Contrasting over time

A lot of what we’ve talked about so far is considered spot analysis: analysis for a single point (or spot) in time, as opposed to assessing trends.

Spot analysis is great if you live in a scenario that repeats the same point in time over and over again; otherwise, the amount of useful information you can derive from a single moment in time is limited. So, instead of looking at your financial ratios and calculations by themselves, you want to compare them to the previous years’ ratios and calculations to see how they’ve changed, if at all.

The goal is to judge the current performance of a company based on the past performance of the same company.

This analysis allows you to look for patterns in performance ratios, identify cyclical changes, note patterns in these changes over time and determine what the overall trend is.

Identifying many of these patterns allows you to begin identifying the causes of those patterns. Being able to recognize what influences your financial performance allows you to be more proactive in responding to those influences, as well as potentially managing the influences themselves to react in your own favor.

In addition, watching for patterns, cycles and current trends allows you to project future financial performance.

But bear in mind that these figures are estimates, because human error tends to be a frequent cause of problems. Even when that’s not an issue, you need to recognize that as you attempt to project farther into the future, your estimates become less accurate. Projecting what your finances are going to look like tomorrow is far easier than forecasting what they’ll look like in ten years’ time.

Recall that the quick ratio is a measure of liquidity that calculates a company’s ability to pay off debt that will become due in the next year.

You calculate it as follows:
Quick Ratio = (Current assets – Stock) / Current liabilities 

With that in mind, take a look at the following example, which shows how a time analysis of financial ratios and calculations can make a big difference compared to just a single calculation of any financial ratio or calculation.

Company A in 2013: Quick ratio = 0.7
In a worst-case scenario where the company can’t sell any of its current stock, it’s still able to account for 70% of its current
liabilities using its highly liquid assets. But, is that really a good thing? Compare that against time.

Company A in 2012: Quick ratio = 0.9
Company A in 2011: Quick ratio = 1.2

The company appears to be losing liquidity at a rate of about 26% annually. It may have a lot of debt coming to maturity this year or it may simply not be making as many sales. In any case, this situation doesn’t look good for the company.

2) Comparing against industry competitors

Imagine that a company you’re analyzing has improved dramatically over the years. The common-size analyses make its asset allocations seem to be steadily improving, supported by a comparison of its financial ratios over the last ten years that shows improved financial health.

Is the company really doing well, though? How can you even tell if you’re looking at only one firm?

If a company has a current ratio of 1.5, which is up from 5 years ago when its current ratio was 0.5, what does that even mean for its operations? If other companies in the same industry (competitors) are maintaining current ratios of 5.5, the improvement from 0.5 to 1.5 still sounds pretty risky.

The firm may simply be better at managing its assets, or perhaps the industry it competes in takes a long time to collect monies owed from customers, requiring businesses to maintain a lot of cash or other liquid assets or else risk insolvency.

In any case, whether it’s good or bad, you never know the company’s situation unless you compare it to other companies in the same industry.

Using industry averages 

Frequently you don’t compare the company against just one other competitor, or even several other competitors individually. When you’re comparing the financial performance of your company against the industry, typically you use industry averages, which are calculated using a simple mean. If you want to know what the industry average is for current ratios, you find out the current ratio for all the competitors in the industry, add them up and then divide by the number of competitors. For example:

Current ratios in industry: 0.5 + 0.6 + 0.6 + 0.9 + 1.0 = 3.6   Divided by the number of competitors in the industry (5) = 0.72

Thus, the industry average current ratio is 0.72. You don’t yet know why it’s 0.72, but you do know that companies in this industry commonly maintain very low liquidity at any given point. You also know that your company has a current ratio of 0.75, which is very close to the industry average.

3) Comparing changes in the industry

One additional thing to take into consideration is a comparison of changes in the industry over time. After you know what the industry average is for a particular ratio or calculation and you know how your company compares, you can also track how this relationship changes over time.

– Is your company increasing its liquidity faster than the industry average?
– Is it decreasing its profitability slower than average?
– Is it improving its asset management at exactly the same rate as the industry average? 

All these questions are relevant to understanding how a company is doing in a competitive market. Like other time-based data, this analysis helps you to project future performance as well as evaluate the health of the business compared to the industry as a whole.

Keep in mind that an entire industry can quite possibly be sporadic, so don’t rely exclusively on industry-based comparisons. Look at how an individual company is
changing over time (as we discussed earlier) as well as the spot rates.

The use of benchmarks — which means comparing the profits of a company with its competitors or industry sector — is a fairly common way of doing this.

Don’t forget to check the quality of the earnings a company is making as well. Just because it’s generating earnings now doesn’t mean that those earnings have any quality; they may be one-off payments that disappear in the next cycle.

Jim Rohn Sứ mệnh khởi nghiệp