FINANCIAL STATEMENT COMPARABILITY Chapter 4

CHAPTER 4 OBJECTIVES Explain the advantage of common size financial statements compared to those disclosed on a monetary basis. Explain the advantage of common size financial statements compared to those disclosed on a monetary basis. Compute vertical and horizontal common size income statements and balance sheets. Compute vertical and horizontal common size income statements and balance sheets. Calculate compound annual growth rates and explain why this method provides better information than alternative methods of horizontal analysis. Calculate compound annual growth rates and explain why this method provides better information than alternative methods of horizontal analysis.

CHAPTER 4 OBJECTIVES (CONT.) Determine financial statement vertical profiles and moving averages. Determine financial statement vertical profiles and moving averages. Use good judgment when reconciling financial statement inconsistencies, rounding numbers, computing ratios, scaling numerical amounts and making qualitative assessments. Use good judgment when reconciling financial statement inconsistencies, rounding numbers, computing ratios, scaling numerical amounts and making qualitative assessments.

BASIC COMMON SIZE CONSIDERATIONS Enables valid comparisons over time or against competition Enables valid comparisons over time or against competition

BASIC COMMON SIZE CONSIDERATIONS (CONT.) Vertical common size financial statements Vertical common size financial statements Disclosures are a percentage of another account in the same reporting period Disclosures are a percentage of another account in the same reporting period Income statement: accounts reported as a percentage of revenues (revenues = 100%) Income statement: accounts reported as a percentage of revenues (revenues = 100%) Balance sheet: accounts reported as a percentage of total assets (or liabilities plus shareholders’ equity) Balance sheet: accounts reported as a percentage of total assets (or liabilities plus shareholders’ equity)

VERTICAL COMMON SIZE EXAMPLE

BASIC COMMON SIZE CONSIDERATIONS (CONT.) Horizontal common size financial statements Horizontal common size financial statements Disclosures are a percentage of the same account from a previous reporting period Disclosures are a percentage of the same account from a previous reporting period Income statement: e.g., this year’s revenues as a percentage of last year’s revenues Income statement: e.g., this year’s revenues as a percentage of last year’s revenues Balance sheet: e.g., this year’s cash balance as a percentage of last year’s cash balance Balance sheet: e.g., this year’s cash balance as a percentage of last year’s cash balance

BASIC COMMON SIZE CONSIDERATIONS (CONT.) Alternative disclosures of horizontal analysis Alternative disclosures of horizontal analysis Anchoring Anchoring Uses the earliest year’s data as the base year (100%) Uses the earliest year’s data as the base year (100%) Subsequent observations are a percentage of the base year’s amount Subsequent observations are a percentage of the base year’s amount

HORIZONTAL COMMON SIZE EXAMPLE

BASIC COMMON SIZE CONSIDERATIONS (CONT.) Alternative disclosures of horizontal analysis Alternative disclosures of horizontal analysis Rolling forward Rolling forward Uses the previous year’s observation as 100% Uses the previous year’s observation as 100% Subsequent year’s observations are a percentage of the previous year’s base amount Subsequent year’s observations are a percentage of the previous year’s base amount

HORIZONTAL COMMON SIZE EXAMPLE

BASIC COMMON SIZE CONSIDERATIONS (CONT.) Types of disclosures: reported as a Types of disclosures: reported as a Percentage of the base year amount Percentage of the base year amount Percentage change from the base year amount Percentage change from the base year amount Illustrated in Exhibit 4-4 (p. 88) Illustrated in Exhibit 4-4 (p. 88)

BASIC COMMON SIZE CONSIDERATIONS (CONT.) Mathematical properties of common size statements Mathematical properties of common size statements Vertical common sizing is appropriate for intraperiod benchmarks Vertical common sizing is appropriate for intraperiod benchmarks Horizontal common sizing is appropriate for interperiod benchmarks Horizontal common sizing is appropriate for interperiod benchmarks Illustrated in Exhibit 4-5 (p. 89) Illustrated in Exhibit 4-5 (p. 89)

COMMON SIZE EXTENSIONS Compound annual growth rates— Compound annual growth rates— better method of horizontal analysis than anchoring or rolling the data forward better method of horizontal analysis than anchoring or rolling the data forward Mathematically valid: considers the affect of percentage changes on previous periods’ numbers Mathematically valid: considers the affect of percentage changes on previous periods’ numbers Superiority illustrated in Exhibit 4-6 (p. 90) Superiority illustrated in Exhibit 4-6 (p. 90) Internal rate of return command on spreadsheet application facilitates computations Internal rate of return command on spreadsheet application facilitates computations

COMPOUND ANNUAL GROWTH RATE EXAMPLE

COMMON SIZE EXTENSIONS (CONT.) Financial statement profiles Financial statement profiles Condenses a vertical common size statement into one “average” reporting period Condenses a vertical common size statement into one “average” reporting period Measures variability over time Measures variability over time See Exhibit 4-7 (p. 91) See Exhibit 4-7 (p. 91)

COMMON SIZE EXTENSIONS (CONT.) Moving averages Moving averages Condenses three, five, or seven year vertical common size statements into an average for that period of time Condenses three, five, or seven year vertical common size statements into an average for that period of time Moves the average period forward by dropping the earliest observation and replacing with the most recent period’s data Moves the average period forward by dropping the earliest observation and replacing with the most recent period’s data See Exhibit 4-8 (p. 93) See Exhibit 4-8 (p. 93)

DATA CONSIDERATIONS Observation quantity Observation quantity Analyzing sufficient reporting disclosures to reach valid conclusions Analyzing sufficient reporting disclosures to reach valid conclusions Usually between five and 10 years of data suffice Usually between five and 10 years of data suffice

DATA CONSIDERATIONS (CONT.) Financial statement inconsistencies Financial statement inconsistencies Format of reported data change over time and differ among companies Format of reported data change over time and differ among companies Use judgment to reduce differences in disclosure sets Use judgment to reduce differences in disclosure sets Use most recent data available if options exist Use most recent data available if options exist

DATA CONSIDERATIONS (CONT.) Scaling disclosures Scaling disclosures Companies report financial statements in thousands or millions of dollars Companies report financial statements in thousands or millions of dollars Be aware of the scale or you will fail to grasp the entity’s size Be aware of the scale or you will fail to grasp the entity’s size

DATA CONSIDERATIONS (CONT.) Numerical rounding Numerical rounding Done to avoid insignificant data disclosures Done to avoid insignificant data disclosures Reduces “clutter” of data disclosures Reduces “clutter” of data disclosures Should only be done when it does not alter analysts’ decisions Should only be done when it does not alter analysts’ decisions

DATA CONSIDERATIONS (CONT.) Qualitative statements Qualitative statements Analysts’ opinions about data (e.g. one company has a better profit margin than another) should be made with care and after sufficient analysis Analysts’ opinions about data (e.g. one company has a better profit margin than another) should be made with care and after sufficient analysis