Agriculture Reference
In-Depth Information
Common-size analysis
Common-size analysis
is another useful method in effectively evaluating a business's fi nan-
cial situation. The greatest benefi t of this tool is to put things in perspective. Common-size
analysis simply expresses the balance sheet and income statement fi gures as percentages of
some key base fi gure, which could be derived from similar businesses or from the fi rm's own
total sales, total assets, budgets, or forecasts. They provide the manager with benchmarks
that give fi gures an added dimension.
For example, the Pacey farm store (
Table 10.2
)
may show a fi gure of $5,374 for sales
promotion in the “This year to date” column. When one realizes that this accounts for 2.9
percent of net sales, the magnitude of the sales promotion fi gure has some meaning. A com-
parison to similar fi gures from previous periods yields even more insight. Realization that
last year's promotion expense was only $4,725 might elicit a hazy reaction, but comparison
with a promotion expense last year that constituted only 2.7 percent of net sales will trigger
an immediate response. When Heidi McClain, the sales manager, looks at this comparison,
she can see that promotion expenses are 19 percent above the budgeted fi gure, [($5,374 -
$4,500) ÷ $4,500]
100. A similar analysis relative to other expenses indicates that “Other
general expenses” are more than triple year-ago levels. Action, or at least an investigation,
is called for at this point.
Common-size analysis should include raw data from the original statements to prevent
distortion or masking. This is particularly true when comparing an individual fi rm's percent-
ages with those of similar fi rms. One fi rm may be very large and have sales in the hundreds
of millions, while a smaller fi rm's sales might be in the millions or even thousands. The
actual dollar fi gures and not just percentages would help amplify and clarify differences.
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Ratio analysis
One of the most important tools for fi nancial analysis is
ratio analysis
. The strength of
fi nancial ratio analysis lies in the fact that the relationships used between data on fi nancial
statements eliminate the weaknesses of dollar comparisons, which are sometimes not only
confusing but may be misleading. Ratio analysis permits relative comparisons of important
fi nancial data and relationships, and such relative comparisons can be very insightful.
For example, we may consider the following relationships for two fi rms:
Firm A
Firm B
Current Assets
$200,000
$1,000,000
Current Liabilities
100,000
900,000
Net Working Capital
$100,000
$100,000
Note that the difference between current assets and current liabilities is called net work-
ing capital. Both fi rms have the same net working capital, $100,000. However, Firm A, all
things being equal, is in a healthier fi nancial condition than Firm B because the current ratio,
an indicator of liquidity (current assets ÷ current liabilities), for Firm A is 2:1; whereas, the
current ratio of Firm B is only 1.1:1. The current ratio is the number of dollars of current
assets available to meet obligations due during the upcoming year. In this case, it is the ratio
of current assets to current liabilities that provides the more accurate reading of the situation,
rather than the straight dollar comparison.
