Join Jim Stice for an in-depth discussion in this video Common-size overview, part of Running a Profitable Business: Understanding Financial Ratios.
- Step one in our Financial Ratio Analysis is the DuPont framework, very elegant, very nice, dividing return on equity into profitability, efficiency, and leverage. Let's now go to step two, common-size financial statements, which, in my opinion, is such an efficient way to get more information out of financial statements. The basic insight is this, you can't compare companies of different size. There's scale issues. Walmart has over 400 billion dollars in sales, Target has less than 100 billion dollars in sales.
To compare those two companies, you have to do some kind of adjustment for size, that's the purpose of common-size financial statements. The raw financial statement numbers for uncertain company, and benchmark company, are tough to interpret because of the scale differences, but if we just do this simple transformation, divide every number in the balance sheet, every number in the income statement by sales for the year, and you get percentages that all of a sudden tell you all kinds of things. Let's start by looking at the Common-Size Income Statement.
We see, for example, that for both companies, uncertain company and benchmark company, cost of goods sold is 40 percent of sales, meaning that they're about the same. The selling price of the goods, is more than the cost to consult. Cost to consult is about 40 percent of sales in each case, there's no difference there. If we're looking for problems, don't look there. Now let's look at wage expense. We see that wage expense for uncertain company is much larger than for benchmark company. 27 percent of sales compared to 23 percent of sales, let's make sure we understand what that means.
If uncertain company collects 100 dollars from customers, 27 of that goes to employees in the form of wages. For benchmark company, benchmark company is able to make that same 100 dollars in sales, and only pay 23 dollars in wages to employees. Somehow, benchmark company is able to do business, good business, paying a lower fraction of its sales to its employees. We see the same thing with research and development. Research and development costs are much higher for uncertain company, as compared to benchmark company. 21 percent compared to 12 percent.
Uncertain company is spending a large, large fraction of each sales dollar, in the form of research and development. For advertising, it's exactly flipped. Uncertain company is spending a very small amount on advertising compared to benchmark company. Eight percent compared to 18 percent. Overall, we see the return on sales that we already saw with the DuPoint framework, for uncertain company, 3.5 percent. For benchmark company, 6.2 percent, but now, with the Common-Size Income Statement, we understand much more.
Why is the uncertain company return on sale so much lower than benchmark company? Well, it's a combination of two things. Uncertain company is spending more on wages, and more on research and development. The Common-Size Income Statement, helps us drill down, and understand better, uncertain company's profitability problem. Now look at the Common-Size Balance Sheet, in particular, the assets in the Common-Size Balance Sheet. These percentages might be a little harder for us to understand, so let's start by looking at the property plant and equipment numbers.
For uncertain company, 40 percent, for benchmark company, 30 percent. What does that 40 percent mean? For uncertain company, to do 100 dollars of sales requires having 40 dollars in property plant equipment laying around. In contrast, benchmark company can do that same 100 dollars of sales, with only 30 dollars of property plant and equipment laying around. Benchmark company is much more efficient at using its property plant and equipment, to generate sales than is uncertain company. Uncertain company, for some reason, needs more property plant and equipment laying around.
The same is true for accounts receivable, uncertain company has a large level of accounts receivable, compared to its sales, compared to benchmark company. 20 percent of sales compared to 11 percent of sales, for some reason, uncertain company has a high level of accounts receivable, given its size. The one strength that we see here for uncertain company, is inventory. Uncertain company is able to do 100 dollars of sales with just nine dollars of inventory laying around. Benchmark company needs 13 dollars of inventory laying around.
Uncertain company is doing a very good job at managing its inventory. So, let's take some simple lessons here. I'm concerned about the efficiency of use of assets by uncertain company. I don't need to talk to uncertain company's inventory management people, they're doing a great job. But I would like to talk to their accounts receivable people, and say, Why do we have so much accounts receivable? Extra accounts receivable means we need to borrow extra money, it's a more costly way of doing business. Why do we have so much property plant and equipment laying around? This very simple thing, dividing each number in the financial statements by sales for the year, converts those balance sheet and income statement numbers into much better reflectors of information.
Now what's the rest of the story? Why do we have more accounts receivable? Why do we have more property plant and equipment? Why is our wage expense so high? Why is our research and development cost so high? Well, that's what Financial Ratio Analysis does. It never tells us the answers, but it does tell us some pretty good questions. We now know some people, with whom we need to speak. We want to talk to our compensation people. Why are we spending more on wages, than the benchmark in our industry? We want to talk to our property plant and equipment people, why do we have so much property plant and equipment after adjusting for our size, compared to the benchmark in our industry? Is this part of some strategic plan? I do this exercise in class many times.
I show my students these same numbers and say, if I'm going to fire you, unless you're going to explain to me whether this is part of your clever strategic plan or not, can you think of a story? And they can, take a look at those numbers, and here's the story that probably, you're inventing in your mind right now. Hey, the reason our wage expense is so high as a percentage of sales is we only hire the best people. We want to hire the best, so we had to pay more. And research and development? Well, we're pointed into technology. We want to have the best products. We don't want current generation products, we want the next generation products.
We want to be ahead of the market. Advertising? We're saving on advertising, now, until we develop those new products. Why are our accounts receivable so high? Because we want to attract new customers. We're offering easy credit to get new customers, and our property plan equipment? Yeah, we've got a lot, but we have built for the future, in other words, this is all part of our strategic plan. So the question is this, is uncertain company in trouble, or is this part of some clever strategic plan? The Financial Ratio Analysis will never tell you that, but it will tell you the questions that you should ask.
Now you know where to go, to talk to the right people, to ask them the right questions, with this simple tool, Common-Size Financial Statements.
- What are financial statements?
- Understanding the DuPont framework
- Working with common-size financial statements
- Reviewing profitability, efficiency, and leverage ratios
- Analyzing potential-pitfall ratio