In this video, discover the need for common-sizing financial statements. This is an income statement in which each account is expressed as a percentage of the value of sales.
- In fiscal 2018, Walmart's net income was $7.17 billion. In that same fiscal 2018 Target's net income was $2.937 billion. So is Walmart better than Target? At the end of fiscal 2018 Walmart had inventory of $44.269 billion, and Target had inventory of $9.497 billion. Which company is more efficiently managing its inventory? Well, without some consideration of the differing size of these two companies, we really can't intelligently answer these questions. Common-size financial statements are an easy and useful tool for transforming financial statement data to adjust for size differences. Simply stated, a common-size financial statement is a financial statement in which all the numbers have been divided by sales for the year. The result is a financial statement composed of percentages. Each number is stated as a percentage of sales for the year. Now here's a common-size income statement for Walmart and for Target for fiscal 2018. Let's start at the bottom. In fiscal 2018 each $100 in sales for Walmart resulted in $1.4 in net income. The same $100 in sales for Target resulted in $3.9 in profit. For Walmart, this is not good news. Why is Walmart's profitability so much lower? Okay, look at the top of this common-size income statement. Walmart is paying a $74.9 purchase price for the item it sells for $100 at retail price. Target is only paying $70.7. This Target purchase price cost advantage is partially balanced by the fact that Walmart pays only 20.8% of each sales dollar in overhead expenses, whereas the corresponding percentage for Target is 23.8%. With this simple analysis we have uncovered what appears to be an important strategic difference between Walmart and Target. The low overhead expense percentage suggests Walmart has a strategy of relentless overhead cost control. Now, the lower cost of goods sold percentage for Target, which is same as saying that Target's profit margin is higher, is probably the result of a different product mix. Target appears to be selling relatively more higher margin items. Now of course, fully understanding the Walmart-Target profitability differences requires much more detailed analysis, but this simple common-size income statement certainly points us to some fruitful areas of inquiry. Now, here's the common-size balance sheet for Walmart and Target as of the end of fiscal 2018. Again, these are just the standard balance sheet numbers with each number divided by sales for the year. Let's focus on just two of these rows. In the inventory row, the Walmart percentage is 8.6%, and the Target percentage is 12.6%. What do these numbers mean, which is better? The 8.6% means that for Walmart to complete $100 in sales to its customers, Walmart needs $8.60 in inventory lying around for the customers to look at. Now, to do that same $100 in sales Target needs $12.60 in inventory lying around. The interpretation is that Walmart is more efficient at managing its inventory than is Target. Walmart needs less inventory lying around in order to support its retail selling effort. Remember, a retail business doesn't make money from having inventory lying around. A retail business makes money from selling inventory. Now, look at the property and equipment row. The 20.3% means that Walmart needs $20.3 in property and equipment to support sales for $100. To support the same sales of $100, Target needs $33.9 in property and equipment. Target needs $33.9 of property and equipment to accomplish the same thing that Walmart can accomplish with just $20.3 in property and equipment. Walmart is using its property and equipment more efficiently than is Target. Common-size financial statements. Just divide all the financial statement numbers by sales, and it is amazing the quantity and quality of insights that come from just this simple tool of financial statement analysis.
- Describe line items that appear on financial statements.
- Differentiate between the three types of financial statements.
- Interpret current accounting issues and trends.
- Calculate the market capitalization of a company.
- Identify the most important expense for a retail company.
- Explain the use of common size financial statements.