Although accounting ratios are useful tools for investors, common-statement analysis provides meaningful comparisons of both inter- and intra-company financial figures.
Investors often analyze a company’s financial statements over a period of time rather than relying on one statement which is really just a snapshot of the company’s operations. By looking at multiple statements over time, the investor can recognize trends, both good and bad, from an investment point of view and gain a more realistic picture of where the company is heading.
Common-Statement Analysis refers to the technique of putting financial records into a more meaningful form so comparisons across time can reveal important investment information. One of the problems with financial statements is that they only reveal what a company looked like at one point in time. The problem with this incremental reporting is that managers are aware of when financial data will be made available to investors. Some managers of a firm, with this in mind, may manipulate certain aspects of a company to make the firm look more profitable than it really is. For example, whenever a firm downsizes, the stock price of the firm typically rises. This is in response to the reduced obligation to pay wages and salaries to fewer employees. Financial statements over time using a common factor can help reveal trends and anomalies that can be difficult to grasp from raw data reporting.
One type of Common-Statement Analysis is called Common-Size Analysis. This method transforms raw figures from a financial statement into percentages rather than leaving the data as amounts of money. Typically, balance sheet items are transformed into percentages of total assets and income statement items are transformed into percentages of total sales. This method also makes it easier to compare companies of different sizes. Certainly, the raw figures for a larger firm will be bigger than a smaller firm. By expressing the raw figures as a percentage of some piece of raw data, comparisons of profitability between companies or between different time periods within a company are more easily comprehended at a glance.
One of the problems with analyzing the profitability of a firm over time has to do with both the time value of money and inflation. Both of these factors diminish the ability to compare raw data because money today is not the same as money tomorrow or yesterday for that matter. Typically, a base year is selected and all figures are transformed to coincide with that year’s figures taking into account time value and inflation. The advantage of Common-Base-Year Analysis is that it is possible to see which items on a financial statement are growing faster than others. This type of analysis makes trends much easier to spot than by using raw figures.
Investors are always on the lookout to reduce the time it takes to analyze company data. The market moves fast and the Principle of Market Efficiency states that information about a company is completely and quickly reflected in its stock price. Any time saved can mean the difference between profitability and loss due to quickly changing market conditions.