Analysis tools: common-size, trend, cross-sectional and the limits of ratios

What is the financial analysis process?

It is a sequence of six phases that starts with a question and ends with a conclusion you can defend. A list of ratios is not an analysis.

The phases are: (1) state the purpose and context, (2) collect the data, (3) process the data, (4) analyze and interpret it, (5) develop and communicate conclusions, and (6) follow up. This module lives in phases 3 and 4.

Computation versus analysis is the distinction that matters. Computation produces a number (inventory turnover of 6.0). Analysis explains it: why did it change, how does it compare with peers, and what does it mean for next year? The financial analysis process exists to move from the first to the second, and the purpose set in phase 1 decides which tools you pick.

What tools do analysts use?

Analysts first scale the numbers, then compare them. Ratio analysis relates one figure to another. Common-size statements express every line against one base. Comparisons then run across time or across companies.

Tool	What it does	Question it answers
Ratios	Relate one number to another	Is the company efficient, liquid, solvent, profitable?
Vertical common-size	Each line ÷ revenue or total assets	How is the cost or asset structure changing?
Horizontal common-size	Each line ÷ the same line in a base year	Which lines grow fastest?
Trend analysis	Same company, several periods	Is it improving?
Cross-sectional analysis	Peers or industry, one period	Is it better or worse than rivals?
Graphs	Visual overview	How do I communicate the finding?
Regression	Relates a variable to drivers	What explains it, and what is unusual?

Financial analysis tools

• Ratios Use it relate one number to another: activity, liquidity, solvency, profitability
• Common-size statements Use it
  • Vertical Memorize each line ÷ revenue or total assets
  • Horizontal Memorize each line ÷ the same line in a base year
• Comparisons Use it
  • Trend (time-series) same company, different periods
  • Cross-sectional different companies, same period
• Pictures and statistics Know the idea
  • Graphs pie, line, stacked column
  • Regression relationships and outliers

How do vertical and horizontal common-size analysis differ?

Vertical analysis shows the mix at one date. Horizontal analysis shows the movement against a base year.

Vertical common-size analysis divides each line by a single base from the same period: revenue for an income statement, total assets for a balance sheet. Everything becomes a percentage, so companies of any size or currency line up.

$$\text{Item \%} = \frac{\text{line item}}{\text{base}} \times 100$$

Horizontal common-size analysis divides each line by the same line in a base year, giving an index where the base year is 1.00. It shows which lines grow faster than others.

$$\text{Index}_t = \frac{\text{item}_t}{\text{item}_{\text{base}}}$$

Exam tip A big percentage change in a small line is rarely the story. Check the amounts, and which lines are large shares of the total.

How do trend and cross-sectional analysis work?

Trend analysis follows one company through time. Trend analysis asks whether ratios and common-size lines are improving or deteriorating, and is most useful when the business and its environment are stable. Cross-sectional analysis (also called relative analysis) compares one metric across companies at the same date, even when they differ in size or currency.

Two habits make both tools sharper.

Compare growth across statements. Use the horizontal view on several statements at once. Suppose revenue grows 6% while inventory grows 24% and the gross margin widens by a point. The wider margin looks good, but stock piling up four times as fast as sales points the other way: demand may be slowing, the stock may be going obsolete, or inventory may be overstated, which flatters profit. Receivables growing faster than revenue is the same warning on the customer side (looser credit, or revenue recognized early). Assets growing faster than revenue means efficiency may be falling.

Use compound growth over several years. A growth rate across a span uses the geometric formula, not the average of the yearly rates.

$$g = \left(\frac{X_n}{X_0}\right)^{1/n} - 1$$

For a current picture between fiscal year-ends, analysts use trailing 12 months (TTM) data: the last fiscal year, plus the current year to date, minus the same stretch of the prior year.

$$\text{TTM} = \text{last fiscal year} + \text{current YTD} - \text{prior-year YTD}$$

If last fiscal-year earnings were 600, and the first six months this year earned 330 against 290 a year earlier, TTM earnings are 600 + 330 − 290 = 640.

When do graphs and regression help?

Know the idea

Graphs show trends and structure at a glance and are a way to communicate conclusions. Graphs fit different jobs: pie charts show the composition of a total at one or two dates, line graphs show how a few items change over a longer time, and stacked columns show composition and amounts together over time.

Regression analysis fits a line between a variable and its drivers, for example a retailer’s sales against consumer spending. It helps identify relationships and correlation, forecast, and flag a period that sits far from the line.

Go deeper Why a regression residual can flag an unusual quarter

If sales normally move with an economic driver, the fitted line gives the sales you would expect for a given value of the driver. A quarter whose actual sales sit far above or below that line has a large residual. That does not prove a problem, but it tells you where to look: a one-off contract, an accounting change, a channel stuffing episode or simply a data error. The regression coefficients and standard error are covered in the quantitative methods topic.

Where do ratios mislead?

Use it

A ratio is an indicator of one aspect of performance. Never read it alone. Four limitations come up on the exam.

• Mixed businesses. A company with divisions in several industries has aggregate ratios that match no single peer group. Look for segment data and industry-specific ratios.
• Accounting choices. First in, first out (FIFO), last in, first out (LIFO) or average cost, straight-line or accelerated depreciation, cost or equity accounting for affiliates: different choices give different ratios for the same economics. LIFO is allowed under US generally accepted accounting principles (GAAP) but not under International Financial Reporting Standards (IFRS).
• Conflicting signals. One set of ratios may flag a problem that another shows is temporary. A rising current ratio with a falling quick ratio usually means inventory is piling up.
• Judgment. Is a number “reasonable” for this industry and strategy? Ratios cannot value a company or rate its credit without the wider operating and economic setting.

Limitations of ratio analysis also include a simple one: “good” ranges differ by industry, and even steady ratios deserve a question, because consistency can come from accounting policies chosen to smooth earnings.

Context for a ratio

• Prior periods is performance strengthening or weakening?
• Expectations analyst or market forecasts made before results
• Peers and industry norms cross-sectional; watch segments and accounting methods
• Company goals and strategy are the targets being met?
• Economic conditions cyclical firms look better in a boom

Go deeper Where ratios come from, and what to check

Ratios can be computed from the filings or taken from data providers, which offer long histories and trailing-12-month data. Check how each provider defines a ratio, because definitions differ (for example, whether “debt” includes leases or whether averages or year-end balances are used). Balance sheet amounts in activity and return ratios are usually the average of the opening and closing balances; for a seasonal business, an average of the interim balances is better.