© 2000 John Petroff

C- Classification of major types of ratios

1)- Common size analysis:

In common size financial statements (also known as normalized financial statements), each item in a financial statement is reduced to a percentage of the total which is gross sales in the income statement and total assets in the balance sheet. This makes comparison between firms of different size possible. Comparison of financial statements distorted by the effects of inflation is also somewhat improved. Table T-5.1 presents Texaco normalized balance sheet, and Table T-5.2 presents AO BOOM normalized balance sheet below.

The two companies presented above are radically different (in terms of size, industry, growth, and country of location), yet their balance sheets can be compared in many ways (e.g. liquidity, equity, debt). For instance, the proportion of equity in total funding is very similar (35% for Texaco and 34% for AO Boom), but the proportion of long term debt is not the same at all (16% for Texaco and 6% of less for AO Boom).

Less disparate but still belonging to different industries, one can see that balance sheets of the companies below have more in common:

Table T-5.4 - The Timken Company - Normalized Balance Sheets 1998-99

Table T-5.6 - Merck & Co., Inc - Normalized Balance Sheet 1997-98

Table T-5.8 - Bell Atlantic Corporation - Normalized Balance Sheets

Table T-5.10 - Lucent Technology - Normalized Balance Sheets

Table T-5.12 - J.C. Penney Company Inc. - Normalized Income Statement

Table T-5.14 - Delta Air Lines - Normalized Balance Sheets

 

Likewise their income statements listed below can also be compared, although their sales strategies and expense structures are different.

 

Table T-5.3  - The Timken Company -  Normalized Income Statements 1998-99

Table T-5.5 - Merck & Co., Inc. - Normalized Income Statement

Table T-5.7 - Bell Atlantic Corporation - Normalized Income Statement

Table T-5.9 - Lucent Technology - Normalized Income Statement

Table T-5.11 - J.C. Penney Company Inc. - Normalized Income Statement

Table T-5.13 - Delta Air Lines - Normalized Income Statement

 

It is true that the actual raw data for these companies has been entered into a uniform spreadsheet which produced the normalized data automatically. To make this possible some items had to be combined, such as different types of miscellaneous current assets. This is a common practice when analysis of a large number of different companies is necessary, but when only companies of a given industries are present, the structure of their financial statements should normally already be very similar.

 

 

Tables T-5.3 through T-5.13, as well as the data used to produce them, will be used repeatedly throughout the remainder of this text.

 

See review questions Q-5C1.1 and Q-5C1.2.

2)- Growth index analysis:

In growth index analysis (also known as index-number trend series), the rate of change for each individual item of consecutive financial statements is calculated and is presented either as a percent change, or as an index (with base 100 assigned to either the first year or the current year). The presentation reveals if some of the items are out of line in comparison to others. Table T-9.3 (which will be used in Chapter 9) presents the growth index income statement of Merck & Co., Inc. below.

One can verify how the index for sales growth was calculated. For instance, the growth index for 1989 of 110 was obtained from sales for 1989 of $ 6,551 millions divided by the base year sales for 1988 of $ 5,940 millions shown in Table T-5.15. Thus 6,551 / 5,940 = 110

The growth index income statement is used to determine how fast different items are growing, and especially highlight items that grew exceptionally fast or not at all. In the case of Merck, it appears that costs of goods sold is growing much faster than sales. Such observation would deserve serious investigation by an analyst.

A growth index balance sheet is used in exactly the same fashion. However, finding data for several years in annual reports is less common for balance sheet than for income statement.

See review questions Q-5C2.1 and Q-5C2.2.

3)- Constructing ratios:

Ratios relate any two items of financial statements. A large number of ratios can be calculated. For instance, at Manufacturers Hanover Trust in 1995, 142 ratios were calculated for each firm analyzed. In constructing ratios one should combine
- matching components: for instance accounts payable matched with purchases would make sense, but not with income from marketable securities;
- same units: inventories are stated in the same units as cost of goods sold, but not sales;
- items with a meaningful functional relationship for the purpose at hand: return on equity may have a meaning to outsiders, but from a performance point of view one ought to look at such measures of profitability as profit margin earned from sales or return on assets, not return on equity.

See review question Q-5C3.1.

4)- Major groups of ratios:

Ratios will be defined and extensively put to use in the coming chapters. They are usually grouped by purpose of inquiry. There are about eight major groups:

- liquidity
- turnover
- asset structure
- capital structure
- gross margin
- profitability
- return on assets or equity
- coverage ratios

One can look up how spreadsheet derivation of ratios produce the sets of ratios for the companies used as examples in this manual:

Table T-5.16 - The Timken Company - Ratios

Table T-5.17 - Merck & Co., Inc - Ratios

Table T-5.18 - Bell Atlantic Corporation - Ratios

Table T-5.19 - Lucent Technology - Ratios

Table T-5.20 - J.C. Penney Company Inc. - Ratios

Table T-5.21 - Delta Air Lines - Ratios

Table T-5.22 - The Dow Company - Ratios

 

See research assignment R-5.2.

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