- Target had almost $9.5 billion in inventory,
Walmart, 44 billion.
Which company is more efficient in managing its inventory?
Well, it's hard to tell just by looking at the raw numbers.
Step one in our financial ratio analysis
is the Dupont framework,
very elegant, very nice.
Dividing return on equity to profitability, efficiency,
and leverage dimensions.
- So let's go on to step two,
common-size financial statements,
which in my opinions, is such an efficient way
to get more information out of the financial statements.
The basic insight is this.
You can't compare companies of different size.
There are scale issues.
Walmart has over $500 billion in sales.
Target has less than $100 billion in sales.
But with the proper sequence of analysis steps,
we can get right down to how many days
each company has its inventory in stores.
That's a powerful number to know.
- It is important to be systematic
and do the financial analysis steps in the correct order.
Step one, Dupont analysis.
Step two, common-sizing the financial statements.
- To compare Target and Walmart,
or any other two companies for that matter,
you have to do some kind of adjustment for size.
That's the purpose of common-size financial statements.
- So let's pick up where we left off
with Uncertain Company and Benchmark Company.
- Those are our two hypothetical examples.
Uncertain's profitability was 3.5%.
Their efficiency and their asset turnover, 1.38,
compared to Benchmark with a profitability measure of 6.2%
and efficiency asset turnover of 1.7.
Both much higher than Uncertain's.
- Now that we've identified these issues,
the next obvious question is why.
For Uncertain, why is profitability so low
and why is efficiency so low compared to the Benchmark?
- Common-size financial statements allow us to drill down
into the financial statement and target where
we will spend our time and energy investigating differences.
There will be some places
where we'll need to spend some time
and other places where we won't need to spend any time.
- For example, we know from our Dupont framework results
that Uncertain and Benchmark's leverage ratios
are identical, so we'll not need to spend a lot of time
drilling down into the debt structure of these companies,
at least not at first.
There are other places that deserve our attention now.
- To investigate profitability issues,
we will start by common-sizing the income statement.
To investigate efficiency issues,
we'll start by common-sizing the balance sheet.
- Now hopefully you're picking up a pattern here.
We don't just cannonball into the deep end
of financial statement analysis by dividing everything
by everything else.
Let's be efficient and systematic.