- The DuPont framework highlights issues
that need further examination.
We drill down into those issues
using common-size financial statements.
The results of our common-size analysis
will lead us to other ratios that might be of interest.
An examination of those other ratios
will eventually lead us to ask questions
of the right people.
The raw financial statement numbers
for Uncertain Company and Benchmark Company
are tough to interpret because the scale differences.
But if we just do this simple transformation,
divide every number in the balance sheet
and every number in the income statement
by sales for the year, you get percentages
that all of a sudden tell you all kinds of things.
Let's start by looking at the common-size income statement.
We see, for example, that for both companies,
Uncertain and Benchmark, cost of goods sold is 40% of sales,
meaning that they're about the same.
The selling price of the goods
is more than the cost of the goods sold.
Cost of goods sold about 40% of sales in each case.
There's no difference there.
If we're looking for problems, don't look here.
Now, let's look at wage expense.
We see that wage expense for Uncertain Company
is much larger than Benchmark Company,
27% of sales compared to 23% of sales.
Let's make sure we understand what that means.
If Uncertain Company collects $100 from customers,
27 of that goes to employees in the form of wages.
For Benchmark Company,
they're able to make the same $100 in sales
and only pay $23 in wages to employees.
Somehow, Benchmark is able to do business, good business,
paying a lower fraction of its sales to its employees.
We see the same thing with research and development.
Research and development costs are much higher
for Uncertain Company as compared to Benchmark Company,
21% compared to 12%.
Uncertain Company is spending a large,
large fraction of its sales dollars
in the form of research and development.
For advertising, it's exactly flipped.
Uncertain Company is spending a very small amount
on advertising compared to Benchmark Company,
8% compared to 18%.
Overall, we see the return on sales
that we already saw with the DuPont framework.
For Uncertain Company, it's 3.5%.
For Benchmark Company, 6.2%
But now, with the common-size income statement,
we understand so much more.
Why is the Uncertain Company return on sales
so much lower than Benchmark?
Well, it's a combination of two things.
Uncertain Company is spending more on wages
and more on research and development.
The common-size income statement helps us drill down
and understand better Uncertainty's profitability problems.
This very simple thing,
dividing each number in the financial statements
by sales for the year,
converts those balance sheet and income statement numbers
into much better reflectors of information.
Now, what's the rest of the story?
Why is our wage expense so high?
Why is our research and development cost so high?
Well, that's what financial statement analysis does.
It never tells us the answer,
but it does tell us some pretty good questions.
We now know some people with whom we need to speak.
We want to talk to our, for example, compensation people.
Why are we spending so much more on wages than Benchmark is?
So the question is this.
Is Uncertain in trouble,
or is this part of some clever, strategic plan?
The financial statement analysis will never tell you that,
but it will tell you the questions
that you should be asking.