- Now look at the common-size balance sheet,
in particular, the assets in the common-size balance sheet.
Now these percentages might be a little harder
for us to understand, so let's start by looking
at the property, plant, and equipment numbers.
For Uncertain Company, 40%, for Benchmark Company, 30%.
So what does 40% mean?
For Uncertain Company to do $100 of sales
requires having $40 in property, plant, and equipment.
In contrast, Benchmark Company can do the same $100 of sales
with only $30 of property, plant, and equipment.
Benchmark Company is much more efficient
at using its property, plant, and equipment
to generate sales than is Uncertain Company.
Uncertain Company, for some reason,
needs more property, plant, and equipment laying around.
Now the same is true for accounts receivable.
Uncertain Company has a large level of accounts receivable
compared to its sales.
When compared to Benchmark Company, it's 20% to 11%.
For some reason, Uncertain Company has a higher level
of accounts receivable given its size.
The one strength that we see
for Uncertain Company is inventory.
Uncertain Company is able do $100 of sales
with just $9 of inventory.
Benchmark, well, they need $13 of inventory.
Uncertain Company seems to be doing a very good job
at managing its inventory.
So let's discuss some simple lessons here.
We are concerned about the efficiency of use
of assets by Uncertain.
I don't need to talk
to Uncertain Company's inventory management people.
It looks like they're doing a great job.
But I would like to talk to their accounts receivable people
and say, "Why do we have so much more accounts receivable
"relative to the industry benchmark?"
We also want to talk to our property, plant,
and equipment people and ask,
"Why do we have so much property, plant, and equipment
"after adjusting for our size,
"compared to the benchmark in the industry?"
Is this part of some strategic plan?
Well, you can imagine a plausible story
to support the numbers revealed
in the common-size financial statements.
Hey, the reason our wage expense is so high
as a percentage of sales is we only hire the best people.
We want to hire the best, so we had to pay more.
And research and development,
well, we're pointed in to technology.
We want to have the best products.
We don't want current-generation products.
We want next generation products.
We want to be ahead of the market.
Advertising?
We're saving on advertising now
until we develop these new products.
Why are our accounts receivable so high?
Because we want to attract new customers,
we're offering easy credit to get those new customers.
And our property, plant, equipment?
Yes, we have a lot, but we built for the future.
In other words, this is all part of our strategic plan.
So the question is this.
Is Uncertain Company in trouble?
Or is this all part of some clever plan?
The financial ratio analysis will never tell ya that.
But it will tell you the questions
that you should be asking.
Now you know where to go to talk to the right people
to ask them the right questions.
With this simple tool, common-size financial statements.