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ANALYZING 
FINANCIAL STATEMENTS 



By 

STEPHEN OILMAN, B. Sc. 



Certified Public Accountant (Wisconsin and Ohio); First Vice-President, International 

Accountants Society, Inc ; Formerly member of the lirm, Tanner, Oilman & Ellis, Certified 

Public Accountants; Formerly Manager of Credit Department, Tennessee Coal, Iron and 

Railroad Company; Author of "Principles of Accounting" 




THE RONALD PRESS COMPANY 
NEW YORK 



Copyright, 1925, by 
RONALD PRFSS COMPANT 



All Rights Reserved 
2 



PREFACE 

Formerly interest in the subject of analysis of financial 
statements was confined almost entirely to credit men. But 
of late years corporation executives, accounting officers, 
investors and public accountants have begun to appreciate 
the importance of statement analysis, and in this volume 
an attempt has been made to cover the subject from the 
broader viewpoint represented by the interests of all these 
various groups. 

Surveying most of the existing literature on this subject 
the reader must be impressed with its vagueness as to 
method and technique of statement analysis, and as to the 
interpretation of the relative significance of facts which the 
analysis develops. 

The author of this volume, while fully recognizing the 
grave dangers involved in definitely outlining methods and 
procedure, feels that a sharper focusing on the subject 
matter will be a help to those readers who have little time 
or inclination to study the pros and cons of each point. 

Most of the procedure advocated has been in practical 
use by credit men for years. There are, however, some 
departures from the conventional treatment. 

The trend percentage method which is advocated repre- 
sents the application to statement analysis of the " index 
number method " which has long been used by statisticians. 
The application of this method to statement analysis is 
interesting, practical and of great value. While a thorough 
study of existing literature in this field fails to show that 
this application of index numbers has ever before been sug- 
gested or discussed, nevertheless the reader may feel entirely 
safe in using it. This method of statement analysis was 
submitted to several thousand certified public accountants 



IV 



PREFACE 



for their criticism and with practically no exception their 
replies indicated complete approval of the method, and, 
indeed, considerable enthusiasm over its possibilities. 

Further, extensive tests covering many months and hun- 
dreds of balance sheets and profit and loss statements, def- 
initely prove its simplicity, quickness and interpretive value. 

Another innovation has been to point the analysis pro- 
cedure toward certain specific business ailments, just as the 
physician's diagnosis points toward specific human ailments. 

While only the two principal financial statements the 
balance sheet and the profit and loss statement have been 
discussed in this book, many of the methods advocated are 
generally applicable to various other exhibits, schedules and 
statistical statements. 

It is recognized that a volume several times this size might 
be written to cover the analysis of internal business state- 
ments, departmental reports and statistics, etc. However, 
it was found necessary to draw a rather sharp line of dis- 
tinction between the internal and external viewpoints and 
with but few necessary exceptions the external viewpoint 
has been consistently maintained throughout. 

In almost all instances fictitious instead of actual names 
of corporations have been used in illustrative statements. 
Otherwise, with but few unimportant changes, these illustra- 
tions represent actual cases. 

Complete and grateful acknowledgment is due my father, 
Stephen W, Oilman, LL.D., C.P.A., and to my dear friend 
and associate, John B. Tanner, C.P.A., for their careful 
reading of the manuscript and many helpful criticisms and 
ideas. And to a host of certified public accountants who 
offered important suggestions, much appreciation is due. 

STEPHEN OILMAN 
Chicago, 111. 

October 15, 1925 



CONTENTS 

CHAPTER PAGE 

I THE FIELD OF STATEMENT ANALYSIS 3 

II THE BALANCE SHEET 14 

III THE APPROACH TO STATEMENT ANALYSIS .... 27 

IV ANALYSIS OF A SINGLE BALANCE SHEET ..... 31 
V COMPARATIVE BALANCE SHEETS 45 

VI SPECIFIC BUSINESS AILMENTS 54 

VII BALANCE SHEET RATIOS 63 

VIII HISTORICAL ANALYSIS OF BALANCE SHEETS RATIO 

METHOD 74 

IX HISTORICAL ANALYSIS OF BALANCE SHEETS RATIO 

METHOD 81 

X COMPARATIVE SERIOUSNESS OF BUSINESS AILMENTS . 96 
XI HISTORICAL ANALYSIS OF BALANCE SHEETS TREND 

METHOD no 

XII HISTORICAL ANALYSIS OF BALANCE SHEETS TREND 

METHOD 123 

XIII STANDARD RATIOS 133 

XIV CONCLUSIONS AS TO ANALYSIS TECHNIQUE .... 150 
XV PROFIT AND Loss ANALYSIS 154 

XVI PROFIT AND Loss ANALYSIS 183 

XVII USING ANALYSIS METHODS IN REPORTS 207 

XVIII RESTATEMENT OF FUNDAMENTALS OF ANALYSIS . . . 212 



ILLUSTRATIONS 



FIGURE PAGE 

1. Chart of Adjusted Ratios of Quick Assets to Current Liabilities 

of Five Bankrupt Companies 103 

2. Chart of Adjusted Ratios of Current Assets to Current Liabilities 

of Five Bankrupt Companies 105 

3. Chart of Adjusted Ratios of Net Worth to Total Debt of Five 

Bankrupt Companies 107 

4. Chart of Adjusted Ratios of Net Worth to Fixed Assets of 

Five Bankrupt Companies 109 

5. Trend Percentage Chart for the Profit and Loss Statement of 

Andrews and Company 171 

6. Trend Percentage Chart of Operating Expenses of Andrews and 

Company 172 

7. Comparison of Trend Percentage Chart and Logarithmic Chart 

from Profit and Loss Statements of Andrews and Company . . 174 , 

8. Trend Percentage Chart of Profit and Loss Statement of the 

Knight Hardware Company 179 

9. Trend Percentage Chart of Operating Expenses of the Knight 

Hardware Company 179 

10. Trend Percentage Chart of Profit- and Loss Statement of the 

Ames Manufacturing- Company 181 

n. Trend Percentage Chart of Profit and Loss Statement of the 

Jones Manufacturing Company 188 

12. Trend Percentage Chart of Selected Items of Manufacturing Cost 

and Operating Expense of the Jones Manufacturing Company 189 

13. Trend Percentage Chart of Profit and Loss Statement of the 

Southern Gas Company 194 

14. Trend Percentage Chart of Production Statistics and Profit and 

Loss Figures of the Smith Mining Company 200 

15. Trend Percentage Chart of Profit and Loss Figures of the Blank 

Tire Company ,. . 203 

1 6. Trend Percentage Chart Comparing Bank Clearings Outside 

New York with Sales of the Blank Tire Company .... 204 

17. Trend Percentage Chart of Sales of Leading Tire Manufacturers 205 



Analyzing 
Financial Statements 



CHAPTER I 

THE FIELD OF STATEMENT ANALYSIS 

The Language o Business. "The language of business 
is figures/' 

In this forceful yet simple manner C W. Patterson, presi- 
dent of Austin, Nicholls and Company, of New York City, the 
largest wholesale grocers in the world, has uttered a statement 
peculiarly striking because of the vital thought expressed in 
those few words. 

For it is literally true that the language of business is fig- 
ures. Business men write, talk and think of every phase of 
commercial activity in terms of figures. Financing, purchas- 
ing, producing, selling and the subdivisions of these activities 
form a complex structure which can only be recorded, discussed 
and understood when translated into the language of figures 
usually dollars and cents. 

The History of a Business. Practically every business 
keeps a written record of its financial activities; and this is 
particularly true in this country where the requirements of the 
income tax laws during recent years make the keeping of such 
records mandatory. 

But even before the requirement by law, and even where 
such requirements do not exist from a legal standpoint, busi- 
ness men have recognized the indispensable value of such a 
written history in the carrying on of their commercial activities. 

The history of any business is recorded in its accounting 
books and records, expressed in terms of figures and for the 
greater part expressed in the terms of money. 

Origin o Accounting. Accounting originated, no doubt, 
in the keeping of what was a mere chronological list or record 
of business happenings, or a diary of business transactions, 

3 



4 ANALYZING FINANCIAL STATEMENTS [Ch. i 

scarcely comparable with the intricate, carefully built account- 
ing systems of today; but still a written record of the business 
activities. 

Double Entry Records. Accounting has kept pace with 
the tremendous strides of industrial activity and has developed 
into a definite procedure known as "double entry." 

While this procedure as used by a particular enterprise may 
appear to be very much different from the procedure used by 
some other enterprise, nevertheless all double entry systems are 
based on certain fundamental principles which are the same for 
every business. 

The Financial Statements. Of these fundamentals of 
procedure, probably the most important is the ultimate goal of 
double entry account keeping, which is the production of two 
financial statements, known as the balance sheet and the profit 
and loss statement, respectively. 

They represent the end toward which the double entry sys- 
tem is constantly working and toward which the whole of the 
double entry machinery is directed. 

This does not mean that the production of these two state- 
ments is the sole purpose of double entry accounting, for there 
are a number of other results which are obtained from the pro- 
cedure; but it may be said that the production of these two 
statements is the foremost purpose since the fundamental struc- 
ture of the procedure is planned toward their preparation. 

In this book the double entry accounting system will be 
viewed only as a means to an end, and attention will be given 
to this principal result of accounting, the balance sheet and the 
profit and loss statement, rather than to the methods of account 
keeping and the various procedures and devices which are used 
to accomplish the result. 

Description of Statements The Balance Sheet. Chief 

consideration, then, will be given to these two statements, the 



Ch. i] THE FIELD OF STATEMENT ANALYSIS 5 

producing of which is the principal purpose of double entry 
accounting : 

1. Balance sheet. 

2. Profit and loss statement. 

While the name "balance sheet" is the one generally ac- 
cepted and generally used to designate the first of these two 
statements, and while it is the name which will be used hence- 
forth in this volume, yet there are several other names by w r hich 
the statement is sometimes known, one of which may be more 
familiar to some readers than the term "balance sheet." Some- 
times this statement is spoken of as a "statement of assets and 
liabilities ;" sometimes it is called a "statement of resources and 
liabilities ;" and sometimes it is referred to as merely a "finan- 
cial statement." 

From a technical standpoint, distinctions might be made 
between these various names, but from the popular understand- 
ing the names are practically synonymous. However, the tech- 
nically correct name for the statement produced by double entry 
accounting, "balance sheet," has come into such general use in 
recent years that probably everyone will recognize it readily as 
the statement showing financial position. 

The Profit and Loss Statement Other names have often 
been used, too, in referring to the profit and loss statement. 

Such names as the "Income account" or "income state- 
ment," the "loss and gain statement," or the "trading and profit 
and loss statement," are often heard and are in more or less 
general use in business today. 

Perhaps "trading and profit and loss statement" is the most 
accurate of these, but it is a cumbersome phrase and for that 
reason no doubt has been largely abandoned for the shorter and 
more convenient phrase "profit and loss statement." 

This short title has not only gained rapidly in favor among 
business men and accountants, but it has also received a some- 



6 ANALYZING FINANCIAL STATEMENTS [Ch. i 

what official sanction through its use by the Federal Reserve 
Board in an important accounting monograph prepared by that 
Board in conjunction with the Federal Trade Commission on 
the subject of "Approved Methods for the Preparation of 
Balance Sheet Statements." 

Grouping of Balance Sheet Items. The balance sheet is 
a statement which exhibits the values that a business owns, 
the amounts the business owes, and the difference, or net worth 
all expressed in dollars and cents. 

Usually the values are grouped in such a way that similar 
items are classed together in one item, so that one description 
and one amount on the balance sheet cover the total of all values 
of a certain class. 

For example, a company may have several different bank 
accounts, but for the balance sheet these may all be added to- 
gether and the total shown as one item on the balance sheet 
described as "cash in banks." 

Similarly, each machine is not listed on the balance sheet, 
but all the machinery values may be added together and shown 
on the balance sheet as one item described as "machinery." 

In a like manner, those who owe money to the company for 
goods purchased on open account are not listed on the balance 
sheet, item after item and name after name, but all such values 
are added together and are shown as one item on the balance 
sheet described as "accounts receivable." 

The balance sheet should include every financial item which 
belongs to the business, and it should show every legal claim 
and debt against that business. It is a statement of ownership 
that conveys to the reader the measurement of the wealth of 
the particular enterprise. 

Nature of Profit and Loss Statement. The profit and loss 
statement presents a story of the business transactions during 
some certain period of time. 



Ch. i] THE FIELD OF STATEMENT ANALYSIS 7 

In the same manner that the balance sheet shows groups of 
items, so does the profit and loss statement exhibit the trans- 
actions that have occurred, in totals of classes of transactions. 

For example, each sale that has been made is not shown 
separately, but all the sales, expressed in monetary value, may 
be added together and shown on the statement as one item, 
called "sales." 

Similarly, the amount of profit resulting from the difference 
between the amount of money paid for an article and the 
amount of money received for the article, is not set down item 
by item for each sale, but total figures are accumulated for sales, 
cost of goods sold, and gross profit, and they may appear in 
the statement as three items, described by their respective 
names. Sometimes these items may be so grouped as to show 
each one of the three by departments, branches, or some other 
division of the business. 

In addition to the sales, cost of goods sold, and gross profit, 
the profit and loss statement presents the expenses and the final 
figure of net profit. The transactions representing expenses are 
not set down item by item, but are usually classified so that ex- 
penses of a like nature are grouped together and presented as a 
single item; and other expenses of a like nature but different 
from the first group, will be grouped in another total figure and 
presented as another single item. 

The resultant figure of the statement is the net profit re- 
sulting from the transactions of the period. 

The work of accumulating like transactions into groups is 
not deferred until the time when the statement is to be pre- 
pared but is carried on continuously through the means of the 
accounting system, which is designed to effect these accumula- 
tions by the means of its various accounts. 

From these accounts are taken the total figures, which have 
been accumulated, for the purpose of preparing the balance 
sheet and the profit and loss statement. 



8 ANALYZING FINANCIAL STATEMENTS [Ch. r 

Frequency of Statement Preparation. Some companies 
prepare these statements only once a year, at the time when the 
fiscal year ends; other companies prepare them semi-annually ; 
others prepare them quarterly; and many companies prepare 
them at the end of each month. 

Usually the monthly statements are not issued for publica- 
tion but are used by the directors and managers in connection 
with the conduct of the business. 

Relation of the Two Statements. These two statements, 
the balance sheet and the profit and loss statements, are some- 
what in the nature of complements. 

Neither standing alone is sufficient to furnish a real grasp of 
the financial situation; but the two together give a completed 
viewpoint in respect to a given period. 

The distinction between these two statements is both in- 
teresting and important. 

The balance sheet shows the condition of the business at 
the end of the period, exhibiting the values which the com- 
pany owns, the liabilities which it owes, and the net worth 
which belongs to the company above its indebtedness. The , 
profit and loss statement shows the transactions during the 
period, exhibiting the income, costs and expenses. 

S. F. Brewster in his book, "Analyzing Credit Risks," 
gives an excellent illustration of the inter-related character of 
these two statements : 

The difference in the situation reflected in these two statements 
(the balance sheet and the profit and loss statement) has been 
likened unto the measurement of the contents of a tank of water 
from time to time. Assuming an inflow and an outflow pipe, 
changes in the volume of the water may be determined either: (i) 
By comparing the actual level of the water (the actual amount of 
the net worth) for different periods; or (2) by comparing the 
total inflow (income from all sources) with the total outflow (all 
costs and expenses). 



Ch. i] THE FIELD OF STATEMENT ANALYSIS 9 

The quotation is not exact since the explanatory paren- 
thetical phrases have been inserted for clearness. 

J. H. Bliss, in "Financial and Operating Ratios in Man- 
agement/ ' says : 

A complete grasp of the situation of a business is obtained 
only by the use of both the income statement and balance sheet. 

These two statements, then, being almost universally used 
and forming the fundamental ground- work of an understand- 
ing of the financial condition of any business, will furnish the 
material for chief consideration and examination in this vol- 
ume on analysis of financial statements. Attention will not 
be centered in the mechanical means and methods by which the 
figures are collected and the statements prepared, but in the 
methods of interpreting and analyzing the information fur- 
nished by the statements themselves. 

Knowledge o Accounting a Prerequisite. While one 
who has only a meager knowledge of the preparation of the 
statements may secure a good understanding of the methods 
of analysis and interpretation, nevertheless it is desirable that 
the analyst have a general knowledge of the meaning of ac- 
counting terms, the general principles of double entry books, 
the flow of figures through the journals to the ledger, the gen- 
erally accepted rules of valuing assets, the nature of deprecia- 
tion, obsolesence, reserves, accruals, deferred and prepaid ex- 
penses, etc., and for the purpose of this book the reader is 
assumed to be possessed of such knowledge. 

Necessity for Statement Analysis. In approaching the 
discussion of any subject similar to the one dealt with in this 
book, it will usually be found desirable to build a foundation 
by considering the purpose o the activity, why it is under- 
taken, and by whom it is undertaken ; so it is appropriate first 
to outline the purpose of statement analysis, and consider the 
reasons for making such analysis. 



10 ANALYZING FINANCIAL STATEMENTS [Ch. i 

The purposes of statement analysis may be outlined as 
follows : 

1. To determine the desirability of: 

a. Loaning money to an organization. 

b. Extending trade credit to an organization. 

c. Buying stock in an organization. 

2. To measure the management efficiency of an organization. 

Bankers, commercial credit men, and prospective stock and 
bond buyers are concerned with statement analysis for the pur- 
poses stated in the first group; while managers, owners, pres- 
ent stockholders, present bondholders and the accountants who 
serve them are concerned with statement analysis for the pur- 
pose stated in the second group. 

An Important Point. No doubt among the readers of this 
book there will be many who are in the first group and for 
that reason it is important to direct attention to a simple but 
significant point that many writers on this subject have over- 
looked. 

Ordinarily the banker, credit man and investor are furnished 
with the financial statements in respect to the organizations in 
which they are interested, but usually they are given no oppor- 
tunity to verify the truth of the figures. It is usually neces- 
sary, therefore, for them to proceed on the assumption that 
the figures are true if the statements are to be of any value 
whatever. 

Untrue Statements Of course, such an assumption car- 
ries with it an element of danger, for the figures may be 
incorrect 

The statements may have been wilfully "doctored" for the 
very purpose of conveying false impressions in respect to the 
organization's condition ; or, on the other hand, the statements 
may have been innocently distorted because of ignorance or 



Ch. i] THE FIELD OF STATEMENT ANALYSIS n 

negligence in their preparation or in the accumulation of the 
figures which enter into them. 

In either event the result is the same for the banker, credit 
man or investor who has proceeded upon the assumption that 
they are true statements and has secured a false impression 
from them. 

Safeguarding Against Misrepresentation. Such misrep- 
resentation would be revealed by an audit of the books and rec- 
ords from which the statements were prepared, but usually the 
banker, credit man or prospective investor is not in a position 
to require such an audit. 

For that reason the matter of the truthfulness of state- 
ments will be covered very briefly in this chapter, and in the 
remainder of the book it is assumed that all statements as 
presented have been properly and truthfully prepared and that 
they accurately reflect the condition of the business at the time 
of their preparation. 

In considering, studying or analyzing any financial state- 
ment one should always be watchful in regard to the possibility 
that it may contain distorted statements or incorrect figures. 
"Who prepared this statement and what motive might he have 
for distorting it?" are questions that one may well ask himself 
whenever he is studying or analyzing a financial statement. 
Often he will find his question answered by the fact that the 
statement has been certified by certified public accountants (and 
reputable appraisers in some cases). 

C. P. A. Certification. Such a certificate gives a sound 
basis for accepting the facts and figures shown as being true 
and correct, for while there are isolated cases of certified pub- 
lic accountants who have been careless in their work, such 
cases are so few as to be negligible ; and the certificates of the 
recognized appraisal companies can also be accepted unhesitat- 
ingly. 



12 ANALYZING FINANCIAL STATEMENTS [Ch. i 

Qualified Certification Of course, it is always wise to 
read the certificate carefully, for certified public accountants 
are often called upon to make audits which do not cover all 
phases of the business. 

When this is done, the accountant qualifies his certificate 
accordingly in order that the reader may know what items of 
the financial statement he has verified and what items he has 
not investigated or has investigated only to a certain extent. 

For example, the auditor may qualify his certificate by 
stating that the inventory is based on certificates from em- 
ployees of the client, which means that the auditor has not 
verified the inventory personally (or through his own em- 
ployees), but instead has accepted the written testimony of 
employees of his client as to the correctness of the inventory. 

It should always be borne in mind that a certified public 
accountant accepts responsibility only to the extent of his cer- 
tificate, and that the qualifications and exceptions which he 
states in his certificate are put there for the purpose of con- 
veying to the person reading the statement the exact extent of 
the accountant's verification of the facts and figures. 

Important Credit Factors. The facts reflected by state- 
ment analysis are by no means the only ones required for a 
well-rounded consideration of the granting of credit or the 
investment of funds. 

Other factors are of considerable importance and should be 
given due weight along with the financial statements. 

The Four Factors. Four credit factors have come to be 
generally accepted as of primary importance in connection with 
matters of credit. They are as follows : 

1. Character honesty, habits, etc. 

2. Capacity business ability and astuteness. 

3. Capital financial condition and earnings. 

4. Conditions general business situation. 



Ch. i] THE FIELD OF STATEMENT ANALYSIS 13 

Thus, the most favorable statement analysis would seldom 
justify entrusting funds or goods to a crooked organization, 
or to an incompetent organization, or, except under special 
safeguards, to any organization at a time of severe financial 
panic. 

The factors of '(*) character, (2) capacity and (4) con- 
ditions are of prime importance. However, their considera- 
tion does not come within the scope of this volume except in 
so far as the methods of statement analysis do bring to light 
facts relating to the competence of management. 

How statements reflect managerial ability will be discussed 
in later chapters. 



CHAPTER II 

THE BALANCE SHEET 

The Balance Sheet Equation. In its simplest form, a 
balance sheet conforms to this equation : 

Funds = Source of Funds 

For the purpose of illustration, assume that the Ames 
Manufacturing Company (which is, of course, a fictitious 
name) had total assets amounting to $78,328 on December 31, 
1924. Then, the most simplified method of expressing this 
fact in balance sheet form would be : 

THE AMES MANUFACTURING COMPANY 

BALANCE SHEET 

As of December 31, 1924 

Funds, $78,328 = Source of Funds, $78,328 

Since the term "funds" is commonly considered to indicate 
cash or its equivalent, while the term "assets" conveys a 
broader meaning of value, the latter term will be better for use 
in considering financial analysis. 

Classification of Assets. The assets of the Ames Manu- 
facturing Company may consist of a number of different kinds 
of values. For example, let us assume that these different 
kinds of values are as follows : 

Cash. . . $10,512 

Accounts Receivable 5 > #57 

Inventories 22,210 

Fixed Assets 37 290 

Prepaid Expense 2,459 

Total Assets $78,328 

These, then, are the assets which the Ames Manufacturing 

14 



Ch. 2] THE BALANCE SHEET 15 

Company had under its control on December 31, 1924, and 
which it might use in any way that it desired. 

Sources o Funds. And now comes the question presented 
by the other side of the equation : From what source did the 
Ames Manufacturing Company secure the funds with which 
it was enabled to hold these values ? 

Usually the source of funds or assets is twofold : ( i ) Con- 
tributed by the owners, and (2) contributed by creditors. 
Here is an important division, because funds contributed by 
the owners represent their permanent investment in the busi- 
ness, being equivalent in many respects to a loan with no 
definite specified date for repayment, whereas funds contributed 
by creditors are legal obligations which must be met within a 
specified time. 

In order to carry out the illustration of the Ames Manu- 
facturing Company's balance sheet in figures, assume that 
this division of the source of funds as of December 31, 1924, 
is as follows : 

Contributed by Creditors $10,248 

Contributed by Owners 68 , 080 

Total $78,328 

Liabilities. The funds contributed by creditors are known 
as liabilities and may be based on many different kinds of 
transactions, of which the following are ordinary examples : 
Merchandise credit extended, usually described as "accounts or 
notes payable ;" money loaned by banks, usually described as 
"notes payable ;" dividends declared but not yet paid, in which 
instance the stockholders become creditors to the amount of the 
dividend owing them; accrued amounts which are not yet 
legally due, but for which the benefit has been received, such 
as payroll, interest, etc. 

Classification of Liabilities. The list of examples does 
not by any means include all the different kinds of possible 



jg ANALYZING FINANCIAL STATEMENTS [Ch. 2 

items that may be found under the classification of liabilities; 
but it will serve as a basis for developing the illustration of 
the Ames Manufacturing Company's balance sheet. 

The following list of items may be taken as making up the 
total of funds contributed by creditors : 

Notes PayableTrade $ 1 ,000 

Notes Payable Bank 2,000 

Accounts Payable 5ooo 

Dividends Payable 2,000 

Accruals Payable 248 

Total $10,248 

Net Worth. The funds contributed by the owners usually 
arise from two sources : the amounts put into the business as 
investments, and profits that have accumulated and have not 
been withdrawn. 

In the case of businesses operating under the corporate 
form of organization, the amounts put in as investments are 
usually represented by the capital stock outstanding, and the 
accumulated profits that have not been withdrawn are usually 
represented by the surplus. 

Both of these items can be classified in the balance sheet 
under the group name of "net worth," and frequently the sum 
of the two is described as "net worth." 

Classification of Net Worth In order to complete the 
illustration of the balance sheet of the Ames Manufacturing 
Company, certain figures may be assumed to represent these 
divisions, as follows: 

Capital Stock Outstanding $50,000 

Surplus 18,080 

Total Net Worth $68,080 

The Complete Balance Sheet This completes the devel- 
opment of the equation of the Ames Manufacturing Com- 
pany's balance sheet as of December 31, 1924, and the balance 
sheet may now be shown in more detailed form by substituting 



Ch. 2] THE BALANCE SHEET 17 

the details for the single figures of $78,328, shown in the first 
equation : 

THE AMES MANUFACTURING COMPANY 

BALANCE SHEET 
As of December 31, 1924 

Assets Liabilities and Capital 

(Funds) (Sources of Funds) 

Cash $10, 512 Notes Payable Bank $ i ,000 

Accounts Receivable 5 , 857 Notes Payable Trade 2 , ooo 

Inventories 22,210 Accounts Payable 5, ooo 

Fixed Assets 37*290 Dividends Payable 2,000 

Prepaid Expense 2,459 Accrued Liabilities 248 

Capital Stock Outstanding. 50 , ooo 

Surplus 18 , 080 

Total $78,328 Total $78,3-28 

Liabilities vs. Net Worth. This form of statement does 
not bring out the distinction between the funds contributed 
by creditors and funds contributed by owners. 

This distinction is of vital importance because of the dif- 
ference existing between the bases on which these funds' are 
contributed, namely, that creditors should be repaid at a speci- 
fied definite date, while the investor's contributions may be 
held in the business so long as they are needed for the proper 
and legal purposes of the corporation. 

For that reason it is usually considered better to draw up 
the balance sheet in such a way as to show the total of the 
liabilities (funds contributed by creditors) and the total of the 
net worth (funds contributed by owners). 

Form of Balance Sheet. In the form of balance sheet 
which follows, provision is made to show these important 
totals. 

This form of balance sheet also presents the advantage of 
being more convenient for typing and printing, since the liabil- 
ities and capital appear below the assets instead of opposite 



x g ANALYZING FINANCIAL STATEMENTS [Ch. 2 

them, thus furnishing space for more detailed descriptions 
when they are needed. 

In this balance sheet the phrases "funds" and "source of 
funds" are not used. 

These phrases do not usually appear in balance sheets and 
consequently they will not be used from now on, but it should 
be understood that the meaning is there even though the 
phrases themselves do not appear. The use of these phrases 
is an important step in developing the theory of the balance 
sheet and represents the viewpoint from which a balance sheet 
should always be considered. But the words themselves are 
never found as part of the statement. 

THE AMES MANUFACTURING COMPANY 

BALANCE SHEET 

As of December 31, 1924 

Assets 

Csah. .- $10, 512 

Accounts Receivable 5 857 

Inventories 22 , 210 

Fixed Assets 37,290 

Prepaid Expense 2 > 459 

Total Assets $78,328 

Liabilities and Capital 

Notes PayableTrade $i ,000 

Notes Payable Bank 2 ,000 

Accounts Payable 5 ,000 

Dividends Payable 2 ,000 

Accruals Payable 248 

Total Liabilities 10,248 

Net Worth $68,080 

Represented by: 

Capital Stock Outstanding $50,000 

Surplus 18,080 68,080 

The items shown in this balance sheet present interesting 
material for consideration and deserve a brief discussion. 

Arrangement of Assets. The assets have not been set 
down without regard to a logical order of arrangement, but 



Ch. 2] THE BALANCE SHEET 19 

a definite plan has been followed, a plan which has grown out 
of accounting practice over a long period of years, until it has 
come to be recognized as a proper arrangement of the assets 
for balance sheet presentation. 

It is not the only plan of arrangement which has been ap- 
proved by accounting practice, but it has met with wide-spread 
favor for all uses, and is strongly advocated for statements 
used for credit purposes. 

Determining Sequence of Items The assets have been 
set down in the order in which they may be expected to be con- 
verted into cash; in other words, in the order of their "cash- 
ability," to coin a word for the expression of this meaning. 

Following this plan the first item, quite logically, is cash 
itself. 

The second item, accounts receivable, represents legal claim 
to cash, which in the ordinary and regular course of business 
will be realized in cash within a short time. 

The next item, inventories, represents, for the most part, 
merchandise which is being held for sale. Normally it will be 
sold and thereby converted into accounts receivable and then 
into cash. 

The fixed assets, consisting of such assets as land, build- 
ings, machinery, furniture, fixtures, etc., is not held for sale, 
but for use ; and under normal regular business operations will 
not be converted into cash at all, although it should be borne in 
mind that any of these items might be converted into cash be- 
cause of unusual conditions. 

The last item, prepaid expense, usually represents the least 
cashable asset of all, since in the normal course of business it 
will never be converted into cash but will be charged off as 
expense during some future period. 

Current Assets. In a going business, the first three items, 
cash, accounts receivable, and inventories, are constantly active 



20 ANALYZING FINANCIAL STATEMENTS [Ch. * 

in a process of continuously changing from one form of asset 
into another. 

Cash is spent to secure merchandise; the merchandise is 
sold and an account receivable is created; the account is col- 
lected and cash takes its place; the cash is spent for more 
merchandise, and the cycle starts again. 

This common group characteristic puts these three forms 
of assets into a class by themselves ; and the name usually given 
to this group is "current assets/' 

Analysis of Current Assets But even within this group 
there is a distinction of prime importance in connection with 
the business operations. 

An account receivable represents a legal claim to cash and 
will normally be converted into cash ; but inventories do not rep 
resent a legal claim to an account receivable. There is r. 
decided break in the chain at this point, and at this break ir> 
directed one of the most vital of the business activities. 

Importance of Selling. The important step between in 
ventories and accounts receivable is the sale, the activity of se'.*~ 
ing the company's merchandise. 

Selling must be done before merchandise is converted into 
receivables. 

By the mere passage of time most of the accounts receivab'o 
naturally and automatically are converted into cash; but the 
process of converting merchandise into a receivable is not a 
mere automatic process, but calls for the highest expenditure 
of effort and money in the activity of selling. 

The importance of this distinction to the analyst cannot be 
emphasized too strongly, for companies which show equally 
good position when viewed as to total current assets, may 
show a decided difference in desirability as credit risks due to 
a difference in the division of these current assets between the 
three items comprising the group. 



Ch. 2] THE BALANCE SHEET 21 

This will be quickly recognized from the following example 
illustrating how two companies may show such conditions : 

Two companies, company A and company B, show balance 
sheets with identical figures except for the differences in the 
amounts of accounts receivable and inventories. 

Company A Company B 

Cash $ 1,000 $ 1,000 

Accounts Receivable 5,000 10,000 

Inventory 10,000 5 ,000 

Liabilities 10,000 10,000 

Comparing the Credit Risk. Both of these companies 
show total current assets amounting to $16,000 and liabilities 
amounting to $10,000 ; and yet if one were called upon to decide 
which presents the better credit risk, the proper choice is quite 
evident. 

Company B, on the basis of these figures, presents the 
better condition from a credit viewpoint, for it can pay all of 
its liabilities out of cash plus the proceeds of its receivables 
and still have $1,000 left; whereas company A would have 
$4,000 of its liabilities left unpaid if it applied all of its cash 
and accounts to this purpose. 

Merchandise cannot be used to pay bills. It must be sold 
before it represents a claim to cash, and selling is often an 
expensive and uncertain gamble. 

Quick and Working Assets. The importance of this dis- 
tinction between cash and receivables on the one hand and 
inventories on the other has led to the practice of introducing 
two group titles as subdivisions of current assets, as follows : 

Quick assets (cash and receivables). 
Working assets (inventories). 

Fixed Assets. Those items of the balance sheet that rep- 
resent fixed tangible plant are grouped together usually under 
some appropriate heading such as "fixed assets" or "plant and 
equipment/' 



22 ANALYZING FINANCIAL STATEMENTS [Ch. 2 

Other Asset Groups. In addition to these standard asset 
groupings which have already been discussed, there will fre- 
quently be found other items such as : 

Prepaid expense Patents 

Deferred charges Franchises 

Copyrights Goodwill 

Of course, this list does not include all items which might 
be found on balance sheets, but it includes those which are 
common to many balance sheets and for that reason deserve 
at least a brief consideration. 

PREPAID EXPENSES. The title of "prepaid expenses" well 
indicates the nature of the items included under this heading, 
for it represents expenses which have been paid for in advance, 
but for which the service has not been used as of the date 
of the balance sheet. 

When the service for which such an expenditure has been 
paid is rendered, the items cease to exist as assets and conse- 
quently disappear from the balance sheet. 

Under this classification are grouped such items as prepaid 
insurance, prepaid advertising and prepaid rent. 

DEFERRED CHARGES. Deferred charges, on the other hand, 
represent costs of service already received, which for good ac- 
counting reasons are not to be charged into the expense of one 
month or year, but are to be spread in instalments over a num- 
ber of such periods. An example of such an item is the ex- 
pense of organizing or starting a business. 

INTANGIBLE ASSETS. The other items mentioned in the 
list, copyrights, patents, franchises and goodwill, fall within 
the group which is usually known as "intangible assets/' 

They are often of the utmost importance to the company, 
which possesses them, being the very foundation of the struc- 
ture upon which the company is built. 

For example, ttie manufacturing company producing a dis- 



Ch. 2] THE BALANCE SHEET 23 

tinctive product the basic, idea of which is protected by patent, 
holds a peculiarly valuable position if this product is in demand 
and can be produced and sold at a satisfactory profit. 

Proof of Value. This last qualification presents the aspect 
of intangible assets which should receive the careful considera- 
tion of the analyst, for if the patented product is being pro- 
duced and sold at a satisfactory profit, that fact should be re- 
flected in the company's profit and loss statements, and if 
properly administered, in the tangible values shown on the 
company's balance sheets. 

In other words, if the patent is valuable, that value should 
be evidenced by having produced tangible values either left in 
the business or withdrawn as cash dividends. So from the 
analyst's viewpoint balance sheet values placed on intangible 
assets have little meaning and are usually of little significance. 

Types of Liabilities. The balance sheet of the Ames 
Manufacturing Company does not exhibit all types of liabil- 
ities which may be found in balance sheets, for there are other 
types that are not at all unusual. 

Such liabilities as mortgages (often in the form of bonds), 
and debentures (which are equivalent to long-time promissory 
notes), are often found on balance sheets and should receive 
special consideration. They differ from the liabilities already 
mentioned because they provide that a long period of time from 
the date of issuing them in many cases 10 years or more 
must pass before they become due and payable. 

Long-Time vs. Current Liabilities. It is quite evident 
that the distinction between such long-time obligations, also 
called "funded," "fixed" or "permanent," and the short-time 
obligations, usually called "current liabilities," becomes a matter 
of exceeding importance in analyzing a balance sheet. 

Liabilities which must be met within a short time from 
the date of the balance sheet must be provided for in cash or 



24 ANALYZING FINANCIAL STATEMENTS [Ch. 2 

its immediate equivalent, whereas long-time liabilities do not 
present the necessity of making provision for early payment. 

The following example will serve to illustrate the point 
involved in connection with this distinction between these two 
types of liabilities : 

The balance sheets of two companies, which are designated 
as company C and company D, present identical figures except 
as to the kind of liabilities. 

Company C Company D 

Current Assets $50,000 $50,000 

Current Liabilities 10,000 40,000 

Long-Time Liabilities 40,000 10,000 

Comparing the Credit Risks. In looking over these figures 
from the balance sheets of these two companies, it is observed 
that both show total liabilities equal in amount to the current 
assets. 

But if the relative financial positions of these two com- 
panies be weighed from the viewpoint of credit risk, it is evi- 
dent that company C is much the better risk; for if its current 
creditors all press for payment at one time, ample current funds 
are available. 

On the other hand, if all the current creditors of company 
D press for payment at one time, the company might find it 
difficult to secure $40,000 in cash out of its current assets of 
$50,000, a substantial part of which probably consists of re- 
ceivables and merchandise. Company D is largely at the 
mercy of its current creditors and is, therefore, the less de- 
sirable credit risk. 

Balance Sheet Grouping "One Year Rule." Because of 
the importance of the distinction between these two kinds of 
liabilities, it has become customary to subdivide total liabilities 
into two groups for the purpose of presenting them on the 
balance sheet. These two groups are : 



Ch. 2] THE BALANCE SHEET 25 

Current liabilities 
Long-time liabilities 

Of course, it is necessary to formulate some rule as to the 
length of time which will mark a liability as belonging to the 
one group or the other. 

Such a rule will, of course, be arbitrary, and consequently 
it is impossible to find a rule which will be universally con- 
sidered as satisfactory. However, the rule which has gained 
the widest acceptance is to include in the first group all liabil- 
ities which must be paid in less than a year and in the second 
group all tho-se of longer maturity. 

C. B. Couchman in his book, "The Balance Sheet/' com- 
ments on this point as follows : 

Liabilities also are divided into two groups, sometimes given 
the same group names as the two chief division of assets, namely, 
current and fixed. The distinction here, however, is purely an 
arbitrary one, depending upon when the liability must be met. 
Current liabilities are those which should be paid within the 
current financing period, which is usually from sixty to one 
hundred and twenty days or perhaps one year. Those which do 
not mature for a longer period, or those which are readily renew- 
able in character, are classed in the second group. For instance, a 
bond or a mortgage might fall due within thirty days after the 
date of a balance sheet, but if arrangements had been made for 
renewal, it would be tabulated among the fixed rather than among 
the current liabilities, 

It is difficult to give any rule fully covering the difference 
between these two classifications of liabilities. Long-time notes 
and bonds are unquestionably fixed liabilities. On the other hand, 
the liabilities resulting from purchases on open accounts, short-time 
loans from banks or other sources, should be grouped as current. 
Judgment and common sense must play a part many times in 
making the right grouping, and it is a fundamental of account- 
ancy that in case of doubt the preference- must lie with the more 
conservative line of action. To list a liability as current is more 
conservative than to list it as fixed if there be a reasonable doubt 
as to its proper classification. Among the current liabilities are 



26 ANALYZING FINANCIAL STATEMENTS [Ch. 2 

found all short-time notes payable, open accounts resulting from 
purchases, accrued payables and similar items. 

Net Worth. The item of net worth presented on the bal- 
ance sheet of a corporation is usually made up of two principal 
items, capital stock and surplus. 

The capital stock may consist of two or more different 
kinds of stock issues such as first preferred stock, second pre- 
ferred stock and common stock. 

Surplus, too, may consist of a number of different items, of 
which the following are typical examples : 

Surplus 

Undivided profits 

Appropriated surplus (or true reserves) 

Capital surplus 

Deficit (the result of a debit balance in a surplus account) 

Deducting Intangible Assets from Surplus. Many au- 
thorities advocate that certain intangible assets, such as good- 
will, should be shown in the net worth section of the balance 
sheet as deductions from surplus. This treatment is particularly 
desirable from the viewpoint of one analyzing the balance sheet 
for credit purposes. 

Balance Sheet Arrangement There are many different 
variations in the arrangement of balance sheets, KildufPs 
Auditing and Accounting Handbook shows eight examples. 
The Accountants' Handbook 1 exhibits five distinct types. 

From the analyst's viewpoint the exact manner of balance 
sheet arrangement is unimportant as compared to the correct- 
ness of the groupings, 

* Published by The Ronald Press Company. 



CHAPTER III 

THE APPROACH TO STATEMENT ANALYSIS 

Defining "Analysis." The word "analysis" as applied to 
the study of the balance sheet may be defined briefly as the 
examination of its component parts. Such an examination 
presents itself from a triple aspect : 

1. Each part separately. 

2. The parts in relation to each other. 

3. The parts in relation to the whole. 

Analysis of a balance sheet is prompted by a desire for in- 
formation about a business which may not be evident through 
a mere cursory survey of the figures shown on the statement. 

The Origin of Balance Sheet Analysis. The origin of 
balance sheet analysis undoubtedly arose from the credit re- 
lation which exists between buyer and seller. 

Before he would extend credit, the seller naturally desired 
to have some assurance that payment would be made when 
the account fell due and in consequence demanded a showing 
of the buyer's financial condition, i.e., a balance sheet. Upon 
securing the statement the seller studied it carefully to satisfy 
himself as to the probability of the buyer's ability to pay the 
account. 

This scrutiny of such balance sheets finally gave rise to 
certain elementary methods of studying the figures, and these 
methods form the basis of present-day analysis procedure. 

Not only has the technique of analysis become more 
definite, complete, and scientific, but there has also been a great 
broadening in the purposes of such analysis. 



2 g ANALYZING FINANCIAL STATEMENTS [Ch. 3 

Classes of Balance Sheet Analysis. Where, formerly, 
only a few credit men were interested in statement analysis, 
there now exist several broad classes of business men who use 
these methods. 

The prospective investor who is contemplating investing 
his money in the stock or other securities of a company, is 
interested in the information shown in the balance sheet from 
a viewpoint different from that of the credit man; and yet he 
finds the technique of statement analysis invaluable to him 
in choosing investment offerings. 

After investment has been made and the prospective in- 
vestor becomes an actual holder of the securities, his interest 
in analysis of the statements of companies in which he is a 
stock or bondholder continues although his viewpoint is per- 
haps altered to some extent. 

Reputable investment bankers have such a well-defined in- 
terest in statement analysis that often they maintain statistical 
or analytical departments to study the financial statements of 
the companies in which they are interested in order to avoid the 
possibility of marketing dubious issues. 

The Business Executive. The business executive is in- 
terested in statement analysis from a still different viewpoint. 

Often he is so engrossed in the day-to-day details of run- 
ning the business that he finds it necessary to fortify himself 
with a bird's-eye view of his business so that he will not lose 
his perspective of the business as a whole and as parts related 
to the whole and to each other. 

Such a bird's-eye view he finds presented to him in the 
study and analysis of the financial statements of the business 
activities and conditions. 

Where for some reason it is not practical for him to make 
this study and analysis himself, it is quite usual for him to 
have this work done for him by his company's comptroller or 



Ch. 3] THE APPROACH TO STATEMENT ANALYSIS 29 

auditor another class of men who are interested in statement 
analysis. 

The Public Accountant. The public accountant is also 
vitally concerned with the various phases of the subject of 
statement analysis. 

The time has long- since passed when the public accountant 
was called upon to serve in the capacity of a mere thief catcher 
a sort of mathematical detective. 

At the present time his function in business goes far beyond 
the search for defalcations; he is called upon to be an expert 
advisor on some of the most important financial phases of busi- 
ness activities. The reports which he renders covering his 
auditing work are expected to cover financial interpretations 
and constructive criticisms, as well as the certification of the 
facts verified in the course of the audit. 

The quality of the public accountant's work, which carries 
with it the satisfaction of his clients, depends much upon his 
ability to see beneath the obvious surface of financial state- 
ments and to draw shrewd conclusions as to business trends and 
conditions. Correct analytical technique is very vital to him. 

The Methods of Analysis. Having reviewed in a general 
way the characteristics of the balance sheet and the purposes 
and trend of analysis of financial statements, the next step is 
to consider the methods of statement analysis, to discuss their 
advantages and disadvantages, and to compare them as to 
purpose and usability. 

This discussion of the analysis of balance sheets will be 
presented in four major divisions, which are as follows : 

1. Analysis of the single balance sheet. 

2. Analysis of two or more balance sheets. 

3. Analysis by the ratio method. 

4. Analysis by the trend method. 



30 ANALYZING FINANCIAL STATEMENTS [Oh. 3 

These four divisions are not sharply distinguished from 
one another, but overlap to some extent and shade into one 
another. However, in a general way they follow the sequence 
of the historical development of analysis technique, which is a 
very satisfactory and valuable method of approaching the study 
of this particular subject. 



CHAPTER IV 

ANALYSIS OF A SINGLE BALANCE SHEET 

History of Balance Sheet Analysis. In the last chapter 
it was stated that balance sheet analysis undoubtedly originated 
from the desire of the seller to be assured that he would re- 
ceive payment from the buyer to whom he sold on credit, and 
that in order to have evidence upon which to base his judgment, 
he often insisted that the buyer furnish a copy of his balance 
sheet or statement of financial condition. 

This led to the development of methods of analyzing one 
balance sheet alone, usually the latest balance sheet of the 
buyer; and sometimes when the latest balance sheet had been 
drawn off a considerable time previous, the seller even insisted 
on a new balance sheet being made up that would show the 
buyer's latest financial condition. 

Old balance sheets were considered of little importance, as 
the seller was principally concerned with the buyer's condition 
at a time close to the date on which the seller was about to 
extend credit. 

Today balance sheets of prior dates are looked to for much 
information of value, but there is still, of course, vital informa- 
tion to be obtained from the latest balance sheet standing alone. 

For this reason it is important to consider what should be 
studied in the examination of a single balance sheet. 

Illustrative Figures The reader will find it easier to fol- 
low and understand the steps in such an examination if figures 
are used, so that he can see the procedure developed from an 
illustrative case, including the description of the balance sheet 
items as well as the figures. So the procedure will be discussed 

31 



32 ANALYZING FINANCIAL STATEMENTS [Ch. 4 

from the background of the following assumed balance sheet 
of the Ames Manufacturing Company. 

THE AMES MANUFACTURING COMPANY 

BALANCE SHEET 
As of December 31, 1924 

Assets 

CURRENT ASSETS: 
Quick Assets : 

Cash $10,512 

Accounts Receivable 5.857 $16,369 

Working Assets: 

Inventory 22,210 

Total Current Assets $3&>579 

FIXED ASSETS 37 , 290 

PREPAID EXPENSE 2,459 

Total Assets $78 ,328 

Liabilities and Capital 
CURRENT LIABILITIES: 

Notes Payable Trade $ 1 ,000 

Notes Payable Bank 2 , ooo 

Accounts Payable 5 , ooo 

Dividends Payable 2 ,000 

Accruals Payable 248 

Total Current Liabilities $10 , 248 

LONG-TIME LIABILITIES none 

Total Liabilities $10, 248 

Net Worth $68,080 

Represented by: 

Capital Stock $50 , ooo 

Surplus 18,080 $6_8 1 o8o 

Solvency of the Business. Probably the first question 
that would occur to any business man interested in the financial 
condition of the Ames Manufacturing Company would be : 
Is the Ames Manufacturing Company solvent ? 

An examination of the balance sheet figures shows that the 
company is solvent on December 31, 1924. Its total assets 
are $78,328 and its total liabilities are $10,248. Deducting the 



Ch. 4] ANALYSIS OF A SINGLE BALANCE SHEET 33 

latter from the former leaves a balance of $68,080, which rep- 
resents the net worth the owners' equity in the business, of 
which $50,000 is a permanent investment in the nature of 
capital stock outstanding, and $18,080 is surplus left in the 
business, probably surplus earnings, and subject to withdrawal 
in the form of dividends. 

Permanency of Surplus. In many cases the surplus may 
be looked upon as practically a permanent investment. Many 
corporations have adopted the conservative policy of continu- 
ously adding to surplus rather than diminishing it. To put it 
in another way, only a part of each year's net profit is with- 
drawn, and the balance is left for permanent use in the business 
operations, thus leaving a margin to provide for the natural 
growth and increase in the volume of business and at the same 
time stabilizing this investment value by additional earned 
surplus. 

Nevertheless, the analyst must never lose sight of the fact 
that all of the surplus may be withdrawn as dividends and that 
such a possibility should always receive consideration when he 
is studying the balance sheet figures. 

Ability to Pay Debts However, the mere fact of sol- 
vency indicated by the figures is only a first step in the chain, 
and is not even conclusive as to probable continuance of the 
business, for it sometimes happens that a solvent corporation 
is forced into bankruptcy. 

A corporation may have a substantial excess of asset values 
over liabilities, which represents a solvent condition, and still 
if it has an insufficient amount of those asset values in current 
form, it may soon be in a condition where liabilities cannot be 
met when they fall due. In aggravated instances such a con- 
dition exposes the corporation to the danger of drastic action 
by creditors and may result in the taking over of the business 
by a receiver. 



34 ANALYZING FINANCIAL STATEMENTS [Ch. 4 

Current Assets and Current Liabilities. Therefore, the 
next step in the analysis is to study the balance sheet figures to 
determine whether such a condition exists. To do this the 
current assets are compared with the current liabilities, thus : 

Current Assets $3$ , 579 

Current Liabilities 10,248 

Net Current Assets $28,331 

The "2 to i" Rule. In analytical procedure credit men for 
many years have figured that if the current assets amounted 
to more than twice as much as current liabilities, such a condi- 
tion could be considered as satisfactory. This relationship 
between the two groups of current items, current assets and 
liabilities, has been called the "current ratio/' and when the 
condition of current assets being more than twice as great as 
liabilities has existed, it has been referred to as a "2 to i cur- 
rent ratio." 

The current ratio may be expressed as a percentage, ob- 
tained by dividing the current assets by the current liabilities, 
thus: 

Current Assets = $38 , 579 , ~ ^ , _, , . 
Current Liabilities -|sS ~ ^ 6 % - Current Ratio. 

If the "2 to i" rule is accepted, then a current ratio of 
ZQQ% would be satisfactory; and certainly the ratio shown on 
the balance sheet of the Ames Manufacturing Company of 
376% would be considered as representing a very satisfactory 
situation, but not always. 

Quick and Working Assets. There is still another pitfall 
to be guarded against. If a large part of the current assets 
consists of merchandise inventory which is difficult to sell, the 
analyst must not be misled by the 376^ current ratio into 
believing that the situation presents an entirely sound condition. 

The 376% current ratio indicates that there is $3.76 worth 
of current assets to meet every $i of liabilities. But if, for 



Ch. 4] ANALYSIS OF A SINGLE BALANCE SHEEt 35 

example, it were found that only a small part of the current 
assets was in the form of cash and receivables and a larger part 
was merchandise, the ratio would not seem as favorable. 

The Acid Test. Therefore, the next step consists of an 
examination of this feature of the balance sheet, which is ac- 
complished by comparing the current liabilities with the quick 
assets. This ratio has sometimes been referred to as the 
"acid test" 

Quick Assets =$16,360 , M . . , . ^ , 

Current Liabilities = fcrfj = l6 % = Acid Test Ratl ' 

This ratio tells that the Ames Manufacturing Company 
has $1.60 of quick assets for every dollar of current liabilities; 
and since it is somewhat of an accepted rule among credit men 
that $i of quick assets per $i of current liabilities indicates a 
safe condition, the balance sheet of the Ames Manufacturing 
Company may be said to present a very satisfactory condition 
from the standpoint of this acid test. 

For many years the use of the "current ratio" and the 
"acid test" comprised practically the whole art of balance sheet 
analysis. 

Scaling the Assets. The next step in the development of 
analysis procedure undoubtedly grew out of the inaccuracies 
and uncertainties which resulted from old-fashioned and un- 
scientific bookkeeping. So many of the balance sheets were 
prepared from poorly kept records that the analyst felt that it 
was necessary for him to discount many of the statements 
which were presented for his consideration. From this re- 
sulted a procedure consisting of discounting marking down 
or "shading" the asset values. 

When using this method of analyzing the balance sheet, 
the analyst would construct a new balance sheet from the old 
one. In building up the new one he would carry over to it all 
the liabilities shown on the old one, but would make heavy 



36 ANALYZING FINANCIAL STATEMENTS [Ch. 4 

reductions in most of the asset values. The motive for this 
drastic revision never appears to have been very sharply de- 
fined but apparently it was an attempt to reach the goal of 
the liquidating value of the assets at a forced cash sale. 

Schedule for Marking Down. One author says that asset 
values should be shaded somewhat as follows : 

Kind of Asset Per Cent 

Merchandise: 

General Store 20-30 

Groceries 10-20 

Dry Goods 20-25 

Hardware 25-30 

Millinery 35~ 6 

Clothing 25-35 

Accounts Receivable i-io 

Plant, Machinery and Tools 50 

Furniture and Fixtures 50 

Intangible Assets 100 

Apparently it is intended that these reductions are to be 
made indiscriminately without regard for the character of the 
management, the geographical location of the business, or other 
factors. 

Just how the analyst would decide whether to deduct 35% 
or 60% from the inventory value of hats in any given instance 
still remains a mystery. 

Proper Balance Sheet Values. Of course, this whole pro- 
cedure is the height of absurdity under present-day conditions. 
It is senseless because it is arbitrary. 

Even though it did result in reducing the assets to a fairly 
accurate cash value, which is improbable, it is still useless be- 
cause it assumes something which is untrue. It assumes that 
the company under analysis is about to liquidate and go out 
of business. 

The modern theory holds that asset values must be judged 
from the viewpoint of a going business. The only possible 



Ch. 4] ANALYSIS OF A SINGLE BALANCE SHEET 37 

basis for accurately valuing assets is their cost and this is now 
universally recognized both by business men and by the courts. 

It is true that good accounting practice requires, in the case 
of inventories, that they should be valued at cost price or 
market price whichever is lower, but when this adjustment is 
necessary it is taken care of by an expedient known as a "valua- 
tion account/' or more commonly, a "reserve account," where- 
by the original cost prices are not altered or lost. 

Nor does the rule imply that depreciation of any asset shall 
be ignored. The original cost is merely the basis of valuations, 
as distinguished from appraisal or forced liquidation values. 
Deductions for depreciation find their place in the accounting 
system in valuation or reserve accounts. 

In most published balance sheets asset values are shown net, 
i.e., at one figure representing the original cost less the accu- 
mulated depreciation. 

Illustration of Markdown Method. In no theory of asset 
valuations is there justification for arbitrary percentage reduc- 
tions in asset values by the analyst. It is a "rule of thumb" 
procedure, based on false assumption, inaccurate and unjust. 

Applying the percentages suggested to typical balance sheets 
gives some absurd results. 

Filene's (Wm.) Sons Company, is a famous store engaged 
exclusively in the sale of ready-to-wear apparel. Its balance 
sheet as given in Moody 7 s Manual is as follows : 

Assets 1923 

Real Estate $ 955, 189 

Goodwill, Patents, etc 1 ,000,000 

Investments , i ,878,220 

Fixtures and Equipment 24 , 326 

Merchandise (i) 2,658, 186 

Cash (g) 379>6n 

Accounts ^Receivable (q} 916,035 

Prepaid Items 93 *97 

Deferred Items 729,810 

IJotal $8,634,574 



38 ANALYZING FINANCIAL STATEMENTS [Ch. 4 

Liabilities 

Capital Stock ' $4,497,300 

Accounts Payable (c) 650 , 414 

Accrued Items (c) 150 , 182 

Reserve for Taxes (c) 815,410 

Other Reserves 946 , 412 

Surplus 1,574,856 

Total $8,634,574 

The quick assets (marked q above) total $1,295,646. The 
inventories (marked i) amount to $2,658,186. The current 
liabilities (marked c) equal $1,616,006. 

The "acid test" shows $.80 for each dollar of liabilities 
while the "current ratio" shows $2.45 for each dollar of liabil- 
ities. This is a good showing. 

Using the percentages previously suggested, the balance 
sheet may next be revised downward: 

Assets 1923 

Real Estate (50% off) (i) $ 477.594 

Goodwill, Patents, etc. (100%) 

Investments (2) 1 , 878 , 220 

Fixtures and Equipment (50% off) 12 , 163 

Merchandise (35% off) 1 , 727 , 821 

Cash 379,6n 

Accounts Receivable (2) 916,035 

Prepaid Items (2) 93 , 197 

Deferred Items (100%) (3) 

Total $5,484,641 

Liabilities 

Capital Stock $4,497,300 

Accounts Payable 650,414 

Accrued Items 150, 182 

Reserve for Taxes 815 ,410 

Other Reserves 946 , 412 

Total $7,059,718 

Deficit (deduct to balance) i , 575 ,077 

Total $5, 484., 641 

The item marked (i) probably consists in part of land. 
Any error involved in marking down that portion is probably 



Ch. 4] ANALYSIS OF A SINGLE BALANCE SHEET 39 

compensated by leaving the other items marked (2) at full 
value. 

While the item marked (3) was not specifically mentioned 
as subject to discount, it seems consistent to mark it down 
1 00%, since it is probably without cash value upon liquidation. 

Effect of the Analysis. What has been the effect of this 
"analysis" upon a well-known, prosperous, splendidly managed 
company ? 

The surplus of $1,574,856 has been changed into a deficit 
of $1,575,077 a total decrease in net worth of $3,149,933. 
The acid test shows the same as before, but the current ratio 
now indicates only $1.87 of current assets for each dollar of 
current liabilities. 

From a splendid credit position, this drastic procedure in- 
dicates a company to whom credit might be offered hesitatingly. 

Applying this unjust method to a less well-rated organiza- 
tion might easily develop figures indicating actual insolvency. 

The Annual Sales. Turning attention again to the figures 
for the Ames Manufacturing Company, there is very little 
further information that can be gained without knowing addi- 
tional facts. The most important fact desired is the amount 
of the annual sales for the year. 

It may well be noted here that information as to the amount 
of annual sales is now regarded as vital to intelligent balance 
sheet analysis. In spite of the fact that such figures belong 
in the profit and loss statement instead of the balance sheet, 
the custom is growing of including figures reflecting sales 
volume as supplementary information to balance sheets even 
when other profit and loss elements are not furnished. 

The sales for the year 1923 amounted to $96,691. What 
help does this give in analyzing the balance sheet? It throws 
some additional light on two important items accounts re- 
ceivable and inventory. 



40 ANALYZING FINANCIAL STATEMENTS [Ch, 4 

Sales and Receivables. Since accounts receivable result 
from sales, there is a natural relationship between them which 
can be reflected by a ratio. 

If all goods were sold on 30 days' credit and all collections 
were made promptly, the balance of accounts receivable at any 
one time should be 1/12 of the sales volume for the year. This 
assumes that the annual sales are made in 12 equal monthly 
amounts. This assumption is never absolutely true and in many 
lines of business never even approximately true. 

Nevertheless it is a roughly accurate guide to consider that 
the ideal relationship between accounts receivable and sales is 
i to 12, where the usual credit terms are 30 days, and i to 6 
where the usual credit terms are 60 days. 

The Ratio of Receivables to Sales. To determine this re- 
lationship for the Ames Manufacturing Company, divide the 
sales by the accounts receivable : - 

Sales $96, 691 = ~ 

Accounts Receivable - $ 5,857 

This indicates $16.50 of sales for each $i of accounts re- 
ceivable. This is better than the "ideal" of $12 of sales to $i 
of receivables just discussed. 

It means that the usual terms are shorter than 30 days, or 
else that attractive cash discounts have induced a large pro- 
portion of customers to pay before due date. 

As a matter of fact the selling policy of Ames Manufactur- 
ing Company is conducted to some extent on a C.O.D. basis. 
Only a part of their sales are on credit. If it were known what 
part of the total sales were made on credit, that part could be 
divided by the receivables. This would furnish information 
about the collection efficiency of this company. 

As it is, the analyst must rest content with the knowledge 
that as far as can be seen the condition of the accounts receiv- 
able as shown by the ratio appears good. 



Ch. 4] ANALYSIS OF A SINGLE BALANCE SHEET 41 

Sales and Inventory. The second use of the sales figure 
is in connection with the inventory. 

There is an obvious relationship between the amount of 
merchandise on hand and the amount sold. 

If the annual sales were reduced to cost and if the inventory 
was an average inventory, the one divided by the other would 
give the "merchandise turnover," which is a significant per- 
centage showing selling efficiency, much used by merchants. 

The Merchandise Turnover. The principle of the mer- 
chandise turnover is based on the fact that the most profit can 
be made by that merchant, 'within a given group, who can get 
the greatest volume of sales with a given average investment 
in merchandise. 

And, of course, the reverse Is true. That merchant with 
the smallest sales in relation to average inventory is making 
the least profit. Usually he may be suspected of merchandising 
inefficiency and his inventory also may be under the suspicion 
of containing a large proportion of obsolete or unsalable stock. 

If it were possible for the analyst to ascertain (i) the 
average inventory and (2) the annual sales at cost price, he 
could divide the first into the second and obtain a valuable 
insight into the character of the inventory item on the balance 
sheet. 

A Substitute for the Turnover. Usually he cannot learn 
the average inventory but only the actual inventory at the 
close of the fiscal period, and usually he cannot determine the 
cost value of the annual sales but is fortunate to learn the 
annual sales at selling price. 

He can use these figures as the basis for a "turnover." It 
will be less accurate but still fairly significant. 

For the Ames Manufacturing Company the calculation is as 
follows : 



Annual Sales = $96,691 
Inventory = $22,210 



' 435%* 



42 ANALYZING FINANCIAL STATEMENTS [Ch. 4 

This indicates roughly that the inventory is "turned" ap- 
proximately four times per year, i.e., that three months' supply 
of merchandise is on hand. 

Without having any standards of comparison, this is diffi- 
cult to interpret. It "looks" all right and that is about as much 
as can be said at this stage in the development of analysis 
methods. 

Danger Signals on the Balance Sheet. There are certain 
general danger signals that will be looked for by the experi- 
enced analyst. These danger signals are : 

1. Very small amount of cash. 

2. Improper combinations of unlike balance sheet items. 

3. Heavy notes receivable. 

4. Large intangible assets (particularly when there is no 

surplus). 

Cash is one asset that cannot be "innocently" misrepre- 
sented. When a weak concern desires to make a good financial 
showing as a basis for credit, it can find excuses for many 
infractions of good accounting practice, but the item of cash 
cannot be "improved" without positive misrepresentation. Ex- 
perience has shown that a trifling cash balance on a balance 
sheet is quite often a reliable warning signal. 

Improper combinations of items may well throw doubt on 
the entire balance sheet. Examples of such improper com- 
binations taken from actual balance sheets are : 

Cash and Accounts Receivable $ 

Plant and Franchise 

Government and Other Bonds 

In a very few lines of business it is customary to accept 
notes in payment of accounts receivable. Usually, however, 
there is a strong presumption that the credit management is 
poor when a substantial item of notes receivable appears on a 
balance sheet. 



Ch. 4] ANALYSIS OF A SINGLE BALANCE SHEET 43 

The combination in one balance sheet of no surplus to- 
gether with heavy intangible assets usually leads the analyst 
to suspect that these intangible assets really represent a deficit, 
either in whole or in part. 

None of these four danger signals are positive indicators, 
but they are serious warnings that the experienced analyst has 
learned to regard with real respect. 

Importance of Current Ratio and Acid Test. Perhaps 
the most important features discussed in this chapter are the 
current ratio and the acid test. 

There has been a tendency on the part of modern writers 
to slight these balance sheet tests. 

It is true, of course, that the rule of "two dollars of cur- 
rent assets for every dollar of current liabilities" is arbitrary. 
Conditions vary in different lines of business and a proper 
ratio for one business might not be proper for another, and 
yet, as a practical credit test applicable to a wide variety of 
statements, it can hardly be abandoned. 

Window Dressing. It is also true that these two ratios 
are subject to "window dressing." This is a term used to de- 
scribe financial operations which have for their only purpose 
the preparation of a more attractive balance sheet. 

A company might normally show the following condition 
at the end of a year : 

Cash $ 2,000 

Accounts Receivable 5 , ooo 

Merchandise 4,000 

Total $11,000 

Current Liabilities $ 6,000 

This shows only $1.83 of current assets for every dollar of 
current liabilities. Desiring to show a "2 to i" ratio on the 
balance sheet a "sale" might be made of $1,000 of merchandise 
for $2,000 to some friendly interest. 



44 ANALYZING FINANCIAL STATEMENTS [Ch. 4 

This would result in the following figures : 

Cash $ 2,000 

Accounts Receivable 7,000 

Merchandise 3>QQQ 

Total $12,000 

Current Liabilities $ 6,000 

The ratio is now $2 of current assets for every dollar of 
current liabilities. The day after the date of the statement the 
"sale" could be reversed in accordance with the previous 
friendly understanding. 

There are other methods of "window dressing" which need 
nqt be discussed. 

Interpreting the Ratio. The balance sheet analyst realizes 
the possibility of "window dressing/' and he does not regard 
a good ratio as a guarantee of good condition. But he does 
look with suspicion on a poor ratio. 

He realizes that a favorable ratio may mean nothing but 
that an unfavorable ratio is significant. He is in the same posi- 
tion as the doctor who does not regard the lack of fever as 
indicative of perfect health but who regards its presence as an 
important warning. 

Other methods used to test financial statements have this 
important characteristic. 

The current ratio and the acid test are both based on sound 
common sense from the viewpoint of the commercial credit 
grantor. 

S. F. Brewster, in "Analyzing Credit Risks," expresses 
this thought forcefully: 

A situation is frequently encountered . . . where the total 
assets are considerably in excess of the total liabilities but where 
the quick liabilities are in excess of the quick assets. To extend 
credit to a concern in such a condition is almost equivalent to 
buying a lawsuit, 



CHAPTER V 
COMPARATIVE BALANCE SHEETS 

Use of Comparative Figures. In the last chapter it was 
shown that a limited amount of information could be gained 
from the study of one balance sheet. 

But the major difficulty in such a study is the lack of 
comparative data. 

All measurement is based upon comparison. Measuring 
the distance between two points involves comparing that dis- 
tance with some other distance. The statement that it is 245 
miles from St. Louis to Kansas City simply means that the 
distance between the two points has been compared with 
another distance known as a "mile" and is 245 times as long. 

Similarly with the measurement of weight. A man's 
weight is obtained by comparing it with another weight known 
as the "pound." 

Instances could be multiplied indefinitely to show that all 
measurement is based upon comparison. 

Methods of Comparison. Usually measurement is based 
upon present comparison with a standard. 

The mile, the pound, the quart and other familiar units are 
standards which have been adopted for convenience. 

There is also historical comparison which is frequently made 
without reference to standards the comparison of the same 
things at different times. 

Thus, one may say, "I drove my car twice as far today as 
yesterday," or, "My weight is 10% greater than it was a year 
ago." 

Historical comparison compares the same thing at two 
different times instead of two different things at the same time. 

45 



46 ANALYZING FINANCIAL STATEMENTS [Ch. 5 

Applied to balance sheet analysis, historical comparison 
refers to the comparison of balance sheets of the same com- 
pany as of two or more different dates. 

Trends Shown by Historical Comparison. Such com- 
parison gives relative results showing trends. 

Trends are all important in the analysis of financial state- 
ments. They answer the vital question as to whether the con- 
dition of the company is improving or not. 

Someone has said, "It is not where you are, but which way 
you are going that counts/' This statement is as true of 
corporations as it is of individuals, and while a company may 
be below standard in some respect, if its condition is consistently 
improving, optimism is justified. 

Statements of Ames Manufacturing Company. Return- 
ing to the illustration of the Ames Manufacturing Company, 
the following comparative figures are valuable. 

THE AMES MANUFACTURING COMPANY 

COMPARATIVE BALANCE SHEET 

As of December 31 

Assets 1923 1924 

Cash $7.190 $10,512 

Accounts Receivable 5,629 5,857 

Quick Assets $12,819 $16,369 

Inventories 28,077 22,210 

Current Assets $40,896 $38,579 

Fixed Assets 36,163 37 2 9O 

Prepaid Expense 2,545 2,459 

Total Assets $79,604 $78,328 

Liabilities and Net Worth 

Notes PayableTrade $ 3>ooo $ i ,000 

Notes Payable Bank 3>ooo 2 ,000 

Accounts Payable 8,000 5 ,000 

Dividends Payable 2 ,000 2 ,000 

Accrued Liabilities 337 248 

Current (and Total) Liabilities $16,337 $10,218 



Ch. 5] COMPARATIVE BALANCE SHEETS 47 

Capital Stock Outstanding $50,000 $50,000 

Surplus 13 , 267 18 ,080 

Total Net Worth $63,267 $68 080 

Total Liabilities and Net Worth $79,604 $78,328 

Sales $90,652 $96,691 

Determining the Ratios In the last chapter certain ratios 
were suggested. If they are calculated for both balance sheets, 
their comparison should be illuminating. 

1923 1924 

Quick Assets $12,819 $16,369 

Current Liabilities $16 , 337 $10 , 248 

Ratio (acid test) 78% 160% 

This is very interesting. For every $i of current liabilities 
there was only $.78 of quick assets in 1923 as compared with 
$1.60 of quick assets in 1924. This trend is obviously 
favorable. 

1923 1924 

Current Assets $40 , 896 $38 , 579 

Current Liabilities $16 , 337 $10 , 248 

Current Ratio 250% 376% 

This trend is also good. From $2.50 of current assets 
in 1923 to $3.76 of current assets in 1924 for every dollar of' 
current liabilities is a favorable change. 

In each instance alone the showing is better than required 
by the "2 to i" rule. The comparison shows the trend and if 
the figures were reversed, i.e., if the 1923 ratio was 376% and 
the 1924 ratio was 250%, the reader would be warned of an 
unfavorable tendency, whereas, with either of the balance sheets 
alone, he might easily be satisfied with the current ratio. 

1923 1924 

Sales $90,652 $96,691 

Accounts Receivable $ 5 ,629 $ 5 ,857 

Ratio i ,610% i ,650% 

The trend of these ratios is favorable. An increase is 



48 ANALYZING FINANCIAL STATEMENTS [Ch. 5 

shown from $16.10 to $16.50 of annual sales for each dollar 
of accounts receivable. 

1923 1924 

Sales $90*652 $96,691 

Inventory $28,077 $22,210 

Ratio 323% 435% 

This comparison Is favorable. When, for every dollar of 
inventory the sales are increased from $3.23 to $4.35 a trend is 
shown toward more profitable merchandising methods lulling 
possible suspicions that the inventory may be getting over- 
loaded with obsolete or unsalable stock. 

While it may be assumed that the reason lies in more 
efficient merchandising, there are other possible causes that 
should not be overlooked : 

1. The 1924 inventory may be lower than the average for 

the year. 

2. The 1923 inventory may be higher than the average for 

the year. 

3. The inventories may consist of proportionally the same 

number of physical units but the 1924 inventory may 
have been acquired at a substantially lower cost. 

4. The sales may consist of proportionally the same number 

of physical units but the 1924 sales prices per unit 
may be greater. 

These are possibilities that exist where sales (at selling 
price) are divided by actual inventory instead of following 
the correct, but often impracticable method of dividing average 
inventory into sales at cost. 

The comparison of these four ratios naturally represents 
the first step in analysis when two or more balance sheets are 
available. However, the availability of two or more balance 
sheets offers an opportunity for a different type of analysis, 

Comparison of Amounts. With two statements available 
the figures may be lined up side by side and the increase or 



Ch. 5 ] 



COMPARATIVE BALANCE SHEETS 



49 



decrease of each item and group ascertained. This is an im- 
portant basic method of analysis for showing changes. 

THE AMES MANUFACTURING COMPANY 

COMPARATIVE BALANCE SHEET 

As of December 31 

Assets 1923 

Cash $ 7,190 

Accounts Receivable 5 , 629 

Inventories 28 ,077 

Fixed Assets 36 , 163 

Prepaid Expense 2 , 545 



1924 
$10,512 

5,857 
22,210 
37,290 

2,459 



Increase 

$3,322 

228 



Decrease 



$5,867 
1,127 

86 



Total Assets $79,604 $78,328 $4,677 $5,953 



Liabilities and Net Worth 

Notes Payable Trade $ 3 , ooo $ I , ooo 

Notes Payable Bank 3 ,000 2 ,000 

Accounts Payable 8 , ooo 5 , ooo 

Dividends Payable 2 ,000 2 ,000 

Accrued Liabilities 337 248 

Capital Stock Outstanding 50 , ooo 50 , ooo 

Surplus 13 , 267 18 ,080 

Total Liabilities and Net Worth $79 , 604 



$2, OOO 
I,OOO 

3ooo 

89 



$6,089 



Presenting the statement . in this form emphasizes the 
changes that have taken place. The facts stand out clearly 
and their relative importance is more easily gauged. 

This method of analyzing is perhaps the one most com- 
monly used. For clearness the above statement does not show 
group headings and sub-totals that would usually be given. 

Application of Funds. As a step further, it is sometimes 
of interest to use the figures of increase and decrease in another 
statement. This statement is based on the fact that : 

INCREASES IN ASSETS 

plus 
DECREASES IN LIABILITIES AND NET WORTH 

equals 
DECREASES IN ASSETS 

plus 
INCREASES IN LIABILITIES AND NET WORTH 



50 ANALYZING FINANCIAL STATEMENTS [Ch. 5 

Applying to this formula the figures of the Ames Manu- 
facturing Company, the following proof is obtained: 

Increases in Assets $4,677 $5,953 Decreases in Assets 

Decreases in Liabilities Increases in Liabilities 

and Net Worth 6,089 4,813 and Net Worth 

Total $10,766 $10,766 Total 

The equation forms the basis for the following statement, 
usually called the "Application of Funds Statement/' which 
shows (i) the classified sources from which funds were re- 
ceived and (2) what was done with the funds. 

THE AMES MANUFACTURING COMPANY 

APPLICATION OF FUNDS STATEMENT 
For the Year Ended December 31, 1924 

SOURCE OF FUNDS: 

Increase in Surplus $4,813 

Decrease in Inventories (i) 5 , 867 

Decrease in Prepaid Expenses (2) 86 

Total to Be Accounted for $10,766 

APPLIED TO THE FOLLOWING PURPOSES: 

Increase in Cash $3 ,322 

Increase in Accounts Receivable 228 

Increase in Fixed Assets i , 127 

Decrease in Notes Payable Trade 2 , ooo 

Decrease in Notes Payable Bank 1 ,000 

Decrease in Accounts Payable ^ ,000 

Decrease in Accrued Liabilities 89 $10,766 

Decreases in assets are theoretically regarded as sources 
of actual funds for the purpose of the above type of statement. 

This viewpoint may be regarded as true in the case of 
marked (i) inventories. In the case of such an item as 
marked (2) prepaid expense, it is only theoretically, not ac- 
tually true. No actual cash was realized in this connection, 
but had not this decrease in prepaid expense occurred, the in- 
crease in surplus would have been greater to the extent of 
$86, so that it amounts to the same thing. 

Also decreases are often noted in fixed asset accounts which 
are not due to some of those assets having been converted into 



Ch. 5] COMPARATIVE BALANCE SHEETS 51 

cash but rather to increases in the allowance for depreciation 
purely a book entry with no effect on the cash. 

Nevertheless, this type of statement assumes that a decrease 
in fixed assets is a source of funds, because the increase in 
surplus would have been larger by the same amount had not 
such depreciation provision been made. 

In spite of the false assumptions as to actual funds result- 
ing from all decreases in asset values, the effect produced by 
the statement is the same as though the false assumptions were 
really true. 

This type of statement is most frequently used by account- 
ants to answer the business man's question : "You say my 
business shows a profit for the year. What has become of it?" 

It is also used often enough by the analyst of financial 
statements to justify its inclusion here as an optional part of 
analysis technique. 

Percentage Analysis of Statements. For the sake of 
completeness it should be mentioned that there is some author- 
ity for a plan which shows on the face of a comparative balance 
sheet the percentage that each item and group of items bears 
to the total assets. 

Applying this plan to the figures for the Ames Manufac- 
turing Company, the statement would appear as follows : 

THE AMES MANUFACTURING COMPANY 

COMPARATIVE BALANCE SHEET 

As of December 31 

In- De- 



Assets 
Cash 


i? 
t 7 


>23 
, IQO 


9. 


o 


IS 

$10 


>24 

,512 


13, 




crease 
$3,322 


crease 


Accounts Receivable. . 


- '5 


,629 


,.7- 


I 


5 


,857 


7- 


5 


228 





Quick Assets 


$12 


,8lQ 


T6 


T 


$16 


,369 


20. 


Q 


3,550 





Inventories 


. 28 


,077 


35. 


3 


22 


,2IO 


28. 


4 




$5,867 


Current Assets . 


. $4.0 


,806 


51. 


A 


$38 


,579 


49 


3 


_ 


2,317 


Fixed Assets . .... 




,163 


45- 




37 


,290 


47 


6 


1,127 




Prepaid Expense 


2 


,545 


3- 


2 


2 


,459 


3 


,1 




86 


Total Assets 


. $7Q 


,604 


IOO. 





$78 


,328 


IOO 


.0 


. 


1,276 



52 ANALYZING FINANCIAL STATEMENTS [Ch. 5 

Liabilities and Net Worth 

Notes Payable^-Trade. $ 3,000 3.8 $ 1,000 1.3 $2,000 

Notes Payable-^-Bank. . 3,000 3-8 2,000 2.6 1,000 

Accounts Payable 8,000 10.0 5.000 6.4 3,000 

Dividends Payable 2,000 2.5 2,000 2.6 

Accrued Liabilities 337 Q-4 248 0.3 89 

Current Liabilities.. $16,337 20 5 $10,248 13.2 6,089 
Capital Stock Outstand- 
ing $50,000 62.8 $50,000 63 8 

Surplus 13,267 16.7 18,080 23 o $4,813 

Net Worth $63,267 79.5 $68,080 86 8 4,813 

Total Liabilities and Net 

Worth $79,604 IPO o $78,328 IPO o 1,276 

Interpreting the Statement. It appears that very little 
value attaches to these percentage calculations. In fact, to 
the untrained reader they might at times be actually deceptive 
as in the following example, occurring in a balance sheet used 
to illustrate this method in a pamphlet, "The Preparation and 
Use of Financial Statements/' published by the Illinois Manu- 
facturers Cost Association : 

Last Year % This Year % 

Surplus $3,938,,ooo 15.2 $4,650,000 15.1 

Total Assets 25,854,000 100.0 30,634,000 100.0 

A superficial survey might give the impression of a poorer 
surplus condition because of the drop in the percentages from 
15.2% to 15.1%. It may appear a trifle far fetched that any 
person could be so easily deceived, yet the example given illus- 
trates the point that the total of the assets does not furnish a 
desirable base figure for determining percentages. 

The fluctuations of the total assets may be out of all har- 
mony with certain items or groups, and no useful purpose 
is served by figuring the percentages, one of the other. 

Use of "Increase and Decrease" Method. The important 
feature of this chapter is the "increase and decrease" method 
of analyzing a comparative balance sheet. 



Ch. 5] COMPARATIVE BALANCE SHEETS 53 

The use of this method plus the calculation of the current 
ratio (and sometimes the "acid test" ratio) represents about 
the sum total of analysis technique in common use at the 
present time. 

And for the ordinary work of credit departments, it is 
usually sufficient. But for the needs of investors, executives, 
public accountants and to meet extraordinary credit situations, 
this limited procedure is quite inadequate. 

The next few chapters will be devoted to the more ad- 
vanced technique of balance sheet analysis and a comparative 
consideration of different methods. 



CHAPTER VI 

SPECIFIC BUSINESS AILMENTS 

Purpose of Analysis This chapter represents an impor- 
tant interlude in the development of analytical technique. 

Before developing finer and surer methods of analysis, it is 
first necessary to consider more definitely the purpose of the 
analysis. 

The physician, in making his diagnosis, follows a systematic 
procedure, each step of which has a specific purpose. 

His is no unorganized survey based on the hope of luckily 
discovering important facts. His entire plan of diagnosis is 
based on positive knowledge that there are certain common 
human ailments. He makes an orderly examination for symp- 
toms of each, thus narrowing his field of investigation sys- 
tematically. 

Diagnosing Business Ailments. Similarly the balance 
sheet analyst should search for common business ailments. He 
should know what those ailments are, the symptoms of each, 
and their relative seriousness. 

This knowledge, like the physician's, must be based on ex- 
perience, i.e., the history of the thousands of cases of business 
"disease" as embodied in the statistics of failure. 

The physician who desires to investigate the causes of 
good health does not study well people, but diseased ones. The 
business analyst who desires to learn the causes of business 
success studies business failures. 

Commercial Failure Statistics. The great mercantile 
agencies, Bradstreet's and R. G. Dun's, have been accumulat- 
ing failure statistics for years. These statistics classify busi- 
ness failures by causes, 

54 



Ch. 6] SPECIFIC BUSINESS AILMENTS 55 

Without attempting to reproduce the statistics which vary 
slightly from year to year, it is sufficient to follow the general 
statement as contained in the Accountant's Handbook : x 

Two chief classes of business failures are : 

1. Those for which the management is responsible. 

2. Outside circumstances for which the management is not 

responsible. 
Under the first class are those resulting from : 

a. Incompetence. 

b. Lack of capital. 

c. Poor credit management, etc. 

About 80% of failures are accounted for by this group. 
Under the second class are those resulting from : 

a. Competition. 

b. Physical disasters. 

c. General business conditions. 

About 20% of failures result from these causes. 

The estimate that 80% of failures are directly chargeable 
to poor management is probably low rather than high, because 
certain of the companies whose failures are ascribed to "com- 
petition" and "general business conditions" probably would 
have overcome the difficulties had their management been 
competent. 

Relation of the Four Credit Factors These statistics 

clearly emphasize the overwhelming importance of the factor 
of business ability. 

It was previously stated that there were four primary fac- 
tors to use in judging the desirability of a credit risk (and these 
four are also important from the viewpoint of other analysts 
than credit men). 

These four factors were stated to be : 

1. Character honesty, habits, etc. 

2. Capacity business ability and astuteness. 



1 Published by The Ronald Press Company. 



56 ANALYZING FINANCIAL STATEMENTS [Ch 6 

3. Capital financial condition and earnings. 

4. Conditions the general business situation. 

From the statistics given it is evident that (2) capacity, 
and (3) capital, are at least four times (80% as compared 
with 20%) as important as the other two. 

Financial Condition Reflects Ability. If, as many think, 
lack of good financial condition and earnings is an evidence of 
lack of business capacity, then there are only three factors 
character, capacity, and conditions. 

In support of this point a quotation from Forbes Magazine 
is interesting. When Harvey Firestone, the well known tire 
manufacturer, was asked what brought success, he said "lack 
of capital" which made him "watch every expenditure." 

"If I had had all the money I needed to start my business, it 
would never have grown so large as it is, because I would not 
have had to study every detail." 

Assuming this to be true, and assuming that lack of 
capacity (or ability) accounts for more than 80% of business 
failures, then the analyst of financial statements will be pri- 
marily interested in studying the elements of business ability 
and the symptoms which evidence lack of ability. 

Five Common Business Ailments. Research into many 
hundreds of insolvent companies indicates that there are five 
common business ailments which are usually the result of 
managerial inefficiency to some degree. 

One or more of the five are found to exist in the case of 
practically every honest failure (the deliberately dishonest 
failures and those due to public calamities are not considered 
in this volume). 

These five common business ailments are : 

1. Insufficient net profits. 

2. Over-investment in inventory. 

3. Over-investment in receivables. 



Ch. 6] SPECIFIC BUSINESS AILMENTS 57 

4. Over-Investment in fixed assets. 

5. Insufficient capitalization. 

Statements Reflect Business Ailments. For (i) insuf- 
ficient net profit, including all the various contributory factors 
such as insufficient sales, etc., the analyst studies the profit and 
loss statement and for the remaining four he studies the 
balance sheet. 

At first thought it may appear rather far-fetched to use 
financial statements as a means of investigating so intangible 
a quality as business ability but the fact remains that these 
statements are, in effect, mirrors which reflect business ability 
more accurately than any other means. 

Since the analysis of profit and loss statements is treated 
later in this volume, the reader need not concern himself now 
with the first common business ailment insufficient net profit 
but proceed directly to a consideration of the remaining 
four. 

The second of the five ailments is over-investment in in- 
ventory. This simply means that a disproportionate amount 
of money is tied up in inventory. 

This has nothing to do with the actual amount of money in 
inventory, but rather the size of the inventory compared to 
other financial elements. A million dollar inventory might be 
too small for one corporation, whereas a $10,000 inventory 
might be too large for another. 

Much depends upon the kind of business. For example, the 
agricultural implement business during certain times of the 
year requires a very high inventory. This holds true in con- 
nection with manufacturers of skates, stoves, automobile 
heaters, blankets, electric fans, companies handling natural ice, 
and other seasonal enterprises. 

Other types of business, because of their very nature, 
require very low inventories. The packing house, because it 
largely handles fresh meats, maintains a low inventory. This 



5 8 ANALYZING FINANCIAL STATEMENTS [Ch. 6 

is also true with grocery stores, artificial ice manufacturers, 
dairies, etc. 

But although enterprises differ considerably with respect to 
the normal size of their inventories, it is true that for any 
particular line of business there is some point beyond which 
the inventory cannot increase without danger. 

Over-investment in inventory is a serious condition. In 
the first place, it ties up money in such a way that it does not 
even earn bank interest; and in the second place, it requires 
storage space, and the cost of providing such space is often 
heavy. Furthermore, excess inventory may depreciate or be- 
come obsolete before use. 

Many corporations have become insolvent due to an ag- 
gravated inventory condition. 

The Holberg Manufacturing Company of Chicago made 
standard machinery. In 1920 they felt the need of additional 
capital. Because this was a small company the securing of 
additional capital was quite a task. 

The banks refused to handle the proposition; brokerage 
houses were unwilling to take on the sale of stock; bond houses 
refused to consider lending assistance. 

An investigation by a public accountant revealed the aston- 
ishing fact that the Holberg Manufacturing Company had 
tied up in excess inventory more than twice the amount of 
money they were so anxiously seeking from outside channels, 
He found that of a certain item there was over seven years' 
supply, while of other items that were part of the same as- 
sembly, there were only a few weeks' supply. 

This is an extreme illustration; yet it reflects the kind of a 
situation that is quite common. 

Over-Investment in Receivables The third common 
business ailment is in many respects similar to the second, except 
that it is probably more commonly encountered. 

Too great generosity in the extension of credit results in 



Ch. 6] SPECIFIC BUSINESS AILMENTS 59 

tying up money in receivables. Properly controlled this may 
do little harm, but it is very easy for such a situation to become 
aggravated. 

Extreme pressure is often brought by a concern's own sales- 
man to allow long terms of credit and to grant unreasonable 
extensions of payments to favored customers. Close, careful 
collecting is an essential of sound business finance. Lax col- 
lecting results in a distorted financial position, and frequently 
in bankruptcy. 

There should be a normal relation between the volume of 
sales and the average amount of receivables. This relation is 
determined, first of all, by the standard terms of credit; where 
the average credit term is 60 days it is reasonable to expect a 
larger volume of receivables than where 30 days' time is 
customary. 

Geographical Location. Geographical location is also 
important. In certain parts of the country long-term credits 
are expected; and even though short terms are specified, cus- 
tomers will feel entitled to take their own time in making pay- 
ment, and will often be seriously affronted by collection effort. 

In other places collectibility of accounts will depend quite 
directly on the prosperity of the leading industry, i.e., cotton 
in Georgia, oil in Oklahoma, wheat in Nebraska, automobiles 
in Michigan, etc. 

It should be carefully borne in mind that this particular 
business ailment has nothing to do with bad debts, although 
the same causes are usually responsible for both. Over- 
investment in receivables is usually due to laxness in collection 
or over-generosity in assigning sales terms, often brought 
about by improper sales policies. 

The remedy for the condition is usually to be enforced 
through the sales department. 

Over-Investment in Plant. The fourth common business 
ailment has to do with over-investment in fixed assets. 



60 ANALYZING FINANCIAL STATEMENTS [Ch. 6 

Land, buildings and machinery are very good assets with 
which to operate, but are very poor assets with which to pay 
bills. Ambitious business men, during periods of prosperity, 
are tempted to over-expand plant facilities, thus tying up 
capital in fixed assets to a greater extent than wisdom justifies. 

In other instances, through pride of possession and per- 
sonal vanity, business men will persuade themselves to over- 
invest in this class of asset. 

This is a cause of business failure the importance of which 
it is difficult to overstate. It leaves the business in a distorted 
financial position and subject to grave danger at the slightest 
indication of unfavorable financial trends. 

Only too often is a new factory or office building the tomb- 
stone of a business. 

Wise business men have an instinctive appreciation of the 
primary importance of keeping funds liquid keeping them 
"turning over" and making a profit on each turnover. 

Many a large and profitable business is operated from 
dingy and unattractive offices and plants. 

Insufficient Capitalization The fifth common business 
ailment is that of insufficient capitalization. 

Many businesses are started on a "shoe string." Often 
they grow quite rapidly, but because of the nature of the 
business or for other reasons, additional invested capital is 
not provided. Since the business must have sufficient capital 
with which to operate, the result is that such capital is secured 
from creditors, i.e., it is either borrowed from banks or 
"borrowed" from vendors under the customary privileges of 
ordinary trade credit. Such capital is not permanent capital 
and must be constantly renewed. 

If too much of this kind of capital is employed, the com- 
pany is continually at the mercy of its creditors. As long as 
general financial conditions are favorable, such a business may 
continue to operate without much difficulty. But at the be- 



Ch. 6] . SPECIFIC BUSINESS AILMENTS 6l 

ginning of a period of depression such companies are among 
the first to be forced into the courts. 

This is largely due to their use of temporary capital, repre- 
sented by their liabilities, in the place of permanent capital, 
represented by shares of stock outstanding. 

Different Classes o Liabilities. Since there are different 
classes of liabilities, it is only fair to call attention to the fact 
that it is "short-time" credits that are dangerous. Capital 
secured through mortgages running a period of years, is, prac- 
tically speaking, almost on a par with invested capital as to 
permanence. 

When a moderate amount of such semi-permanent capital 
can be secured at a reasonable interest cost, Its use represents 
good financing and reacts to the benefit of the company and 
stockholders. 

The Armstrong Company has a capital of $1,000,000, all 
common stock, and an average annual profit of $100,000. It, 
therefore, earns 10% on its common stock. If the Barnes 
Company has the same profit and the same amount of capital, 
half represented by common stock and half by 5% bonds, it 
will have to pay out $25,000 in bond interest leaving $75,000 
to apply to $500,000 of the common stock, or a 15% return. 

Thus, under similar conditions, the stockholders of the 
Armstrong Company get 10%, while the stockholders of the 
Barnes Company get 15%. 

In a highly speculative business with widely fluctuating 
sales, a heavy mortgage indebtedness may easily represent a 
menace, since its interest requirements represent a fixed 
charge that must be met. Such a company should be financed 
through stock ownership, since dividends need not be declared 
at any definite time. 

Other Business Ailments. It is hardly necessary to state 
that these common business ailments are not the only important 



62 ANALYZING FINANCIAL STATEMENTS [Ch. 6 

ones in business. A business may have many ailments. 
Some of them may be complicated, but the ones that have been 
selected for discussion are so commonly found that they de- 
serve to be set ahead of all the others. 

In succeeding chapters the symptoms of each of these ail- 
ments and the methods used to detect them will be considered. 



CHAPTER VII 

BALANCE SHEET RATIOS 

Instruments o Control. A man driving an automobile 
has certain definite things to watch. In addition to steering 
the machine towards his destination, he must also be con- 
stantly on the watch for troubles which will hinder his 
progress. 

There are certain common automobile ailments that must 
be constantly guarded against. 

Such things as underinflated tires, insufficient water in the 
radiator, insufficient gasoline, or insufficient distilled water in 
the battery may cause trouble. 

As an aid to the motorist certain control instruments are 
provided which are called "gauges." 

Thus there is the moto-meter, the battery tester, the oil 
gauge, the air gauge, the speedometer, and the gasoline gauge. 

None of these gauges help to make the car go. Their sole 
purpose is to act as instruments of control to keep the driver 
informed regarding possible happenings that may stop his 
progress or involve him in real danger. 

There is a certain resemblance between a man operating an 
automobile and one operating a business. And in studying 
analysis of financial statements it will be helpful to consider 
this similarity. 

Common Ailments of Business. Just as there are certain 
things that may happen to any automobile which will impair 
its efficiency, so, as was developed in the preceding chapter, 
there are certain common ailments in business. 

These have already been described, but it will do no harm 
to repeat them : 



64 ANALYZING FINANCIAL STATEMENTS [Ch. 7 

1. Insufficient net profit. 

2. Over-investment in inventory. 

3. Over-investment in receivables. 

4. Over-investment in plant. 

5. Insufficient capitalization. 

There is practically no business which is immune from these 
ailments, although some may be of greater importance in cer- 
tain lines of business than in others. 

This list does not include all of the various ailments which 
a business may have. It does represent the common ones to 
which every business may be subject and for which every 
one interested must be constantly on the watch. 

Gauging Business Ailments. If a system of gauges is im- 
portant to the automobile driver, a. system of gauges is of 
greater importance to a business manager. 

A business organization is a far more complicated mecha- 
nism than any automobile. 

It is far easier for a business to develop undetected ail- 
ments than for an automobile to do so. 

The automobile will usually stop if anything goes wrong, 
but a business can sometimes survive for years handicapped 
by one of the common ailments without anyone really sensing 
the trouble. 

Just as human beings are sometimes blind to their own 
insidious diseases, so are business managers often blind to 
aggravated conditions within their own businesses. Because 
these difficulties are frequently hard to diagnose, is the reason 
why special methods of analysis are needed to detect them. 

For many years accountants, statisticians and credit men 
have been hunting for such gauges ; the search is not yet fin- 
ished and perhaps never will be. But their work so far has 
developed certain fairly reliable gauges. 

Since all business activities of any kind are presented in 



Ch. 7] BALANCE SHEET RATIOS 65 

terms of figures, it is only natural that these warning gauges 
should be in the form of figures. 

The procedure of modern balance sheet analysis is based 
on the thought that for any particular business, there are 
certain normal relationships, i.e., the various factors in that 
business should be in a harmonious relationship with one 
another. 

Balance Sheet Relationships Therefore, the effort to 
discover gauges useful to the executive has been directed 
toward finding relationships between certain groups of busi- 
ness facts each of which will tell a plain story to the business 
manager, just as the height of the red line in the moto-meter 
tells a plain story to the automobile driver. 

It would be a lengthy task to review all of the steps in 
the research work which has been done in this field. But in 
order to illustrate, consider briefly the common business prob- 
lem of over-investment in inventory. 

Over-Investment In Inventory. Everyone knows how im- 
portant a problem this is. 

Everyone realizes that money tied up in inventory is non- 
productive is not even earning bank interest. Everyone real- 
izes that a large inventory is liable to drastic shrinkage when 
commodity prices drop. A large percentage of the failures 
in 1920 and 1921 were caused by the shrinkage of top heavy 
inventories. 

How is one to determine whether an inventory Is too 
large or too small ? 

A $10,000,000 inventory might be small fo-r one company, 
while a $10,000 inventory might be too big for another. Much 
depends, therefore, on the size of the company, the amount 
of business they are doing, the amount of their sales, etc. 

Relation of Inventory to Sale. There is, as already ex- 
plained in Chapter IV, a very direct connection between the 



66 ANALYZING FINANCIAL STATEMENTS [Ch. 7 

size of the merchandise inventory and the volume of sales. 
Everything else being equal, the larger sales volume the com- 
pany has, the more inventory it must carry. 

If a company's annual sales be divided by the amount of 
actual inventory, the result will be a percentage which can be 
used as a gauge to show whether the company is investing too 
much money in inventory or not. 

For companies operating under similar conditions, the per- 
centages will generally be about the same. Thus for five 
copper companies in 1920 the percentages were as follows : 

86% 

144% 



105% 

102% 

While for three general merchandising companies for the 
same year the figures were : 

652% 



579% 

In other words, there is a certain general uniformity of 
this percentage within an industry, subject to important ex- 
ceptions to be discussed in Chapter XIII. 

The Ratios Such a percentage is technically called a 
"ratio," and this term will be used hereafter. 

It should be borne in mind that a ratio is always a per- 
centage obtained by dividing one figure by another, i.e., in 
this instance, by dividing the yearly sales by the inventory. 

Average vs. Actual Inventories. As heretofore explained, 
it is seldom possible to learn the average inventory of a com- 
pany, and it has been customary to use the actual inventory 
that appears on the balance sheet at the end of the accounting 
period. 

This may or may not be the same as the average inventory, 



Ch. 7] BALANCE SHEET RATIOS 67 

depending upon the nature of the business; but since a rough 
gauge is better than none at all, it is usually the one that must 
be used. 

If the ratio of sales to inventory is lower than it ought to 
be, it may mean one of two things. 

It may mean that the inventory is too large, or on the 
other hand, that the sates are too small. (Insufficient sales 
as a contributing factor to insufficient net profit is treated 
in Chapters XV and XVI.) 

Comparison of Inventory and Current Items. Therefore, 
in order to shed further light on the current status of the 
inventory, another ratio based upon different factors should be 
used. 

It has been found that a certain normal relationship should 
exist between the inventory and the quick assets and liabilities. 

Since this involves three sets of figures, it will be neces- 
sary to work out two more ratios; one, the "acid test/' which 
shows the relationship between quick assets and current lia- 
bilities, and the other, the current ratio, which shows the 
relationship between the current assets (the sum of the quick 
assets and the inventory) and the current liabilities. These 
two used together will cast additional light on the inventory, 
problem. 

Thus, if the ratio obtained by dividing the quick assets 
by the current liabilities is abnormally low, and the ratio 
obtained by dividing the current assets by the current liabili- 
ties is unusually high, it tends to confirm the impression that 
the inventory is too heavy for the size of the business. 

Here are two tests or gauges which help the analyst to 
decide whether a business is ailing from over-investment in 
inventory. 

The Eight Ratios. Without attempting to go into the 
reasoning which is responsible for the other ratios, a list fol- 



68 ANALYZING FINANCIAL STATEMENTS [Ch. 7 

lows of the five common business ailments together with the 
ratios which may be used to diagnose all except the first, 
which is to be treated in Chapters XV and XVI. 

1. Insufficient net profit. 

2. Over-investment in inventory: 

a. Ratio of annual sales to inventory. 

b. Ratio of quick assets to current liabilities (the "acid 

test"). 

c. Ratio of current assets to current liabilities. 

3. Over-investment in receivables : 

a. Ratio of annual sales to receivables. 

b. Ratio of quick assets to current liabilities. 

4. Over-investment in plant : 

a. Ratio of annual sales to fixed assets. 

b. Ratio of net worth to fixed assets. 

5. Insufficient capitalization : 

a. Ratio of annual sales to net worth. 

b. Ratio of net worth to total liabilities. 

The use of the "acid test/' the current ratio and the ratio 
of annual sales to inventory has already been discussed in 
Chapters IV and V. 

Over-Investment in Receivables. Over-investment in in- 
ventory is perhaps the most common business mistake. But 
of almost equal importance is the mistake of over-investing 
in receivables. 

By receivables is meant all indebtedness owed to a company 
by its customers for goods sold. Receivables usually include 
accounts receivable, notes receivable, and may also include 
sight drafts, when accompanied by bills of lading, and C.O.D. 
items. 

Too much money becomes tied up in receivables through 
too liberal extensions of credit and through lax collection 
efforts. 

When this condition exists it simply means that the com- 
pany is allowing an unwarranted amount of its capital. to be 



Ch. 7] BALANCE SHEET RATIOS 69 

"loaned" to others in such form that it does not even pay 
interest. 

It frequently happens that a concern will permit itself to 
get into this condition and at the same time -be so hard 
pressed for funds as to be forced to seek new capital, whereas 
the correct solution should be to release some capital from this 
non-productive use. 

Ratio of Sales to Receivables. The first test is to compare 
the receivables with the annual sales. 

Since the receivables result from sales there should be a 
certain relationship between the two. This is determined by 
dividing the annual sales by the actual amount of receivables 
as shown on the last balance sheet, although this may be de- 
ceptive in certain seasonal lines of business. 

If the resulting percentage should be 100%, it would mean 
that the equivalent of a whole year's sales was tied up in re- 
ceivables. If 200% it would indicate that six months' sales 
were tied up in receivables, and so on. 

Naturally, for any line of business this depends on the 
average terms of sales. It would be smaller for long terms, 
and it would be larger if 30 days or less was the usual credit 
extension. - 

This percentage if too small may indicate that the receiv- 
able item is too large. 

As a check, therefore, the current ratio sheds further light 
on this subject, since with most business concerns current 
assets consist very largely of receivables. 

Over-Investment in Plant. Another very common error 
is to build up too heavy a plant investment account. 

It is a temptation to many business executives to let their 
pride of ownership get the better of their good judgment and 
to invest large sums of money in land, buildings, machinery, 
office equipment and other fixed asset items. 

They seem to forget that their plant is merely a means 



70 ANALYZING FINANCIAL STATEMENTS [Ch. 7 

by which raw materials are to be ^re-worked and sold for a 
profit, and that their plant should not be any more elaborate 
than is necessary to accomplish this purpose. 

From the accounting viewpoint immediately after a fixed 
asset is bought, money invested in it is still an asset of the 
same value as it was before. But from the financing view- 
point there is a great difference, since cash can be used to 
pay bills or take advantage of special business opportunities, 
whereas the money invested in buildings remains "frozen" 
permanently and when it is most needed it is often most diffi- 
cult to realize. 

Ratio o Sales to Fixed Assets. There should be a distinct 
relationship between the size of the plant and the volume of 
a company's sales, i.e., the more goods sold, the larger the plant 
needed to make or handle the goods to sell. 

This may be expressed as a ratio between sales and fixed 
assets, the total amount of the annual sales being divided by 
the book value of the fixed assets. The normal and desirable 
situation is for the sales to increase at a somewhat faster rate 
than the fixed assets, so that if from year to year this ratio is 
increasing it will be a favorable sign. If it is constantly de- 
creasing, it is usually unfavorable. 

Since the change in the ratio of sales to fixed assets may 
be due to fluctuation in sales volume rather than to increases in 
fixed asset investment, it is also customary to compare the 
fixed assets with the net worth of the company. 

Ratio of Net Worth to Fixed Assets. This ratio is ob- 
tained by dividing the net worth by the value of the fixed 
assets. 

If over a period of time this ratio increases, it may be 
taken as a favorable indication since it shows that the net 
worth is increasing at a faster rate than the fixed asset in- 
vestment. 

Of course, this is only true if the increases in net worth 



Ch. 7] BALANCE SHEET RATIOS 71 

are the result of earnings. If they are the result of stock 
sales, a different, although perhaps equally favorable, conclu- 
sion might be reached. 

Under-Capitalization. Ambitious but unwise managers of 
small companies frequently attempt to do a larger amount of 
business than they are financed to handle. 

This results in overworking their capital and is given by 
the commercial agencies as one of the most frequent causes 
of business failures. To compare the amount of capitalization 
with the amount of sales is a natural step. 

Capitalization for this purpose is the net worth of the 
company, since retained earnings appearing as surplus are a 
form of capital of the same general nature as the original 
investment made by the stockholders. 

Ratio of Sales to Net Worth. This ratio is obtained by 
dividing the annual sales by the net worth. 

Up to a certain point an increase in this ratio is a favorable 
indication since it shows aggressiveness on the part of the 
manager. Past that point it represents a warning signal. 

In order to determine whether the ratio is increasing too 
rapidly, it is wise to examine another ratio which usually 
furnishes additional evidence bearing on the point. 

Ratio of Net Worth to Liabilities. This ratio is the one 
between net worth and total liabilities, and is obtained by 
dividing the net worth by the total liabilities. 

As already set forth, each item on the liability and capital 
side of the balance sheet represents a source of funds. Lia- 
bilities represent funds temporarily loaned by creditors, even 
though these funds happen to be in the form of merchandise 
or supplies. The capital stock represents funds permanently 
loaned by the stockholders. 

Since it is usually safer for a company to secure most of 
its capital from stockholders rather than from creditors, it 



72 ANALYZING FINANCIAL STATEMENTS [Ch. 7 

will be seen that a consistent increase in this ratio from year 
to year can be taken as a favorable indication, whereas a con- 
sistent decrease may represent a danger signal. 

The above two ratios taken together shed considerable 
light on the question of insufficient capitalization. 

Use of More Than One Ratio Necessary. The foregoing 
discussion has involved eight different ratios. 

These ratios are valuable to the analyst only when they 
are used intelligently. 

In order to use them intelligently it must be understood 
that a ratio is after all only a percentage: and always involves 
two factors the dividing figure and the one divided. Thus a 
single ratio expresses two varying amounts. 

Hence no definite conclusions should be made from the 
study of one of these ratios alone. Ordinarily it requires two 
ratios in order to insure even a fair degree of certainty as to 
the diagnosis of a business ailment. 

Intelligent use of these ratios also requires that the user 
understand that they are rough and only partially accurate 
gauges, and that their reliability depends upon numerous 
factors. 

Ratios Give Warning. If these ratios are used in the same 
way as the control gauges of an automobile are used to give 
warning of approaching trouble they perform a very satis- 
factory service. 

The fact that the moto-meter on a car shows overheating 
is merely a warning which must be followed by further inves- 
tigation. 

The trouble may come from insufficient water in the radi- 
ator, insufficient lubrication, breakage of the fan belt or other 
causes. No driver could find out exactly the trouble with 
the car by merely observing the height of the red line in the 
moto-meter. 

Similarly with ratios. They merely point out symptoms 



Ch. 7] BALANCE SHEET RATIOS 73 

more or less accurately, but they do not furnish a complete 
diagnosis. 

The ratios can be no more accurate than the original fig- 
ures from which they are calculated. Balance sheet values in 
many instances are only shrewd estimates, and sometimes they 
are far from reflecting the truth. 

These warning statements are sufficiently justified, because 
some authors on this subject, without actually saying so, ap- 
pear to imply that balance sheet ratios are a new "cure-all" 
for business ills a supposition which is most decidedly not 
true. 

Intelligent Use o Ratios. There are many other balance 
sheet ratios which have been suggested from time to time by 
various authors, none of which seem to be sufficiently re- 
liable or important to be mentioned here. 

The eight which have been discussed are not all of equal 
importance, as will appear later. But they probably represent 
the eight best and most practical of all the balance sheet ratios 
which have been suggested. 

The next few chapters will discuss these ratios in much 
greater detail They represent an important and fascinating 
study. In the hands of experts they often afford an uncanny 
insight into the affairs of a company whose bare figures tell 
but little. 

Used with intelligence and a liberal amount of common 
sense, it is possible to develop quite accurate conclusions as to 
business trends and conditions. 

This is particularly true when the ratios are used in search- 
ing for specific symptoms of common business ailments. 



CHAPTER VIII 

HISTORICAL ANALYSIS OF BALANCE SHEETS- 
RATIO METHOD 

Standard Ratios. The point has already been brought out 
that all measuring is a matter of comparison, so in order to 
measure balance sheet ratios, it is necessary to have some- 
thing to compare them with. 

Most balance sheet ratios taken from a single balance sheet 
are practically meaningless until compared with something 
else. 

If there were standard ratios for every kind of business, 
just as there is a standard yard-stick or a standard pound 
weight, there would be something definite with which to com- 
pare ratios from a single balance sheet. 

But as will be seen later, significant standard ratios are 
difficult, if not almost impossible, to obtain. The best sub- 
stitute is to compare the ratios from successive balance sheets 
of the same company. 

Historical Analysis. Most ratios standing alone mean 
almost nothing, but compared with similar ratios of the year 
before, two years before, etc., may assume the greatest sig- 
nificance. 

The Boston Machine Company's balance sheets for three 
years developed the following figures : 

RATIO SALES TO INVENTORY 

1922 200% 

1923 250 

1924 300 

Perhaps an "ideal" figure would be 500%. Nevertheless 
the trend of the figures shown is good, and as long as they 

74 



Ch. 8] HISTORICAL ANALYSIS RATIO METHOD 75 

are on the up-grade, the situation may be viewed more op- 
timistically than if the following had been the ratios: 

1922 550% 

i9 2 3 500 

1924 450 

The vitally important thing is trend first, last, and always. 

And to get any real meaning out of ratio figures, it is neces- 
sary to calculate them not merely for one year, but for two or 
more years. 

And this brings up a point of the utmost importance. 

Uniformity o Balance Sheets. It is essential that the 
various groups of assets and liabilities be made up of the same 
kind of items for each of the various years. 

This may sound elementary, but it represents a real source 
of difficulty in this type of analytical work, since there is 
hardly any concern which does not change its accounting 
methods from time to time. Even if the accounting methods 
remain unchanged over a period of years, changes in the ac- 
counting personnel may result in different groupings in the bal- 
ance sheet. 

While it may not be possible to insure that identical classi- 
fication of accounts be maintained from year to year, never- 
theless unusual care should .be exercised that balance sheet 
groupings from year to year are similar. 

Optional Classification. A balance sheet for one year may 
include certain items in current assets that a later balance sheet 
may show in some other group. 

Either arrangement may be justifiable, since the arrange- 
ment of a balance sheet is, to some extent at least, a matter 
of individual taste and judgment. It is not safe, therefore, to 
use the group totals as they appear on the balance sheet, but 
each balance sheet should be recast in such a way that the 
groupings from year to year are uniform. 



76 ANALYZING FINANCIAL STATEMENTS [Ch. 8 

Interpreting Account Names. The actual facts about 
every kind of asset and liability are of much more importance 
than the names of the accounts. 

Thus, a mortgage, without an offsetting sinking fund, may 
be a long-time liability or a current liability, depending upon 
its due date and attendant circumstances. A "reserve" may 
be a deduction from an asset, as in the case of a "reserve for 
depreciation; 7 ' or it may be a liability, as in the case of a "re- 
serve for taxes;" or it may be a net worth item, as in the 
case of a "sinking fund reserve." 

The name of the item appearing on the balance sheet, 
therefore, does not always tell in just what group it really 
belongs. 

Working Sheet Where a series of balance sheets of dif- 
ferent years are to be analyzed, the reclassification of the items 
may often be simplified by the use of a working sheet which 
provides a wide left-hand column for the various groups of 
items and a series of money columns, one for each year. 

The figures contained on the various balance sheets can be 
transferred into the standard groupings as given on the work- 
ing sheet, 'which will then furnish uniform group totals for 
ratio calculations. 

Slide Rule Calculation. The calculations represent simple 
division, and can best be made with a slide rule. 

Dividing on a slide rule is rapid and easy. The slide 
rule is not a mysterious or complicated instrument, and its 
use, so far as multiplication and division are concerned, can 
be completely mastered in 10 minutes by a grade-school gradu- 
ate. Its accuracy is quite sufficient for statement analysis pur- 
poses. 

Slide rules can be purchased at engineering supply houses 
and many book stores at prices ranging as low as $i for the 
cheapest make. 



Ch. 8] HISTORICAL ANALYSIS RATIO METHOD 77 

Effect of Kind o Business. Since balance sheet ratios 
and balance sheet figures merely reflect business activities, any- 
one attempting to analyze balance sheets should have a gen- 
eral idea as to the important business factors involved in each 
industry. 

The balance sheets of a bank, a railroad and an instal- 
ment house have but little in common. Similarly balance sheets 
of other corporations differ from one another. The contents 
and groupings of a balance sheet are largely dependent upon 
the business policies of the company and trade customs of the 
industry. 

Where long-term credits are given, the effect on the balance 
sheet is very noticeable, the item of accounts or notes receiv- 
able usually being very large, and the amount of current in- 
debtedness quite heavy. 

Where a product is sold practically on a cash basis, an en- 
tirely different balance sheet is to be expected. It is clearly 
evident, therefore, that ratios which might be favorable for 
one kind of a business might be very poor for another kind 
of business. 

This is clearly confirmed by published facts. 

Eighty-seven companies noted by J. H. Bliss in "Financial 
and Operating Ratios in Management" fell into 22 groups. 
The average ratio of sales to accounts receivable for all of 
them covering a six-year period was about 682%. 

It is interesting to observe some selected groups that were 
above and below this average : 

INDUSTRIES SHOWING RATIOS ABOVE AVERAGE 

Auto and Truck Manufacturing &5 8 % 

Auto Accessory Manufacturing 967 

Copper Mining and Manufacturing 14.30 

Drug Manufacturing and Distributing 883 

Mail Order Merchandising 938 

Sugar Product and Refining 1304 

Tobacco Products 910 



78 ANALYZING FINANCIAL STATEMENTS [Ch. 8 

INDUSTRIES SHOWING RATIOS BELOW AVERAGE 

Chemical Products 3?o% 

Coal Bituminous 341 

Cotton Goods Manufacturing 380 

Electrical Machinery Manufacturing 353 

Railway Equipment ... 429 

Rubber and Tire Manufacturing 492 

Sales Policies. Sales policies may have a very important 
effect on balance sheet ratios even for companies in the same 
line of business. 

One company may find it desirable to sell to jobbers and 
thus collect payment quickly. This tends toward high ratios 
of sales to receivables and to inventory. Others may sell di- 
rectly to the retail trade and keep heavy stocks of goods in 
distributing warehouses at various strategic points and the 
ratios tend to become lower. 

Others may go a step further and establish their own retail 
stores, which means a further increase in inventories and also 
in fixed asset items. 

Manufacturing Policies. Finally, manufacturing policies 
must be considered. 

A manufacturer may attempt to control his sources of raw 
materials which means that he may have to operate mines, 
blast furnaces, railroads, mills, and a variety of other indus- 
tries, while his competitor may buy the corresponding products 
on the market. 

It is to be expected that the balance sheets of two such 
companies will present a different appearance and that it will 
be difficult to make comparisons between their ratios. 

Illustrative Figures. Figures furnishing considerable 
food for thought are quoted by J. H. Bliss from his study of 
published reports. These figures have to do with the ratios 
of sales to fixed assets of 94 corporations divided in 24 
lines of business showing an average ratio of 183%. 



Ch. 8] HISTORICAL ANALYSIS RATIO METHOD 79 

Some of the groups whose ratios were above the average 
are as follows : 

INDUSTRIES SHOWING RATIOS ABOVE THE AVERAGE 

Auto and Truck Manufacturing 295% 

Auto Accessories . 477 

Cotton Goods Manufacturing 270 

Drugs 470 

Electrical Machinery 455 

General Merchandising 1047 

Mail Order Merchandising 974 

Retail Chain Stores 896 

Slaughtering and Meat Packing 962 

The merchants in the above list show much better ratios 
than the manufacturers, as would be expected. 

Industries with simple manufacturing processes also show 
good ratios. 

Looking at the other side of the picture for a moment the 
following situation is found: 

INDUSTRIES SHOWING RATIOS BELOW AVERAGE 



Coal Bituminous 34 

Iron and Steel Manufacturing 70 

Lead Production and Manufacturing 75 

Petroleum Oil 75 

Paper Manufacturing 101 

Sugar Production and Refining in 

The mining and oil companies have their heavy holdings 
of land to account for their low ratios. Iron, steel, paper and 
sugar manufacturing require complex and expensive machinery. 

Turning finally to the inventory situation, there are the 
statistics for 94 companies divided into 24 groups with an 
average ratio of sales to inventory of 421%. Some of the 
groups are as follows : 

INDUSTRIES SHOWING RATIOS ABOVE AVERAGE 

Auto Accessories 425% 

Chemical Products , 54 2 

Coal Anthracite 1422 



So ANALYZING FINANCIAL STATEMENTS [Ch. 8 

Coal Bituminous 893 

General Merchandising 542 

Retail Chain Stores 593 

Slaughtering and Meat Packing 748 

The reason for most of these high ratios is obvious. It 
will be interesting, however, to compare the types above with 
those in the following list : 

INDUSTRIES SHOWING RATIOS BELOW AVERAGE 

Automobile and Truck Manufacturing 317% 

Cotton Goods 342 

Electrical Machinery 267 

Lead Production 221 

Leather 155 

Machinery 216 

Petroleum 235 

Rubber and Tires 279 

Tobacco 177 

Some of these companies have to purchase far in advance 
either to insure their supply or because of buying crops. 

With others, such as automobile manufacturing and elec- 
trical machinery, the processes of manufacturing are long and 
complicated, while with still others, the element of time is part 
of the process involving large stores in storage, as in the case 
of ageing tobacco and tanning hides. 

An Important Caution. The figures that have been quoted 
in this chapter are shown solely for their comparative value 
and not their absolute accuracy. It is doubtful whether such 
average percentages can be used as measures, but there is no 
doubt that a comparative survey of them is stimulating and 
broadening, and throws considerable light on the relation be- 
tween ratios and the kind of business conducted by each group. 



CHAPTER IX 

HISTORICAL ANALYSIS OF BALANCE SHEETS- 
RATIO METHOD (Continued) 

Illustrating Use of Ratios. The best way to understand 
the method of constructing and using balance sheet ratios is to 
follow a hypothetical case. 

Below are given four successive balance sheets of the Ames 
Manufacturing Company. 

The Ames Manufacturing Company actually exists and 
with a few unimportant changes the figures given are actual. 
The name, however, is fictitious and the dates given are not the 
actual dates. This has been done to conceal the identity of 
the corporation since the figures are shown merely to illustrate 
method. 

After examining the ratios the reader can compare his 
final conclusions with those first formed, and thus gain an 
appreciation as to the value of ratios in balance sheet analysis. 

THE AMES MANUFACTURING COMPANY 

COMPARATIVE BALANCE SHEET 

As of December 31 



Assets 
Cash 


1921 

. . $ 4,652 


1922 

$13,371 


1923 

$ 7,190 


1924 

$10,512 


Accounts Receivable (Net) 


.. 14,468 


8,217 


5,629 


5,857 


Net Quick Assets 


.. $19,120 


$21,588 


$12,819 


$16,369 


Inventories 


.. 17,556 


20 , 607 


28,077 


22,210 


Total Current Assets 


. $36,676 


$42,195 


$40,896 


$38 , 579 


Fixed Assets (less Depreciation) . 


17,922 


25 , 707 


36,163 


37 , 290 


Prepaid Expense 


76 


213 


2,545 


2,459 



TotalAssets $54,674 $68,115 $79,604 $78,328 

81 



82 ANALYZING FINANCIAL STATEMENTS [Ch. 9 

Liabilities and Capital 

Notes Payable Trdtde $ i ,000 

Notes Payable Bank 4,000 

Accounts Payable 7. ooo 

Dividends Payable 2,000 

Accrued Liabilities 128 

Current (and Total) Liabilities $14* 128 

Capital Stock Outstanding $50,000 

Surplus (Deficit) 9>454 

Total Net Worth $40 > 54-6 

Total Liabilities and Net Worth . . $54,674 
Sales $52,088 

Ratio of Quick Assets to Current Liabilities. The first 
ratio to determine is that of quick assets to current liabilities. 

Quick assets will be divided by the current liabilities in 
order to determine the "acid test" ratios. (Slide-rule calcula- 
tion gives sufficient accuracy for every purpose. Fractions of 
a per cent have been omitted) : 





1922 

1923 

1924 

To state these figures somewhat differently, they simply 
mean that in 1921 for every dollar of current liabilities there 
was $1.35 in quick assets. 

In 1922 for every dollar of current liabilities there was 
$2.48 of quick assets. 

In 1923 for every dollar of current liabilities there was 
$.78 of quick assets, and in 1924 for every dollar of current 
liabilities there was $1.60 in quick assets. 

In three out of the four years there were more quick assets 
than current liabilities by a substantial margin. In the year 
1923, however, there was a substantial increase in current Ha- 



Ch 9] HISTORICAL ANALYSIS RATIO METHOD 83 

bilities and a decrease in quick assets, which resulted in a lower 
ratio. 

Ratio o Current Assets to Current Liabilities. The next 
ratio to determine is that of current assets to current liabilities : 



1923. 
1924. 



$10,248 

Ratio of Sales to Receivables The third ratio is that of 
sales to receivables : 

1921 feS' 

1922 ^ Q*or^ 



1924 



$ 5.857 

Ratio of Sales to Inventory. The fourth ratio is that of 
sales to inventory : 

$ 52, 088 

1921 <-_ ftf A 



'9*3 $^7 = 323% 

" " ~ % 



Ratio of Sales to Net Worth. The fifth ratio is that of 
sales to net worth: 



- 



84 ANALYZING FINANCIAL STATEMENTS [Ch. 9 



1924 -r~ : 

Ratio of Net Worth to Fixed Assets. The sixth ratio is 
that of net worth to fixed assets : 



1922 

1923 



; $36,163 

$68,080 
1924 



Ratio of Net Worth to Liabilities. The seventh ratio is 
that of net worth to total liabilities. In this illustration the 
total liabilities are the same as current liabilities, but this might 
not be true. In other instances there might exist a mortgage or 
bonds payable or a purchase money obligation which wouM 
not form part of current liabilities but would have to be in- 
cluded in total liabilities. 



'** ........................... 

T021 $63.267. 

1923 ............................ 



Ratio of Sales to Fixed Assets. The eighth and last ratio 
is that of sales to fixed assets : 



1923 



, 163 



Ch. 9] HISTORICAL ANALYSIS RATIO METHOD 85 

It has been pointed out by J. H. Bliss, in "Management 
Through Accounts/ 5 that: 

The effect of changing price levels on sales must not be over- 
looked. If a business has a measure of physical volume such as 
cases, tons, hundredweight, etc., it is better to state this ratio as 
the cases, hundredweight, or other units of volume, per dollar 
of fixed property investment. In this manner the ratio would 
be figured on bases unaffected by changing price levels. Where 
statistics on physical volume are not available, it may be ap- 
proximated by eliminating from the sales the effect of changes 
in average price levels. This may readily be done by applying a 
price index figure to the sales volume. For most industries pub- 
lished price indexes may be used. 

Mixed Production. Comparatively few business organiza- 
tions are able to express their sales in terms of a single unit 
because they market a diversified line of products. 

Thus, the United States Rubber Company is engaged in 
manufacturing rubber foot wear, mechanical goods, tires and 
also supplies needed in the manufacturing of rubber goods. 
It would be difficult if not impossible for the outside analyst 
to convert all these various products into terms of a single 
unit. 

This same condition holds true for the majority of con- 
cerns. 

There are a few, of course, which produce one and only 
one commodity. The Ford Motor Company may be con- 
sidered in this class and also certain producers of raw ma- 
terial, such as mining companies, lumber companies, etc. 

Furthermore the outside analyst very rarely has access to 
the statistics of physical production. 

Adjusting Sales by Price Indexes. Reverting to the sec- 
ond suggestion, that "the effect of changes on average price 
levels may be eliminated from sales by applying price index 
figures to sales volume," certain grave difficulties must be faced. 

Perhaps the principal difficulty has to do with the fact that 



86 ANALYZING FINANCIAL STATEMENTS [Ch. 9 

published price indexes are nearly all concerned with simple 
materials or raw materials and very few with manufactured 
products. Therefore, even though a company under analysis 
made but one product, if that product was not represented in the 
published price indexes, this plan could not possibly be applied. 

The next objection refers to the fact that averages are 
always dangerous when applied to the interpretation of a specific 
situation. Price indexes are, of course, averages. 

It is, therefore, doubtful whether this suggested plan of 
adjusting sales is feasible even in the relatively few instances 
where it could be used. 

Purpose of the Analysis, Furthermore, there is some 
question as to whether such a plan would actually serve to pro- 
mote the purpose of the analyst. 

His interest in the analysis is largely financial. The ratio of 
fixed assets to sales is shown in terms of dollars and is, there- 
fore, stated in terms of finance. 

If such a ratio were constructed by dividing dollars of fixed 
assets into the number of actual units of production, a useful 
ratio might be obtained to indicate the operating efficiency of the 
plant. But this is an internal problem that the analyst is not 
usually interested in. 

The attention of the reader is again called to the fact that 
this entire discussion of financial analysis is considered pri- 
marily from the viewpoint and opportunities of the external 
analyst, and not from the viewpoint of the internal analyst, 
who is almost wholly concerned with the welfare of his par- 
ticular company. 

Over-Investment in Inventory. The next step is to ex- 
amine the eight ratios in their relation to four of the five com- 
mon business ailments, omitting the first one of "insufficient 
net profits." 

An overgrown inventory is one of the most common, and at 
the same time a very dangerous business symptom. 



Ch. 9] HISTORICAL ANALYSIS RATIO METHOD 87 

To- diagnose this condition, first examine the ratio of sales 
to inventory: 

Year Ratio 

1921 297% 

1922 322 

1923 323 

1924 435 

Since this ratio is constantly increasing, it shows that the 
inventory is not increasing as fast as the sales. Anyone con- 
sidering such a ratio should bear in mind that the inventory at 
the end of the year may be quite at variance with the average 
inventory during the year. 

Also the inventory is usually valued at cost, while the sales 
are expressed in terms of cost plus the mark-up, which is 
supposed to be sufficient to cover all operating expenses and still 
leave a margin for profit. 

The factors which influence the amount of the mark-up 
may vary from year to year, which may result in a situation 
where an equal number of units of product are sold in two suc- 
cessive years but where the annual sales in dollars are different. 

Usually the analyst must accept the figures as submitted, 
but he should constantly bear in mind that the factors mentioned 
may distort his ratios to a point where they represent only 
rough guides. 

The figures as given appear to show a healthy inventory 
trend, but this may be verified by examining the two ratios : 
(i) Quick assets to current liabilities, and (2) current assets 
to current liabilities : 



Year 

IQ2I , 


Ratio No. I 
135% 


Ratio No. 2 
260% 


IQ22 


248 


486 


IQ2^ 


78 


250 


IQ2A 


160 


376 



Reducing Ratios to Common Base. These tell their own 
story, giving no indication that the inventory is out of propor- 



135 


100% 


260 


100% 


135 

248 


184% 


260 

486 


188% 


135 

78 


58% 


260 
250 


97% 


135 
1 60 


119% 


260 

376 


145% 


135 




260 





88 ANALYZING FINANCIAL STATEMENTS [Ch. 9 

tion, but the variations between the two sets of ratios may be 
clearer if they are reduced to a common base. 

This may be done by considering the 1921 ratios as being 
100%. To do this, divide all the No. I ratios above by 135 and 
all of the No. 2 ratios above by 260, with the following results : 

No. i Ratio No. 2 Ratio 
1921 

1922 

1923 
1924 

The adjusted No. 2 ratios are increasing faster than the No. 
i. Since the only difference between them is the inventory 
item, it seems clear that swelling inventories are responsible 
for the increase. 

The situation is, however, far from alarming, and by no 
means contradicts the conclusions already formed. The dif- 
ference between 119% and 145% is moderate. Had these 
figures been considerably farther apart, the interpretation 
might have been less favorable. 

Ordinarily it will not be necessary to go through the last 
mathematical step of reducing the ratios to a common base, 
since a mere inspection of the two sets of actual ratios them- 
selves will tell a sufficiently complete story. 

From this study a reasonably safe conclusion may be drawn 
that the inventory of the Ames Manufacturing Company shows 
a satisfactory trend. 

But if the following ratios from the cotton goods business 
were offered for analysis, what would be the conclusion ? 

1913 1914 1915 

Ratio Sales to Inventory 595% 3*7% 288% 

Ratio Quick Assets to Current Liabilities 74 45 47 

Ratio Current Assets to Current Liabilities 125 116 120 



Zi = 100% 


H5 , I00 % 


74 /0 

15 ^ 6l% 


125 uu/0 
116 M 

= Ql>% 


74 /0 
4Z- 64% 


125 93 /0 
I2O m 

as 06% 


74 4/ 


125 y /0 



Ch. 9] HISTORICAL ANALYSIS RATIO METHOD 89 

The last two sets of ratios may be reduced to a comparable 
basis as follows : 

Acid Test Ratio Current Ratio 

1913 
1914 

1915 

The ratio of sales to inventory shows a bad condition, and 
the adjusted ratios of quick assets to current liabilities and of 
current assets to current liabilities confirms the conclusion, the 
difference between 64% and 96% being relatively large. 

Over-Investment in Receivables. The next question to 
consider is whether the Ames Manufacturing Company is tying 
up too much money in receivables. 

The first ratio which has a bearing on this problem is the 
one of sales to receivables : 

Year Ratio 

1921 , 360% 

1922 808 

1923 1,610 

1924 1,651 

This ratio is constantly increasing, which simply means that 
sales are increasing faster than the volume of receivables. 

For the year 1921 there was $3.60 of sales for every dollar 
of receivables offhand, a rather poor record. To state the 
situation a little differently, it means that more than three 
months 7 sales were tied up in receivables ($3.60 divided by 12 
months equals $.30. $i is more than three times $.30). 

The steady improvement up to 1924, when there was 
$16.51 of annual sales for every dollar of receivables, is re- 
assuring. In 1924 only about three weeks' sales were tied up 
($16.51 divided by 52 weeks equals approximately $.32. $i 
is about three times $.32). 

It should be remembered that changes in these ratios may be 



90 ANALYZING FINANCIAL STATEMENTS [Ch. 9 

influenced by the following factors, which may not be known to 
the analyst : 

1. The terms of sale may have been changed. 

2. Sharp increases or decreases in sales prices may have 

been made during some of the years, which would 
result in the receivables (because they largely represent 
recent sales) reflecting the price changes to a greater 
extent than the annual sales do. 

3. The basis for figuring the provision for doubtful accounts 

may have been changed to a disturbing degree. 

To check the foregoing figures consider again the ratio of 
quick assets to current liabilities: 

Year Ratio 

1921 135% 

1922 248 

1923 78 

1924 160 

These figures tell no story to contradict what has already 
been learned, and it is fair to conclude that the Ames Manu- 
facturing" Company shows no trend toward over-investment in 
receivables. 

But less favorable conclusions would prevail if the ratios 
of sales to receivables were as follows from the coal mining 
industry : 

Year Ratio 

1918 -507% 

1919 487 

1920 383 

1921 361 

The following ratios are from the railway equipment 
business : 

Year Ratio 

1919 987% 

1920 341 

1921 290 



Ch. 9] HISTORICAL ANALYSIS RATIO METHOD 91 

The following ratios are from the meat packing industry: 

Year Ratio 

1918 1,140% 

1919 890 

1920 760 

1921 570 

Over-Investment in Fixed Assets Coming back to the 

Ames Manufacturing Company, the next symptom to search 
for is over-investment in fixed assets. The first ratio to ex- 
amine is that of sales to fixed assets. 

Year Ratio 

1921 291% 

1922 258 

1923 251 

1924 259 

These figures show no particular trend. They indicate a 
fairly harmonious relation between the rate of increase in 
volume of sales and volume of fixed assets. There was a 
moderate unfavorable tendency the first three years, but an 
improvement was shown in the fourth. 

It seems evident that fixed assets are not being increased too 
fast, but before reaching a final conclusion the increase in fixed 
asset investment should be compared with the rate of increase 
in net worth. The increase in fixed asset accounts might not 
be out of harmony with sales and still might be inconsistent 
with net worth, thus resulting in an unbalanced financial 
position. 

The ratios of net worth to fixed assets follow : 

Year Ratio 

1921 226% 

1922 231 

1923 - 175 

1924 182 

The first set of ratios indicated a slight unfavorable trend. 
These confirm that the fixed asset increase is somewhat out of 



9 2 ANALYZING FINANCIAL STATEMENTS [Ch. 9 

proportion to net worth. This is probably not a very alarm- 
ing condition, since an improvement is noted in the 1924 figure, 
but it puts the analyst on guard. 

Interpreting the Ratios. Here is a good example of the 
function of ratio analysis. An unfavorable trend has been dis- 
closed, but does this mean that the Ames Manufacturing Com- 
pany is "going broke" ? Not at all. It is merely a warning 
indicator and its purpose is to fix the starting point for further 
and more detailed investigation. 

There is nothing conclusive about the findings so far. The 
analyst has merely learned in what direction to investigate and 
what general symptoms are evident. 

It occasionally happens that a sharp decrease in this ratio 
may be due to a heavy but legitimate investment in plant to- 
ward the end of a fiscal year, the effect of which will be to in- 
crease sales during years following. 

Also companies -who own properties not used for direct 
operating purposes, such as land held for future expansion, 
may sell such properties. This might affect the ratios materially 
without carrying important significance. 

The matter of uniformity of depreciation policy should also 
be borne in mind by the analyst. 

The following ratios of sales to fixed assets come from the 
automobile accessory business : 



Year 

TQT7 


Ratio 
802% 


TOTS 


683 


TQIQ 


396 


IQ20 . . 


, 341 


IQ2I 


137 



Here the ratios clearly point out a dangerous tendency. 

Following are similar ratios from a shoe manufacturing 
company which are also unfavorable but not positively 
alarming : 



Ch. 9] HISTORICAL ANALYSISRATIO METHOD 



93 



Year Ratio 

1919 586% 

1920 563 

1921 430 

Next follow the ratios of one of the largest electrical 
machinery manufacturers : 

Year Ratio 

1917 496% 

1918 485 

1919 446 

1920 406 

1921 322 

These are interesting because they show a very gradual 
trend. In many companies where the figures are not closely 
analyzed, such a trend might continue unnoticed for a long 
time until a really dangerous situation developed. 

Insufficient Capitalization. The question as to whether 
the Ames Manufacturing Company is sufficiently capitalized 
is the next one for investigation. 

The ratio of net worth to total liabilities is quite signifi- 
cant, because it shows the relation between permanent capital 
supplied by stockholders and temporary capital supplied by 
creditors. Within reason, the larger the proportion that per- 
manent capital bears to temporary capital, the better. 

A decreasing ratio is unfavorable because it shows that 
the company is pointed toward a situation of being under- 
supplied with permanent capital and thereby being compelled 
to make up the deficiency by increasing its liabilities : 

Year Ratio 

1921 287% 

1922 684 

1923 387 

1924 664 

The general tendency is favorable, because the ratio is 
becoming larger. 



94 ANALYZING FINANCIAL STATEMENTS [Ch. 9 

To check these findings sales may be compared with net 
worth : 

Year Ratio 

1921 128% 

1922 112 

1923 143 

1924 142 

A reasonable increase in this ratio is usually a favorable 
indication, but too great an increase shows that the company 
is heading toward the point of doing more business than its 
capital justifies. In this instance there is no indication that the 
Ames Manufacturing Company is tending towards under- 
capitalization. 

Ratio Interpretation. This study of the ratios of the 
Ames Manufacturing Company has been described at length 
to show just how ratios are prepared, used, and interpreted. 

This interpretive work must be supported at all times by 
common sense. It is easy, when working with ratios, to "get 
off the track " and reach wild conclusions. 

Important issues frequently hang on the results of this 
analysis work. A wrong interpretation may easily involve 
thousands of dollars in credit unwisely granted, investments 
unwisely made, etc. 

After making his study of the ratios, the analyst may well 
"stop, look, and listen/' and apply the test of common sense to 
his conclusions. 

The Value o Ratios. A complete diagnosis of four of the 
five principal ailments of business has been made. It is a 
fairly conclusive diagnosis. It has been made entirely through 
the study of ratios. 

This simply means that a method of technique or analysis 
has here been presented which, if intelligently used, is of great 
value to the accountant, public or private, and to the business 
executive, as well as to investors, bankers, credit men, etc. 



Ch. 9] HISTORICAL ANALYSIS RATIO METHOD 95 

This method is one commonly used by advanced analysts, 
and while it has certain faults, it is quite effective and practical 
It leads directly into the subject of standard ratios which is 
to be discussed in Chapter XIII. A better and simpler method 
of historical analysis (analysis of successive balance sheets of 
the same company) is developed in Chapters XI and XII. 

Chapter X discusses the relation of the ratios to the com- 
mon business ailments from the viewpoint of the relative seri- 
ousness of the ailments. 

This is naturally an important study and one which will 
enable the analyst to interpret balance sheets with much greater 
sureness and accuracy. 



CHAPTER X 

COMPARATIVE SERIOUSNESS OF BUSINESS 
AILMENTS 

Purpose of Diagnosis. A physician might be thoroughly 
trained in all various methods of diagnosing human ills; he 
might be thoroughly skilled in the technique of searching for 
symptoms; his program of testing might be ultra scientific; 
and yet if he did not know the relative seriousness of the 
various diseases much of his work would be valueless. 

This is equally true of the balance sheet analyst. He 
searches for certain common business ailments. Certain meth- 
ods are devised to aid him in his search. These methods 
involve the use of ratios and are presumed to be helpful to him 
in his diagnosis. 

And yet some of these ailments may be of but minor 
importance, while others may be quite serious. 

A doctor may have an accurate method of diagnosis for 
measles and another equally accurate method of diagnosis for 
typhoid fever. Both methods may be of equal accuracy, and 
yet the diseases which they indicate are not comparable in their 
seriousness. 

Comparative Importance of Ailments Therefore, in 
order to use balance sheet ratios intelligently, the analyst 
should know something of the comparative seriousness of the 
common business ailments. 

Some of them may be of moderate importance to be com- 
pared to minor human ailments, and some of critical impor- 
tance to be compared to dangerous diseases. 

Field for Research. It is doubtful whether anyone can 
answer this question of relative importance with any degree of 
certainty. 

96 



Ch. 10] SERIOUSNESS OF BUSINESS AILMENTS 97 

Here lies a wonderful field for business research. Were it 
possible for some statistical organization to have current access 
to all the financial statements of all the business concerns in 
the United States, it might contribute some remarkable in- 
formation to the sum total of business knowledge informa- 
tion so vital that its importance is difficult to estimate 
information that would probably strike deep into the very 
roots of business itself. 

Business men will and should assume certain risks in con- 
ducting their enterprises, but with the knowledge such a re- 
search would give they would be able to assume such risks 
intelligently. 

Measurement of Business Risks. If the over-investment 
in inventory is only moderately dangerous, the business man 
might then compare the risks he takes through swelling his 
inventory with the extra profits which might be made through 
a rising market. 

Given the proper information, he might decide not to take 
such great risks for a modest profit or vice versa. 

Perhaps one reason business men disbelieve in some phases 
of balance sheet analysis and prefer to use their own "rule 
of thumb" judgment, may be that they have an instinctive 
understanding that while balance sheet ratios point out dan- 
gers, the seriousness of the dangers themselves is not capable 
of measurement. 

Common Sense Analysis. While the present state of 
knowledge does not appear to give much information as to 
the relative seriousness of the common business ailments, 
still it is true that common sense alone does shed some light on 
this problem. 

Common sense tells, for example, that over-investment in 
plant is a much more serious condition than over-investment 
in inventory for the very simple reason that an inventory is 



gg ANALYZING FINANCIAL STATEMENTS [Ch. 10 

in a constant state of movement and given sufficient time will 
usually be liquidated. 

Inventories Self-Liquidating. Over-investment in inven- 
tory does not necessarily have a permanent effect upon the 
condition of a business. 

Inventories may be too high at one time and at the expira- 
tion of a few months may be entirely too low. This is due to 
the character of the asset itself. 

In other words, over-investment in inventories is not an 
incurable disease. It represents a condition which once de- 
tected can be remedied. The remedy may involve a loss of 
money, to be sure, but except in aggravated instances, it is 
not likely to involve serious financial embarrassment. 

Of course, when an inventory is swollen with obsolete, 
unnecessary, or unsalable items, or has been bought for specu- 
lative purposes to a highly inflated point, having been financed 
to that point through short-time loans, and the business is then 
hit by a slump in sales as a result of a depression in general 
conditions, it is unquestionably at the mercy of its banker or 
trade creditors, and may naturally expect a call from the 
sheriff. - 

Over-Investment in Receivables. But on the whole, 
swelling inventories usually are only dangerous when unrec- 
ognized. Much the same thing is true of over-investment in 
receivables. 

To permit too much working capital to be concentrated in 
the form of receivables where it is not even earning interest, 
is unquestionably bad business policy. It is a fundamental of 
business management to collect closely and to keep the invest- 
ment in receivables at a minimum. 

The failure to do this is not necessarily fatal, but it may 
cause temporary embarrassment and in aggravated cases even 
bankruptcy. Assuming that all the receivables are good and 
that they are reasonably self-liquidating, all that is then re- 



Ch. 10] SERIOUSNESS OF BUSINESS AILMENTS 99 

quired to cure conditions is a change in collection or sales 
policies and the passage of a few months' time. 

This particular ailment is nearly always chargeable against 
the sales department of a business, which in its eagerness to 
build up a big volume of business is continually fighting for 
over-liberality of credit fighting to have credit accommoda- 
tions continued to doubtful customers, and longer and longer 
credit terms extended to good customers. 

When this cause of swollen receivables is removed and the 
sales policy is readjusted, a long step is taken toward curing 
this evil. 

Over-Investment in Plant. But the situation with respect 
to over-investment in plant is an entirely different proposition. 

Money put into bricks, mortar and steel is permanently 
invested, or practically so, while money tied up in receivables 
or inventories will usually be coming back in the form of 
money again at the expiration of a few weeks or months. 

Of course, permanent assets can be and often are sold, but 
they usually bring only a fraction of their original cost and 
their sale represents so drastic a step that it would hardly if 
ever be undertaken except under the most critica! circum- 
stances. From the viewpoint of an operating business, it is 
perfectly safe to consider fixed tangible assets as permanent 
investments. 

Money invested in plant is money permanently lost in so far 
as paying bills, meeting pay rolls, purchasing and the general 
requirements of doing business are concerned. 

And it is right here that the danger of over-investment in 
plant becomes evident. The business man does not appreciate 
the value of money until he needs it in the form of actual 
currency for the purpose of saving his business. 

It is then he of ten. looks back with vain regret to the thou- 
sands of dollars he has overinvested in buildings, land, ma- 
chinery, delivery equipment, desks, filing cases, and the thou- 



100 ANALYZING FINANCIAL STATEMENTS [Ch. 10 

sand odd items which go to make up the total of the fixed 
assets. 

Therefore, from the common sense viewpoint, unsupported 
by statistical facts, it is quite evident that over-investment in 
plant is a very much more serious ailment than over-investment 
in either inventories or receivables. 

A Serious Symptom. By a similar method of reasoning, 
the conclusion is reached that insufficient- capitalization is also 
far more serious. 

This is particularly true in the case of the smaller business 
house. The large ones have access to financial assistance which 
the smaller organization may not use. 

The large corporation, feeling the need of additional cap- 
ital, will ordinarily find no difficulty in disposing of capital 
stock, and thus obtain money with which to retire notes, bonds 
and current liabilities. It may in this way readjust its unbal- 
anced condition. 

The smaller organization has no such ready solution. The 
amount of money it requires is ordinarily not sufficient to 
attract brokers or investment houses, and unless it can sell its 
capital stock among its employes, among those from whom it 
buys goods, or among its customers a rather long, difficult, 
and not entirely satisfactory plan its situation is not readily 
curable. 

Not being well known, the offering of its stock is looked 
upon with suspicion, and if "fly-by-night" brokers can be 
secured to market the stock, it is usually at a ruinous rate of 
commission with no assurances whatever of completing the 
financing. 

About the only real cure for insufficient capitalization in 
the case of the small corporation is through building up a 
permanent surplus out of profits. 

While this is the best solution, it represents a long drawn 
out process which seldom appeals to the management, since 



Ch. 10] SERIOUSNESS OF BUSINESS AILMENTS ioi 

it requires the conduct of operations on a moderate scale. 
This, of course, is entirely out of harmony with the American 
ideal of making a "killing'' quickly. 

Analyzing Statements o Bankrupts. Another rather in- 
teresting angle from which to approach the problem would be 
to analyze balance sheets of bankrupt companies to see what 
the ratios foretold and how accurately each of them prophesied 
the coming insolvency. 

No definite conclusions could be drawn from any statistical 
survey of bankrupt companies unless hundreds or even thou- 
sands of financial statements were available for analysis, and 
even then it would be necessary to eliminate the figures of all 
companies whose failures were due to dishonesty a rather 
difficult task in many instances. 

Moreover, the findings would not be significant unless a 
survey were also made of successful concerns to find whether 
any showed the same symptoms. 

The fact that a thousand bankrupt companies showed 
undercapitalization would be meaningless if it could also be 
shown that there were a thousand very successful ones that 
were under-capitalized. 

To reach definite conclusions by the study of bankrupts 
alone would be like trying to prove that the possession of a 
right hand is the cause of death, based on the fact that nearly 
all dead men have right hands. 

However, a general, rather than a statistical survey of 
business, points out that a great majority of failures show 
symptoms of one or more of the common business ailments, 
and that a great majority of successful concerns show either 
no evidence or negligible indications of any of the common 
business ailments. 

With this foreword, it is believed safe to introduce purely 
for illustrative purposes the statistics of five bankrupt com- 
panies. These statistics are, of course, insufficient to prove 



102 ANALYZING FINANCIAL STATEMENTS [Ch. 10 

anything, but they present certain features that are 
interesting. 

Adjusting Ratio of Quick Assets to Current Liabilities. 

In the accompanying table are the figures from five companies 
all of which went bankrupt within one year from the date of 
the last figures: 

RATIO OF QUICK ASSETS TO CURRENT LIABILITIES 

Years Prior to Insolvency 

765432 i 

Company A Ratio. .. 556% 164% 238% 125% 51% 

Company B Ratio ... 92 79 51% 43 41 

Company C Ratio . . . 104% 88 80 78 69 

Company D Ratio 91 49 58 60 

Company E Ratio 119 59 42 

A certain amount of information is obtainable from this 
table. From mere inspection it is noted that all companies 
showed a decreasing ratio of quick assets to current liabilities. 

But because of various factors such as geographical loca- 
tion, nature of the business, etc., the ratios are not closely 
comparable. 

For instance, company A shows a high ratio of 556%, 
while company B shows a high ratio of only 92%. Such a 
wide range makes interpretation of trends somewhat difficult. 
For that reason the figures may be shown in a somewhat dif- 
ferent form. The highest (not the earliest) ratio for each 
company may be considered 100% and the remaining ratios 
for the same company figured in corresponding proportion. 

In the case of company A this is accomplished by dividing 
all the ratios by 556. This makes the first 100%, the second 
29%, the third 43%, etc. This leaves them at the same relative 
value, one to another that they were before. 

In order to distinguish the new figures from the actual 
ratios, they may be called "adjusted ratios." These new 
figures are shown in the accompanying table ; 



Ch. 10] SERIOUSNESS OF BUSINESS AILMENTS 



103 



ADJUSTED RATIO OF QUICK ASSETS TO CURRENT LIABILITIES 

Years Prior to Insolvency 



Company A: 7 
Ratios 


6 5 4 3 2 i 
556% 164% 238% 125% 51% 
100 29 43 22 9 

92 79 51% 43 41 
100 86 55 47 45 

7 88 80 78 69 
85 77 75 66 

91 49 58 60 
100 54 64 66 

119 59 42 
100 50 35 


Adjusted Ratios. ... 
Company B : 
Ratios 


Adjusted Ratios. ... 
Company C: 
Ratios . . 104^ 


Adjusted Ratios. ... 100 
Company D: 
Ratios 


Adjusted Ratios. ... 
Company E: 
Ratios 


Adjusted Ra 
100 

90 
80 
70 
60 

! s 

40 
30 
20 
10 

A 


tios ... 


S> 


^ 


\ 














\ 


V 


A 














v 


A- \ 




\ 


Com pan 
Compan 




\ 


\ 






\ 


\ 


V 


^ 


yD 

yC 






\ 


^ 


\\ 












/ 


\ 


\ 




Compan 


SB 




/ 




\ 


\ 


Compan 


yE 






' 




\ 


\ -, 
















\ 


Compan 
















yA 



V 7 6 5 4 3 2 1 

Years Prior to Insolvency 

Figure I. Chart of Adjusted Ratios of Quick Assets to Current Liabilities 
of Five Bankrupt Companies 



I04 ANALYZING FINANCIAL STATEMENTS [Ch. 10 

The exhibit now becomes more interesting and is even 
more startling if shown in graphic form as in the chart in 
Figure i. 

A study of this chart shows that all the companies except 
company D present a declining ratio of quick assets to current 
liabilities during the last three years. 

Adjusting Current Ratio. For the same five companies, 
the ratios of current assets to current liabilities are shown : 

RATIO OF CURRENT ASSETS TO CURRENT LIABILITIES 

Years Prior to Insolvency 
765432 i 

Company A; 

Ratios 9^0% 238% 543% 201% 132% 

Adjusted Ratios 100 24 56 21 14 

Company B : 

Ratios - 191 226 258% 153 144 

Adjusted Ratios .... 74 88 100 59 56 

Company C: 

Ratios 139% 134 Hi 131 141 

Adjusted Ratios . . 98 95 100 93 100 

Company D : 

Ratios 234 188 169 104 

Adjusted Ratios . . 100 80 72 44 

Company E: 

Ratios 370 210 in 

Adjusted Ratios . . 100 57 30 

When these adjusted ratios are plotted graphically, the 
chart in Figure 2 results. 

In this chart company C does not appear to conform to 
the trends established by the other companies. 

Nevertheless, there appears to be a substantial indication 
that a declining ratio of current assets to current liabilities was 
a clear danger signal, although probably not as significant as 
the former ratio of quick assets to current liabilities. 

This, of course, is due to the inclusion of inventories in 
the calculation. It has already been shown that the inventory 



Ch. 10] SERIOUSNESS OF BUSINESS AILMENTS 



105 



situation may not always represent an influence of primary 
importance on insolvency. 

Adjusting Ratio of Total Debt to Net Worth. To deter- 
mine whether a corporation is under-capitalized according to 
its volume of business is primarily a matter of ascertaining 
the trend of the ratio between invested capital and loaned 
capital, i.e., accounts, bills, notes and mortgages payable. 




654321 
Years Prior to Insolvency 

Figure 2. Chart of Adjusted Ratios of Current Assets to Current Liabilities 
of Five Bankrupt Companies 

This ratio is important because invested capital can be 
retained in a business, whereas loans must be repaid sooner 
or later. Obviously a decreasing ratio of net worth to total 
worth from year to year is unfavorable. 



106 ANALYZING FINANCIAL STATEMENTS [Ch. 10 

Using the same five bankrupt corporations and reducing 
the ratios to a comparable basis the following table results ; 

ADJUSTED RATIO OF NET WORTH TO TOTAL DEBT 

Years Prior to Insolvency 
7654321 



Company A: 










Ratios 


. 385% 


910% 


714% 


455% 


Adjusted Ratios. . . 


. 42 


IOO 


71 


50 


Company B : 










Ratios 


X 82 


222 


263% 176 


176 


Adjusted Ratios.. . 


. 69 


4 6 


100 67 


67 


Company C: 










Ratios 


. 110% 102 


104 


105 


69 


Adjusted Ratios. . . 


. loo 93 


95 


96 


62 


Company D : 










Ratios 


. 270 


227 


- 185 


156 


Adjusted Ratios. . . 


I00 


84 


- 69 


58 


Company E : 










Ratios 





588 


270 


124 


Adjusted Ratios . . 


t __ 


IOO 


- 46 


21 



Plotting the adjusted ratios graphically, results in the 
chart shown in Figure 3. 

In studying this chart, it is seen that without exception all 
the companies showed a sharp decrease in the ratio of net 
worth to total debt for the last two years prior to bankruptcy. 

Adjusting Ratio of Net Worth to Fixed Assets One of 
the common financial ailments is over-investment in fixed 
assets. 

Investment in fixed assets should be made in a reasonable 
proportion to the growth of net worth. When such additional 
investments in fixed assets are made regularly on borrowed 
capital, an unbalanced situation arises which may easily lead to 
bankruptcy. 

For this reason the ratio of net worth to fixed assets is an 
important one. A decrease in this ratio from year to year is, 
of course, an unfavorable sign. It shows that fixed assets are 
increasing faster than net worth. 



Ch. 10] SERIOUSNESS OF BUSINESS AILMENTS 
100 



107 



Company B 
Company C 
Company D 




654321 
Years Prior to Insolvency 

Figure 3. Chart of Adjusted Ratios of Net Worth to Total Debt of Five 
Bankrupt Companies 

Determining this ratio for the five bankrupt companies 
and reducing to a comparable basis the table on page 108 is 
obtained. 

When these adjusted ratios are charted, they appear as 
shown in Figure 4. (See page 109.) 

The uniformity of trend for all the companies during the 
three years prior to bankruptcy is particularly noticeable in this 
chart. The slight upward slant of the line for company C 
during the last year is hardly sufficient to justify an exception. 

Significance of Ratios. The analysis at the beginning of 
this chapter indicated that over-investment in fixed assets is 
a serious business offense and one not easily remedied. 



108 ANALYZING FINANCIAL STATEMENTS [Ch. 10 

ADJUSTED RATIO OF NET WORTH TO FIXED ASSETS 

Years Prior to Insolvency 
765432 i 

Company A: 

Ratios 178% 154% 192% 107% 101% 

Adjusted Ratios 93 80 100 56 53 

Company B : 

Ratios 186 191 184% 134 128 

Adjusted Ratios ... 98 100 97 70 67 

Company C: 

Ratios 167% 161 175 86 105 

Adjusted Ratios. ... 95 92 100 ' 49 60 

Company D : 

Ratios 238 170 160 102 

Adjusted Ratios 100 71 67 43 

Company E: 

Ratios 215 201 no 

Adjusted Ratios 100 93 51 

Apparently the common sense analysis and this brief statis- 
tical survey agree. 

Certainly there is evidence which points toward the state- 
ment that of the common business ailments discussed in this 
chapter, two are moderately serious and two are dangerous. 

The moderately serious ones are : 

1. Over-investment in receivables. 

2. Over-investment in inventories. 

The dangerous ones are : 

1. Insufficient capitalization. 

2. Over-investment in fixed assets. 

It seems almost obvious that with this knowledge of the 
relative importance of business ailments the analyst will be able 
to perform his diagnosis with greater shrewdness and greater 
sense of security in his conclusions. 

Those readers whose work as credit men, bankers or in- 
vestigators puts them into daily contact with balance sheets of 
corporations, will find their use oi balance sheet ratios a source 
of much greater satisfaction when they approach each situa- 



Ch. 10] SERIOUSNESS OF BUSINESS AILMENTS 



109 



tion not only from the viewpoint of analyzing for the common 

ailments of business, but also give to each Its proper emphasis. 

Public accountants will find their analysis service much 

sounder when approached from the viewpoint set forth in this 
100 




654321 
Years Prior to Insolvency 

Figure 4. Chart of Adjusted Ratios of Net Worth to Fixed Assets for Five 
Bankrupt Companies 

chapter. It will afford them a basis for constructive business 
counsel that should win enthusiastic clients. 

He who constantly watches the affairs of one company, 
whether as its comptroller or chief executive, will find his 
analysis of monthly statements more profitable when ap- 
proached from the viewpoint of the common ailments and their 
relative importance. Such an analysis forces him to take a 
bird's-eye view a salutary thing for one who as the result of 
his customary activities is immersed in details. 



CHAPTER XI 

HISTORICAL ANALYSIS OF BALANCE SHEETS- 
TREND METHOD 

Theory of Balance Sheet Analysis. In studying technique 
and methods it is wise not to overlook the purpose of balance 
sheet analysis. 

As already stated, its purpose is to bring to light informa- 
tion which the balance sheet figures themselves do not clearly 
reveal. 

Just as the doctor's diagnosis develops facts which would 
not be apparent even to his skilled eye through mere observa- 
tion, so does balance sheet analysis shed light on hidden busi- 
ness symptoms which mere inspection of the actual figures 
would not discover. 

The theory of balance sheet analysis assumes that the 
financial condition of every business is constantly changing 
for better or worse. 

Distortion of financial position means that the various 
classes of balance sheet items are out of their proper relation 
with one another. It is to show such distortion that the balance 
sheet reader makes his analysis. 

From this viewpoint, therefore, the problem is not one 
of studying the actual amounts appearing on the balance sheet, 
but rather one of determining relationships between the various 
classes of items composing the statement. 

It is upon this theory that previous chapters have been based. 
A number of relationships or ratios have been worked out. 
These ratios are constructed from successive balance sheets 
of the same- company and are then compared to see if any 
definite trends are to be found. 



Ch. ii] HISTORICAL ANALYSIS TREND METHOD m 

Balance Sheet Ratios The ratio method of balance sheet 
analysis undoubtedly was started by the old time banker and 
credit man to whom the beginning and end of balance sheet 
analysis was to compare the current liabilities with the current 
assets. 

Just as the alleged trail made by the wabbling calf later be- 
came well beaten and turned into a road, and finally into the 
most crooked street of Boston, so was the "current ratio" of 
the old time credit man responsible for the present ratio method 
of balance sheet analysis. 

Objections to the Ratio Method. There are certain strong 
objections to the ratio method of balance sheet analysis. 
These are as follows : 

1. Any balance sheet ratio represents a relationship between 

two varying factors and any change in a ratio from one 
year to another must be interpreted by the examina- 
tion of the changes in the two items from which the 
ratio is built. 

2. The ratio is so artificial a figure that it is difficult for 

the analyst to keep in mind its connection with the 
actual balance sheet under survey. 

3. The ratios give an unwarranted impression of finality, 

whereas the different ratios probably vary in their 
reliability. 

4. In studying balance sheets by the ratio method it is diffi- 

cult to obtain a bird's-eye view of the relation of various 
elements to one another. 

The first objection has already been discussed. If the cur- 
rent assets of a company in one year amount to $10,000 and 
the current liabilities are $5,000, the ratio is 200%. If the next 
year current assets remain at $10,000 and the current liabilities 
fall to $2,500, the ratio is 400%. 

But the ratio is also 400% if the liabilites remain at $5,000 
and the current assets increase to $20,000. This means that 



112 ANALYZING FINANCIAL STATEMENTS [Ch. n 

the ratio method of analysis requires a continual comparison 
back and forth between the ratios and the actual balance sheet 
figures. 

It is also partly responsible for the fact that it requires at 
least two ratios to diagnose properly each of the common busi- 
ness ailments. 

Ratios are Artificial. An even more important objection 
is the second one. 

The reader has probably experienced the feeling that ratios 
are rather artificial figures. Working with ratios imposes a 
mental strain. It is hard to keep in mind the connection be- 
tween the ratios and the balance sheet from which they are 
constructed. 

Reliability of Ratios. Also there appears to be quite a 
difference between the reliability of the different ratios. Some 
seem to be fairly sure indicators, others not. Those working 
with ratios will always have to be on guard against forming too 
positive conclusions. 

Analysis and Common Sense. Balance sheet analysis re- 
quires the use of a good deal of common sense. 

It is somewhat difficult to exercise the required amount of 
common sense in analyzing balance sheets by the ratio method 
because the ratio method splits the problem into different parts 
and it is easy to lose the bird's-eye view of the entire balance 
sheet situation. 

Such a bird's-eye view is essential if common sense is to 
be exercised. 

Trend or Percentage Method of Analysis Because of 

these various objections to the ratio method, another method, 
which may be called the trend percentage method, has been 
devised to take the place of the ratio method in so far as the 
determination of trends is concerned. 



Ch. 11] HISTORICAL ANALYSISTREND METHOD 113 

The method is simple. It first involves grouping the various 
items of assets and liabilities for the various years into classes 
such as : 

1. Quick assets. (This should usually be sub-divided to 

show receivables separately.) 

2. Inventories. 

3. Current assets. 

4. Fixed assets. 

5. Current liabilities. 

6. Long-time liabilities. 

7. Net worth. 

The next step is to divide the totals of each class for each 
year by the total of the first class (in point of time). 

This converts all of the actual group total figures into 
percentages of the first. 

In order to show just how this method works out, the 
original balance sheet figures of the Ames Manufacturing Com- 
pany are repeated here : 

THE AMES MANUFACTURING COMPANY 
COMPARATIVE BALANCE SHEET 

As of December 31 

Assets 1921 1922 1923 1924 

Cash $ 4,652 $13,371 $ 7,190 $10,512 

Accounts Receivable (Net) 14,468 8,217 5,629 5,857 

Total Quick Assets $19,120 $21,588 $12,819 $16,369 

Inventories ! 17,556 20,607 28,077 22,210 

Total Current Assets $36 , 676 $42 , 195 $40 , 896 $38 , 579 

Fixed Assets (less Depreciation) . . 17, 922 25 , 707 36 , 1 63 37 , 290 

Prepaid Expense 76 213 2,545 2,459 

Total Assets $54,674 $68,115 



Liabilities and Capital 

Notes Payable Trade $ 1 ,000 $ 

Notes Payable Bank 4,000 4,000 

Accounts Payable 7 . oo 4 , ooo 

Dividends Payable 2 , ooo 

Accrued Liabilities 128 690 



Current (and Total) Liabilities. $14,128 $ 8,6qo $16,337 $10,248 




II 4 ANALYZING FINANCIAL STATEMENTS [Ch. n 

Capital Stock Outstanding $50 , ooo $50 , ooo $50 , ooo $50 , ooo 

Surplus (or * Deficit) * 9,454 9,425 13,267 18,080 

Total Net Worth $40,546 $59,425 $63,267 $68,080 

Total Liabilities and Net Worth. . 554,674 $68,115 $79,604 $78,328 

Sales $52,088 $66,383 $90,652 $96,691 

Analyzing the above by the ratio method the following 
figures result : 



Ratios 
Quick assets to cur- 


$19 


1921 

120 ^ 


$21 


i< 
,588 


p22 


$12 


192; 
,819 


3 


*I6, 


I! 


P24 


rent liabilities. . 
Current assets to 


$14 
$36 


,I28~ I35 ' 
676_ 26( ~ 


$ 8 

$42 


,690 
,195 




$16 
$40 


,337 
,896 




$10, 

38. 


248 
579 




current liabilities 


$14 

$52 


, 128 

,088 AnC y, 


8 
$66 


,690 
,383 




$16 

$90 


,337 
,652 




^10, 

596, 


248 
691 






$14 
$52 


, 468 /V 
' 88 * <7^ 


$ 8 
$66 


,217 
,383 




$ 5 
$90 


,629 
,652 




$ 5, 
$96, 


857 
691 


4 JC'V 




$17 
$52 


,S56~ 297% 
,088 _~ 


$20 

$66 


,607 
,383 


322% 


$28 
$90 


,077 
,652 




$22, 


210 




Net worth to fixed 


$40 
$40 


,546 I28/ 
.546 Mf ~ 


$59 
$59 


,425 
,425 




$63 
$63 


,267 
,267 


143% 


$68, 
$68, 


08O 
080 




assets, .... 


Sl7 


r\T> **O/u 


Si? " 


707 


231 /o 


$36 


163 




$37 


290 


182% 


Net worth to liabil- 


$40 


.546 .o.rv 


$59 


,425 


AOiC!/ 


$63 


,267 


iftHOf 


$68, 


080 




ities 


$14, 
$52, 


,i28~ 2Sy>0 
,088 _ Q ^ 


$ 8 
$66 


,690 
,383 




$16 
$90 


,337 
,652 




$10, 
$96, 


248 
691 




asse s 


$17, 


,922 ~0 0/t/ 


$25 


,70? 




$30 


,163 


251% 


$37, 


290 


- 259% 



Certain definite conclusions regarding the trend of affairs 
with the Ames Manufacturing Company can be reached by 
studying the above tabulation, but the same conclusions can be 
reached more easily, quickly, and certainly by a glance at the 
following : 

THE AMES MANUFACTURING COMPANY 
COMPARATIVE BALANCE SHEET 

As of December 31 
(Percentage based on 1921 figures.) 

1921 1922 1923 1924 
Percent- Percent- Percent- Percent- 
1921 age of age of age of age of 
Assets Amount 1921 1921 1921 1921 

Accounts Receivable $14,468 100 56 39 40 

Quick Assets 19 , 120 100 113 67 86 

Inventories 17,556 ioc 117 160 127 

Current Assets 36,676 100 115 112 105 

Fixed Assets 17,922 100 143 202 208 

Prepaid Expense (omitted) 



Ch. n] HISTORICAL ANALYSIS TREND METHOD 115 

Liabilities and Capital 
Current Liabilities (also to- 
tal) $14,128 loo 62 116 73 

Net Worth 40,546 100 147 156 168 

Sales 52 ,088 100 127 174 186 

Interpreting the Percentage Statement A rather serious 
study of ratios requiring considerable time will finally tell that 
the only one noteworthy symptom is the disproportionate in- 
crease in fixed assets. 

The percentage statement tells the same story, but it tells 
it far more quickly and vividly. 

By inspection only it is possible to compare the increase 
or decrease of each of the various factors with any of the 
others. If it is desired to compare fixed assets with sales, a 
mere glance will show that the fixed assets have increased to 
208%, where sales have increased to only 186%. 

This furnishes just as much information as is given by the 
ratio of sales to fixed assets which dropped from 290% in 1921 
to 259% in 1924. 

But there is an additional advantage. At the same time 
that the increase of fixed assets is compared with the sales, it 
it also possible to compare the increase in fixed assets with other 
items in the balance sheet. For example, fixed assets may be 
compared with net worth which has increased to 168%. That 
the fixed assets have increased faster than the net worth is 
immediately apparent, and the belief that the fixed assets have 
increased somewhat too rapidly is confirmed. 

These conclusions are formed by mere inspection of all 
the percentage figures. The conclusions are much more certain 
to be supported at all times by common sense, since all of the 
trends are surveyed at one time. 

In attempting to diagnose the common business ailments, 
this method is just as effective as the ratio method, if not 
' more so. 



Il6 ANALYZING FINANCIAL STATEMENTS [Ch. 11 

Illustrations of Trend Method. As further evidence 
of the value of this trend method, examine the following com- 
parative balance sheet and the accompanying analysis : 

STEEL PRODUCTS COMPANY 

COMPARATIVE BALANCE SHEET 

As of the Dates Shown 



Assets 
Cash 


Dec. 31, 3 
1916 

. . . . $ 18,565 $ 


Dec. 31, 
1917 
13*717 


Dec. 31, 
1919 

$ 52,178 


Sept. 28, 
1920 

$ 445 


Notes and Accounts Receivable 


176,551 


175,536 


239,123 


27L5I7 


Current Assets 


. . . . $IQS, 116 $ 


189,253 


$ 291,301 


$ 271 962 


Inventories 


307,965 


535,684 


548,379 


198,094 


Current and Working Assets . * 


. , . $503,081 $ 


724,937 


$ 839 680 


$ 470 056 


Fixed Assets 


292,955 


544,605 


574,066 


693,264 



Total Assets $796, 036 $i , 269 , 542 $1,413,746 $i, 163, 320 

Liabilities and Capital 

Current Liabilities $215,386 $ 386,218 $ 497,856 $ 452,810 

Net Worth 580,650 883,324 915.890 710.510 

Total $796 , 036 11,269,542 $1.413,746 $1,163,320 

STEEL PRODUCTS COMPANY 
COMPARATIVE BALANCE SHEET 

As of the Dates Shown 
(Based on percentage of 1916 figures.) 

Dec. 31, 1917 1919 1920 

1916 Percentage Percentage Percentage 

Assets Amount of 1916 of 1916 of 1916 

Receivables $176,551 99 *35 *54 

Quick Assets 195 , 116 97 149 139 

Inventories 307,965 174 178 64 

Current Assets 503,081 144 167 93 

Fixed Assets 292 ,955 186 196 236 

Liabilities and Capital 

Current Liabilities $215,386 179 231 210 

Net Worth 580,650 152 158 122 

The increase to 210% in current liabilities as compared 
with only 122% in net worth is a danger signal, showing that 
the company is financing itself more through its creditors. 

The decrease in current assets to 93% and the increase of 
fixed assets to 236% show a decidedly unfavorable trend. 



Ch. 11] HISTORICAL ANALYSIS TREND METHOD 



117 



As a matter of fact the company (the name is fictitious) 
became insolvent shortly after the date of the last balance 
sheet. 

Applying the trend method to another set of balance sheets, 
the following appears : 

WIRE AND IRON COMPANY 

COMPARATIVE BALANCE SHEET 

As of December 31 

Assets 1922 1923 1924 

Cash $ 6,040 $ 6,375 $ 95 

Accounts Receivable (Net) 38,500 41 ,385 43 ,920 

Current Assets $ 44,54O $ 47,760 $ 44,015 

Inventories 94 , 425 122 , 825 72 , 800 

Current and Working Assets $138 , 965 $170 ,585 $116,815 

Fixed Assets 113,600 127,200 117,500 

Total Assets $252 ,565 $297,785 $234,315 



Liabilities and Capital 

Current Liabilities $ 37,564 $ 80,704 $104,924 

Net Worth 215,001 217,081 129,391 

Total $252,565 $297,785 $234,315 



WIRE AND IRON COMPANY 

COMPARATIVE BALANCE SHEET 

As of December 31 

(Trend percentages based on 1922 figures.) 



Assets 



1922 

Amount 



Receivables f 38,500 

Quick Assets 44, 540 

Inventories 94,425 

Current Assets 138,965 

Fixed Assets 113,600 

Liabilities and Capital 

Current Liabilities $ 37,564 

Net Worth 215,001 



1923 1924 

Percentage Percentage 

of 1922 of 1922 



107 
107 
130 
123 

XI2 



215 
101 



114 

99 

77 

84 

103 



279 
60 



ANALYZING FINANCIAL STATEMENTS 



[Ch ii 



1 hese figures tell a story of a desperate attempt to finance 
a losing venture. Shortly after the date of the last balance 
sheet, this company became bankrupt. 

Another interesting set of figures is as follows : 

ORNAMENTAL IRON WORKS 

COMPARATIVE BALANCE SHEET 

As of Dates Shown 





Jan. i, Jan. i, Dec. 31, Mar. n, 


Jan. i, 


Assets 


1908 1910 1910 1912 


1013 


Cash 


$ 7,588 $ 5,604 $ 6,069 $ 450 


$ 7,028 


Receivables 


.. . . 244,687 217,712 205,347 203,872 


381,279 


Quick Assets .... 


. . . $252,275 $223,316 $211,416 $204,322 


$ 388,307 


Inventories 


82,727 113,298 162,322 141,691 


408,368 


Current Assets 


. 5335,002 $336,614 $373,738 $346,013 


$ 796,675 


Fixed Assets 


169,669 172,354 166,140 523,355 


581,165 


Total Assets 


$504,671 $508,968 $539,878 $869,368 


$1.377.840 


Liabilities and Capital 


Current Liabilities . . 


$240,362 $252,068 $265,018 $263,968 


$ 563,783 


Mortgage Liabilities. . 


... 160,000 


250,000 


Total Liabilities . , 


$240, 362 $252,068 $265,018 $423,968 


$ 813,783 


Net Worth 


. .. . 264,309 256,900 274.860 445,400 


564,057 


Total 


Sn.67i Iio8.o68 $539,878 $869,368 


$1,377,840 


ORNAMENTAL IRON WORKS 


COMPARATIVE BALANCE SHEET 




As of Dates Shown 




(Trend 


percentages based CD 1908 figures.) 






1910 1911 1912 


1913 




Jan. i, Percent- Percent- Percent- 


Percent- 




1908 age of age of age of 


age of 


Assets 


Amount 1908 1908 1908 


1908 


Receivables 


. . $244,687 89 84 83 


156 


Quick Assets 


. . 252,275 89 84 81 


154 


Inventories . . ... 


82,727 137 196 171 


494 


Current Assets 


-- 335 2 IO II2 IO 3 


238 


Fixed Assets 


169,669 102 98 308 


34. ^ 


Liabilities and Capital 






Current Liabilities 


$240,362 105 no no 


214. 


Total Liabilities 


240,362 105 no 176 


3^0 


Net Worth 


. . 264, 30Q 97 104 I6Q 


21.-? 



Ch. uj HISTORICAL ANALYSIS TREND METHOD 119 

What conclusions can be drawn from this analysis ? 

Not having the sales figures available, it is a little difficult 
to extract the full meaning from the figures, but it is signifi- 
cant that the inventories have increased to 494% > while the 
quick assets have increased only to 154%, and net worth to 
only 213%. There is a strong indication of too much money 
being tied up in inventories. 

An increase in fixed assets to 342% as compared to the 
increase in net worth to 213%, also shows a trend toward over- 
investment in fixed assets. 

The increase of current liabilities to 234% as compared 
with the increase of quick assets to only 154^ and the increase 
of net worth to only 213%, is a bad indication. The company 
is apparently financing itself too much through its creditors 
and not enough through permanent investment. 

Everything considered, the company seems to be in a badly 

BRIDGE AND STEEL WORKS 

COMPARATIVE BALANCE SHEET 

As of the Dates Shown 

May 31, Aug. 31, Jan. 31, 

Assets 1908 1909 1911 

Cash $35368 $ 205,371 $ 227,482 

Accounts Receivable (Net) 333 , 809 88,721 260,813 

Quick Assets $369, 177 $ 294,092 $ 4 88 2 95 

Inventories 33,30! 192, 822 ^ 96,269 

Uncompleted Contracts, etc 189,936 272,737' 515.240 

Current Assets $592,414 $ 759.651 $1,099,804 

Real Estate and Plant 322,902 1,256,400 1,742,769 

Total Assets $915.316 $2,016,051 $2,842,573 

Liabilities and Capital 

Current Liabilities $294,839 $ 573 .292 $1,031,494 

Mortgage 4,500 150,000 400,000 

Deferred Liabilities 98*215 33 355 29,860 

Total Liabilities $397,554 $ 756,647 $1,461,354 

Capital and Surplus (less Goodwill) 517,762 1,259,404 1,381,219 

Total $915,316 $2,016, OS* $2,842,573 



120 ANALYZING FINANCIAL STATEMENTS [Ch. n 

distorted financial position, and it would not be far wrong to 
anticipate financial difficulties. As a matter of fact the Orna- 
mental Iron Works did go into receivership in the year 1913. 

This case offers a good example of how a company can 
be making money (as indicated by the increase in net worth) 
and still become insolvent through improperly distributing the 
proceeds of its profits. 

The figures for the Bridge and Steel Works on page 119 
and below tell a similar story : 

BRIDGE AND STEEL WORKS 
COMPARATIVE BALANCE SHEET 

As of the Dates Shown 
(Based on percentage of 1908 figures.) 

May 31, 1909 1911 

1908 Percentage Percentage 
Assets Amount of 1908 of 1908 

Accounts Receivable $333 , 809 27 78 

Quick Assets 369, 177 So 132 

Inventories 33 , 301 579 289 

Uncompleted Contracts 189 , 936 144 271 

Current Assets 592 ,414 128 186 

Fixed Assets 322 , 902 389 540 

Liabilities and Capital 

Current Liabilities $294,839 194 350 

Long-Time Liabilities 102 , 715 179 418 

Total Liabilities '. 397554 190 3^8 

Net Worth 517,762 243 267 

A marked tendency toward over-investment in fixed assets 
is clearly indicated in these figures. 

The heavy increase in liabilities as compared with net worth 
shows an improper financing policy. The decrease in quick 
assets and the small increase in current assets as compared 
with the other classes of items on the balance sheet indicate 
an approaching bad credit position. 

Receivership of this company actually resulted in 1911. 



Ch. 11] HISTORICAL ANALYSIS TREND METHOD 121 

Comparison of the Two Methods. In conclusion, it should 
be noted that both the ratio method and the trend method of 
analysis tell the same story. But the trend method tells the 
story quickly and by mere inspection, while the ratio method 
tells it in an involved way, which requires study to obtain the 
facts. 

The trend method of balance sheet analysis has advantages 
over the ratio method as follows : 

1. It furnishes a bird's-eye view of the problem. 

2. The facts are presented in comparative form. 

3. The trends are shown vividly. 

4. The figures are easier to interpret. 

5. Less highly trained help is required to work out the 

figures for analysis, and the calculations can be made 
much more quickly. 

6. There is less liability for gross error because the result- 

ing percentages are partially self -auditing through com- 
parison with the actual figures. 

This method has none of the disadvantages and has every 
advantage of the ratio method so far as the analysis of the 
trends of successive balance sheets of the same company is 
concerned. It also has some further advantages as will be seen 
in the next chapter. 

Explaining Analysis Method to Others. This method is 
much easier to explain to a client or general executive than 
the ratio method. Sometimes such explanation is necessary, 
although not often desirable. 

It is usually not desirable, because the explanation of either 
method is confusing to the non-technical person. Either one 
of them should be used simply as a working tool to help form 
conclusions. 

There is usually no necessity to explain just exactly the 
ways and means by which those conclusions were reached. 
Further discussion of this point will be found in Chapter XVII. 



122 ANALYZING FINANCIAL STATEMENTS [Ch. 11 

The first hasty objection to this trend method might have 
to do with the selection of the basic year, i.e., in the last ex- 
ample, the year 1908. The claim might be made that it is not 
a normal or typical year. 

This, however, is not a valid objection since the method 
does not pretend to show variations from normal, but rather to 
show the trend of changes, and for this purpose the figures of 
any previous year may be taken to represent 100%. 

As a matter of fact it is doubtful whether there is a "normal 
year" in any industry. A bulletin of the National Bureau of 
Economic Research says, a No year is, strictly speaking, a 
normal year." 



CHAPTER XII 

HISTORICAL ANALYSIS OF .BALANCE SHEETS- 
TREND METHOD (Continued) 

Two Advantages of Trend Method. The credit man who 
has been using ratios in his analysis work will welcome the 
trend method for two important reasons : 

1. By the addition of narrow columns to the printed form 

he regularly uses for comparative balance sheets, he 
can show the balance sheet figures and the trend per- 
centages on the one form. 

2. The calculations by the trend method require considerably 

less time and less highly trained help than calculations 
by the ratio method. 

These two advantages are more important in credit depart- 
ments than elsewhere because of the large volume of analytical 
work to be done. The executive, accountant, or investor does 
not usually analyze a great number of statements currently. 

With the ratio method the credit man requires either a 
lengthy cumbersome form, the upper portion providing for the 
comparative balance sheet figures and the lower for the ratio 
calculations, or else two forms requiring reference back and 
forth from one to the other. 

By adding narrow columns for the trend percentages to 
his regular comparative statement form, the credit man 
secures a compact analytical exhibit which is easier to prepare, 
use, and interpret accurately. 

The second advantage is also important. In the credit de- 
partments of large manufacturing and wholesale organizations 
there is a constant stream of new statements. Each must be 
transferred to a comparative statement form, which is usually 

123 



124 ANALYZING FINANCIAL STATEMENTS [Ch. 12 

the first page of each customer's credit file. They are then 
analyzed and conclusions are drawn. 

If the calculations for this analysis can be done more 
quickly and by cheaper help, it will release higher class 
assistants for more difficult work. 

The trend method is quicker than the ratio method because : 

1. The divisor is constant in finding the trend percentages 

of any given row of balance sheet items, whereas the 
divisor changes as many times as there are years in 
the comparative balance sheet in the case of any given 
ratio. This constant divisor shortens the operation 
greatly when calculating with a slide rule. 

2. The trend method involves fewer calculations than the 

ratio method to get the same information. In Chapter 
XI the balance sheets of the Ames Manufacturing 
Company were analyzed by both methods. The ratio 
method required 32 separate calculations while the 
trend method required only 24, or 25% less. 

Trend Method More Flexible. Also, the trend method 
possesses greater flexibility for all classes of users. 

It works well with unusual balance sheets of non-trading 
companies, where the standard ratios do not seem to be entirely 
adequate or appropriate, or give false impressions. Railroad 
companies, banks, public utilities, etc., fall in this class. 

The following condensed balance sheets are of a street rail- 
way company. 

The balance sheets themselves are not noteworthy and are 
shown only to illustrate the application of the trend method to 
this type of statement. 

The most noticeable feature of this statement is the small 
amount of current assets as compared to the current liabilities. 

The nature of the business requires practically no receiv- 
ables, while the inventory is a minor factor, consisting not of 
merchandise for resale but of materials and supplies for the 
company's own use. 



Ch. 12] HISTORICAL ANALYSIS TREND METHOD 125 

STREET RAILWAY COMPANY 

COMPARATIVE BALANCE SHEET 

As of December 31 



Assets 
Cash 


1921 

Amount 

, $ TT ?T8 


1922 
% of % of 
1921 Amount 1921 

S IT.3OI 


1923 
%of 
Amount 1921 
$ 0.877 


Receivables 




3 


,685 




I 


,175 







i 


.241 





Quick Assets 


$ 


IS 


003 


IOO 


$ 12 


,476 


83 


5 


II 


,118 


74 


Inventories 




23 


,186 


IOO 


22 


,294 


90 




20 


,952 


90 


Current Assets 


$ 


38 


189 


IOO 


$ 34 


770 


91 


JE 


32 


,070 


R/t 


Special Funds. 






500 




32 


430 






93 


,002 




Property and Plant 




506 


796 


IOO 


1 ,599 


,680 


IOO 


I 


,633 


,855 


102 


Deferred Charges 




85 


,874 




79 


,237 






84 


,524 




Total 


. .. . . Si 









Sr .'7A6 


. 117 





ST 






__ 



Liabilities and Net Worth 
Accounts Payable 


$ 


107 


431 




5 


I3O 


208 




$ 


62,973 




Due City 




17 








5 


982 










Due Stockholders 






















48,426 





Current Liabilities. 


.. $ 


125 


,412 


IOO 


$ 


136, 


190 


IO9 


H 


III, 399 


89 


Unredeemed Tickets 




2 


9 I 5 






3> 


616 






4 595 




Equipment and Other Notes .... 




200 


,000 






178, 


766 






I73OOO 




Bonds 




877 


,500 


IOO 




877, 


500 


IOO 




917,500 


105 


Total Liabilities 


... $i 


2O5 


,827 


IOO 


fr 


196 


072 


99 


ft 


206 494 


IOO 


Capital Stock . . . 


$ 


1QA 


200 




F~ 


436 


AIK 




F" 


478 900 




Surplus 




155 









113. 


630 







158,057 





Total Net Worth 


-- $ 


549 


,532 


IOO 


f 


5")0 




IOO 


?t 


636 957 


TT6 


Total 


= 


755 


359 




JfT 


746 


117 




fr 


843 451 




Gross Earnings 


,... J" 


All 


~607 


IOO 


= 
* 


,"" 

AIO. 


Hi 1 


IO2 


~ 


',.j 11 

AI7.6O2 


IOI 



Testing the statement for each of the common business ail- 
ments, the following conclusions are reached : 

Over-investment in inventory Trend O.K. 

Over-investment in receivables " " 

Over-investment in plant " " 

Insufficient capitalization " " 

The credit position is, of course, bad from the viewpoint of 
a trading concern, since the current assets are inadequate to 
meet the current liabilities. 

This series of balance sheets shows another application of 
the trend method which is. of some interest to the investor in 
bonds. 

The fixed assets increased to 102%, while the bonded debt 



126 ANALYZING FINANCIAL STATEMENTS [Ch. 12 

increased to 105%. This, of course, is unimportant, but since 
instances have been known of over-bonding, to the investor's 
detriment, this particular examination of trends is one well 
worth making before purchasing bonds. 

The point is well illustrated by the following figures taken 
from the balance sheets of a well known public utility company : 

Trend Trend 

Year Plant % Bonds % 

1919 $1,703,000 100 $ 604,600 100 

1920 I,8lI,OOO 106 736,000 122 

1921 2,I2I,OOO 125 923,000 153 

1922 2,174,000 128 923,000 153 

1923 2,508,000 147 I,28l,OOO 212 

There is obviously a steady tendency toward over-bonding 
that might not be detected from a mere inspection of the 
figures or from a calculation of the customary ratios. 

It should not be inferred that the company is actually over- 
bonded in 1923. There still appears to be an ample margin 
of safety, but the trend toward over-bonding is evident and the 
investor is put on guard accordingly. A bond of this company 
bought in 1919 may be less adequately protected in 1923, and 
to that extent, other things being equal, may be less valuable. 

Trend o Operating Statistics. Excellent use may be 
made of the trend method when, as frequently happens with 
the published statements of non-trading companies, certain 
operating statistics are available. 

The following figures are taken from the annual reports of 
a large gas company (unimportant items being omitted) : 

1920 1921 1922 1923 

% of % of % of % of 

Statistics Amount 1920 Amount 1920 Amount 1920 Amount 1920 

Miles of Mains. .. $ 1,007 100 $ 1,274 127 $ 1,551 154 $ 1,906 189 
Number of Con- 
sumers 56,500 100 70,752 125 87,374 *55 121,618 215 

Output (M cu, ft.) 7t383.4S>8 100 9,546,925 129 I7,H3,529 232 25,405,140 344 



Ch. 12] HISTORICAL ANALYSISTREND METHOD 



127 



Assets 
Quick 

Inventories. . 



527,202 
501,984 



Current $ 1,029,186 

Fixed $13,074.767 

Liabilities 
and Capital 
Current Liabilities $ 1,477,706 

Bonds 4.596,ooo 

Total Liabilities $ 6.073.706 

Net Worth $ 7,668,319 

Sales $ 3,110,311 



100 $ 726,789 138 $ 1,274.890 242 $ 1,199.029 22? 

100 398,211 79 592,267 Ii8 755.86g 151 

100 $ I ' I2 JL'Q. f I09 $ 1,867.157 181 _i_,9S4j898 190 

100 $15,737,635 120 18,348,509 140 $22,822,804 175 



100 $ 1,157,308 78 $ 1,606,331 109 | 2,435,317 165 

100 7.378.000 161 9,344,000 203 11,825,000 257 

100 f 8 535,308 141 JIQ.95Q.33I 180 $14,260,317 235 

100 $ 8,029,394 105 $ 8,363,864 109 $ 9,361,858 122 

100 $ 4,268,335 137 $ 5.739,154 185 9 7.349,607 236 



A study of the trend of the statistics illuminates the balance 
sheet trends. 

The increases in the trend of "number of mains," "number 
of consumers" and "output" all compare favorably with the 
trend of the plant investment, and serve to confirm the con- 
clusion that the company is not over-investing in plant. 

A rather marked tendency toward under-capitalization is 
evident, the total liabilities having increased to 235% as com- 
pared with an increase in net worth to only 122%. 

The trends of the statistics show rapid growth in 1922 and 
1923. This sudden expansion was undoubtedly responsible for 
the character of the financing. 

The most obvious and practical remedy would be to sell 
stock, preferably to the company's customers, and use the 
proceeds to reduce current indebtedness. As a matter of fact 
this plan was actually adopted in 1923, but the effect on the 
1923 balance sheet of this financing, the cash returns from 
which were undoubtedly on the instalment basis, was slight. 

There is also a marked tendency toward over-bonding. 
The fixed assets increased to 175% as compared with an 
increase in bonded indebtedness to 258%. There is, however, 
no indication -that a dangerous condition of over-bonding has 
yet been reached. 

The general conclusions from the analysis appear as 
follows : 



I 2 8 ANALYZING FINANCIAL STATEMENTS [Ch. 12 

Over-investment in inventory Trend O.K. 

Over-investment in receivables Trend O.K. 

(Receivables were not shown separately 
on the balance sheet, being an unimpor- 
tant factor in this kind of business.) 

Over-investment in plant Trend O.K. 

Insufficient capital Unfavorable trend 

Special Business Problems The trend method possesses 
a flexibility that enables it to be used effectively, not only in 
studying the complete balance sheet figures, but also in studying 
special problems peculiar to certain types. of business, as, for 
example, over-bonding by public utilities. 

Also, a tendency toward insufficiency of depreciation pro- 
visions may be developed, in special cases, by studying the 
percentages showing trends of fixed assets and depreciation 
reserves (valuation accounts). 

And finally, the trend method readily permits the inclusion 
of other factors, such as operating statistics, whereas the ratio 
method is awkward when dealing with more than two factors. 

In some instances this may be important. In analyzing 
the statement of an automobile parts company, the inclusion 
of trend percentages of the volume of business of one or more 
automobile manufacturers might be illuminating. 

Trend of Sales Volumes The following calendar year 
figures were taken from the balance sheets of a corporation 
making an important item of equipment for automobiles and 
sold to the manufacturers thereof. 

Refinancing operations in 1922, whereby the bond issue 
was created, also involved the sale of $750,000 of preferred 
stock. This- accounts in large part for the increase in "Net 
Worth (a)." 

The actual trend of net worth as nearly as can be deter- 
mined by eliminating the $750,000 item is shown as "Net 
Worth (b)." This trend is the significant one from the oper- 
ating viewpoint. 



Ch. 12] HISTORICAL ANALYSIS TREND METHOD 129 

1921 1922 1923 

% of % of % of 

Assets Amount 1921 Amount 1921 Amount 1921 

Quick Assets $ 314.386 100 $ 473,936 150 $ 402,045 128 

Inventories 1.73 7 ,996 100 1,542,862 89 1,762,032 101 

Current Assets $ 2,052,382 100 $ 2,016,798 98 I 2,164,077 105 

Fixed Assets 1,354,860 100 1,461,551 108 1,847,260 136 

Liabilities and Capital 

Current Liabilities 12,297,761 100 $ 792,829 35 $ 1,110,248 48 

Long- Time Liabilities none i , ooo , ooo i , ooo , ooo 

Total Liabilities $2,297,761 100 $ 1,792,829 78 $ 2,110,248 92 

Net Worth (a) 1,525,390 100 2,306,497 150 2,456,581 161 

Net Worth (b) 1,525,390 zoo 1,556,497 102 1,706,581 112 

Sales of This Company 1,852,836 100 2,947,873 159 3,778,910 204 

Sales of Automobile Manufac- 
turing Co 96,690,644 100 133,178,881 138 166,153,683 172 

The inclusion of the sales figures of the automobile parts 
manufacturer gives an indication of general trends in the 
industry, and helps in forming a judgment as to the sufficiency 
of the sales of the company under analysis. This matter is 
more completely discussed in Chapter XVI. 

Trends Only Shown by Trend Method. The suggestion 
has been made that the trend method and the ratio method 
are not two different ways of accomplishing identically the 
same thing, but rather that they supplement one another. 

There is a certain amount of truth in this contention. Any 
value which the ratio method may have in analyzing a single 
balance sheet is also of value in supplementing the trend 
method of analyzing a series of balance sheets. 

Only in so far as the ratio method is used to show trends 
is it found a cumbersome instrument which can be replaced 
more effectively by the trend percentage method. 

In other words, the trend percentage method shows trends 
and nothing but trends. 

The ratio method shows the interrelationship of the various 
elements in a single balance sheet, and when the ratios for 
several single balance sheets are considered together, they shed 
some light on the trends but they represent a clumsy instru- 
ment for this purpose. 



130 ANALYZING FINANCIAL STATEMENTS [Ch. 12 

Trends vs. Condition. It is perfectly obvious that a com- 
pany may show very bad trends and still be in good condition. 

Thus in the gas company figures shown on a preceding 
page, it was shown that fixed assets showed an increase to 
175% and bonded indebtedness an increase to 258%. It was 
explained that this was a bad trend, but that it did not signify 
that a dangerous point had yet been reached. 

As a matter of fact, even at the end of 1923 there was 
approximately $2 of fixed assets for every dollar of bonds. 
Here is an illustration of using the ratio method to supple- 
ment the trend study. 

Or again, there are instances of small current assets and 
large current liabilities where the trend constantly shows a 
greater increase in current assets than the increase in liabilities. 
Such a trend, of course, is favorable, and yet the ratio between 
the two on the last financial statement might still be so far 
out of line that credit men would not feel justified in extending 
accommodations. 

Both Methods Useful. It is not fair, therefore, to say that 
the trend percentage method is a complete substitute for the 
ratio method. 

It is fair to say, however, that the trend percentage method 
is far more effective than the ratio method for showing trends. 
It is also fair to say that the study of trends is vitally im- 
portant in diagnosing the capability of business management, 
which is, after all, the major factor, as every business man 
realizes. 

The common sense judgment in the case of ratio method 
versus the trend percentage method involves a judicious com- 
promise. The well-rounded analyst will adopt the trend per- 
centage method as the most effective instrument for studying 
trends and will supplement it by determining the few really 
significant ratios for the latest of a series of balance sheets 
under survey. 



Ch. 12] HISTORICAL ANALYSIS TREND METHOD 131 

This does not necessarily mean that al! of the ratios already 
discussed will be calculated for the most recent balance sheet 
of a series. 

Often the mere survey of the figures themselves may sup- 
plement the trend study without the actual calculation of any 
ratios. In the great majority of remaining instances, deter- 
mination of the current ratio and the "acid test" will suffice. 
In rare instances or in special studies even further ratio calcu- 
lations may be made, but it is safe to say that these occasions 
will be quite rare. 

Analysis Methods as Tools. This distinction between 
studying present condition (involving ratios) and studying 
trends (involving the trend percentage method) is an im- 
portant one, and failure to appreciate it may lead into ab- 
surdities. 

An attempt to use the ratio method as the sole instrument 
of financial analysis is equivalent to a carpenter using one tool 
for two quite dissimilar operations. Because a plane has a 
cutting edge, and might, therefore, be used as a chisel, is no 
good reason for so employing it. Similarly, because the ratio 
method will, in a clumsy way, indicate trends, is no reason "for 
employing it when a better, quicker, and more graphic method 
is available. 

The vital importance of trend study seems to have been 
recognized by Alexander Wall, Secretary of the Robert Morris 
Associates, whose contributions to the ratio method, particu- 
larly in the field of credit analysis, have been great. 

In his book, "Analytical Credits," he says, 'The real fun- 
damental value of a study of the current ratio lies not so much 
in the development of the percentage at which the current 
ratio rests, as in a study of the direction in which the current 
ratio is traveling." 

Other authors, by exhibiting comparative statements, admit 
the overwhelming importance of trend study. 



132 ANALYZING FINANCIAL STATEMENTS [Ch. 12 

Combining the Two Methods. An interesting suggestion 
has been made by Mr. Wall, the apparent purpose of which is 
to combine the good features of both the ratio method and 
the trend method. He attempts to do this by first figuring 
out all the ratios for a series of statements. He then calculates 
the trends of the ratios, and finally he assigns weights to each 
ratio based on his estimate of their relative importance, and 
adjusts the trend percentages of the ratios accordingly. 

Without attempting to discuss the mathematical merits and 
demerits of Mr. Wall's suggestion, it is nevertheless true that 
simple analysis methods are the best, and that there is great 
danger in getting too far away from the actual figures. Sim- 
plicity appears to be one of the principal advantages of the 
trend method over the ratio method. 

Mr. Wall's method takes (i) the ratios which are already 
too cumbersome for practical use, (2) converts them into 
trends, and (3) again into weighted trends, i.e., three complete 
steps away from the original figures themselves. 

Even if this method gave a closer interpretation of the 
balance sheet, which is extremely doubtful, it would still be 
impracticable for ordinary use because of the difficulty of 
explaining the method to a client or employer. 



CHAPTER XIII 

STANDARD RATIOS 

A Second Use for Ratios. So far balance sheet ratios have 
been discussed from only one angle that of ratios taken from 
successive balance sheets of the same company. 

From this study certain information may be secured as to 
the trend of the company's affairs. While the trend per- 
centage method gives a quicker and clearer view of trends, it 
must be admitted, as stated in the last chapter, that trend 
studies are possible with the ratio method. 

Thus, for the Ames Manufacturing Company the ratio of 
sales to fixed assets was: 

Date Ratio 

1921 290% 

1922 258 

1923 - 251 

1924 260 

These figures show a slightly unfavorable trend. This 
has already been discussed, and it has been shown that the 
Ames Manufacturing Company tended somewhat toward over- 
investment in fixed assets. 

Where Is the Danger Point? But there is still another 
important question to be settled. Has the situation with the 
Ames Manufacturing Company reached a danger point yet? 

There must be some ratio of sales to fixed assets which 
represents such a danger point. But from an examination of 
the Ames Manufacturing Company ratios it is impossible to 
tell whether they have already fallen below such a danger 
point in 1921 or whether they were still above it in 1924. 

If there was some way of knowing the ideal ratio of sales 

133 



ANALYZING FINANCIAL STATEMENTS [Ch. 13 

to fixed assets for such a business as that of the Ames Manu- 
facturing Company, then it would be a simple matter to 
compare the Ames' figures with such a standard figure. 

Standard Ratios. This idea of determining standard ratios 
for each line of business is not new. The first research work 
along these lines was probably undertaken in a limited way 
by the credit departments of very large manufacturers. 

The first important published contribution to the subject 
appears to have been made by Alexander Wall, formerly a 
Detroit banker, who was commissioned by the Federal Reserve 
Board at Washington to make a thorough study of standard 
ratios and who later became Secretary of the Robert Morris 
Associates, an organization of bank credit men formed for the 
purpose of doing research work in standard ratios. 

A much later study was made by James H. Bliss, Comp- 
troller of Libby, McNeill and Libby, in his books entitled 
"Financial and Operating Ratios in Management" and "Man- 
agement Through Accounts." 

There are many who show much enthusiasm over standard 
ratios. The author of a recent article in a well-known technical 
journal refers to standard ratios as "enabling one to determine 
not only the standing of a given unit in an industry at a given 
moment, but also, with a precision no less exact, enabling one 
to point out the course that has been pursued and the rate 
attained in reaching that standing; and by the same means 
enabling one to foretell the fate of that industrial unit, that is, 
whither it is bound and what factors are accelerating or retard- 
ing its progress/' 

And again he says, "It furnishes a standard of normalcy, 
and any function of the concern that is not normal may be 
quickly determined and a remedy may be pointed out! 9 

Portions of these quotations have been italicized to bring 
out the broad character of claims made for the standard ratio. 
If the standard ratio is so important an instrument for locating 



Ch. 13] STANDARD RATIOS 135 

business diseases, it is most decidedly worthy of detailed con- 
sideration here. 

Construction of Standard Ratios. The standard ratio idea 
is a very simple one. 

If balance sheets could be secured from a number of differ- 
ent concerns in the same line of business, the ratios could be 
calculated separately and then averaged. Each such average 
ratio could then be considered a standard with which to com- 
pare the similar ratio of any individual company engaged in 
that line of business. 

Reverting to the ratio of sales to fixed assets for the Ames 
Manufacturing Company, it seems that there are certain other 
companies in the same line of business whose balance sheets 
are available covering the same years of 1921 to 1924. These 
are given below. The dates and names are, of course, ficti- 
tious, but all the ratios given are based upon actual published 
balance sheets. 

The ratios of sales to fixed assets for these various com- 
panies are as follows : 

1924. 

Ames Manufacturing Company 260% 

Kard Manufacturing Company 143 

General Manufacturing Company 144 

Black Manufacturing Company 367 

International Manufacturing Company 303 



Comparison of Ratios. When the 1924 ratios for the 
Ames Manufacturing Company are compared with those of 
the other four companies, its situation does not seem so bad. 

Its 1924 ratio of 260% is above the ratios of two of the 
companies and below the ratios of the other two, and is above 
the average for the five. 

It seems plain, therefore, that while the trend of this ratio 
for the Ames Manufacturing Company is downward, still it 



136 ANALYZING FINANCIAL STATEMENTS [Ch. 13 

has quite some distance to go before falling as low as the ratio 
of other representative companies in that same line of business. 

Of course, there are a number of questions about the above 
figures which any alert person would immediately ask : 

Is the industry as a whole stiff ering from some depression ? 

Are the companies in the above list representative ? 

Are there enough companies represented so that the result- 
ing average may be considered reliable ? 

With five companies all engaged in the same line of busi- 
ness, why should one of them (The Black Manufacturing 
Company) show a ratio almost three times as large as that of 
another company (The Kard Manufacturing Company) ? 

Can this be accounted for because they are in different 
parts of the country? 

Or, is it simply a false assumption that they are engaged 
in similar work? 

Or is it a false assumption that well managed companies in 
the same line of business should all have ratios fairly close to 
the average ? 

These are only a few of many questions that might be 
asked. Certainly, the management of the Ames Manufactur- 
ing Company should not be complacent in view of their de- 
creasing ratio when they see their competitors, The Black 
Manufacturing Company and The International Manufacturing 
Company with higher ratios. 

Deviation of Figures Perhaps the most noticeable thing 
about the above figures is the difference between each of the 
figures and the average. 

This is most clearly brought out by "over and under" 
figures, revealing how much each company's ratio is above or 
below the average. 

From this table can be seen how the different ratios vary 
from the average. 

In other words the average is not typical. 



Ch. 13] STANDARD RATIOS 137 

1924 Average Over Under 

Ames Manufacturing Company 260% 243% 17% 

Kard Manufacturing Company 143 243 100% 

General Manufacturing Company .... 144 243 99 

Black Manufacturing Company 367 243 124 

International Manufacturing Company 303 243 60 

Just what does this mean? 

As an illustration, if John is two years old and George 
is 22 years, their average age is 12. But this average is not 
typical and if the average age of George and John is given as 
12 years, a false impression is created. 

If John is ii and George is 13, this also gives an average 
age of 12, but is more nearly typical. 

In the first instance, there is a large deviation from the 
average, John's age being 10 years on one side of the average 
and George's age 10 years on the other side of the average. 

In the second illustration, John's and George's ages deviate 
only one year from the average. 

Value of Averages. The less deviation shown by in- 
dividual numbers from their average, the more typical and 
reliable that average is. 

In other words, the individual figures should "cluster 57 
closely around their average if the average is to mean any- 
thing. 

As a matter of fact, there is not a single one of the five 
companies which shows for the year 1924 a ratio of sales to 
fixed assets close to 243%. Not only does the average not 
typify the group, but it does not even typify any members of 
the group. 

A careful study of the foregoing paragraphs will justify 
the conclusion that it is not safe to consider that the standard 
ratio of sales to fixed assets for the year 1924 is 243%, nor 
would anyone feel justified in using that as a yardstick for 
judging the position of the Ames Manufacturing Company. 

What then is the remedy? 



138 ANALYZING FINANCIAL STATEMENTS [Ch. 13 

Securing Better Averages. The remedy quite obviously is 
not to use five balance sheets, but 50. 

And a further remedy is not to use the arithmetic average 
as has been done so far in this chapter, but to use some 
substitute for it which will more closely typify the actual 
figures. 

The trouble with the arithmetic average, in this and other 
uses as well, is that it gives effect to unusual or "freak" 
figures. 

To illustrate this in a simple manner, observe the following 
figures showing the daily incomes of six employees : 

i $50.00 

2 *... 400 

3 3-oo 

4 3-00 

5 3-00 

6 3 oo 

Total $66.00 

Average $11 oo 

While mathematically speaking the average income is $11 
per day, this average is deceptive because one $50 man was 
included. The common or typical income is $3 per day. This 
is the income earned by four out of the six employees. 

Any average figure must properly summarize the whole. 
It must be significant or typical of the whole, or it is a mis- 
leading average. The $11 average in the above example does 
not conform to this fundamental rule. 

As one authority says : 

Every average is a sort of fictitious substitute for the details 
which it replaces, serviceable when the conditions for which it 
stands are known, but deceptive when they are ignored. 

Substitute for Arithmetic Average. For most business 
uses the arithmetic average should not be employed. 

In place of the average it is better to use another figure 



Ch. 13] STANDARD RATIOS 139 

(sometimes improperly called an average), which is known as 
the "mode." 

The mode is the typical figure. 

It is the one which occurs most frequently. 

Thus, there might be 10 companies showing ratios of sales 
to fixed assets as follows : 

i 100% 6 300% 

2 200 7 300 

3 300 8 500 

4 300 9 1,000 

5 300 10 1,200 

The arithmetic average of these is 450%. But the typical 
figure, or mode, is 300%, because the greatest number of the 
companies show 300% as the ratio. Therefore, 300% is the 
common or typical figure of the group. 

It would be much wiser to use 300% as a standard instead 
of 450%, because the method of obtaining the 300% elimi- 
nates the "freak" figures of 1,000% and 1,200%. 

But in order to determine the mode it is necessary to have 
quite a large number of individual figures. The ratios of the 
five companies that have been used as an illustration are not 
sufficient in number to calculate a mode. The ratios from 50 
companies might be enough, but several hundred would be 
even better. 

The "Mode" Illustrated. The importance of the mode as 
compared with the arithmetic average in determining standard 
ratios was thoroughly recognized by Alexander Wall in his 
book, "Analytical Credits." 

He showed there exactly the method by which he accumu- 
lated his figures. For one type of business he had 139 bal- 
ance sheets from similar companies. From each he calculated 
the ratio of sales to inventories. This gave him 139 ratios. 

He then took a sheet with 16 columns. In the first column 
he made a separate notation of each ratio that was under 
300%; the second column he made a memorandum of each 



I 4 o ANALYZING FINANCIAL STATEMENTS [Ch. 13 

ratio that was 300% or more, but less than 350% ; in the third 
column he put down each "ratio that was 350% or more, but 
less than 400%, and so on. 

When he was all through, his sheet, with slight changes, 
appeared somewhat as follows : 

WORKING SHEET FOR SALES TO INVENTORY STANDARD RATIO 



300 350 400 450 500 550 600 650 700 7SO 800 850 900 950 1000 

Below to to to to to to to to to to to to to to and 

300 349 399 449 499 549 599 649 699 749 799 849 899 949 999 Over 



280 308 376 


418 


498 


Si6 


575 


613 694 


733 


758 820 921 


IOIO 


337 389 


444 


472 


504 


552 


634 694 


720 


763 841 923 


1030 


314 397 


416 


468 


533 


563 


612 674 


712 


772 817 948 


1040 


346 389 


427 


459 


508 


575 


614 658 


710 


768 841 926 


1000 


343 398 


441 


491 


504 


552 


630 655 


710 


788 820 941 


1145 


387 


439 


481 


539 


593 


600 669 


702 


754 932 


1113 


391 


412 


473 


517 


591 


675 


725 


787 


1181 


389 


444 


464 


535 


558 


665 


717 


796 


1305 


393 


412 


478 


525 


560 


650 


733 




1311 




439 


454 


533 


593 


677 






1370 




401 


450 


523 


574 












438 


498 


529 


563 












432 


452 


531 


556 














461 


516 


578 














478 


506 


563 














484 


512 


564 














450 


513 


592 














452 


533 
















486 


529 
















474 


















478 














No. in Group 


















I 5 9 


13 


21 


19 


17 


6 10 


9 


85 6 


10 



The greatest number of ratios appear in the fifth column. 
This is the column which shows the ratios between 450% and 
499%, 

In other words, the mode lies somewhere between 450% 
and 499%. 

Group Location. This is close enough for all practical 
purposes. It is seldom possible to locate the mode exactly. 
Usually it is necessary to locate it somewhere within a group, 
as in the above illustration. 



Ch. 13] STANDARD RATIOS 141 

As a matter of fact the typical figure is closer to 499% 
than it is to 450%, because the sixth column is also a long one, 
containing 19 figures, and the seventh one is quite long as 
well. 

In fact, 57 of the 139 ratios fall in these three columns, i.e., 
between 450% and 599%. It is contended, therefore, that 
any individual company in this same line of business whose 
ratio of sales to inventories is under 599% and more than 
450%, conforms to the standard or average. 

A study of the above table shows what great difference in 
ratios are to be found between different companies in the same 
line of business. In other words, there is great deviation 
from the average. 

It appears to be almost impossible to summarize all of 
these 139 ratios by one single average. A much better method 
would be to summarize all of the ratios into groups as 
follows : 

No. of 
Groups of Ratios Companies 

299 and lower I 

300 to 349 5 

350 to 399 9 

400 to 449 13 

450 to 499 21 

500 to 549 19 

550 to 599 17 

600 to 649 6 

650 to 699 10 

700 to 749 9 

750 to 799 8 

800 to 849 5 

850 to 899 o 

900 to 949 6 

950 to 999 o 

1,000 and above , 10 

139 

With the figures summarized in this manner they are much 
easier to interpret, and the standing of any given company is 



142 ANALYZING FINANCIAL STATEMENTS [Ch. 13 

much easier to determine by comparison with this table than 
by comparison with one average. 

Objections to Standard Ratios Geographic Distribu- 
tion. The balance sheet ratios of any company depend upon 
a number of factors which are the result of business policies 
and are influenced by the size of the company, its geographical 
location and other factors. 

Alexander Wall, at the time he made his investigation for 
the Federal Reserve Board, found it necessary to divide the 
United States into nine sections and to determine standard 
balance sheet ratios for each separately. 

This means that a very large number of balance sheets of 
similar companies are necessary in order to obtain dependable 
averages for each geographical section. Procuring such a 
large number of balance sheets is a difficult task unless handled 
by an association or governmental body. 

Great difficulties are faced by individuals in attempting to 
gather such balance sheets. It is observed that J. H. Bliss, 
author of "Financial and Operating Ratios in Management," 
was able to procure for analysis the balance sheets of less than 
250 companies. These were distributed over more than 40 
different lines of business with the result that some of the 
lines of business were so small as to include only one, two or 
three companies. 

His largest group of companies whose figures were avail- 
able for determining the ratio of sales to inventory was 12 

an entirely inadequate number of instances to serve as the 
basis for determining a mode for a standard ratio. Bliss did 
not attempt to follow Wall's example of accumulating his 
averages geographically. Had he done so the resulting groups 
would have been even more scanty. 

A large number of balance sheets are necessary, but where 
such a large number are involved there is still another diffi- 
culty. 



Ch. 13] STANDARD RATIOS 143 

Factor of Business Mortality. Failure statistics show 
that the mortality among business concerns is very heavy. 

Figures have been published showing very small chances 
of life of more than 15 years among manufacturers, whole- 
salers and retailers. 

When it is also borne in mind that the average business 
life of a retailer, manufacturer, or wholesaler is somewhere 
between seven and seven and one-half years, it can be appre- 
ciated that any large number of balance sheets must include 
many concerns w r hose span of life is short. 

Size of Business Furthermore, most business concerns 
are small and not very successful. 

The 1919 statistics, as quoted by Lincoln in "Applied Busi- 
ness Finance," show that 79.6% of manufacturing concerns 
reported gross annual sales of less than $100,000. Moreover, 
nearly one-third of all industrial organizations in that same 
year showed deficits instead of profits. 

These facts put the user of standard ratios in a serious 
predicament. If he uses the balance sheets of successful 
concerns only, he will find the number so few, after dividing 
them geographically, that unreliable averages must result. 

On the other hand, if he is fortunate enough to secure a 
large number of balance sheets, he must face the fact that this 
number will include a heavy proportion of small or unsuccess- 
ful concerns. The resulting standard ratios must, therefore, 
be misleading if they are to be considered as "ideal." 

Accounting Classification. Furthermore, standard ac- 
counting classification throughout an industry is almost essen- 
tial before reliable standard ratios can be hoped for. 

Oftentimes two different companies will show different 
ratios due to the fact that their bookkeeping methods are dif- 
ferent, whereas, they might show almost identical ratios if 
their bookkeeping methods were uniform. 

Considerable work has been done to promote standard 



I 4 4 ANALYZING FINANCIAL STATEMENTS [Ch. 13 

accounting classification, particularly in such lines as the 
baking, biscuit and cracker business, face brick, paving brick, 
caskets, foundries, portland cement factories, chair factories, 
cotton finishers, electrical products, envelope makers, granite 
makers, ice manufacturers, knit goods manufacturers, laundries, 
lithographers, machine tool manufacturers, millwork, paint, 
paper, pottery, and stove manufacturers, tanners, toy makers, 
and wooden ware manufacturers. 

At the present time, however, the attitude of the Federal 
Trade Commission toward uniform accounting systems is 
somewhat unfavorable because of its belief that such uniform 
accounting systems lead to price fixing and elimination of 
competition, which is in restraint of trade. 

Importance o Recent Figures As the author firmly be- 
lieves that published standard ratios as given in certain books 
are almost valueless, no attempt has been made here to include 
lengthy tables showing such ratios. 

Most of the available figures are old, and standard ratios 
unless right up to date certainly are not safe guides, even 
assuming no other objections to them. 

This is quite clearly brought out by published facts. Ratios 
of sales to inventories of six automobile accessory manufac- 
turers, as reported by one author, dropped from 499% in 1918 
to 401% in 1920. 

Another startling illustration is that of 12 copper mining 
and smelting manufacturers, whose average ratio of sales to 
inventories dropped from 268% in 1920 to 85% in 1921. 

Any balance sheet analyst who would attempt to compare 
the 1921 ratio for any particular copper mining company with 
the 1920 average of 268% (assuming later figures not avail- 
able) would obtain an entirely misleading impression. 

Uniformity of Policies. The assumption underlying the 
standard ratio is that of uniformity of policy, method, pro- 
cedure and product within a given line of business, 



Ch. 13] STANDARD RATIOS 145 

Unfortunately the assumption is often untrue. Simply 
because two companies make automobiles is no indication of 
uniformity in certain factors that influence their ratios. One 
may manufacture a large part of its product. The other may 
buy standard parts and assemble them into finished cars. 

Since the first would require much more extensive plant, 
machinery and equipment than the other, is it reasonable to 
assume that their ratios of sales to fixed assets would be 
comparable? 

One, like the Ford Motor Company, might sell for cash. 
Another might have the cash basis as its ideal but actually sell 
on long terms. 

Would it be fair to consider that their ratios of sales to 
receivables ought to be nearly alike ? 

One might be financed entirely through stock widely dis- 
tributed. The other might be directly financed to a limited 
extent by a few men of ample means who would prefer to 
finance the remainder of all capital required by lending their 
credit through their endorsement of the company's notes to the 
bank. 

Would the ratios of net worth to fixed assets and to total 
liabilities for the two companies be the same? 

Similarly with other factors which influence ratios. It 
often happens that companies that seem to be alike are really 
very dissimilar. 

Elements of Value in Standard Ratios* But the standard 
ratio idea cannot be entirely condemned. It has elements of 
value under very special circumstances. 

FOR THE PUBLIC ACCOUNTANT. Thus the public account- 
ant who serves a number of clients in the same general industry 
can perform a helpful service to them all by using this standard 
ratio idea. 

He can use it effectively because of his intimate familiarity 



I4 6 ANALYZING FINANCIAL STATEMENTS [Ch. 13 

with the accounting records and the policies of each company. 
His information in regard to each is so detailed that differ- 
ences between the balance sheet ratios of the various com- 
panies can be reconciled. 

The public accountant's knowledge of the peculiar condi- 
tion under which each operates will enable him to make a 
shrewd comparative analysis as the basis for constructive 
suggestions of inestimable value to each client. 

And this may be done without divulging any information 
having a competitive bearing. 

The public accountant will ordinarily figure the ratios of 
each such plant separately and since they will usually be few 
in number, he need not average the results. 

Preferably, he will list the similar ratios for the various 
clients in their proper order from low to high, and then 
through his detailed knowledge of the circumstances of each 
will satisfy himself as to the causes underlying the very low or 
very high ratios. 

FOR THE COMPTROLLER. The comptroller of a corpora- 
tion, or any of its general executives, may attempt much the 
same plan, except that it is usually necessary to secure the 
balance sheets of competitors from financial manuals, such as 
Moody's, or from other sources. 

The keen analyst will secure a surprising amount of val- 
uable information through such comparative study. His knowl- 
edge of his own business and of the policies of his competitors 
will enable him to explain or reconcile many peculiarities of 
the balance sheets. 

No formal system of analyzing the facts need be followed 
by one making such an analysis. His inspection of the various 
balance sheets will alone give much information. His figuring 
of ratios may not be on a formal statistical basis. In fact, the 
procedure will probably be quite different from that required 
to determine nation-wide standard ratios for an entire industry. 



Ch. 13] STANDARD RATIOS 147 

Summary o Important Factors. In conclusion it seems 
clear that the "standard ratio" is not feasible except under an 
unusual combination of conditions where : 

1. A large number of balance sheets taken at the same time 

of year are available. 

2. The corporations furnishing the balance sheets are finan- 

cially sound. 

3. The corporations operate under similar geographic con- 

ditions. 

4. The balance sheets are of recent date, 

5. The deviations of the individual ratios from the average 

ratio are not too great. 

6. Accounting methods throughout the industry are sub- 

stantially uniform. 

7. The business policies which influence ratios are substan- 

tially uniform. 

8. The products manufactured and sold are substantially 

similar. 

This combination occurs so rarely as to deserve little 
consideration. 

The chief, if not the only value, of the standard ratios lies 
in the fact that they represent starting points for further 
investigation. 

Unfortunately the average individual analyst has no oppor- 
tunities to make such further investigations. 

Thus, the prospective investor contemplating the purchase 
of stock in the Texas Company might observe that its 1921 
ratio of sales to inventory was 137%. 

He might compare this with the 1921 ratios of other oil 
companies as published by one author : 

Texas Oil Company 137% 

Associated Oil Company 627 

California Petroletun Company 2 , 88 1 

Tide Water Oil Company. 293 

Union Oil Company of California 261 

Pure Oil Company 557 

Average 252% 



148 ANALYZING FINANCIAL STATEMENTS [Ch. 13 

The average is evidently a weighted average, since it is not 
a mode and since the arithmetic average is 792%. 

After the prospective investor has compared the ratio of 
137% with the others and with the average, he is at a stand- 
still. He would like to use the figures as a basis for further 
investigation but has -no facilities for doing so; no opportu- 
nities for access to the detailed figures which form the basis of 
the several ratios; no right to inquire into the causes that 
result in the wide deviations. 

The credit man is in about the same position interested 
but often powerless to press the searching questions which 
might shed light on the differences between these oil companies. 

If the analyst were an executive of the Texas Company or 
its consulting auditor, he might be able to go further in recon- 
ciliation, because of knowledge of various petroleum trade 
practices, marketing and collection policies, etc. 

As already said, to such an analyst the standard ratic 
represents a starting point for further investigation and a 
challenge to his analytical ability. 

But the great majority of analysts would find their com- 
parison with the standard ratio an unsatisfactory finishing 
point rather than a starting point. 

Ideal vs. Standard Ratios. A suggestion has been made 
by some who admit that reliable average ratios are difficult, if 
not impossible to obtain. 

This suggestion has to do with the possibility of securing 
"ideal" ratios. 

These would not be averages of ratios of good, bad and 
indifferent companies, imperfectly grouped because of insuffi- 
cient investigation. 

Rather "ideal" ratios would result from a thorough scien- 
tific study of the most efficient companies in a given group, 
taking into consideration variations in at least the following 
items : 



Ch. 13] STANDARD RATIOS 149 

1. Geographical location. 

2. Products sold. 

3. Methods of marketing. 

4. Terms of sale. 

5. Collection policies. 

6. Manufacturing policies. 

7. General financial policies, etc. 

8. The business cycle. 

Each has its effect on one or more of the common ratios. 
A careful weighing of these factors in connection with such 
a research would be a great stride forward in the hunt for the 
4 'ideal" industry ratio. 

As far as is now known, no attempt has been or is being 
made to carry on such a research. It may be an impossible 
task. Certainly it would be a costly one, since it would require 
patient examination into the affairs of each company. 

It would involve much more than the securing of balance 
sheets from published sources, such as Moody's Manuals, the 
clerical compilation of ratios and their averaging in a purely 
mechanical way, proceeding on the assumption that the com- 
panies are alike in policies, methods and products simply 
because they are engaged in what superficially appears to be 
the same "line of business/' 



CHAPTER XIV 

CONCLUSIONS AS TO ANALYSIS TECHNIQUE 

Summary of Analysis Methods. The following methods 
of balance sheet analysis have been discussed in previous 
chapters : 

A. Single balance sheets : 

1. General ratios (Chapter IV). 

2. Arbitrarily scaling down balance sheet values 

(Chapter IV). 

3. Danger signals (Chapter IV) : 

a. Small amount of cash. 

b. Improper combinations of balance sheet items. 

c. Heavy notes receivable counter to trade prac- 

tice. 

d. Large intangible assets particularly when there 

is no surplus. 

4. Standard ratios (Chapter XIII). 

B. Two or more balance sheets: 

1. General ratios (Chapter V). 

2. Increase and decrease calculations (Chapter V). 

a. Application of funds. 

3. Percentages using total assets as 100% (Chapter 

V). 

4. Ratios directed toward specific business ailments 

(Chapters VI, VII, VIII, and IX). 

5. Trend percentage method for showing trends toward 

specific business ailments (Chapters XI and XII). 

6. Standard ratios (Chapter XIII). 

Since some of these methods are better than others, it 
seems appropriate to furnish a list or schedule representing 
recommended steps in analyzing (i) a single balance sheet, 
and (2) two or more balance sheets of the same company. 

150 



Ch. 14] CONCLUSIONS AS TO ANALYSIS TECHNIQUE 151 

Analysis Program pr One Balance Sheet For the single 

balance sheet, the following will usually be found sufficient : 

1. Calculate the ratios: 

a. Acid test. 

b. Current ratio. 

c. Ratio of sales to receivables (if sales figures are 

available). 

d. Ratio of sales to inventory (if sales figures are 

available). 

2. Check for danger signals : 

a. Disproportionately small amount of cash. 

b. Improper combination of balance sheet items. 

c. Disproportionately large amount of notes receivable 

counter to trade custom. 

d. Disproportionately large intangible assets, particu- 

larly when there is no surplus. 

3. Scrutiny of the balance sheet in order to insure common- 

sense conclusions. 

Analysis Program for Two or More Balance Sheets. For 

two or more balance sheets of the same company the following 
is the line of analysis to be followed : 

1. Calculate the trend percentages for: 

a. Receivables. 

b. Quick assets. 

c. Inventories. 

d. Current assets. 

e. Fixed assets. 

f . Current liabilities. 

g. Long-time liabilities. 
h. Total liabilities. 

i. Net worth (or capital stock and surplus separately). 

2. Study the trend percentages for trends toward : 

a. Over-investment in receivables. 

b. Over-investment in inventory. 

c. Over-investment in fixed assets. 

d. Insufficient capitalization. 



152 ANALYZING FINANCIAL STATEMENTS [Ch. 14 

3. For the latest balance sheet of the series: 

a. Calculate the "acid test" ratio. 
b* Calculate the current ratio. 
c. Check for the four danger signals. 
d Determine whether unfavorable trends have reached 
a danger point. 

4. Scrutinize the balance sheets in order to insure common- 

sense conclusions. 

Discussion o Analysis Programs. It should be observed 
that these two schedules, covering the single balance sheet and 
two or more balance sheets, are designed to fit the usual 
analytical requirements. They represent the bare essentials 
of complete balance sheet analysis, and for unusual cases addi- 
tional ratio, trend, or other studies may be made. 

Special circumstances justify elasticity in the analysis pro- 
cedure. Unusual types of business may call for resourceful- 
ness in devising methods of interpreting statements. 

Also the analyst will always be eager to employ all available 
information to test his conclusions. Thus where a company's 
stock is listed on a stock exchange, a comparison of its quoted 
prices with the book value of shares as shown by the balance 
sheets, is often illuminating, not only to prospective investors 
but also to other classes of analysts. 

Special importance should attach to the last item in each 
of these "analysis programs/' 

What may be termed the "common-sense scrutiny " should 
be the last step not the first as so often occurs. 

It should be the last step because the previous steps often 
bring out certain trends toward common business ailments. 

It is after those trends have been observed that a deliberate 
general scrutiny of the statement or statements is of real value 
in insuring that common sense is back of the conclusions. 

The Checking List The conclusions finally reached may 
profitably be put in written form as answers to the following 



Ch. 14] CONCLUSIONS AS TO ANALYSIS TECHNIQUE 153 

questions (and in offices where a great many statements are 
analyzed a checking list based on these questions may well be 
employed) : 

1. Is there any dangerous tendency toward: 

a. Over-investment in receivables? 

b. Over-investment in inventory? 

c. Over-investment in fixed assets? 

d. Insufficient capital ? 

2. Is the present position, as evidenced by the acid test, 

current ratio and other ratios, satisfactory? 

3. Are any of the four danger signals present.' 



CHAPTER XV 
PROFIT AND LOSS ANALYSIS 

Changing Conditions in Relation to Profit and Loss 
Analysis. While a great deal has been published at different 
times on the subject of balance sheet analysis, little if anything 
has been written about analyzing profit and loss statements. 

There is an excellent reason for this. 

Until recently books and articles dealing with analysis of 
financial statements have approached the subject purely from 
the viewpoint of the credit man, engaged in either commercial 
or bank credit work, and, generally speaking, credit men have 
been able to secure from their customers only balance sheets. 
Profit and loss figures have been considered by -business men 
entirely too confidential for even limited distribution. 

Since the balance sheet has usually been the only financial 
statement available to credit men, authors have concentrated 
their attention on balance sheet analysis. 

Profit and loss statements are difficult to obtain. Only 
too rarely have they been completely published in the past. 

Conditions are changing and business men are realizing 
more and more that publicity given to their profit and loss 
statements, either through commercial agencies or direct to 
their creditors will seldom prove harmful. 

Another reason why so little has been written on the sub- 
ject is that much analysis work is from the internal viewpoint. 

Within each corporation there is some major executive 
who makes it his task to study carefully his company's own 
profit and loss figures. Such work is of the most fundamental 
and far reaching significance in business administration and 
forms an important basis for increasing profits. 

Such an executive is able to make a complete investigation 



Ch. 15] PROFIT AND LOSS ANALYSIS 155 

in connection with every questionable item he discovers, since 
he has access to all the supplementary and subsidiary records 
from which the statement was built. 

The public accountant in serving his client possesses this 
same advantage. 

Need for Method of Analysis But there are many others 
who are called upon to analyze profit and loss statements 
without having the privilege of detailed investigation in con- 
nection with particular items upon which they desire further 
information. 

To meet such needs, a distinct method or technique of 
analysis should be available. Such a technique has been estab- 
lished for balance sheet analysis and the present purpose is to 
outline similar plans and methods for diagnosing the profit and 
loss statement. 

These methods can well be used by the executive, even 
though he does have access to the detailed figures, in his pre- 
liminary analysis of the periodical statements, as a means for 
localizing unfavorable symptoms. Also, they may be used by 
the public accountant for the same purpose. 

But these methods are of even more vital importance to 
credit men, bankers, and investors. 

Purpose of Analysis. Therefore, the present question is 
how to make a general analysis of profit and loss statements 
for the purpose of diagnosing symptoms rather than for the 
purpose of a complete investigation to determine remedies for 
unfavorable symptoms. 

The fundamental structure of a profit and loss statement 
is simplicity itself, since it conforms to the following formula ; 

TOTAL INCOME 

less 
TOTAL COSTS 

equals 
NET PROFIT 



156 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

More Detailed Classification. The actual structure of a 
profit and loss statement must be somewhat more elaborate for 
several reasons. 

In the first place income is of two kinds : ( i) Operating in- 
come and (2) non-operating income, such as interest from in- 
vestments, rent from non-operating properties, etc. 

Secondly the costs are commonly of three general kinds : 

1. Direct costs of furnishing the service or of manufacturing 

or buying the merchandise sold. 

2. Operating expenses necessitated thereby. 

3. Non-operating expenses. 

Therefore, the general structure of most profit and loss 
statements closely conforms to the following formula: 

OPERATING INCOME 

less 
COST OF SERVICE RENDERED OR OF GOODS SOLD 

equals 
GROSS TRADING PROFIT 

less 
OPERATING EXPENSE (usually highly classified) 

equals 
NET OPERATING PROFIT 

plus 
NON-OPERATING (or other) INCOME 

less 
NON-OPERATING (or other) EXPENSE 

equals 
NET PROFIT 

The important factors in this formula are (i) the oper- 
ating income, (2) the cost of goods (or services) sold, and 
(3) the operating expenses. The combination of the first two 
results in the significant figure of gross profit or gross trading 
profit, and the combination of the three results in the significant 
figure of net operating profit. 

Usually, but not always, the non-operating items are in- 
significant from the analyst's viewpoint. The first three men- 
tioned are the ones of primary importance. 



Ch. 15] PROFIT AND LOSS ANALYSIS 157 

Illustrative Figures For the purpose of having definite 
figures to illustrate the various points involved, the balance 
sheets and profit and loss statements for a trading organiza- 
tion, which, for the purpose of making the illustration specific, 
may be called Andrews and Company, are shown here : 

ANDREWS AND COMPANY 

COMPARATIVE BALANCE SHEET 

As of December 31 

Assets 1917 1918 1919 1920 

Quick Assets $ 24 , 414 $ 32 , 063 $ 38 , 509 $ 42 , 326 

Inventories 79 , 891 93 , 817 94 , 756 97 , 622 

Fixed Assets 46,720 45*352 43,79* 42,802 

Total $151,025 $171,232 $I77<>56 $1^2,750 

Liabilities and Capital 

Current Liabilities $ 38,045 $ 52,927 $ 50,952 $ 75,483 

Net Worth 112,980 118,305 126,104 107,267 

Total $151,025 $171,232 $177,056 $182,750 

Sales (Net) ' $140, 161 $194,324 $273,040 $286,445 



ANDREWS AND COMPANY 

COMPARATIVE TRADING AND PROFIT AND Loss STATEMENT 
Years Ended December 31 

1917 1918 1919 1920 

Gross Sales $141 ,479 $196,028 $279,229 $288,757 

Less: Goods Returned j ,318 1 , 704 6,189 2,312 

Net Sales $140,161 $194,324 $273,040 $286,445 

COST OF GOODS SOLD: 

Inventory Beginning $ 72,991 $ 79*891 $ 938i7 $ 94*756 

Purchases 114.293 165,987 209,536 260,642 

Freight on Purchases i>357 1,674 2,358 2,629 

$188,641 $247,552 $305,711 $358,027 

Less; Inventory End 79*891 93,817 94,756 97*621 

Cost of Goods Sold $108,750 $153*735 $210, 955 $260,406 

Gross Profit $31,411 $ 40*589 $ 62,085 $ 26,039 



I 5 8 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

OPERATING EXPENSES: 
Store Expense: 

Salaries -Dept. Managers ..$ 4, TOO $ 5,656 $14,700 $13,646 

SalariesSalesmen 5 , 820 6 , 369 10 , 043 12,012 

Light and Power 203 133 187 187 

Insurance 457 962 7$5 77i 

Luxury Tax 122 166 

State Income Tax 643 958 1,113 

City Tax 1,900 1,405 1,634 2,104 

Fuel . 3 2 3 240 352 286 

Depreciation i ,482 i ,484 i ,484 i ,493 

Repairs 83 23 8 311 

General Store Expense 153 93 135 n? 

Paper and Twine . . . 117 220 355 230 

Total... 15,881 $ 17,51-3 $ 30 9*8 $ 31*323 



General and Administrative 

Expense: 

Telephone and Telegraph . . $ 31 $ 61 $ 51 $ 64 

Printing and Stationery .... 247 132 106 155 

Charity and Donations 25 

Subscriptions and Dues ... 22 62 64 144 

Legal and Auditing 129 

Advertising 511 480 697 784 

Traveling Expense 37 33 86 75 

Bad Debts 197 648 5 70 



Total $ 1,174 $ 1,416 $ i , 009 $ 1,317 

Total Operating Expense . $ 17,055 $ 18,9.59 $ 31,927 $32 . 640 
Net Operating Profit (or 

Loss*) $ 14,356 $ 21,630 $ 30,158 $ 6,601* 

OTHER INCOME: 

Rent Earned 225 225 225 225 

$ 14 , 581 $ 21,855 $ 3Q , 383 $ 6,376* 
OTHER EXPENSES: 

Interest Paid $ 2,054 I 2,846 $ 2,911 $3,765 

Soldier's andEducationalBonus 

Surtax 936 

Capital Stock Tax 108 95 1 13 

$ 2,054 $ 2,954 $ 3,942 $ 3,878 

Net Profit or Loss* $ 12,527 $ 18,901 $ 26,441 $10 , 254* 



Ch. 15] PROFIT AND LOSS ANALYSIS 159 

Analysis of the Balance Sheets. Since there always exist 
important relationships between balance sheets and profit and 
loss statements, it is interesting and instructive to make a brief 
survey of the balance sheet before starting on the profit and 
loss figures. 

ANDREWS AND COMPANY 

ANALYSIS OF COMPARATIVE BALANCE SHEET 

As of December 31 

(Based on percentages of 1917 figures) 

1918 1919 1920 

1917 Percentage Percentage Percentage 

Amount of 1917 of 1917 of 1917 

Quick Assets $ 24,414 131 158 173 

Inventories 79 ,891 117 119 122 

Fixed Assets 46,720 98 94 92 

Total $151,025 

Current Liabilities $38,045 139 134 198 

Net Worth. 112,980 105 112 95 

Total $151,025 

Sales $140, 161 138 195 204 

Without attempting a complete diagnosis of the balance 
sheet, it is sufficient to note that the outstanding features are 
the heavy increase in quick assets, the heavier increase in cur- 
rent liabilities, and an indication of insufficient capitalization. 

It is quite evident that in 1920 Andrews and Company 
was in a less favorable balance sheet position than in 1917, or 
in either of the two years intervening. With this picture of 
conditions clearly in mind, the analysis of the profit and loss 
statement may proceed. 

First Step in Profit and Loss Analysis. The first step is 
to determine the sufficiency of the net profits, i.e., the relation 
of the net profits to the net worth of the company. 

For this purpose either the net worth at the beginning of 
each year or the average of the beginning and ending net 
worths should be used. Both methods are shown here. 



Year 


Year 


Net Worth 


or (*) Deficit 


of Year 


1917... 








$12,527 





1918... 


. $112,980 


$115,642 


18,901 


17 


1919... 


. 118,305 


122,204 


26,441 


22 


1920... 


126,104 


116,685 


10,254* 






160 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

Net Worth Percentages 

Beginning of Average Net Profits on First Net Worth 

Average 

16 

22 



It is difficult to state what represents a sufficient profit. 
Few, if any, business men would ever admit that they were 
making a sufficient profit. 

As to what constitutes an insufficient profit there is also 
uncertainty. Surely the profit from an enterprise should be in 
excess of current interest rates on high-class investments, as 
otherwise the stockholders would be better off if their money 
were withdrawn and put into bonds or commercial paper. 

Insufficient Profits. But current interest rates certainly 
represent the very minimum that profits should reach. 

In a speculative business they should be substantially in 
excess of the average return on good bonds in order to com- 
pensate stockholders for the risks they assumed in investing. 
There is no reliable guide as to what represents a reasonable 
return on a business venture, but it probably lies somewhere 
between 10% and 15% of the net worth of the business. Prof- 
its between 6% and 10% may be considered unsatisfactory, 
while profits below 6% may be considered insufficient. 

These rather arbitrary figures require some modification in 
any given instance, based upon the hazards of the enterprise. 
Other things being equal, the more risk there is involved, the 
greater should be the minimum percentage of net profit 
returns. 

If these figures are accepted as substantially correct, then 
Andrews and Company showed satisfactory profits until 1920. 

The next step is to determine the reason for the bad profit 
showing in 1920. 



Ch. 15] PROFIT AND LOSS ANALYSIS 161 

Summarizing the Profit and Loss Statement, The profit 
and loss statement as above given is entirely too detailed for 
the next step in analysis. 

The next step is to determine which of the three basic 
divisions of the profit and loss statement is responsible for the 
insufficient profit. 

This leads directly into the fundamental theory of net 
profit. 

In a trading business, net profit conies from buying goods 
at one price and selling them at a price sufficiently greater to 
provide a margin which will more than absorb all the oper- 
ating expenses of the business. 

This means, as already set forth, that there are really three 
important factors to be watched in connection with profit and 
loss analysis : 

1. Income from operations or net sales. 

2. Costs of goods sold. 

3. Operating expenses. 

Locating Losses. The cause of a loss may be found in any 
of these three divisions. Even if merchandise is purchased at 
the right price and expense is kept at a reasonable amount, a 
net profit may be turned into a net loss by a failure to sell 
goods at a sufficiently high price. 

Or on the other hand, the sales price may be right, operat- 
ing expenses may be normal, and a loss be traceable to unwise 
purchases. 

Even more commonly, the difficulty may be charged against 
the operating expense classification. This means that goods 
may be bought right and sold right, and still a net lost occur 
because the operating expenses are larger than the gross profit. 

Analysis of Expense. This often comes about because 
many items composing operating expense are in the nature of 
charges which do not fluctuate in direct proportion to the 
volume of sales. 



1 62 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

In the Andrews and Company statement a number of items 
fall into this class. Consider light and power, which in 1917 
amounted to $202.68 and in 1920 to $187.35, in spite of the 
fact that the volume of business was more than doubled. 

This is also true in connection with fuel, an item which 
actually decreased over the four years' period in spite of the 
increase in the volume of business. 

Depreciation was practically a fixed quantity during those 
years. 

Examples of such expense items from other businesses are : 

Rent Taxes 

Bond interest Executives 7 salaries, etc. 

Such expenses must be met if a company is to keep in busi- 
ness, and they go on just about the same month after month 
and year after year regardless (or practically so) of the volume 
of business which is being performed. The aggregate of such 
items represents almost an inflexible quantity a fixed charge 
which cannot be reduced readily to fit a decreasing volume of 
business. 

Other Classes of Expense. There are other expenses 
which are partially fixed and which vary but slightly with in- 
creases or decreases in the amount of sales. The cost of that 
insurance which represents protection of merchandise has 
ordinarily some fairly definite relationship to sales volume. 

Items such as paper and twine have a relationship to sales 
as do telephone and telegraph; also traveling expense under 
usual circumstances, although this does not appear to be true 
in the Andrews and Company statement. 

Finally, there are expense items, such as salaries of sales- 
men, which one would naturally expect to increase or decrease 
in rather close relationship to sales volume, although they are 
easier to increase than to decrease unless a strict commission 
basis of compensation is followed. 



Ch. 15] PROFIT AND LOSS ANALYSIS 163 

Danger in Operating Expense. In operating expense, 
therefore, usually lies the greatest menace to net profit. 

It Js the inflexibility of many of the operating expense 
items which forces sales volume. There is always a certain 
minimum of sales volume absolutely necessary in order that 
the resulting gross profit be as great as the operating expense. 

Since, generally speaking, operating expenses should not 
increase as rapidly as sales volume, it is usually thought by ex- 
ecutives that the answer to the problem of insufficient profit lies 
in increasing sales. While this is oiten one of the solutions of 
the net profit problem, it is not the only solution. 

Trading vs. Manufacturing The foregoing discussion 
refers to trading enterprises only. 

With reference to manufacturing, there are certain fixed 
charges due to manufacturing overhead expense, which form 
a large part of the cost of goods sold. Naturally in a trading 
business where all merchandise is purchased in finished form, 
this factor of . manufacturing overhead does not complicate 
the situation. 

Usual Percentage Analysis. The analysis ordinarily 
made of a profit and loss statement is to determine the per- 
centage each item for each year bears to the net sales of that 
year. This is not to be confused with the trend percentage 
method. 

ANDREWS AND COM PAN Y 

COMPARATIVE TRADING AND PROFIT AND Loss STATEMENT 
For the Years Ended December 31 

1917 1918 1919 1020 

Amount % Amount % Amount % Amount % 

Net Sales $140,161 100 1194,324 100 $273,040 100 $286,445 100 

Cost of Goods Sold 108,750 77 153.735 79 210, 955 77 260.406 __9_i 

Gross Profit $31,411 22 $40,589 21 $62.085 23 $26,039 o 

Operating Expense I7.Q55 J i8,9S9 _io^ 31.927 _*2_ 32,640 n 

Net Operating Profit (or 

Loss*) $ 14.356 i< $ 21.630 n $ 30.158 n $ 6.601* 



164 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

On the face of it the situation of Andrews and Company 
requires serious and prompt attention. The 1920 figures show 
$140,000 increase in sales over 1917, while the net profit de- 
creased $20,000. Obviously something is wrong with 'their 
affairs. This kind of a percentage analysis seems to show that 
the trouble lies entirely in the increase in cost of goods sold, 
which was raised from 77% of sales in 1917 to 91% of sales 
in 1920. 

Principle Underlying This Method. The principle under- 
lying this method of analysis seems to be based on the thought 
that if cost of goods sold and operating expenses aggregated 
less than 100% of sales and remained at the same constant per- 
centage relation to sales from year to year, it would be im- 
possible to show a net operating loss, regardless of fluctua- 
tions in sales volume. And that if a net loss or undue decrease 
in profit appears, it is due to one or both of these elements 
getting out of such proper proportion to sales. And the next 
"logical step" appears to be to figure the percentages and find 
which item has gotten out of proportion. 

Based on this reasoning the trouble in the case of Andrews 
and Company seems to be all chargeable against cost of goods 
sold, since the operating expense percentages have remained 
about the same, being 11% for 1920 as compared -with 12% 
in 1917. 

This type of percentage calculation usually represents the 
beginning and the end of profit and loss analysis. Seldom, if 
ever, does the analysis go any further than such a mere deter- 
mination of percentages of the various items composing the 
profit and loss statement for each year, using sales of that 
year as 100%. 

Advantages and Disadvantages of the Method. There is 

nothing improper about the method. It is indeed quite useful 
when properly interpreted. 

There should be a direct percentage relationship between 



Ch. 15] PROFIT AND LOSS ANALYSIS 165 

sales, cost of goods sold and gross profit that part of the above 
percentage statement can be considered good practice in the 
analysis of any trading business. 

It will be observed that, for analysis purposes, the figures 
have only been carried down to net operating profit or loss and 
that the items of other income and other expense have not been 
taken into consideration. Had these items been of real im- 
portance, they should, of course, have been included. 

Wrong Impressions Where this analysis fails is in con- 
nection with operating expense. 

The operating expense percentage for 1917 is 12% and for 
1920 11%. This gives the impression that the cause of the 
dwindling profits did not lie even in part in this item. Super- 
ficially the operating expense seems entirely reasonable. If any- 
thing, improvement appears to have been shown. 

As a matter of fact, there is but little logical relationship 
between operating expense and net sales in the average busi- 
ness. It has already been mentioned that a goodly portion of 
the operating expense usually consists of non-fluctuating items 
which change but little from year to year in direct relationship 
to the volume of business. To express such operating expenses 
as percentages of net sales is to deny this well-known fact. 

A desirable method of analysis should bring sharply to 
attention all unfavorable factors rather than conceal any of 
them through illogical percentage relationships. 

Standard Profit and Loss Ratios. With this brief survey 
of the fault of this common type of percentage analysis, the 
next method is submitted. 

In previous chapters standard balance sheet ratios were 
discussed. 

If standard balance sheet ratios could be obtained, it should 
be possible to obtain equally good standard ratios for profit 
and loss statements, and some attempts have been made to do 



166 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

so. The difficulty of obtaining profit and loss ratios is much 
greater than in the case of balance sheet ratios, since fewer 
companies publish profit and loss figures. 

It appears that standard profit and loss ratios are almost 
an unattainable ideal, although in some instances it is possible 
to obtain through the financial manuals or other sources, re- 
ports which show sufficiently detailed profit and loss state- 
ments of other companies in the same line of business to enable 
an executive to make a fairly intelligent comparison of his own 
figures with those of his competitors. 

In spite of the difficulties in the way of obtaining profit 
and loss ratios, it is nevertheless theoretically true that for 
every line of business there exists certain normal profit and 
loss ratios. These are influenced by the type of business, busi- 
ness policies, geographical location and the size of the 
enterprise. 

Averaging the Statements A fairly good picture of the 
normal ratios for one particular business often can be obtained 
by combining statements for several years and then calculating 
the percentages. 

If the individual percentages do not deviate too greatly 
from the averages thus calculated, and if the percentages of 
such a combined statement can be considered reasonably 
normal, these normal percentages can then be applied to the 
net sales of any single year and an "ideal" profit and loss state- 
ment constructed therefrom. This can then be compared with 
the actual figures for that year. 

The results of such an analysis for Andrews and Company 
are shown herewith : 

This method of analysis is not impractical. When properly 
used under correct conditions by a chief executive, or public 
accountant, such an analysis often forms the basis for remedy- 
ing improper conditions. But as a general tool of statement 
analysis it finds no place. 



Ch. 15] PROFIT AND LOSS ANALYSIS 167 

ANDREWS AND COMPANY 
ANALYSIS OF COMPARATIVE PROFIT AND Loss STATEMENT 

(Metnod involving average of three previous years as 
basis for standard percentage figures to be applied to 
sales of a later year, resulting in a fictitious " ideal 
statement" for comparison with actual statement of 
the later year.) 



Net Sales 


Obtained by Increase 
Composite of 3 Applying Average Actual or 
Previous Years % to 1920 Sales 1920 ^Decrease 
$607 525 100% $286 445 100% $286 445 


Cost of Goods Sold. . , , 


. . . 473,440 78 223,427 78 260,406 $36,979 


Gross Profit 
Operating Expense . . . 


$134,085 22 $ 63,018 22 $ 26,039 *$36,975> 
, . . 67,941 ii 31,509 ii 32,640 1,131 



Net Operating Profit (or *Loss) $ 66,144 " $ 3L5Q9 it *S 6.601 *$3S,iio 

Following are a few important objections to its use. 

1. It is difficult to explain to the non-technical business man 

who is inclined to resent, as "theoretical/' the arti- 
ficial figures created by the averaging process. 

2. It involves the untrue assumption that there exists an 

important relationship between net sales and operating 
expense which may lead to unsound conclusions. 

3. Only in a fairly stable business will a series of individual 

profit and loss percentages be found which will not 
deviate too greatly from their average to be used as a 
reasonable standard. 

These various serious objections render this method of 
analysis an impractical, if not a dangerous tool, except under 
the special circumstances already stated. 

This analysis brings out very distinctly one cause of the 
lost profits in 1920. 

It clearly indicates that if the percentage of costs of goods 
sold to net sales had been the same in 1920 as prevailed in the 
other three years, the company would have made a profit of 
$31,200 instead of suffering a loss of $6,60 1. 

In other words, the difference between what actually hap- 
pened and what should have happened based on past per- 



1 68 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

centages is $37,801, of which $37,266 represents an excess in 
cost of goods sold. 

The Trend Method. The next procedure is to apply the 
trend percentage method of analysis to the Andrews and Com- 
pany statement. 

Each one of the three major elements of the 1917 state- 
ment may be considered as 100% and the figures of the succeed- 
ing years may be converted into percentages of the 1917 
figures. 

ANDREWS AND COMPANY 

ANALYSIS OF COMPARATIVE PROFIT AND Loss STATEMENT 
Years Ended December 31 

(Trend percentage method ) 

1917 1918 1919 1920 

1917 % of Percentage Percentage Percentage 

Amount 1917 of 1917 of 1917 of 1917 

Net Sales $140,161 100 139 195 204 

Cost of Goods Sold 108,750 100 141 194 239 

Gross Profit. ... $ 31,411 

Operating Expense. .. 17,055 100 in 187 191 

Net Profit (or *Loss) $ 14, 3 56 

This method is valuable because it brings out vividly the 
variations in operating expense as compared to* variations in 
the other two factors. 

It develops by mere inspection alone the interesting fact 
that operating expenses increased to 111% in 1918 and to 187% 
in 1919. In other words, the operating expenses for the year 
1919 increased at a faster rate than the sales volume, which 
increased from 138% to 195%. 

This a very important point and one which the previous 
methods of analysis did not clearly set forth. (The expense 
percentages based on net sales were 10% in 1918 and 12% 
in 1919.) Attention is immediately directed to the operating 
expense section of the 1918 and 1919 statements, where it is 
seen that the total operating expense increased from $18,959 
in 1918 to $31,927 in 1919, an increase of $12,968. 



Ch. 15] PROFIT AND LOSS ANALYSIS 169 

Analyzing Operating Expense Detail. Usually this is as 
far as the analyst can proceed, because published profit and loss 
statements seldom furnish the detail of items composing oper- 
ating expense. 

But if such details are available, the next step is to narrow 
the investigation to the particular item or items responsible for 
the unfortunate showing. This additional investigation is 
fully set forth for completeness, in spite of the fact that obvious 
conclusions could be drawn from mere inspection of Andrews 
and Company operating expense details. 

Each set of group totals within the operating expense sec- 
tion and the more important items composing each such group 
should be analyzed for trends in order to locate the difficulty 
as specifically as possible. Unlike the profit and loss state- 
ment of Andrews and Company, which only shows two 
divisions of operating expense, many statements show a num- 
ber of such groups of items. The method to be followed is 
the same regardless of the number of such groups. 

ANDREWS AND COMPANY 

ANALYSIS OF OPERATING EXPENSE 

Years Ended December 31 

(Trend method.) 

1917 1918 1919 1920 

1917 % of Percentage Percentage Percentage 

Amount 1917 of 1917 of 1917 of 1917 
STORE EXPENSE: 
Salaries Dept. 

Managers $ 4,700 100 120 313 290 

Salaries Salesmen. 5,820 100 109 173 206 

Other Items 5,361 100 103 115 106 

Total & 15,881 loo in 195 197 

GENERAL AND ADMIN- 
ISTRATIVE EXPENSE: 

Advertising $ 511 100 94 136 153 

Other Items 663 100 141 47 83 

Total $ i, 17 \ loo 120 87 112 

Net Sales $140, 161 100 138 195 204 



170 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

Interpretation o Statement. The smallness of the gen- 
eral and administrative expense renders its effect on net profit 
insignificant. But inspection of the trends of store expense 
and the items composing it, tells an important story. 

Considerable responsibility for the bad net profit showing 
evidently falls on the two salary items. 

Of the total increase of operating expense of $12,968, by 
far the greater part ($12,716) was due to an increase in the 
two items, salaries of department managers and salaries of 
salesmen. Had these salaries not been increased so sharply in 
1919 and remained practically constant thereafter, it is more 
than possible that 1920 would have shown some net profit in 
spite of the sharp shrinkage in gross profit for that year. 

Here is an important discovery which previous methods of 
analysis failed to indicate sharply. 

Classification. A survey of modern practice shows little 
uniformity in methods of classifying profit and loss state- 
ments, particularly in the division of operating expenses. 

Some corporations fully departmentalize all the operating 
expenses by assigning to departmental accounts all direct de- 
partmental charges and then prorating general charges to such 
departmental accounts. 

Other companies partially departmentalize their expenses, 
i.e., make direct charges to departmental accounts, but do not 
distribute the indirect charges to those accounts. 

Still other companies do not classify their expense accounts 
departmentally at all. 

The matter of expense classification is of particular impor- 
tance to the public accountant's analysis, for when it appears 
that the decrease in profits is due to the operating expense 
factor, he should make an investigation of the details compos- 
ing the operating expense total and endeavor to locate particu- 
lar items or departments responsible. 



Ch. 15] 



PROFIT AND LOSS ANALYSIS 



171 



Importance of Trends. The principal value of this method 
of analysis lies in the bird's-eye view it gives of the trends of 
factors influencing net profit. 

The same deductions could undoubtedly be drawn from a 
careful study of the actual figures themselves, but this is an 
operation which requires considerable time. Furthermore, 
there is ever present the danger of that detail viewpoint which 
someone has described as "not being able to see the forest on 
account of the trees." 

300 




1917 1918 1919 1920 

Figure 5. Trend Percentage Chart for the Profit and Loss Statements of 
Andrews and Company 

Charting Trend Percentages. The trend method of 
analysis can very well be charted. The chart in Figure 5 shows 
the trend percentages for Andrews and Company. 

The chart visualizes only the trends of the three factors of 
net sales, cost of goods sold, and expense, and as long as it is 
clearly understood that this is a percentage chart and a work- 
ing tool of the analyst, and not an attempt to portray actual 
figures for the layman, it is invaluable* 



172 



ANALYZING FINANCIAL STATEMENTS 



[Ch. 15 



It will be found worth while to compare this chart with 
the actual percentage figures themselves given in a previous 
table. 

In this chart it is the slope of the line which is significant. 

For 1919 it will readily be seen that the incline of the 
expense line is steeper than the line for sales. This is the 



400 




1917 
Figure 6. 



1918 



1919 



1920 



Trend Percentage Chart of Operating Expenses of 
Andrews and Company 



danger signal, since it shows that the expense has increased at 
a faster rate than the sales. The steepness of the slopes on 
such a chart show the rate of increase or decrease of the items. 
The "operating expense" line should not show a steeper up- 
ward slant than the "sales'* line. As a general proposition it 
should show much less of a slope either upward or downward. 



Ch. 15] PROFIT AND LOSS ANALYSIS 173 

Ordinarily it should not be fully responsive to changes in sales 
volume because it contains fixed and semi-fixed items. The 
expense line slope in 1918 and 1920 probably represents about 
a normal rate of increase in operating expense as compared 
to the rate of increase in sales. 

Also, the line representing the "cost of goods sold" should 
seldom show a steeper upward slant than the line for "net 
sales/' When this occurs, a dangerous trend is indicated. 

For those who desire to study the trend of the expense 
percentages in greater detail, the chart shown in Figure 6 has 
been prepared. Such a study as this is always valuable when 
expense as a factor w r hich seems to be responsible for a poor 
profit showing. 

Logarithmic Paper. For the benefit of those who have 
been accustomed to analyzing profit and loss figures on 
logarithmic paper, it might be well to explain that a chart of 
trend percentage is equivalent to a chart on logarithmic paper 
using the actual figures themselves. This is clearly demon- 
strated in Figure 7, where the slopes of corresponding lines on 
the two charts are identical. 

Logarithmic paper has been popular for years with some 
accountants for analyzing profit and loss figures. The only 
reason it is not in general use is because of the current mis- 
belief that charting on logarithmic paper requires a knowledge 
of advanced mathematics. This is not absolutely true. 

Logarithmic paper enables anyone to construct a trend 
percentage chart without having to figure the percentages, the 
ruling of the paper itself being so designed as to give the effect 
of a trend percentage chart by posting the actual figures 
themselves. 

Importance of Charting Trends. While the use of loga- 
rithmic paper is much quicker, the actual figuring of percentages 
according to the trend method is not a burdensome task, 
particularly if a slide rule is used, and the resulting chart is 



174 



ANALYZING FINANCIAL STATEMENTS [Ch. 15 






8 



8" 8 



8 

t-i 
SJBjjOQ 



S 




\i 







8 



8 

or) 



8 8 



s 



Ch. 15] PROFIT AND LOSS ANALYSIS 175 

clearer because all of the three lines start from exactly the 
same point, i.e., 100%. It is, therefore, easier to compare 
their slopes. 

This charting of the trend percentages is a very important 
part of the analysis. It may be done quite roughly and still be 
sufficiently accurate. 

It is important, particularly from the administrative view- 
point, because it shows vividly just when dangerous trends 
started which often fixes a basis for investigating conditions 
at that time in an attempt to find a remedy. 

Variation of Trend Method. The same purpose could be 
served by a variation of the trend percentage method which 
would consider each year (instead of only the first year) as a 
100% basis for figuring the percentages of the year following. 

The following calculation illustrates the method : 

1917 1918 1919 1920 

Actual Sales $140, 161 $194,324 $273 ,040 $286 ,445 

1918 sales -r- 1917 sales 100% 139% 

1919 sales -* 1918 sales 100% 141% 

1920 sales -s- 1919 sales 100% 105% 

Actual Cost of Goods Sold $ 108 , 750 $i 53 , 735 $210, 955 $260 , 406 

1918 C.G.S. -r 1917 C.G.S 100% 141% 

1919 C.G.S. * 1918 C.G.S - 100% 137% 

1920 C.G.S. -^ 1919 C.G.S 100% 123% 

Actual Operating Expense $ 17 ,055 $ 18 ,959 $ 31 ,927 $ 32 ,640 

1918 Exp. -i- 1917 Exp 100% 111% 

1919 Exp. -s- 1918 Exp 100% 168% 

1920 Exp. -J- 1919 Exp 100% 102% 

In shortened form this analysis would appear as follows: 

ANDREWS AND COMPANY 
ANALYSIS OF TRADING AND PROFIT AND Loss STATEMENTS 

Years Ended December 31 
(Each year's percentages based on previous year's figures as ioo%.) 

1917 1918 1919 1920 

Net Sales $140, 161 139% 141% 105% 

Cost of Goods Sold 108 ,750 141 137 123 

Operating Expense , 17 ,055 n i 168 102 



176 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

These figures clearly indicate that the big jump in operating 
expense occurred in 1919 and that the increase of 1920 over 
1919 was apparently normal. They show that disproportionate 
increases in cost of goods sold occurred in 1918 and 1920. 

But the graphic chart of the trend percentages shows the 
same facts just as vividly and eliminates the need for this 
rather complicated calculation, which may be confusing to in- 
terpret and very difficult to explain to the non-technical man. 

Second Illustrative Case. The following illustration fur- 
ther demonstrates the trend method of analysis : 

KNIGHT HARDWARE COMPANY 
COMPARATIVE TRADING AND PROFIT AND Loss STATEMENT 

Years Ended December 31 

1920 1921 1922 1923 

Net Sales * $53,842 $58,738 $66,059 $42,710 

COST OF GOODS SOLD: 

Inventory Beginning $15,856 $14,139 $12,347 $16,006 

Purchases 40,058 44,155 f 55,272 29 , 947 

$55 , 914 $58.294 ' $67,619 $45 , 953 

Less Inventory End 14,138 12,346 16,006 13,271 

Cost of Goods Sold . 

Gross Profit $12,066 

GENERAL ADMINISTRATIVE AND 
SELLING EXPENSE: 



Salaries and Wages 


$ 2,441 
37 
44 

9 
26 

81 

10 

3 
39 
147 
48 
664 
907 

112 

5 

494 

5 


$ 5>i8o 
36 
283 

101 

19 

97 

2 

119 

343 
60 
629 
1,002 
244 

2 

5 
552 
3 
25 


$ 4,447 

12 

198 

94 
65 
735 
85 
23 

263 
456 
61 
692 
1,225 

24 I 

447 
17 


$ 3>920 
28 
16 
109 
60 
246 
37 
59 
3H 
, 2 43 
89 

793 
1,094 

245 

10 

3i 

12 

I 7 8 
42 


Donations 


Advertising 


Telephone, Telegraph and Postage. 
Printing and Stationery 
Insurance 


Miscellaneous Expense 
Repairs on Stores and Equipment . 
Truck and Delivery Expense 


Taxes 


Light, Heat and Water. 


Rent . . . . 


Freight and Express 


Depreciation ... . ... 


Subscriptions and Dues . 


Traveling Expense 


Bad Debts. 


Collection Expense 


Legal and Auditing 


Loss by Theft 


Total 


ff 5,153 - 

$ 6,QI3 


$ 8,702 
A, 088 


$ 9,071 \ 
$ S.^TK ; 


t 7^526 
2 . 5O2 


Net Operating Profit 



Ch. 15] PROFIT AND LOSS ANALYSIS 177 



OTHER INCOME: 
Interest Earned 




$ 7 


$ 23 


Discounts Earned 


. . $ 541 $ 522 


771: 


47 5 


Miscellaneous Income 




6 




Bad Debts Collected 





162 





OTHER EXPENSE: 
Interest Paid . 


$ 7,454 $ 4,610 

. . . . $ 87 $ 147 


$ 6,325 

$ 471 


$ 3ooo 
$ 612 


Discounts Lost , 




III 




Net Profit 


$ 87 _$ UJ 
. ... $ 7.^67 & A.&fa 


$ 582 


$ 612 
$ 2.188 



KNIGHT HARDWARE COMPANY 

SUMMARY COMPARATIVE TRADING AND PROFIT AND Loss STATEMENT 
For Years Ended December 31 

1920 1921 1922 1923 

Amount % Amount % Amount % Amount % 

Net Sales $53.842 100 $58,738 100 $66,059 100 $42,710 100 

Cost of Goods Sold 41,776 78 45.948 78 51,613 78 32,682 77 

Gross Profit $12,066 22 $12,790 22 $14,446 22 $10,028 23 

Operating Expense 5,153 9 8,702 15 9,071 14 7,526 17 

Net Operating Profit $ 6,913 13 $ 4,088 7 $ 5,375 8 $ 2,502 6 

KNIGHT HARDWARE COMPANY 

ANALYSIS OF TRADING AND PROFIT AND Loss STATEMENTS 
For Years Ended December 31 

(Trend method.) 

1921 1922 1923 

1920 Percentage Percentage Percentage 

Amount of 1920 of 1920 of 1920 

Net Sales $53,842 109 122 79 

Cost of Goods Sold 41,776 no 124 78 

Gross Profit $12 , 066 

Operating Expense 5,153 169 176 146 

Net Operating Profit $ 6,913 

This typifies a common situation where sales keep on in- 
creasing over a period of years and then suddenly slump. The 
prosperous feeling engendered by increasing sales causes re- 
laxation of watchfulness in connection with the expense items, 
which often grow out of all proportion to the increase in sales. 
When sales decrease, expense is usually difficult to influence 
downwards with the result that the profit is greatly reduced. 



I7 8 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

Interpretation of Statement This appears to have hap- 
pened with the Knight Hardware Company. 

The actual cause of the very poor profit situation in 1923 
was due in large part to the heavy rise in expense two years 
previously. This is clear from an inspection of the chart in 
Figure 8. An increase in expense to 169% in 1921 as com- 
pared with an increase in sales to only 109% seems out of line 
on the face of it. 

There was apparently some attempt made at expense reduc- 
tion in 1923, but it was not at a rate sufficient to equal the rate 
of drop in sales. The trends of sales and cost of goods sold 
seem fairly uniform throughout. 

The trend method may, in this instance, be applied to some 
of the details composing the operating expense. 

KNIGHT HARDWARE COMPANY 

ANALYSIS OF OPERATING EXPENSE 

For Years Ended December 31 

1921 1922 1923 

1920 Percentage Percentage Percentage 

Amount of 1920 of 1920 of 1920 

Salaries and Wages $2,441 212 182 161 

Rent 664 95 104 1 19 

Freight and Express 907 no 135 121 

Other Expenses i , 141 166 237 151 

Total $5,153 169 176 146 

While the chief responsibility for the trend of expense 
probably rests on the item of salaries and wages, an upward 
tendency is noted throughout the above statement. This is 
reflected in the chart shown in Figure 9. 

Third Illustration. As a third illustration of the use of 
the trend method in profit and loss statement analysis, a sum- 
mary statement of the Ames Manufacturing Company is pre- 
sented. It will be recalled that the Ames Manufacturing Com- 
pany is an actual company, disguised for the purposes of illus- 



Ch. 15] 



PROFIT AND LOSS ANALYSIS 



179 



tration by changing the dates of the statements and the 
corporate name. 




f920 1921 1922 1923 

Figure 8. Trend Percentage Chart of Profit and Loss Statements of the 
Knight Hardware Company 

300 



Salaries and Wages 
Other Expense 




1920 1921 1922 1923 

Figure 9. Trend Percentage Chart of Operating Expenses of the 
Knight Hardware Company 

Because this statement is in a highly summarized form it 
does not offer the interesting analytical possibilities that the 



180 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

other two statements did. Nevertheless, because its balance 
sheet was analyzed in Chapters IX and XI, the profit and loss 
figures are shown here for completeness. 

THE AMES MANUFACTURING COMPANY 
COMPARATIVE PROFIT AND Loss STATEMENT 
For Years Ended January I 
1921 1922 1923 1924 

Net Sales $52,088 100% 66,383 100% $90,652 100% $96,691 100% 

Cost of Goods Sold and 

Operating Expense . 42,270 81 SS.ioo 83 78,521 87 84,158 87 

Operating Net Profit.. $ 9,818 19% $11.283 J7% $ 12 > JC3J 13% fe,533 13% 

For simplicity, non-operating income and expense are not 
shown. 

Very little can be done toward analyzing the factors in- 
fluencing the decreasing ratio of profits to sales because no 
division is made between cost of goods sold and operating 
expense. The last profit figure shown ($12,533) is 15% of 
the net worth at the beginning of the year, which cannot be 
regarded as insufficient. 

Because of the nature of the statement, application to it of 
the trend method can hardly be expected to yield any im- 
portant information, but for completeness the trend percent- 
ages are shown here. 

THE AMES MANUFACTURING COMPANY 

ANALYSIS OF PROFIT AND Loss STATEMENTS 

For Years Ended January i 

(Trend percentage method.) 

1922 1923 1924 

1921 Percentage Percentage Percentage 

Amount of 1921 of 1921 of 1921 

Net Sales $52,088 127 174 186 

Cost of Goods Sold and Oper- 
ating Expense 42,270 130 186 199 

Operating Net Profit $ 9,818 

The figures as charted in Figure 10 clearly indicate that the 
years 1922 and 1923 are primarily responsible for the decreased 



Ch. 15] 



PROFIT AND LOSS ANALYSIS 



181 



profit showing, the slopes of the two lines for 1924 being 
practically parallel. 

Program of Analysis. The general philosophy of profit 
and loss analysis coincides with that of balance sheet analysis. 
The purpose of the analysis in each instance is twofold: 

1. Determine the trends as evidenced by a series of state- 

ments. 

2. Determine how far the trends have gone by a study of 

the most recent statement of the series. 



300 



200 



100 




'Costs and Expenses - 
Net Sales 



Figure 10. 



1921 1922 1923 1924 

Trend Percentage Chart of Profit and Loss Statements of tlie 
Ames Manufacturing Company 



When possible, the trend study should go into details, 
although it should again be noted that details are seldom avail- 
able to the prospective or actual investor or the credit man. 

The second purpose is served by what is equivalent to a 
ratio study of balance sheets, i.e., by determining the percent- 
ages of each principal item in the profit and loss statement to 
the sales. 



182 ANALYZING FINANCIAL STATEMENTS [Ch. 15 

The percentage of cost of goods sold to sales, or the "oper- 
ating ratio," as it is usually called, is such an important figure 
in any profit and loss statement that many analysts would 
determine it for each of a series of statements instead of the 
most recent one. While this is not necessary if a trend study 
is made and properly interpreted, still no erroneous impres- 
sions will be formed thereby. 

The greatest usefulness of the trend study lies in the light 
it throws on the operating expense. 

The following minimum analysis procedure is, therefore, 
recommended for a series of profit and loss statements of a 
trading business : 

1. Determine the percentage of net profit for each year to 

the net worth at the beginning of the year, or to the 
average net worth during the year. 

2. Study the operating expense trends in as much detail as 

possible in relation to sales trades, and roughly chart 
the trend percentages to obtain graphic comparison of 
slopes. 

3. Study the operating ratios for all statements. 

4. Observe the operating ratio and the ratio of operating 

expenses to net sales and the ratio of net profit to net 
sales for the most recent statement of the series. 

5. General scrutiny of statements prior to forming conclu- 

sions in order to insure common sense viewpoint. 

For a series of manufacturing statements about the same 
procedure should be followed except that the trend study 
should be extended to include the labor, material and manu- 
facturing expense elements of the cost of goods sold. This 
will be more fully set forth in the following chapter. 



CHAPTER XVI 

PROFIT AND LOSS ANALYSIS (Continued) 

Manufacturing Statements. The profit and loss state- 
ments of manufacturing companies differ to some extent from 
those of trading companies. 

Whereas the trading company buys the merchandise which 
it intends to resell, the manufacturing company produces such 
merchandise from various raw materials which it purchases. 
This involves a complete realm of activity which is unknown 
to the trading company and which introduces new elements 
into the analytical procedure. 

To illustrate the difference in the form of the statements, 
the following may be taken to represent the first section, down 
to the gross profit point, of the detailed profit and loss state- 
ment of a trading company : 

JONES MANUFACTURING COMPANY 

TRADING AND PROFIT AND Loss STATEMENT 

For Year Ended December 31, 1920 

Net Sales $525,679 

Cost of Goods Sold: 

Inventory at Beginning of Year $ 77, 107 

Purchases 495 635 

Total $572,742 

Less: Inventory Dec. 31 104,284 

Cost of Goods Sold 468,458 

Gross Profit g 57, 221 

If the title "Cost of Goods Manufactured" should be sub- 
stituted in the above statement in place of "Purchases," the 
statement would then be turned into a statement for a manu- 
facturing business : 

183 



184 ANALYZING FINANCIAL STATEMENTS [Ch. 16 

JONES MANUFACTURING COMPANY 

MANUFACTURING, TRADING AND PROFIT AND Loss STATEMENT 
For Year Ended December 31, 1920 

Net Sales $525,679 

Cost of Goods Sold: 

Inventory at Beginning of Year $ 77 , 107 

Cost of Goods Manufactured 495.635 

Total $572,742 

Less: Inventory Dec. 31 104,284 

Cost of Goods Sold 468,458 

Gross Profit $ 57,221 

But where one item, "Purchases, $495,635," represents 
sufficient information on a trading statement, it must be recog- 
nized that the manufacturing procedure which results in the 
same figure is so important and so complicated that further 
detail supporting the corresponding item, "Cost of Goods 
Manufactured, $495,635," should be had. 

Sometimes this is put in the form of a supplementary ex- 
hibit as follows : 

JONES MANUFACTURING COMPANY 

MANUFACTURING STATEMENT 
For Year Ended December 31, 1920 

Goods in Process, January i $ 28 , 892 

Material Used 418 ,610 

Freight and Express 6 , 281 

Direct Labor 48,081 

Total $501 , 864 

Less: Goods in Process Dec. 31 33 , 686 

$468,178 

Manufacturing Expense 27 , 457 

Cost of Goods Manufactured $495 > 635 

This exhibit forms the analytical explanation of the single 
item, "Cost of Goods Manufactured, $495,635." 

While for explanatory purposes the profit and loss state- 
ment and the manufacturing statement of the Jones Manufac- 
turing Company have been shown separately, it is equally good 
practice to combine the two. 



Ch. 16] PROFIT AND LOSS ANALYSIS 185 

Illustration. The last column of the following compara- 
tive manufacturing, trading and profit and loss statement in- 
cludes the same figures as those given in the foregoing illus- 
tration, except that the figures are exhibited in greater detail 
and the operating expenses and other items are shown. 

This statement is one of an actual company with the name 
and dates changed, but no changes have been made in the 
arrangement of the statement. 

It appears open to some criticism from the viewpoint of 
the best modern practice in the presentation of such statements, 
but this is a matter of slight importance from the viewpoint 
of the analyst who must usually accept statements as he finds 
them. 

JONES MANUFACTURING COMPANY 
COMPARATIVE MANUFACTURING, TRADING AND PROFIT AND Loss 

STATEMENT 
Years Ended December 31 



Sales 


19 

$372 


17 
612 


10 

$508 


18 
186 


19 
$469 


19 
603 


192 

$526 




0^6 


Less: Prepaid Parcel Post 




273 




310 


i 


,153 


i, 


257 


MANUFACTURING : 
Goods in Process . . ... 


$372 
$ 33 


,339 
083 


$507 
$ 29 


,876 
907 


$468 

$ 21 


>450 
,888 


$525 , 
$ 28, 


679 

R<T> 


Material Used 


269 


656 


300 


053 


283 


464 


418 


6lO 


Freight and. Express 


5 


,464 


5 


,393 


6 


,456 


6, 


?RT 


Direct Labor 


43 


,639 


45 


,223 


38 


,798 


48, 


081 


Less: Goods in Process Dec. 31 


$351 
29 


,842 
,908 


$380 

21 


,576 
,888 


$350 
28 


,606 
,892 


$501, 
33, 


864 
686 


Prime Cost 


$ 21 


,934 


$3*8 


,688 


$321 


,714 


$468, 


178 


MANUFACTURING EXPENSE: 
Salaries 


$ 10 


,299 


$ II 


,726 


f TO 


,378 


$ II, 


895 


Light 




484 




559 




349 




<VjT 


Power 




750 


I 


,034 




860 




731 


Fuel 




926 


I 


,308 




860 


I, 


496 


Belting 




166 




182 




25 




S7 


Needles 




281 




178 




55 




40 






40 




32 




IO 




T8 


Oil 




33 




16 




16 




TT 


Miscellaneous Supplies 




206 




540 




418 




I*? 1 ? 


New Parts for Machines 




857 




680 




502 




67O 






138 




230 




177 


it 


266 






870 




983 




555 




777 


Taxes State County and City 




746 


I 


,392 


I 


,509 


i, 


7T 


Rent 


2 


,092 


5 


,680 


$ 


,680 


6, 


880 


Telephone and Telecraoh 




70 




&3 




68 




60 



186 ANALYZING FINANCIAL STATEMENTS [Ch. 16 





. . 282 


503 


342 


344 






694 


640 


141 


Water . 


. . 52 


53 


66 


60 




957 


769 






Miscellaneous 




177 


141 


218 




$ 20,172 


$ 26,819 


$ 22 651 


$ 27,457 


Cost of Goods Manufactured 


$342,106 


$385,507 


$344 , 365 


$495,635 


Finished Goods Inventory 


50,519 


102,623 


102,847 


77,107 


Less: Finished Goods Inventory Dec. 31 ... 


$392,625 
102,623 


$488,130 
102,847 


$447,212 
77,107 


$572,742 
104,284 


Cost of Goods Sold 


. . . $290.002 


$385.28^ 


$370,105 


$468 , 458 


Gross Profit . 


. , . . $ 82,337 


$122,593 


$ 98,345 


$ 57,221 


OPERATING EXPENSE: 
Delivery and Selling Expense: 
Salaries 


. . . $12, 754 


$ 15,079 


$ 15,410 


$ 15,502 


Commissions . . . 


13,609 


18,645 


20,585 


20,861 


Traveling Expense . . . 


, . . 2,688 


2,485 


2,274 


2,068 


Drayage and Express Outbound 


433 


415 


498 


915 


Rent . . 


. . . . 5 


10 


10 


10 


Depreciation 


. . . 160 


157 


53 


52 


Light Heat and Water 


6 


6 


6 


6 


Burlap . . . 


I2O 


607 


30 


IO 


Cases 


... 381 


415 


300 


391 


Paper 


347 


311 


417 


174 


Rope . . .... 




51 


72 


10 


Advertising 









98 


War Tax 


. . . . 22 


138 


139 


177 


Miscellaneous Expense 






3 




Total 


$ 30,525 


$ 38,319 


$ 39,797 


$ 40,274 


Administrative Expense: 
Salaries 


$ 10,328 


$ 11,832 


$ 13,278 


^ 'I 
$15 ,953 


Traveling - 


184 


522 


135 


85 


Legal and Accounting ... 


192 


281 


172 


150 


Subscriptions and Dues 


62 


220 


173 


266 


Stationery and Printing . . 


. - . 351 


415 


437 


359 


Bad Debts 


250 


114 


312 


189 


Commercial Agencies 


290 


183 


350 


290 


Collection Expense 


J82 


54 


86 


339 


Rent 


5 


10 


10 


10 


Depreciation . . . . 


. ... 56 


56 


66 


65 


Light, Heat and Water 


4 


4 


4 


4 


Postage , 


529 


605 


608 


471 


Telephone and Telegraph 


163 


214 


212 


216 


Total 




$ 14,510 


$ 15,843 


$18 ,397 


Total Operating Expense . . . 


$ 43, 121 


$52,829 


$ 55 640 


$58 671 


Net Operating Profit (or Loss *) 


, . . . . $ 39,216 


$ 69,764 


$ 42 , 70S 


$ I 450* 


OTHER INCOME: 

Interest Earned Notes 


54 


166 


2 




Interest Earned 'U. S. Bonds 




895 


I 701 


784 


Discount Earned 


5 787 


7 098 


8 082 


8 226 


Collection Bad Debts 






I c 


2 


Rags Sold 


2 , 047 


1,567 


1,182 


3,288 




$ 47,104 


$ 79,490 


$ 53,687 


$10,850 



Ch. 16] PROFIT AND LOSS ANALYSIS 187 

OTHER EXPENSE: 

Interest Paid $ i , 161 $ 1,175 $ 435 I 381 

Interest Paid U. S. Bonds 185 

Discount Allowed 2 ,382 3 ,083 3 , 127 3 ,415 

Exchange 156 133 6 2 

Federal Income and Capital Stock Tax 10,526 44,779 8,654 356 

Donations . 16 401 124 49 

Loss on Liberty Bonds 2, 743 

State Income Tax 4,464 2 ,928 i ,499 



$ 18,705 $ 52,499 $ 14.030 $6,946 

Net Profit $ 28,399 $ 26,991 $ 39 , 657 $ 3,904 

Interpretation of Statement The first analysis of this 
statement will follow the procedure already set forth for 
trading statements. 

JONES MANUFACTURING COMPANY 

COMPARATIVE TRADING AND PROFIT AND Loss STATEMENT 
Years Ended December 31 



Net Sales 


Amc 
$372 


191? 

>unt 

,339 

,002 


100 
78 


1918 

Amount 
$507,876 
385,283 


TOO 

76 


1919 

Amount 
$468,450 
370,105 


100 
79 


1920 

Amount 

$525 , 679 
468,458 


100 

89 


Cpst of Goods Sold 


290 


Gross Profit 


$ 82 


,337 

,121 


22 
12 


$122, 
$2, 


593 
829 


24 
10 


$ 98,345 
55,640 


21 
12 


$ 57 
58 


,221 
,671 


II 
ii 


Operating Expense 
Net Profit (or Loss*) . 


43 


$ 39 


,216 


10 


$ 69, 


764 


14 


$ 42,705 


9 


$ I 


,450* 


_ 



JONES MANUFACTURING COMPANY 

ANALYSIS OF TRADING AND PROFIT AND Loss STATEMENT 

Years Ended December 31 

(Trend percentage method) 

1918 1919 1920 

1917 Percentage Percentage Percentage 
Amount of 1917 of 1917 of 1917 

Net Sales $372,339 *& I26 HI 

Cost of Goods Sold 290,002 133 127 161 

Gross Profit $ 82,337 

Operating Expense 43,121 123 129 136 

Net Profit (or Loss*) $ 39,216 

The year 1918 made a fairly favorable showing but the 
trends in 1919 were bad, as may be seen in Figure n. 

Cost of goods sold decreased but net sales themselves de- 
creased still more, while operating expense continued its up- 
ward climb. The effect of this was felt in 1920 in spite of 



r88 



ANALYZING FINANCIAL STATEMENTS 



[Ch. 16 



an increase in sales to a high point of 141%. Cost of goods 
sold increased faster, reaching 161%. Expense continued to 
increase but not at a rate disproportionate to the slope of the 
sales line. 

200 




1917 



1918 



1919 



1920 



Figure II. 



Trend Percentage Chart of Profit and Loss Statements of the 
Jones Manufacturing Company 



These conclusions are obvious from the analytical figures 
already established. Since further details are available, it 
should be possible to trace the difficulties more specifically by 
making a trend analysis of some of the items on the manufac- 
turing statement and of the operating expenses : 

JONES MANUFACTURING COMPANY 

ANALYSIS OF MANUFACTURING COSTS AND OPERATING EXPENSE 
Years Ended December 31 



(Trend percentage method.) 



1918 



1919 



I92O 



1917 
Items to Be Analyzed Amount 

Material Used $269 ,656 

Freight and Express 5 ,464 

Direct Labor 43 ,639 

Manufacturing Expense 20 , 172 

Salaries 10 , 299 

Fuel 926 

Repairs 138 

Taxes 746 

Rent 2,092 



Percentage Percentage Percentage 



of 1917 
in 

99 
104 

133 
114 
141 
167 
187 
272 



of 1917 

105 

118 

89 

112 
101 

93 

128 

202 
272 



of 1917 
155* 

no 

136 

162* 
917* 
230* 



Ch. 16] 



PROFIT AND LOSS ANALYSIS 



189 



Operating Expense $ 43 , 121 123 129 136 

Delivery and Selling Ex- 
pense 30,525 125 130 132 

Salaries 12,754 118 121 122 

Commission 13,609 137 151 153* 

Traveling Expense 2 ,688 92 84 77 

Administrative Expense 12,596 115 126 146* 

Salaries 10,328 115 129 154* 

The survey of this detailed trend analysis points to the 

items marked (*) as being the ones that have increased at a 
faster rate than sales. 

Scrutinizing the amounts on the statement again to deter- 

400 



300 



u 200 

& 



100 




Rent 



Freight and Express 

Material Used 

Commissions and 

A dmin istra t he Sa la ries 



1917 1918 1919 1920 

Figure 12. Trend Percentage Chart of Selected Items of Manufacturing Cost 
and Operating Expenses of the Jones Manufacturing Company 

mine the relative importance of these various items, it is found 
that material used overshadows all of the others. 



190 ANALYZING FINANCIAL STATEMENTS [Ch. 16 

As seen in the chart in Figure 12, the trend of the labor 
cost appears quite reasonable. The trend of manufacturing 
expense in total seems high, although it has not increased at 
as fast a rate as sales. Certain of the items in the manufac- 
turing expense group, particularly, rent and taxes, are respon- 
sible for the trend which would have been much more unfa- 
vorable had not the substantial item of salaries been kept down 
to a reasonable increase. 

The operating expense group shows a more rapid increase 
than would appear proper, and yet as a total it does not appear 
to have accelerated at a dangerous rate. Acceleration would 
have been less rapid had the increase in sales commissions not 
been completely out of proportion with the increase in sales. 
Also there would have been a better showing had administra- 
tive salaries been controlled more carefully. 

Using the Trend Analysis. This method of detailed trend 
analysis enables one to pick definitely the items which are 
responsible for a poor showing. That this can be done prac- 
tically at a glance is, of course, a most valuable feature. 

The mental process involved in scrutinizing the statement 
allows, first, the noting of trend percentages that are out of 
line and then mentally evaluating the importance of each factor 
by reference to the actual amounts. 

Thus an increase in an expense from $i to $5 represents 
a trend percentage of 500%, whereas an item increasing from 
$10,000 to $12,000 represents a trend increase to only 120%. 
And yet one involves an increase of but $4, while the other 
increase amounts to $2,000. Merely to consider trend per- 
centages alone would lead to absurd conclusions. It is the 
combination of the scrutiny of the trend percentages with the 
relative importance of the actual items themselves that com- 
prises the complete procedure. 



Ch. 16] PROFIT AND LOSS ANALYSIS 191 

Importance of Expense Trends. In studying the state- 
ments of trading organizations it was observed that the great- 
est menace to net profit is the inflexible character of certain 
of the fixed operating expenses and that it was the normal 
tendency for cost of goods sold to keep a fairly uniform rela- 
tionship to sales. 

In the manufacturing statement there are fixed items to be 
found in both the operating expense group and the manu- 
facturing expense group. In this type of statement, therefore, 
it is important that a special study should be made of both 
classes of expenses. 

Material and Labor Costs Material costs and labor costs 
are usually fairly uniform in their relationship to sales, al- 
though the statement of the Jones Manufacturing Company 
represents a violent exception. 

Usually where the cost of goods sold in a manufacturing 
business shows an upward trend as compared to sales, the 
trouble can be pretty definitely traced to the manufacturing 
expense group. This is because such expenses usually contain 
a large proportion of fixed or practically fixed items. 

Availability of Detailed Figures, It should, of course, be 
understood here, as in previous examples, that it is unusual 
for the analyst to find as much detail for his study as is shown 
for the Jones Manufacturing Company. 

Published statements are usually in summary form and 
those furnished to commercial agencies are often in no greater 
detail, so that the analyst can usually make no more intensive 
study of a manufacturing company's statement than he can 
of a trading organization. 

However, the public accountant or financial executive does 
have access to the detailed figures of his client or employer, 
and will often find that valuable information may be gained 
from detailed trend studies. 



I 9 2 ANALYZING FINANCIAL STATEMENTS [Ch. 16 

Analyzing Non-Trading Companies. The profit and loss 
statements of non-trading companies, such as banks, public 
utilities, etc., may be analyzed according to the same general 
procedure as has already been outlined. 

The fact that non-trading organizations use different meth- 
ods of grouping items on their profit and loss statements is 
a mere detail The analyst who undertakes this task must 
keep in mind the two fundamental principles : 

1. Trend study. 

2. Scrutiny of the composition of the most recent statement. 

Public Utility Statement. This is well illustrated by the 
following brief analysis of the statement of a large gas 
company : 

SOUTHERN GAS COMPANY 

COMPARATIVE PROFIT AND Loss STATEMENT 

Years Ended December 31 

1921 1922 1923 

Gross Earnings $4.268,335 $5,739.154 $7, 349, 607 

Operating Expense and Taxes 3,151,534 4,208,089 5,285,645 

Net Earnings $i, 116,801 $1,531,065 $2,063,962 

Other Income 38,294 50,336 54,393 

Total Net Income $1,155,095 $1,581,401 $2,118,355 

Fixed Charges 392,882 534,274 687,155 

Balance '. $ 762,213 $1,047,127 $1,431,200 

Depreciation 209 , 099 295 , 600 380 , 704 

Surplus $ 553 ^H $ 75 1.527 $1,050,496 

In the statement of any public utility company, there are 
two items of special importance. These are depreciation and 
fixed charges. 

For this reason they are usually exhibited separately and 
not included among operating expenses and taxes. 

It is, of course, a commonplace of accounting that depre- 
ciation is as much an operating expense as salaries and wages, 
and in industrial profit and loss statements it is regarded as 



Ch. 16] PROFIT AND LOSS ANALYSIS 193 

erroneous not to show depreciation in the operating expense 
group. 

The fixed charges which represent interest on bonded 
indebtedness are ordinarily considered by the accountant to 
represent non-operating expenses, or as sometimes called, 
financial expense, in industrial statements. 

Because these items are important in public utility state- 
ments, they are exhibited separately. 

Many accountants may take exception to some of the 
terminology used. The most glaring misnomer is that of net 
earnings which is shown before deducting depreciation and 
fixed charges, but it is customary to sanction this usage in 
connection with public utility statements. In any event the 
form above given is the one substantially adopted and must 
therefore be accepted. 

The first step in the analysis is a trend study : 

SOUTHERN GAS COMPANY 

ANALYSIS OF PROFIT AND Loss STATEMENTS 

Years Ended December 31 

(Trend percentage method.) 

1921 1922 1923 

1921 % of Percentage Percentage 

Amount 1921 of 1921 of 1921 

Gross Earnings $4^68,335 100 134 172 

Operating Expenses and Taxes ... 3,151,534 100 134 * 168 

Net Earnings $i, 116,801 

Other Income 38,294 100 131 142 

Total Net Income $i , 155 95 

Fixed Charges 392,882 100 136 175 

Balance $ 762,213 

Depreciation 209,099 100 141 182 

Surplus I 553 , 114 

Interpretation of Statement. With but minor exceptions, 
the trends as charted in Figure 13 seem entirely satisfactory 
and harmonious one to the other. 



194 



ANALYZING FINANCIAL STATEMENTS 



[Ch. 16 



The sales have increased nicely. Operating expenses and 
taxes have increased, but not so fast. The fixed charges and 
depreciation have increased slightly faster than gross earnings, 
but not sufficiently to represent a warning of danger. 



200 



o 




-Depredation \ 
-Fixed Charges 
"*Gross Earnings 
^Operating Expense ana Taxes 



'-Other Income 



1921 1922 1923 

Figure 13. Trend Percentage Chart of the Profit and Loss Statements o the 
Southern Gas Company 

The next step is to scrutinize the latest statement of the 
company which may be done by a percentage study of the 
1923 statement. 

SOUTHERN GAS COMPANY 
PROFIT AND Loss STATEMENT 
Year Ended December 31, 1923 

Gross Earnings $7,349,607 

Operating Expenses and Taxes 5 ,285 ,645 



100. 0%* 

72.0 * 
28.0%^ 



Net Earnings $2,063,962 

Other Income 54*393 

Total Net Income $2,118, 355 

Fixed Charges 687,155 5.8 

Balance $i , 431 , 200 

Depreciation , 380, 704 1.7 

Surplus $1,050,496 14. o 



The percentages marked (i) are based on gross earnings 
as 100%. The item marked (2) represents -the percentage of 
fixed charges to the total amount of notes and bonds as shown 
on this company's balance sheet. The item marked (3) rep- 



Ch. 16] PROFIT AND LOSS ANALYSIS 



195 



resents the percentage obtained by dividing depreciation by 
fixed assets as shown by the balance sheet. The item marked 
(4) represents the percentage of surplus net earnings to the 
sum of gross earnings plus other income ($7,349,607 plus 
$54>393> which equals $7,404,000). 

Another percentage which should be calculated represents 
the percentage which surplus earnings bear to the total net 
worth of the company. This percentage is 11% (not shown 
above) . 

For the benefit of those who wish to make a further study 
of these figures, attention is called to the fact that a summary 
balance sheet of this company together with statistics, appeared 
in Chapter XII. 

The operating ratio has already been discussed and is con- 
sidered by many analysts as a most important percentage calcu- 
lation. This operating ratio can be determined for practically 
any kind of a profit and loss statement. 

The Margin of Safety. The profit and loss statements of 
companies the nature of whose business permits a large bonded 
indebtedness, are also subject to a further ratio calculation 
which is usually called the "margin of safety/' 

This margin of safety attempts to show the relationship be- 
tween the fixed interest charges and the income available to 
meet such charges. It is a ratio which is universally used in 
the Moody Financial Manuals, and investors have learned to 
look upon it as a very significant figure. 

This percentage is obtained by dividing the total net income 
before deducting fixed charges into the balance which is left 
after deducting fixed charges. In the Gas Company statement 
above this works out as follows: $1,431,200 divided by 
$2,118,355 equals 68%. 

This ratio is considered of such importance by investment* 
authorities that it is usually published in the financial manuals 
right along with the profit and" loss statements. 



196 ANALYZING FINANCIAL STATEMENTS [Ch. 16 

The bonds of a company showing no great fluctuation in 
margin of safety from year to year are a better purchase than 
those of a less stable nature. 

Where the margin of safety is increasing each year, the 
investment appears more attractive than if the margin of safety 
stays stationary or decreases. 

The margin of safety is a ratio interesting primarily to 
bond buyers, and therefore, should be classified as a special 
instrument of analysis rather than one of universal application. 

Net Profits per Share o Stock. Another ratio popular 
with investors is "net profits per share of stock outstanding." 

This is obtained by dividing the net profits (less the amount 
of preferred dividends) by the number of shares of common 
capital stock outstanding at the end of the year. It affords a 
good check on the stock market quotations, but as a general 
tool of analysis, it possesses little merit. 

Efforts at Establishing Standard Ratios. As intimated 
in a preceding chapter, considerable effort has been expended in 
attempting to work out standard profit and loss statements for 
concerns in the same line of business. 

The most note-worthy attempts along this line have been 
the studies by Harvard University and Northwestern Uni- 
versity. 

HARVARD BUREAU OF BUSINESS RESEARCH. For a num- 
ber of years Harvard University, through its Bureau of Busi- 
ness Research of the Graduate School of Business Administra- 
tion, has been studying the problems of the following: 

Retail shoe business 
Wholesale shoe business 
Department stores 
Wholesale groceries 
Retail groceries* 
Retail hardware business 



Ch. 16] PROFIT AND LOSS ANALYSIS 197 

Retail jewelers 
* Retail drug stores 

The Bureau has issued more than 30 bulletins on these lines of 
business. 

It is probable that the work they have done on profit and 
loss statements is far more useful than any which has been 
done looking toward standard balance sheet ratios. 

The reason lies in the fact that early in their research 
program, they recognized the importance of the uniformity 
of financial statements. By getting in touch with a large num- 
ber of individual firms in each of the above classes, they suc- 
ceeded in working out plans of co-operation whereby individual 
firms adopted standard accounting and statement procedure 
and made periodical reports to the research bureau. 

By insuring uniformity of classification at the source of the 
figures, the Harvard Bureau avoided a very serious difficulty 
in connection with standard ratios. 

They also* adopted an educational campaign among their 
contributors looking toward better accounting methods, and 
they continually fostered this by furnishing their important 
reports gratis to contributing members. 

It is difficult to tell from their published reports just how 
accurately the ratios picture the facts, because while they pub- 
lish the number of firms reporting, they give only the modal 
averages, or common ratios, for the entire group in each classi- 
fication. This gives no indication how closely the individual 
ratios cluster to the average, and until that is known, it is 
difficult to pass an opinion as to the usefulness of the average 
as a guide. 

In some instances they do show high and low percentages 
in addition to the modal or common average, and these appear 
to indicate in many divisions a rather close grouping of the 
items. 



X g8 ANALYZING FINANCIAL STATEMENTS [Ch. 16 

NORTHWESTERN BUREAU OF BUSINESS RESEARCH. The 
Bureau of Business Research of Northwestern University, has 
been concentrating its attention on three industries : Printing 
industry, retail clothiers and retail meat industry. 

Two bulletins have been issued on the first, 10 on the 
second, and 10 on the third. Reports of this bureau are given 
in considerably greater detail than those of the Harvard 
Bureau. Their most recent study has to do with retail 
clothiers, which gives an analysis for seven years of sales and 
expenses of 120 retail clothiers. The bureau took particular 
pains to insure that these stores were properly grouped. 

In spite of these precautions there were quite noticeable 
deviations of individual ratios from the averages. 

Since this appears to be quite an important point in judging 
the value of such averages as an operating guide, the following 
figures are given representing the ratios of operating expense 
to sales for the 16 retail clothiers who contributed from towns 
having a population of 20,000 to 40,000 people. 

For convenience in surveying the figures, fractions of i% 
have been eliminated. 

RATIOS OF OPERATING EXPENSE TO SALES 

As Represented by Northwestern University Bureau of Research 
For 16 retail Clothiers in 16 cities between 20,000 and 40,000 population, year 1922. 

37% 27% 26% 20% 

35% 27% 25% 20% 

32% 27% 25% 15% 

3i% 26% 24% 14% 

The modal average or common percentage for the above 
table is close to 25%, but it will be seen that there are quite 
wide deviations from this figure. Had the individual per- 
centages been more closely grouped about the average, it would 
appear that the average would represent a safer guide to any 
individual retailer who desired to use it as a standard. 

Practicability of Profit and Loss Ratios. There can be 
little doubt that the standard ratio is theoretically more feas- 



Ch. 16] PROFIT AND LOSS ANALYSIS 199 

ible in connection with profit and loss statements than it is with 
balance sheets, but there is grave question whether in either 
instance the standard ratio is an effective tool of analysis. 

As the methods of making such standard ratio studies im- 
prove and greater uniformity is obtained in account classifi- 
cation and accounting methods, as well as in business policies 
and other important factors, it is conceivable that the standard 
ratio may become a more practical instrument for management 
guidance, 

Returned Goods. Before closing the general subject of 
profit and loss analysis, there are a few special points that 
justify brief consideration. 

In any analysis of a trading concern the item of returned 
goods represents an important factor. 

It is important not only because of its effect on net profit, 
but also as an indication of the efficiency of manufacturing 
operations and selling. It is felt by many that where the fig- 
ures representing volume of returned goods are available, these 
figures represent quite a reliable index and that the trend 
method of analysis should be applied to them in conjunction 
with the trend study of sales. 

It is safe to say that any sharp upward trend in returned 
goods which is out of harmony with the trend of sales repre- 
sents a danger signal. This is a point which is probably of 
greater interest to the public accountant or to executives of a 
business than it is to investors, credit men or other analysts 
who seldom have access to such detail figures. 

Trend of Operating Statistics. In Chapter XII it has 
already been pointed out that interesting sidelights may be 
thrown on the balance sheet by comparing with the balance 
sheet trends, the trends of certain operating statistics. 

Equal, if not more valuable, information can often be ob- 
tained by comparing operating statistics and profit and loss 



200 



ANALYZING FINANCIAL STATEMENTS 



[Ch. 16 



figures in the same trend analysis, 
following example : 



This is illustrated by the 



SMITH MINING COMPANY 

COMPARATIVE PROFIT AND Loss STATEMENT 

Years Ended March 31 

(With Trend Percentages.) 



1921 




1922 1923 






%of 


%of 


%of 


Amount 


1921 


Amount 1921 Amount 


1921 


Tons of Ore Mined . $ 89 022 


100 


$ 84 463 95 $ 134 80 I 


T si 


Ounces Silver Produced . . i , r 50 , 963 


100 


889,778 77 1,553,652 


I3S 


Ounces Gold Produced 11,324 


100 


8,845 78 16,254 


144 


Sales of Bullion . $1255321 


100 


$989 4SO 79 $1 874 718 


T AQ 


Operating Expenses $ 973 310 


100 


$864 819 89 $i ^95 472 


T-J } 


Depreciation.. ... 5^ 674 




52 898 * 55 721 








$ 71,733 $ 523 525 




Interest Earned 32 , 279 





28,779 21,961 





Net Income $ ^61 616 




$100 512 -~~ $ 545 4.86 




Depletion. ... 197 , 633 


roo 


187,508 95 299,258 


151 


Net Profit (or Loss*) . . . . $ 63 , 983 

9flA 





$ 86,996* $ 246,228 










Tons of Ore 


Mined 














J 


:- Salts 
















4? 


"'"Ounces Gold Produced 












/yfo 


N* * Ounces Silver Produced 








o i AH 




<p 


"'Operating E 


xpense 












Q 


""SJ^^^r^; 


/fly 












1921 1922 1923 





Figure 14. Trend Percentage Chart of Production Statistics and Profit and 
Loss Figures of the Smith Mining Company 

These trend percentages are shown graphically in Figure 
14. The fact that the money value of sales increased at a 
faster rate than the actual physical production of metal in 
ounces is indicative of a rise in prices. 

The discrepancy between the increases in tons of ore mined 



Ch. 16] PROFIT AND LOSS ANALYSIS 201 

and ounces of metal produced would appear to indicate that 
the ore was becoming leaner in metallic content. 

The fact that the trend of operating expenses did not in- 
crease as fast as the trends of any of the production figures 
is favorable in 1923, although less so in 1922. 

The item of depreciation is evidently on a fixed basis in 
its relation to fixed assets, while depletion is arranged on a per 
ton basis. 

The analyst should welcome an opportunity to include in a 
trend study relevant statistics of this type. 

Unsatisfactory Sales Trends It often happens that profit 
and loss trends, particularly sales trends, are apparently un- 
satisfactory, and the question sometimes arises if such unsatis- 
factory trends are the result of poor management or of general 
business conditions. 

A partial answer to this question can be had if it is remem- 
bered that there are quite a number of so-called "business 
barometers' 7 with which the sales can be compared. These 
business barometers represent fundamental statistics. There 
are a great number of different barometers which have been 
proposed as being reliable indicators of general business con- 
ditions, or of what is technically called the "business cycle." 

Such compilations of figures as pig iron prices, bank clear- 
ings, interest rates, stock exchange prices, and many others, 
are used as business barometers. 

Business Forecasting Bureaus* There are also two com- 
mercial organizations which conduct business forecasting serv- 
ices. These organizations compile fundamental statistics and 
then by various means of weighting and combining the sta- 
tistics produce figures and charts representing general business 
conditions. 

These organizations are the Brookmire Service and the 
Babson Statistical Organization. In addition there are other 



202 ANALYZING FINANCIAL STATEMENTS [Ch. 16 

reliable services conducted by the Harvard Economic Bureau 
and a variety of financial institutions. 

Trend of Business Conditions. Most of these sources 
furnish reliable figures which can be used to interpret sales 
trends. This can be done by intelligently selecting a business 
barometer. 

Then, by applying the trend method both to the barometer 
and sales figures, a series of trend percentages will result which 
can be compared to each other. If the business barometer was 
wisely chosen in the beginning, i.e., if common sense indicates 
that its trends should correspond with the sales trends of the 
company under analysis, then the unfavorable discrepancies in 
the sales trends of that company may be due to misman- 
agement. 

An example of this method of analysis is submitted here. 
The Blank Tire Company is engaged in the manufacture of 
rubber tires. A survey of its statements indicates a sharp de- 
crease in profits in 1923. A trend study of its sales for three 
years appears as follows : 

Actual Trend Operating Costs Trend 

Year Sales % and Expenses % 

1921 $14,690,932 100 $13,562,272 100 

1922 20,487,324 139 18,630,128 137 

1923 14,013,832 95 15,178,238 112 

Figure 15 shows these percentages graphically. 

The insufficient profit is clearly caused by the fact that in 
1923 the sales volume decreased at a much more rapid rate 
than the costs and expenses. 

But it is sometimes important to know which was at fault. 

The analyst is then often faced with this question. Is this 
decrease in sales a reasonable decrease ? Perhaps general busi- 
ness conditions were responsible for the drop in sales volume. 
This may be important to know, if a cure for the condition 
is to be sought. 



Ch. 16] 



PROFIT AND LOSS ANALYSIS 



203 



If the sales decrease is normal, then the cure must be found 
in the reduction of costs and expenses. If abnormal, the cure 
must be looked for elsewhere often in the sales department, 
the advertising department or the design of the product, etc. 



200 



100 




Costs and E pmses 



1921 1922 1923 

Figure 15. Trend Percentage Chart of Profit and Loss Figures of the 
Blank Tire Company 

Comparison of Trends. The first step, therefore, is to 
compare the trend of the sales with the trend of some reliable 
business barometer. 

Probably the best reflection of general business conditions 
is given by the figures for "bank clearings outside of New 
York City." These figures are obtainable from a number of 
different sources, such as financial periodicals and services. 



Year 
1921 . 
1922. 
1923. 



Blank Tire Co. 

Sales Trend 

Percentages 

too 

140 

95 



Bank Clearings 
Outside New York 
Trend Percentages 

100 

109 
13 



Both of these sets of percentages are charted in Figure 16. 

Since the trend of the bank clearings is consistently up- 
ward, it is obvious that the trend of the Blank Tire Company's 
sales in 1923 is out of line. 

But are there peculiarities about the tire manufacturing 



2O4 



ANALYZING FINANCIAL [STATEMENTS 



[Ch. 16 



business as an industry which make it unreasonable to expect 
the volume of tires sales to harmonize with the business cycle? 



200 



100 




Bank Clearings Outside New York 
Sales -Blank Tire Company 



1921 1922 1923 

Tr< 
New York with Sales of the Blank Tire Company 



Figure 16. Trend^Percentage Chart Comparing Bank Clearings Outside 



That can be answered by investigating the sales trends of 
other tire manufacturers. 

SUNDRY TIRE MANUFACTURERS 

STATEMENT OP SALES TREND PERCENTAGES 

For the Calendar Years 

1921 1922 1923 

Percentage Percentage Percentage 

of 1921 of 1921 of 1921 

Blank Tire Company ioo 140 95 

B. F. Goodrich Company ioo 108 124 

Miller Rubber Company ioo 120 142 

United States Rubber Company ioo 102 113 

Goodyear Tire and Rubber Company . . ioo 104 108 

Firestone Tire and Rubber Company. .. ioo 97 117 

General Tire and Rubber Company. . . . ioo 135 149 

Since the Blank Tire Company is the only one showing a 
decrease in 1923, the previous conclusion is supported. 

The chart in Figure 17 shows all of these trend percent- 
ages graphically. In studying them it should be borne in mind 
that tires are not the only product of some of the companies, 
but in most instances are conspicuously the principal product. 



Ch. 16] 



PROFIT AN-D LOSS ANALYSIS 



205 



The comparison of sales trends with general business trends 
is likely to be most accurate with companies dealing in products 
widely used and less accurate with companies whose sales are 
restricted to few customers or a limited geographical area. 

The resourceful analyst will usually be able to locate some 
barometer figures which will be helpful to him when under the 
restricted conditions mentioned. 

Selection of Barometers. The selection of business bar- 
ometers to serve as a guide for such analytical work represents 
a difficult task. 



200 



100 




General Tire and Rubber Company 

"-Miller Rubber Company 

B. F Goodrich Company 
-Firestone Tire and Rubber Company 
"^-United States Rubber Company 

'"-Goodyear Tire and Rubber Company 
''"Blank Tire Company 



1921 1922 1923 

Figure 17. Trend Percentage Chart of Sales of Leading Tire Manufacturers 

It is unfortunately true that the trends of all the various 
business barometers do not absolutely agree, and this may 
throw a certain amount of doubt on their value to the state- 
ment analyst Nevertheless, if two or more such barometers 
are subjected to a trend analysis and then intelligently com- 
pared with the trend of sales of any given company, it is likely 
that more light will be thrown on sales fluctuations than if the 
trade barometer trends had not been used at all. 

In dealing with artificial groups of figures, such as business 
barometers, the analyst is required to use special intelligence 
and common sense in order to insure fair conclusions. Such 



206 ANALYZING FINANCIAL STATEMENTS [Ch. 16 

aids represent keen weapons of analysis, but it must be borne 
in mind that they are dangerous in the hands of the unskilled. 

Internal vs. External Viewpoints. It has been difficult to 
discuss profit and loss analysis because of the fact that readers 
have two different viewpoints. 

There are those who have the inside viewpoint because of 
the fact that they are executives of companies who wish to 
apply analytical methods to the affairs of their own company, 
or they are public accountants who wish to apply these methods 
to their client's figures for the purpose of remedying unfavor- 
able conditions. Because they have access to the detailed fig- 
ures of the company under analysis, they are able to trace 
unfavorable trends to the very source. 

There is another group whose motive is primarily of credit 
granting. Such an analyst investigates financial statements to 
determine whether or not credit should be extended. This 
may be in the form of temporary credit, such as trade or bank 
credit, or it may be in the form of investment, such as is made 
by one purchasing stock, bonds or commercial paper. 

Thus far in this volume an attempt has been made to keep 
the requirements of this latter group of readers foremost in 
mind. Their facilities for making a detailed study is limited, 
and their analysis procedure with reference to profit and loss 
statements is usually confined to simple trend studies and a 
general scrutiny of the interrelationship of items on each most 
recent statement. 

In spite of the fact that an attempt has been made to keep 
this viewpoint consistently throughout, there have been nu- 
merous instances where a more intensive study has been sug- 
gested or illustrated. It should be clearly understood that 
where this has been done, it was for the purpose of offering 
suggested procedure to analysts of either group who have 
access to more detailed data than is usually included in pub- 
lished statements. 



CHAPTER XVII 

USING ANALYSIS METHODS IN REPORTS 

The Viewpoint o Some Executives. While many readers 
will be interested in analysis methods for their own use, there 
are perhaps even more who are interested on behalf of some- 
one else. 

Thus, the comptroller or auditor of a company is often 
required to report verbally or in writing upon the results of 
his work. The public accountant invariably must report to his 
client. Sometimes the credit man will have to explain his 
reasons for rejecting a large order by showing just how he 
reached his conclusions. 

It is often difficult for the technical man to explain to the 
layman just how he forms his conclusions. 

In the business world particularly it is observed that some 
chief executives, particularly those of the old school, have only 
a very rudimentary knowledge of accounting and business 
statistics and that they are inclined to be impatient with the 
technical aspects of accounting. 

It, therefore, becomes the duty of a department head in 
such an organization, or the public accountant serving it, to 
consider with great care the presentation of reports. 

Chief executives, untrained in the uses of accounting, have 
often graduated into their positions through the sales depart- 
ment or one of the production departments, where they have 
been accustomed to thinking synthetically rather than analyti- 
cally, and they often take no pains to conceal their contempt 
for the "fine spun theories" of an accounting department head 
or even of their public accountants. 

Referring more particularly to the occasional necessity of 
reporting results of statement analysis, it should first of all be 

207 



208 ANALYZING FINANCIAL STATEMENTS [Ch. 17 

borne in mind that all the various analysis methods the whole 
scheme of analysis technique is nothing more or less than a 
technical tool. The executive is, and should be, much more 
interested in results than he is in the means by which they were 
accomplished. 

Therefore, whenever possible, the analyst should merely 
formulate his conclusions, test them with common sense, and 
present them without setting forth the technical methods by 
which they were reached. 

Rules of Reporting. Unfortunately, it only too often 
happens that the results of such an analysis represent con- 
clusions which are at variance with the "rule of thumb" opin- 
ions of an important 'executive. 

The analyst will then be faced with the necessity of defend- 
ing his position and he may be forced to answer the question : 
Just exactly how did you reach these conclusions ? 

There are two fundamental rules to be followed in present- 
ing a description of technical methods to a layman, particularly 
where he is in a position of real authority: 

1. Avoid technical words and phrases. 

2. Build up an explanation which will appeal to the common 

sense of the layman. It should always be borne in 
mind that people have contempt for what they do not 
understand. 

With certain types of clients or corporate officers nothing 
could be more fatal to successfully "selling" an idea than to 
clothe it with technical words and phrases. 

Very few people like to admit ignorance in any form. 
They will, therefore, frequently pretend to understand a techni- 
cal explanation, and failing to do so will condemn it as "theo- 
retical." 

Unquestionably there are many successful business men 
who would not understand as simple a technical word as 
"ratio." 



Ch. 17] USING ANALYSIS METHODS IN REPORTS 209 

Any report, therefore, which attempts to explain to any 
degree, the methods of financial analysis should be presented 
in every-day language, and it is well to make sure that the 
methods are so stated as to appeal to the common sense of the 
hearer. 

Fortunately the more effective methods of statement analy- 
sis are not particularly complex. 

Thus in presenting a trend analysis of a balance sheet in a 
public accountant's report, the following form is recommended : 

WIRE AND IRON COMPANY 

SUMMARY COMPARATIVE BALANCE SHEET 

As of December 31 

(Together with percentages based upon 1922 figures to 
indicate the trends of important items, i.e., the rate 
of increase or decrease.) 



Assets 


1922 

%of 
Amount 1922 


1923 

%of 
Amount 1922 


1924 

? 

Amount 


of 
1922 


Cash 


$ 6 


04.0 





% 6 


.^75 





$ 


05 


. 


Accounts Receivable (Net). 


38, 


500 


100 


41 


385 


107 


43, 


92O 


114 


Quick Assets . 


$4.4., 


54-0 


IOO 


$ 47 


,760 


107 


$ 44, 


OI5 


99 


Inventories 


94. 


425 


IOO 


122 


,825 


130 


72, 


800 


77 


Current Assets 


$1^8, 


965 


IOO 


$170 


,585 


123 


$116, 


815 


84 


Fixed Assets 


"3. 


600 


100 


127 


,20O 


112 


117, 


500 


103 


Total 


$252, 


565 


IOO 


$207 


,785 


118 


$234, 


^1,5 


Q3 



Liabilities and Capital 

Current Liabilities ........ $ 37,564 100 $ 80,704 215 $104,924 279 

Net Worth .............. 215,001 100 217,081 101 129,391 60 

Total ................. <352 565 loo $297,785 118 $234,315 93 



There are four points in connection with this statement 
which deserve brief discussion: 

I. It is not presented as a percentage statement, but as a 
summary comparative balance sheet, such as is often 
used without the trend percentages by public account- 
ants in the early pages of their reports. While the 
real purpose of the above statement is to show the 



2io ANALYZING FINANCIAL STATEMENTS [Ch. 17 

trends, the method of presentation intentionally covers 
this purpose. 

2. The explanation of the percentages as given in the main 

heading is an important part of the exhibit. 

3. The headings of the percentage columns are also im- 

portant. 

4. Both the amounts and trend percentages should always 

be shown together. Trend percentages should never 
be exhibited separately from the amounts, in a report, 
since a percentage statement alone is often confusing 
to the layman. 

Substitutes for Technical Words. The phrases "faster 
rate" and "slower rate" may be used in discussing such a 
statement, thus : "It would seem apparent from the above per- 
centages that current liabilities are increasing at a faster rate, 
.while net worth is rapidly decreasing. This is a dangerous 
tendency because " 

The words "tendency" and "trend" are not technical words 
and are usually perfectly intelligible to the layman. 

The word "ratio" is one which should practically never be 
used in a verbal or written report. To the layman it represents 
something complicated and mathematical. Because he was 
taught ratio and proportion about the same time that he studied 
cube root and logarithms, he is inclined to think that the word 
"ratio" involves "impractical mathematics," instead of "good 
business arithmetic." 

It is sometimes a little awkward to dispense with the word 
"ratio," since it involves a more roundabout phraseology. 
Probably the best way to avoid the difficulty is always to dis- 
cuss ratios in terms of "dollars per dollar," thus: "In 1921 
your company had $2.59 current assets for every dollar of cur- 
rent liabilities, in 1922 there were $4.86 current assets for 
every dollar of current liabilities, while in 1923 there was a 
drop, with only $2.50 current assets for every dollar of current 
liabilities." 



Ch. 17] USING ANALYSIS METHODS IN REPORTS 211 

Figuring Percentages It is usually, unwise to figure per- 
centages too closely. 

It is the tendency of accountants to strive for accuracy be- 
cause the nature of double entry bookkeeping makes absolute 
accuracy essential. But percentage calculations used in state- 
ment analysis need never be figured to a fine point. It is 
strongly recommended that no fraction of a percentage be 
shown in any report analyzing financial statements. 

The Three Year Analysis. Finally it appears that there 
are two good reasons why a statement analysis by the trend 
method in a report should not cover more than three years : 

1. Since it is essential that both amounts and percentages 

be shown for each year, it would be difficult to put a 
larger statement on standard 8^2 x 11 paper. 

2. Great masses of figures confuse the lay mind. When a 

statement contains more than six columns (three 
amount columns and three percentage columns), it is 
too large to be easily grasped and the significance of 
trends may be lost. 

Reports in Summary Form. It is a commonplace experi- 
ence of accountants that reports over which they have labored 
long and carefully are often never read. They are put aside 
for later attention which they never receive. 

Figures may tell a vital story about profits, but the lay mind 
rejects great compilations of figures and excuses itself on the 
ground "that they probably don't mean anything anyway/' 
If they were simply presented in summary form with the im- 
portant elements properly emphasized, they would receive re- 
spectful attention. 

This is a general observation applicable to all reports which 
deal with figures, and of course, is equally applicable to that 
portion of such reports which have to do with this particular 
subject of analysis. 



CHAPTER XVIII 

RESTATEMENT OF FUNDAMENTALS OF 
ANALYSIS 

Restatement of Fundamentals. This volume has at- 
tempted to set forth all the commonly recognized methods of 
analyzing financial statements and has also embodied some pro- 
cedure which is in advance of general current practice. 

Of the various methods proposed, some are good and some 
are bad ; some are effective and some are cumbersome. 

Therefore, in order to clarify the entire subject, it seems 
desirable to restate a few fundamentals: 

1. Balance sheets and profit and loss statements available to 

the analyst are usually not subject to verification, and 
therefore, must be assumed to be truthful and accurate. 

2. A frequent purpose of statement analysis is to determine 

the desirability or undesirability of extending credit 
in some form or other, i.e., trade credit, bank credit, or 
investment. If this is the analyst's purpose, it should 
be constantly borne in mind by him. It would be 
absurd to spend time analyzing financial statements of 
the United States Steel Corporation before deciding as 
to the wisdom of extending it $100 credit. It would be 
equally absurd for the banker to spend time analyzing 
the financial statements of a corner grocer who is 
requesting a million-dollar loan. It is usually only in 
the "border line" cases that analysis procedure need 
be employed to its full extent. 

3. The purpose of statement analysis is to determine : 

a. Trends. 

b. Present condition for the purpose of proving or dis- 

proving symptoms of each of the five following 
common business ailments : 
212 



Ch. 18] FUNDAMENTALS OF ANALYSIS 213 

(1) Insufficient profit 

(2) Over-investment in receivables. 

(3) Over-investment in inventories. 

(4) Over-investment in plant. 

(5) Insufficient capital. 

4. Since conclusions reached through statement analysis 
usually influence important decisions, involving sub- 
stantial amounts of money, it is vitally essential that 
the conclusions be carefully examined in the light of 
common sense. 

Use o Analysis Methods by Executives and Public Ac- 
countants. While this volume has been primarily written for 
the man who has no access to information supplementing the 
balance sheet and the profit and loss statement, nevertheless 
the methods proposed are equally useful to corporate executives 
or public accountants : 

1. For the purpose of giving a bird's-eye view and forming 

tentative conclusions and for pointing out symptoms 
to be more thoroughly investigated. 

2. For analyzing exhibits, schedules and statements sub- 

sidiary to the balance sheets or profit and loss state- 
ments. 

While but little emphasis has been placed upon special tech- 
nique required in unusual cases or applicable to special forms 
of enterprises, it should nevertheless not be overlooked that 
each type of business has its own peculiarities. The analyst 
will not be able to adopt a rigid, standardized form of tech- 
nique, but will sometimes find it necessary to vary his proced- 
ure to fit the requirements of unusual situations. 



INDEX 



Ability, 
financial condition as reflection of, 

56 

Account Names, 

interpretation of, 76 
Accounting, 

double entry records, 4 
origin of, 3 

standard classification, 143 
Analysis, 

balance sheet, 159 
annual sales, 39 
checking list, 152 
classes of, 28 
conclusions as to technique, 

150-153 

defined, 27 

discussion of programs, 152 

history of, 31 

methods of, 29 

of bankrupts, 101 

origin of, 27 

ratio-method of historical, 74-95 

ratios, (See "Ratios") 

scaling of assets, 35 

single, 15, 31-44 

single, comparison of current as- 
sets and liabilities, 34 

summary of analysis, methods, 
150 

trend method, 110-132 

"2 to i" rule, 34 
common sense applied to, 112 
comparative balance sheet, 45-53 

(For detailed index see under 

"Balance Sheet, Comparative") 



Analysis (Continued) 
comparison of ratio and trend 

methods, 121 
current assets, 20 
fundamentals of, 212 
historical, significance of, 74 
manufacturing statements, 183 

illustration, 185 

interpretation, 187 

trend percentage method, 187 
Chart, 188 

use of trend, 190 

Chart, 189 
methods, 

as tools, 131 

combination of, 132 
non-trading companies' statements, 

192 

percentage method, (See be- 
low under "Analysis, Trend 

Method") 
profit and loss statement, 154-206 

cause of insufficient profit, 161 

changing conditions in relation 
to, 154 

expense, 161 

illustrative figures, 157 

location of losses, 161 

need for method of, 155 

operating expense detail, 169 

profits, 159 

program of, 181 

purpose of, 155 

returned goods, 199 

standard ratios, 165 

trading vs. manufacturing, 163 



215 



2l6 



INDEX 



Analysis ( Continued) 

profit and loss statement 
(Continued) 

trend percentage method, 168, 
171, 173, 175, 176, 17^, 194, 

202 

Charts, 171, 172, 179, 181, 194, 
203, 205 

usual percentage, 163 
public utility statement, 192 
purpose of, 54 
special business problems, by trend 

method, 128 
statement, 

approach to, 27-30 

field of, 3-13 

necessity for, 9 

purpose of, 10 
trend method, 112 

illustration of, 112 

interpretation of, 115 

simplicity of, 121 

trends only shown by, 129 
trend of sales volumes, 128 
use of methods by executives and 

public accountants, 213 
use of methods in reports, 207-211 
usefulness of both ratio and trend 

method, 130 

Application of Funds Statement, 50 
Assets, 
arrangement of on balance sheet, 

18 

classification of, 14 
comparison of as regards credit 

risk, 21 
comparison of quick with working, 

34 

current, 
analysis, 20 

comparison with current lia- 
bilities, 34 ~~ 
defined, 19 
ratio to current liabilities, 83 



Assets (Continued) 
fixed, 

on balance sheet, 21 

over-investment in, 91 

ratio of net worth to, 70, 84 

ratio of sales to, 70, 84 
intangible, 

deduction from surplus, 26 

defined, 22 

value of, 23 
marking down on balance sheet, 

36 
quick, 

comparison with current lia- 
bilities, 35 

defined, 21 

ratio to current liabilities, 82 
scaling of, 35 
sources of, 15 
working, defined, 21 



B 



Balance Sheet, 14-26 
account names, interpretation of, 

76 
analyses of, 159 

annual sales, 39 

checking list, 152 

classes of, 28 

comparison of ratio and trend 
methods, 121 

conclusions as to technique, 150 

defined, 27 

historical ratio methods, 74-95 

history of, 31 

methods of, 29 

origin of, 27 

quick assets compared with 
working, 34 

ratios, 34 

scaling of assets, 35 

summary of methods, 150 

theory of, no 



INDEX 



217 



Balance Sheet (Continued) 
analyses of (Continued) 

trend method, (See below under 
"Trend Method") 

two or more, 151 

"2 to i" rule, 34 

working sheet for, 76 
analysis of single, 31-44, 151 

comparison of current assets and 

liabilities, 34 
arrangement, 26 
assets, 

arrangement of, 18 

classification of, 14 

current, 19 

deferred charges, 22 

intangible, 22 

marking down of, 36 

prepaid expense, 22 

scaling of, 35 

sources of, 15 
classification, optional, 75 
comparative, 

amounts, 48 

analysis, 45-53 

application of funds, 49 

increase and decrease method of 
analysis, 52 

interpretation of, 52 

percentage analysis of, 51 

ratios, 47 

trends shown by historical com- 
parison, 46 

use of comparative figures, 45 
complete, 16 
danger signals in, 42 
described, 4 
equation, 14 
fixed assets, 21 
form of, 17 
inclusions in, 6 
items, grouping of, 6 
liabilities, 

classification of, 15 

grouping of, 24 



Balance Sheet (Continued) 
liabilities ( Continued) 

long-time vs. current, 23 

types of, 23 

vs. net worth, 17 
net worth, 

classification of, 16 

inclusions in, 26 

vs. liabilities, 17 
of bankrupts, analysis of, 101 
ratios, (See "Ratios") 
relation to financial statement, 8 
solvency, indication of, on, 32 
trend method, of analysis, 110-132 

advantages of, 123 

flexibility of, 124 

for operating statistics, 126 

illustration of, 116 

interpretation of, 115 

simplicity of, 121 
uniformity of, 75 
"window dressing," 43 
Bankruptcy, 

balance sheets of, analysis of, 101 
statistics, 54, 143 

Bookkeeping, 4 (See "Accounting") 
Business, 
ailments, 

classification of, 56, 63 

common sense analysis, 97 

comparative seriousness of, 96- 
109 

diagnosis of, 54, 96 

gauges of, 64 

insufficient capitalization, 60, 71, 
93, ioo 

miscellaneous, 61 

over-investment in fixed assets, 

9i 

over-investment in inventory, 57, 

65, 86, 98 
over-investment in plant, 59, 69, 

99 

over-investment in receivables, 
58, 68, 89, 98 



218 



INDEX 



Business ( Continued) 
ailments ( Continued) 

ratios for diagnoses of, 67 

specific, 54-62 

statements reflecting, 57 
average life of, 143 
barometers, selection of, 205 
condition of, trends vs., 130 
conditions, trend of, 202 
danger point in, 133 
history of, 3 
language of, 3 
problems, special, trend method for 

analysis of, 128 
risks, measurement of, 97 
size of, influence on standard 

ratios, 143 
Business Forecasting Bureaus, 201 



C. P. A. Certification, 

of financial statements, n 
Capital Stock, Inclusions in, 26 
Capitalization, Insufficient, 60, 71, 93, 

100 

Certification, 
of financial statements, n 

qualified, 12 

Charges, Deferred, Defined, 22 
Comparative Balance Sheet, (See 
"Balance Sheet, Comparative' 1 ) 
Comparison, Methods of, 45 
Comptroller, 

value of standard ratios for, 146 
Copyrights, On Balance Sheet, 22 
Costs, 

material and labor on manufactur- 
ing statement, 191 
Credit, 
factors, 12 
geographical location, effect of, on, 

59 
over-extension of, 58 



Credit (Continued) 
risk, comparison of assets in re- 
gard to, 21 
risk, comparison of liabilities as 

regards, 24 

short-time, dangers of, 61 
Current Assets, 
analysis, 20 
comparison with current liabilities, 

34 

defined, 19 
Current Liabilities, 
comparison with current assets, 34 
long time vs., 23 

D 

Debts, Ability to Pay, 33 
Deferred Charges, Defined, 2J 
Double Entry Bookkeeping, 4 

E 

Executive, 

interest of balance sheet for, 28 

use of analysis methods by, 213 
Expense, 

analysis of, 161 

importance of trends, 191 

operating, 
analysis of, 169 
danger in, 163 

prepaid, defined, 22 



Failures (See "Bankruptcy") 
Financial Condition, 

ability as reflected by, 56 
Financial Statements (See also 

"Balance Sheet," "Profit and 

Loss Statement") 
analysis, 

approach to, 27-30 

field of, 3-13 

necessity for, 9 

purpose of, 10 



INDEX 



219 



Financial Statements ( Continued) 
as goal of double entry account- 
ing, 4 

business ailments reflected m, 57 
certification, qualified, 12 
C. P. A. certification of, n 
frequency of, 8 

safeguards against misrepresenta- 
tion, ii 
untrue, 10 

Fixed Assets, (See "Assets, Fixed") 
Fixed Liabilities (See "Long Time 

Liabilities") 

Forecasting, Bureaus, 201 
Franchises, on Balance Sheet, 22 
Funded Liabilities (See "Long Time 

Liabilities") 

Funds (See also "Assets") 
application of, 49 



Goodwill, 
on balance sheet, 22 

H 

Harvard Bureau of Research, 
studies by, 196 



Income Account (See "Profit and 

Loss Statement") 
Income Statement (See "Profit and 

Loss Statement") 
Intangible Assets, 

deduction from surplus, 26 

defined, 22 

value of, 23 
Inventory, 

average vs. actual, 66 

comparison net current items, 67 

over-investment in, 57, 65, 86, 98 

ratio to sales, 41, 65, 83 

valuation, 37 



Investor, 

interest of balance sheet analysis 
for, 28 



Liabilities, 

classification of, 15, 61 
comparison of, as regards credit 

risk, 24 
current, 
comparison with current assets, 

34 

comparison with quick assets, 35 
ratio to current assets, 83 
ratio to quick assets, 82 
grouping on balance sheet, 24 
long time vs. current, 23 
net worth vs., 17 
ratio of net worth to, 71, 84 
types of, 23 
Logarithmic Paper, 
use of for charting trend percent- 
ages, 173 
Long Time Liabilities, Current vs., 

23 
Loss and Gain Statement (See 

"Profit and Loss Statement") 
Losses, Location of, 161 

M 

Manufacturing Policies, 

effect on ratios, 78 
Manufacturing Statements, 
analysis, 183 
illustration, 185 
interpretation, 187 
trend percentage method, 187, 

190 

Chart, 1 88, 189 

availability of detailed figures, 191 
expense trends, 191 
material and labor costs, 191 



22O 



INDEX 



Merchandise Turnover (See "Turn- 
over") 
Mode, Definition, 139 

N 

Net Worth, 

capital stock, 26 

classification of, 16 

inclusions in, 26 

liabilities vs., 17 

ratio to fixed assets, 70, 84 

ratio to liabilities, 71, 84 

ratio to sales, 71, 83 

surplus, 26 
Non-Trading Companies Statements, 

analysis of, 192 

Northwestern Bureau of Business 
Research, 

studies by, 198 



Operating Statistics, 
comparison with profit and loss 

figures, 199 
Chart, 200 
use of trend method for, 126 

Over-investment, 
in fixed assets, 91 
in inventory, 57, 65, 86, 98 
in plant, 59, 69, 99 
in receivables, 58, 68, 89, 98 



Patents, on Balance Sheet, 22 
Permanent Liabilities (See "Long 

Time Liabilities") 

Plant, Over-investment in, 59, 69, 99 
Prepaid Expenses, Defined, 22 
Production, 
mixed, effect on ratio of sales to 

fixed assets, 85 



Profit and Loss Statement (See also 
"Manufacturing Statement") 

analysis, 154-206 
cause of insufficient profit, 161 
changing conditions in relation 

to, 154 
expense, 161 
illustrative figures, 157 
internal vs. external viewpoint, 

206 

location of losses, 161 
need for method of, 155 
operating expense detail, 169 
profits, 159 
program of, 181 
purpose of, 155 
standard ratios, 165 
trading vs. manufacturing, 163 
trend method, (See below under 
"Trend Method of Analysis") 
usual percentage, 163 

classification, 156, 170 

described, 5 

inclusions in, 7 

interpretation of, 170, 178 

items, grouping of, on, 7 

margin of safety, 195 

nature of, 6 

operating statistics compared with, 

199 
Chart, 200 

ratios, (See "Ratios, Profit and 
Loss Statement") 

relation to balance sheet, 8 

returned goods, 199 

sales trends, unsatisfactory, 201 

trend method of analysis, 168, 171, 

172, 179, 181, 194, 202 
Charts, 171, 172, I79> 181, 194, 

203, 205 

illustration of, 176, 178 
importance of charting trends, 

171, 173 
variations in, 175 



INDEX 



221 



Price Index, 
adjustment of sales by, 85 

Public Accountant, 
interest of balance sheet for, 29 
use of analysis methods by, 213 
value of standard ratios for, 145 

Public Utility Statements, 
analysis of, 192 
interpretation of, 193 



Quick Assets Defined, 21 



Ratios, 

"acid test," 35 
adjusted, 102 
artificiality of, 112 
assets, 

current to current liabilities, 83 
quick to current liabilities, 82 
balance sheet, 34, 63-73 
development of, in 
comparative balance sheet, 47 
current assets to current liabilities, 

34 

effect of kind of business on, 77 
effect of sales policies on, 78 
for diagnosis of business ail- 
ments, 67 
historical analysis of balance sheet 

by, 74-95 
important, 43 
intelligent use of, 73 
interpretation of, 44, 92, 94 
manufacturing policies, effect on, 

78 

net profit per share of stock, 196 
net worth to fixed assets, 70, 84 
net worth to liabilities, 71, 84 
objections to analysis by, in 



Ratios ( Continued ) 
profit and loss, 

averaging-, 166 

net profit per share of stock, 196 

practicability of, 198 
quick assets to current liabilities, 

35 

receivables to sales, 40 
reduction of, to common base 87 
reliability of, 112 
sales to fixed assets, 70, 84 

effect of mixed production, 85 
sales to inventory, 41, 83 
sales to net worth, 71, 83 
sales to receivables, 69, 83 
significance of, 107 
standard, 74, 133-149 

comparison of, 135 

construction of, 135 

deviations from, 136 

elements of value in, 145 

group location of mode, 140 

history of, 133 

ideal vs., 148 

importance of recent figures, 144 

influence of size of business on, 
143 

mode, 139 

objection to, 142 

profit and loss, 165, 196 

securing of better averages, 138 

standard accounting classifica- 
tion necessary for, 143 

substitute for arithmetic aver- 
age, 138 

summary of important factors, 
147 

uniformity of policies necessary 
for, 144 

value of averages, 137 
use of, illustration of, 81 
use of several, 72 
value of, 94 
warning given by, 72 



222 



INDEX 



Receivables, 

over-investment in, 58, 68, 89, 98 

ratio to sales, 40, 69, 83 
Reports, 

figuring percentages, 21 

rules for reporting, 208 

substitutes for technical words, 210 

summary form of, 211 

three year analysis, 211 

use of analysis methods in, 207-211 
Reserve Account (See "Valuation 

Account") 
Returned Goods, 

as factor of profit and loss 
analysis, 199 



Sales, 

adjustment by price index, 85 
annual, balance sheet analysis of, 

39 

policies, effect on ratios, 78 
ratio to fixed assets, 70, 84 
ratio to inventory, 41, 83 
ratio to net worth, 71, 83 
ratio to receivables, 40, 69, 83 
relation to inventory, 65 
unsatisfactory trends, 201 
volume of, trend of, 128 

Selling, Importance of, 20 

Slide Rule, Use of, 76 

Solvency, 

balance sheet figures showing, 32 

Statement of Assets and Liabilities 
(See "Balance Sheet") 



Statement of Resources and Lia- 
bilities (See "Balance Sheet") 
Statements (See "Financial State- 
ments") 
Surplus, 
deduction of intangible assets from, 

26 

inclusions in, 26 
permanency of, 33 



Trading and Profit and Loss State- 
ment (See "Profit and Loss 
Statement") 

Trend Study (See "Analysis") 
Turnover, ascertainment of, 41 
substitute for, 41 



Valuation, 

assets, 36 

inventories, 37 
Valuation Account, 

adjustment of inventories by, 37 
Value, 

intangible assets, 23 

W 

"Window Dressing," 

of balance sheet, 43 
Working Assets, 

defined, 21 
Working Sheet, 

for analysis of balance sheets, 76 






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