Analysis By Sales

A method of analysis requiring detailed study of both the Balance Sheet and the Income Statement is analysis by sales. After outlining the objectives of an analysis by sales, this essay examines certain conditions upon which a successful analysis depends, and provides examples of an analysis of both a wholesaler and a manufacturer.  To make a thorough financial statement analysis, you need both the customer's latest Balance Sheet and Income Statement. However, many customers that are willing to share their Balance Sheet will not provide a copy of their Income Statement.

The methods of analysis discussed in earlier topics pre-supposed this reluctance. In some cases sketchy income statement figures were provided and except for the occasional use of a sales or net profit figure in computing a ratio, they were virtually ignored.  It is time to examine how you can use these figures from the income statement when they are available. The most popular method is commonly referred to as Statement Analysis on the Basis of Sales.

In making an analysis on the basis of sales, the credit analyst attempts to answer the most important question about a prospective customer requesting open account terms, which is this:  "Is this applicant company likely to pay our invoices on time?"  Unless a business has a working capital line of credit or personal financial resources to draw n, collections from customers is the primary source of cash to pay its creditors. Creditors want to know if a company's sales will be sufficient to pay employees, the rent and other operating expenses, and will provide enough cash to pay trade creditors on time.  In order to make such an analysis on the basis of the customer's latest financial statements the following conditions must apply:

1. You must assume that expenditures for the year to come will remain in the same proportion as they were for the year past. An adjustment must be made for any anticipated capital expenditures such as major equipment purchases, construction projects, etc. 
2. Sales must remain at a relatively constant level, or if any significant increase or decreases expected in the coming year it must be accurately predicted. 
3. Seasonal fluctuations must be adjusted for. If the financial statement you have was issued at either end of the selling season, your analysis will be distorted by the customer's seasonality. In these cases, the credit analyst must try to arrive at a yearly average figure for each asset and liability. 

For purposes of illustration in the following examples, it is assumed that expenditures remain in the same proportion from one year to the next, that sales remain at a constant level, and that there are no seasonal fluctuations.

Analysis by Sales of a Wholesaler or Retailer:  A recent financial statement of the Jones Company, a wholesaler, appears below. To make an analysis by sales of this firm you must first reduce the major items on the income statement to monthly figures. You do this by dividing each of them by 12.   (Note: The percentage of profit is ordinarily so small that it is included in the expense figure. The resulting total is, of course, equal to the gross profit figure.)

The next step should be to examine the current asset figures on the balance sheet to determine what supply of each item is on hand. To determine this, first you divide the asset figure by the monthly income statement figure, and then you multiply your answer by 30 to get the number of days the asset will last:

Given the obvious limitation of this method of analysis, these figures in days are hardly precise. They are, however, indicators of possible problems. A firm like this one that sells on 30-day terms should have a maximum collection period of about 40 days.

All of this information is subordinate to the real aim of this analysis - which is to discover whether the Jones Company's income would be adequate to meet its obligations. To answer this question you must refer to the current liabilities section of the balance sheet. By dividing accounts payable by the monthly cost of goods sold, you can in theory determine how long the company will take to pay its trade debts:

Analysis by Sales of a Manufacturer:  An analysis by sales of a manufacturer is a somewhat more complicated process than that of a wholesaler or retailer. This is due to the more complex makeup of the cost of goods sold section of the manufacturer's income statement. Notice in the following financial statement of the Smith Manufacturing Company that instead of a single figure for merchandise purchases, entries appear for raw materials purchases, manufacturing labor, and factory overhead. For analysis purposes, the manufacturer's income statement must be broken down as follows:

Net Sales: $200,000
Raw Materials Costs: 100,000*
Labor (+Factory Overhead): 70,000
Expenses: 30,000

Then these items are reduced to monthly figures. Next these monthly figures are divided into the appropriate current assets to determine the number of days' supply of each asset on hand. In the manufacturer's case both the expense figure and the labor figures are divided into cash, since each is an immediately maturing expense.

Finally the accounts payable figure is divided by the monthly raw materials costs to determine the length of time the Smith Company needs to pay its trade debts.

Accounts Payable $12,000 ÷ $8,300 = 1.4 X 30 = 42 days

It must be emphasized that these figures are not precise. For example, we cannot conclude that the Smith Company has exactly a 36-day supply of cash, or that its accounts payable are being retired in exactly 42 days. Instead, this type of analysis gives the credit analyst an idea of the general condition of the credit applicant's assets and liabilities. It also points to areas that may require closer scrutiny.

Edited by Michael C. Dennis