Analysis By Sales

A method of analysis requiring detailed study of both the balance sheet A financial statement listing the assets, liabilities and owner’s equity of a business entity as of a specific date. and the income statement is the analysis by sales. After outlining the objectives of an analysis by sales, this topic discusses certain conditions upon which a successful analysis depends, and provides examples of an analysis of both a wholesaler A business that purchases goods from a manufacturer and sells to retailers (aka distributor). 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 presupposed this reluctance. In some cases sketchy income statement figures were given, but, except for the occasional use of a sales or profit figure in computing a ratio A mathematical relationship between two elements, derived by dividing one into the other (e.g., the current ratio results from dividing current assets by current liabilities). , they were virtually ignored. Now the time has come to examine how you can use these figures when they are available. The most popular method is commonly referred to as "Statement Analysis on the Basis of Sales."

In making an analysis by sales, the credit The privilege of buying goods, services or borrowing mone A medium of exchange; coined or stamped currency. y in return for a promise of future payment. analyst attempts to answer what is usually the most important question about a prospective credit customer "Is this company likely to pay our invoices on time?" Unless a business has a working capital The net assets of an individual enterprise, partnershi A partnership is defined as “an association of two or more persons to carry on as co–owners of a business for profit.” While no particular form of contract is necessary to create a partnership, a partnership contract usually provides what the partners’ ri p, corporation, including not only the original investment, but the gains and profits from the business. line of credit or personal financial resources to draw upon, collections The process of prompting for and obtaining payment of a debt or other outstanding obligation. Collection actions to secure payment of a past due balance. (See also Documentary Collection.) from its customers will be the primary source of cash to pay its creditors. Creditors want to know if a company's income will be enough to pay the payroll, the rent, and other operating expenses, with enough cash left over to pay trade creditors without undue delay.

In order to make such an analysis on the basis of the customer's latest financial statements The balance sheet, income statement, statement of changes in financial position, statement of changes in owners' equity accounts, cash flow statement and notes. 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 Any partial loss or damage due to insured perils. 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 The excess of net over the cost of merchandise sold. figure.)

Notice that these figures also roughly represent one month's supply of each major current asset. Expenses are immediately maturing liabilities. So, to meet them for a month, the firm must have a Cash balance of $6,250. Similarly, the $35,400 monthly cost of goods sold figure represents a one-month supply of inventory Goods held for sale or leas A contract granting the use and possession of real property for a specified time and for fixed payments. e that are furnished under contracts of service, usually raw materials, work in proces The direct material costs, the direct labor costs and the factory overhead costs, that have entered into the manufacturing process but are associated with products that have not been finished. s, or materials used or consumed in a business. . Assuming the Jones Company sells exclusively on Net 30 day terms, the $41,700 monthly net sales figure should represent a month's accumulation of Accounts Receivable A clai A right to payment or other equitable remedy in the event of a breach of contract. m against a customer for services rendered or goods sold on credit. .

Your next step should be to examine these 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. They suggest that the Jones Company has a minimal amount of cash on hand. These figures indicate inventory is heavy. The 72-day supply should make the analyst suspicious that the company may be burdened with a considerable amount of obsolete or otherwise unmarketable inventory.

These figures also show that accounts receivable may be in an unhealthy condition. 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 In the case of a secured interest, the secured party may agree to make his security interest inferior to another security interest. 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 Debts or obligations that will be due in one year or less. section of the balance sheet. By dividing accounts payable A liability created by a purchase on credit by the monthly cost of goods sold, you can in theory determine how long the company will take to pay its trade debts:

Accounts Payable $120,000 ÷ $35,400 = 3.4 X 30 = 102 days

It appears that the proportion of the Jones Company's income that can be earmarked for paying trade debts will be too small to retire those debts within a reasonable time frame. The conclusion from this type of analysis would be that this company is a poor credit risk Conditions in which the decision maker has to estimate the likelihood of certain outcomes. .

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 Industrial products that are composed of farm and natural products. purchases, manufacturing labor, and factory overhead. For analysis purposes, the manufacturer's income statement must be broken 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 Cash or other assets that are expected to be converted to cash or sold or utilized within a year or less through the normal operations of a business. 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

Again it should be emphasized that these figures are far from precise. You 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 you an idea of the general condition of the firm's assets and liabilities. It also points to areas that may require closer scrutiny.