Unit 11: Using Managerial Accounting: Trends and Ratios
In this unit we examine the three-pronged approach managerial accountants and potential investors typically use to analyze a company’s financial information. First, we use trend analysis and common-size analysis to examine trends the company has experienced within its own financial sphere, such as sales and earnings from one year to the next. Secondly, we compare the company's financial measures with its main competitors in the industry. Finally, we compare the company's financial ratios with industry-wide averages or standards.
Completing this unit should take you approximately 7 hours.
Upon successful completion of this unit, you will be able to:
- perform trend analysis to evaluate financial statement information;
- perform common-size analysis to evaluate financial statement information;
- use ratio analysis to measure profitability, short-term liquidity, long-term solvency, and market valuation; and
- develop and analyze non-financial performance measures using a balanced scorecard.
11.1: Introduction
Financial stability is an important attribute of how your company is perceived by customers and competitors. Similarly your company will be evaluated by others – customers, supplier or stakeholders. All but privately held corporations published annual financial information; even privately held corporation can be and often are asked for their financials. The principles of managerial accounting are used to determine trends and ratios to evaluate the strength of each company’s income statement and balance sheet. Trends and "common size analysis" and ratio analysis are all used to make intra- and inter- comparisons of performance. This unit should give you a better idea about how financial stability is determined and used for any company.
Financial analysis is an important skill set which integrates all that you have learned so far in this course. Think about your own skills, having completed most of this course. Can you do what it is that Tony is talking about?
11.2: Trends, Horizontal Analysis
You have already seen ‘trend analysis’. You called it ‘least squares’ or ‘regression analysis’, better still linear regression analysis. This was discussed in Unit 3. Here you look at how relevant variables move (increase or decrease) over time. The idea is to use that movement to spot problems, i.e. declining profits or increasing sales. Trend analysis looks for both strengths and weaknesses. It separates out one-time events and negates the need for anecdotal evidence. It is an objective measure of performance over time. The time measured can be year to year or for multiple years. This method is also known as horizontal analysis.
Watch as Bell does an horizontal/trend analysis for Elky Co.
11.3: Common-Size, Vertical Analysis
When you are dealing with many numbers of comparatively large magnitudes, it becomes difficult to distinguish important features or attributes of those numbers. With common size analysis, you reduce numbers to percentages and then compare percent difference. For example if you have a company that has $450,000 in profit on sales of $2,220,000, while another has profit of only $375,000 on sales of $1,500,000, how do you compare these numbers? This is the strength of common size analysis, which is also known as vertical analysis.
Tony Bell helps a client, Harpreet Gill, compare his financial statements to another company's statements with vertical analysis.
11.4: Ratio Analysis
The most robust type of analysis is ratio analysis. A ratio is a comparison of two numbers and normally takes the form of a fraction, decimal or percentage. A ratio can be specific to a company, to companies within a region, to an industry or to a stock exchange. Ratios are versatile and powerful. Ratios are powerful. In the text you are shown how to use ratios to explain and compare companies, to companies or companies to industries.
Coca Cola
Pepsi Co.
Beverage Industry
Profit margin ratio
34%
11%
20%
There are four basic types of ratios that you will learn about:
- Ratios
used to measure profitability
- Ratios
used to measure short-term liquidity
- Ratios
used to measure long-term solvency
- Ratios
used to measure market valuation.
- Ratios
used to measure profitability
In these two videos, Tony Bell examines the financial statements for Squirrel Co. and develops several examples of useful ratios.
11.5: Chicken Deluxe’s Choice
Before you read the final two sections of Chapter 13, go back to the beginning of this chapter and review the problem Chicken Deluxe had. Review the analysis that the management accountants at Chicken Delux produced and note the use of all the elements you have been reading about in this unit. In coming to a management decision, seldom will numbers provide an answer on their own. A good CEO and a good team will also consider nonfinancial performance measures in coming to a decision. This process of considering nonfinancial performance measures is considered and you will note how similar the methodology is to those we have discussed above for financial performance measures.
Unit 11 Conclusion
You end this unit and the course on a practical and important topic. You have learned to use managerial accounting to produce great deals of information germane to management decisions. Trends and ratio are critical, but so too is non financial analysis critical for successful managerial decisions.
Margaret Heffernan in MoneyWatch reports that 50 to 80 percent of mergers fail! Before a merger is entered into there is copious and scrupulous managerial accounting information produced and reviewed, yet the merger failure rate has been far too high for decades. The lesson here is that, although the numbers you can now produce and analyze are important, they cannot, on their own answer complex management questions. Management accounting information serves a critical role, but decision-makers always need to look beyond the numbers and use a balanced approach.