Perform Financial Comparatives Over Time
The goal of comparing financial metrics over time is to judge the current performance of a corporation based on the past performance of the same corporation. Instead of looking at your financial measures and metrics by themselves, you want to compare them to the previous years’ metrics and see how they’ve changed, if at all.
This analysis allows you to look for patterns in performance metrics, identify cyclical changes, note patterns in these changes over time, and determine whether the overall trend is good or bad. Identifying many of these patterns, such as whether there are cycles, allows you to begin identifying the causes of those patterns.
Being able to recognize what influences your financial performance allows you to be more proactive in responding to those influences, as well as potentially even managing the influences themselves to react in your own favor.
Spot analysis is analysis for a single point (or spot) in time, rather than for assessing trends. Spot analysis is great if you live in a time-loop that repeats the same moment over and over again; otherwise, the amount of useful information you can derive from a single moment in time is pretty limited.
Watching for patterns, cycles, and current trends allows you to project future financial performance as well. It’s important to note that these are estimates, though, because human error tends to be a frequent cause of problems.
Even when that’s not a factor, it’s important to recognize that as you attempt to project further into the future, your estimates will be less accurate. It’s much easier to project what your finances will look like tomorrow than it is to project what they’ll look like in ten years.
Take a look at a couple examples of how a time analysis of financial metrics can make a big difference compared to just a single calculation of any financial metric.
The quick ratio is a measure of liquidity that calculates a corporation’s ability to pay off debt that will become due in the next year. It’s calculated as follows: [(current assets-inventories)/current liabilities]. With that in mind, here’s the first example.
Corporation A in 2012: Quick Ratio = 0.7
That doesn’t sound so bad, does it? In a worst-case scenario where the company can’t sell any of its current inventories, it’s still able to account for 70 percent of its current liabilities using its highly liquid assets. But, is that really a good thing? Compare that against time.
Corporation A in 2011: Quick Ratio = 0.9
Corporation A in 2010: Quick Ratio = 1.2
Uh oh! The company appears to be losing liquidity at a rate of about 26 percent annually! That’s very fast! It may have a lot of debt coming to maturity this year, it may not be collecting revenues quickly enough, or it may simply not be making as many sales. In any case, this doesn’t look good for the corporation.
Don’t take this example the wrong way, though. Take a look at a second, almost-identical example to see how they differ in important ways.
Corporation A in 2012: Quick Ratio = 1.0
Corporation A in 2011: Quick Ratio = 1.3
Corporation A in 2010: Quick Ratio = 1.7
The corporation is still losing liquidity at a rate of about 26 percent annually during the same three years, but the significant difference is that the ratio is still much higher. It’s still able to cover all of its current liabilities using only highly liquid assets. Not only is this not as severe as the other example, but it may actually be considered a good thing!
Holding all your assets in a highly liquid form means you’re not using them to generate more revenues. The corporation in this example may be intentionally lowering its liquidity in order to increase its returns on investment or increase the efficiency of its asset management.
As you can see, finding trends is much easier than interpreting them. Whether a reduction in liquidity is helping or harming the corporation’s financial well-being depends greatly on a number of other factors. You may want to consider combining this example with a horizontal common-size comparison of the corporation’s balance sheet and income statement to see whether it’s having trouble generating revenues or turning sales into cash.
You can also do this via a time-comparison of receivables turnover or turnover in days to determine whether the company is collecting revenues or taking longer than normal to do so.
The key to understanding context in these time comparison metrics is to look at what variables will influence or be influenced by the change. In the liquidity example, the things that really matter are how much debt is changing, how much revenue is changing, projections of revenue collection on old sales, projections of new sales, and the amount of debt the company will be able to pay off after other bills are also accounted for.
This type of analysis is a great way to understand the state of a corporation and what to expect out of it in the future.