Why Comparative Statements Reveal Far More Than Financial Statements
Comparative statements are financial reports that compare a given financial statement with either a prior time period or another company. Comparative statements add two critical dimensions to the analysis of a company that can't be seen using the financial statements alone.
The trend is your friend
The three financial statements -- the income statement, balance sheet, and statement of cash flows -- each do an excellent job of informing investors and managers of the financial condition of a business.
The income statement is great for understanding how a company's sales and expenses translated into earnings over a period of time. The balance sheet shows what a company owns, what it owes, and its net worth at a point in time. The statement of cash flows reconciles the income statement and balance sheet to show how a company is managing its cash.
All of this information is critical to understanding how a company's operations translate into financial results. However, it doesn't tell the full story.
First, financial statements alone can't show us trends. Has the company grown over the past five years? How are profit margins changing over time? Is the company increasing or decreasing its debts since new management took over three years ago? Understanding trends is just as important as understanding the numbers on the three financial statements.
For example, an income statement may tell you that last year a company generated $100 million in profits on revenue of $500 million. At first blush, that seems great. That's a huge sum of money with a pretty solid profit margin.
However, when you use a comparative statement to view the financials over a longer time period, you discover that just three years ago the company's profits were $2 billion, and sales were $3 billion. The comparative statements show that profits are down 95%, sales are down 83%, and profit margins have tightened from 67% to 20%. Suddenly, last year's results don't look so rosy.
This is obviously an exaggerated example, but it serves as a lesson all investors should learn. No financial analysis is complete without understanding trends, and you can't see trends in the financial statements alone.
A company doesn't operate in a vacuum
Second, financial statements do not include any information on competitors, the marketplace, or industry conventions. A proper financial analysis must compare a company's performance to industry benchmarks and competitors.
Let's say that a company's balance sheet shows that it has $100 million in assets and $50 million in total liabilities. Is this an appropriate level of debt, or is the company borrowing too much and taking on excessive risk?
It's impossible to say without understanding established best practices in the company's industry. It could be that this particular industry tends to use a lot of leverage, as in real estate. In that case, the company may need to increase its debts and grow its balance sheet to fully optimize its earnings potential. On the flip side, perhaps this industry tends to shy away from debt, and the company is taking on too much risk by racking up such large liabilities.
As an analyst, you won't know the answer unless you use comparative statements that compare the company in question with its competitors and its industry. If there's a discrepancy between the company and its competition, that isn't necessarily a bad thing, but it does mean that the analyst needs to find out why the company has elected to stray from the industry norm. It could indicate that the company has found a better way to do business, or it could be a sign of poor management. Either way, this comparative analysis cues the analyst to dig deeper and ask more questions.
A financial analysis starts with the financial statements, but it doesn't end there
To understand a company's financials, an analyst must start with the financial statements. These three documents are the best way to understand a company's financial position at a given point in time. However, using the financial statements alone is not enough.
Comparative statements are a powerful tool to fill in the gaps left by the financial statements. Specifically, they can provide context to how a company is trending over time and how the company compares to its competitors and the rest of its industry.
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