Financial Statements Analysis and Long-
Answers to Concept Questions
Time trend analysis gives a picture of changes in the company’s financial situation over
time. Comparing a firm to itself over time allows the financial manager to evaluate whether
some aspects of the firm’s operations, finances, or investment activities have changed. Peer
group analysis involves comparing the financial ratios and operating performance of a
particular firm to a set of peer group firms in the same industry or line of business.
Comparing a firm to its peers allows the financial manager to evaluate whether some aspects
of the firm’s operations, finances, or investment activities are out of line with the norm,
thereby providing some guidance on appropriate actions to take to adjust these ratios if
necessary. Both allow an investigation into what is different about a company from a
financial perspective, but neither method gives an indication of whether the difference is
positive or negative. For example, suppose a company’s current ratio is increasing over time.
It could mean that the company had been facing liquidity problems in the past and is
rectifying those problems, or it could mean the company has become less efficient in
managing its current accounts. Similar arguments could be made for a peer group
comparison. A company with a current ratio lower than its peers could be more efficient at
managing its current accounts, or it could be facing liquidity problems. Neither analysis
method tells us whether a ratio is good or bad, both simply show that something is different,
and tells us where to look.
If a company is growing by opening new stores, then presumably total revenues would be
rising. Comparing total sales at two different points in time might be misleading. Same-store
sales control for this by only looking at revenues of stores open within a specific period.
The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets,
employees, and, in fact, just about every aspect of its operations and financing exist to
directly or indirectly support sales. Put differently, a firm’s future need for things like capital
assets, employees, inventory, and financing are determined by its future sales level.
Two assumptions of the sustainable growth formula are that the company does not want to
sell new equity, and that financial policy is fixed. If the company raises outside equity, or
increases its debt-equity ratio, it can grow at a higher rate than the sustainable growth rate.
Of course, the company could also grow faster than its profit margin increases, if it changes
its dividend policy by increasing the retention ratio, or its total asset turnover increases.