FINANCIAL STATEMENTS ANALYSIS
AND LONG-TERM PLANNING
Answers to Concepts Review and Critical Thinking 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 appropriate.
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.