Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

II. Financial Statements

and Long−Term Financial

Planning

3. Working with Financial
   Statements

© The McGraw−Hill^93

Companies, 2002

relative to the base amount. We will call the resulting statements common–base year
statements.
For example, from 2001 to 2002, Prufrock’s inventory rose from $393to $422. If we
pick 2001 as our base year, then we would set inventory equal to 1.00 for that year. For
the next year, we would calculate inventory relative to the base year as $422/393 
1.07. In this case, we could say inventory grew by about 7 percent during the year. If we
had multiple years, we would just divide the inventory figure for each one by $393. The
resulting series is very easy to plot, and it is then very easy to compare two or more dif-
ferent companies. Table 3.7 summarizes these calculations for the asset side of the bal-
ance sheet.

Combined Common-Size and Base-Year Analysis

The trend analysis we have been discussing can be combined with the common-size
analysis discussed earlier. The reason for doing this is that as total assets grow, most of
the other accounts must grow as well. By first forming the common-size statements, we
eliminate the effect of this overall growth.
For example, looking at Table 3.7, we see that Prufrock’s accounts receivable were
$165, or 4.9 percent of total assets, in 2001. In 2002, they had risen to $188, which was
5.2 percent of total assets. If we do our analysis in terms of dollars, then the 2002 figure
would be $188/165 1.14, representing a 14 percent increase in receivables. However,
if we work with the common-size statements, then the 2002 figure would be 5.2%/4.9%
1.06. This tells us accounts receivable, as a percentage of total assets, grew by 6 per-
cent. Roughly speaking, what we see is that of the 14 percent total increase, about 8 per-
cent (14%
6%) is attributable simply to growth in total assets.

CONCEPT QUESTIONS

3.2a Why is it often necessary to standardize financial statements?

3.2bName two types of standardized statements and describe how each is formed.

CHAPTER 3 Working with Financial Statements 61

PRUFROCK CORPORATION TABLE 3.6

Common-Size Income Statement

2002

Sales 100.0%

Cost of goods sold 58.2

Depreciation 11.9

Earnings before interest

and taxes 29.9

Interest paid 6.1

Taxable income 23.8

Taxes (34%) 8.1

Net income 15.7%

Dividends 5.2%

Addition to retained earnings 10.5

common–base year

statement

A standardized financial

statement presenting all

items relative to a certain

base-year amount.