The Alexandroff-McCord approximative sequence

The basic idea behind Common-Size Financial Statements is to show Income Statements, Balance Sheets, etc. with all quantities normalized to a key item. For example, a Common-Size Income Statement shows each quantity as a percent of sales in the period. (So here, sales is the key normalizing item). By comparing Common-Size Income Statements for several periods, we can quickly determine if costs are rising relative to sales, or if profit (Net Income) is increasing in proportion to sales.

Similarly, Common-Size Balance Sheets show all items on a company's Balance Sheet as a percent of its total assets. Again looking at statements from several adjacent periods, we can quickly determine, for example, if a company's debt is increasing relative to its assets (increasing the entity's financial risk), or whether its equity base is shrinking.

C

-S

S

E

:

C

A

(CAL) D

G

R

Lets create and scrutinize Continental's (CAL's) Common-Size Income Statements for part of the Great Recession. First, here is a bit of background:

At the onset of the period, CAL was typical of the legacy airlines. It shared with its peers:

 A high fixed cost structure, due in part to its great variety of old planes with inefficient engines, and its unsustainable union contracts.

 Lots of debt relative to its ability to repay it and relative to its equity.

 Difficulty competing with new, low-cost rivals, such as Southwest, Alaska Air and JetBlue.

 A struggle to cope with the skyrocketing cost of jet fuel², which was caused by stagnant global supply and escalating demand in developing countries.

2 Demand was especially growing in China, where it was increasing by about 8% per year at the start of the recession. As a result of this supply/demand imbalance, the price of jet fuel increased from $1.65 per gallon in January 2007 to $3.89 per gallon in July of 2008. The price subsequently declined as the worldwide recession reduced global demand.

http://www.indexmundi.com/commodities/?commodity=jet-fuel&months=120.

“Causes and Consequences of the Oil Shock of 2007-08.” James Hamilton.

http://dss.ucsd.edu/~jhamilto/Hamilton_oil_shock_08.pdf

CHAPTER 13 – FINANCIAL STATEMENT ANALYSIS: PART I PAGE 3

Here are CAL's Income Statements for the six quarters ending 6/30/2008:

To make these Common-Size Statements, we divide each entry of each quarter's Income Statement by the sales (Revenue) of the quarter. For example, SGA for the quarter ending 12/31/2007 will be:

Cost of Goods Sold (COGS) / Revenue = 3102 /3523.0 = 88.0%

Performing this division for each item in each quarter yields six Common-Size Statements for CAL:

Before we start analyzing the Common-Size statements, we need to decide how to compare quantities across time periods. In particular, should we

CHAPTER 13 – RATIO ANALYSIS PART I PAGE 5

compare quarter by quarter (quarter ending 3/31/2008 to quarter ending 12/31/2007) or year over year (quarter ending 3/31/2008 to quarter ending 3/31/2007)?

The answer depends on whether or not CAL is a “seasonal” company. Seasonal entities experience peaks and troughs in revenues and/or costs during various times of the year. Non-seasonal companies generally experience steady sales and costs throughout the year. Retail banks are good examples of non-seasonal companies.

Like most airlines, CAL experiences its biggest sales at particular times of the year, such as the summer vacation season, when many consumers travel. So we can safely conclude that CAL is seasonal and we should compare its numbers for each quarter to their year-ago counterparts.

Don't worry if this was not obvious to you – you can always look it up. Publicly-traded

companies like CAL report their seasonality (or lack thereof) in annual filings to the Securities and Exchange Commission (SEC) called 10-K reports. CAL's filing from 2008, for example, states:

Due to greater demand for air travel during the summer months, our revenue in the second and third quarters of the year is generally stronger than revenue in the first and fourth quarters of the year. Our results of operations generally reflect this seasonality,…

You could also try to determine if CAL is seasonal by plotting its quarterly revenue. This technique works for steady-state companies in steady-state economic conditions. It does not work well for volatile companies during volatile economic periods, because seasonality in revenues may be masked by sales swings from other causes.

Having established CAL's seasonality, we are ready to analyze its performance via its Common-Size Income Statements. The best place to start reviewing Income Statements is usually with Revenue and Revenue growth. This is because Revenue is the cardinal measure of the scale of a firm, and because many changes in companies' performance are down to changes in sales.

For studying Revenue and Revenue growth, CAL's raw Income Statements are actually more helpful than its Common-Size equivalents, because all the Common-Size sales numbers read 100%. So lets put this research aside for now, and look at the second best place to start reviewing an Income Statement: Net Income. Net Income is good to look at because, as we know, it shows what a company earns from day-to-day operations, after also making required payments like interest, taxes, etc.

A quick glance shows us that CAL's Net Income is collapsing. It declined from 0.7% of sales in the quarter ending 3/31/2007 to -3.5% in the quarter ending 3/31/2008. Worse, CAL's Net Income swung from 6.3% of sales in the 6/30/2007 period to -1.1% in the period ending 6/30 2008.

Our next step is to suss-out why CAL's Net Income is dropping. For this we scan other Income Statement items for big changes. We see that CAL's Cost of Goods Sold (COGS) has increased over the same periods that its Net Income has declined from 81.6% to 85.5% and 75.8% to

84.1% respectively. A careful review of all the Income Statement items confirms that these are the biggest increases in CAL's expenses by far.

CAL's COGS-to-sales increases resulted from either its revenues decreasing relative to COGS, or its COGS increasing relative to sales. By looking at CAL's raw Income Statements, we see that sales have been growing (year over year) by about 9% to12%. From this we infer that the problem is not caused by a sales decline. Instead CAL's COGS Expense has been increasing faster than its revenues.

The reason for CAL's COGS increase in this period is the skyrocketing price of jet fuel. For airlines, fuel is part of COGs Expense. In the period we are reviewing, the jump in jet fuel prices has driven up CAL's COGS expense so much that it caused the firm's Net Income to swing from positive to negative.

Good to Know:

In financial statement analysis, and throughout finance generally, the changes that matter are usually big, and small changes may often be ignored. This is because there are many variables contributing to financial performance, and most of them are somewhat unpredictable. As a result, we can often focus on big changes to the exclusion of other “noise.” This is in contrast to some other fields of study, like many engineering disciplines, where small changes are important and numbers must be monitored to many significant figures.

We could perform a similar analysis of CAL's Balance Sheets by preparing Common-Size Balance Sheets. This would yield several decent insights, but I think our time will be better spent by moving on to a more useful technique.