The focus of today’s post will be the conduction of a meaningful analysis. When you are working or writing an exam, it is easy to feel overwhelmed when you are requested to identify why one department or company is performing better than another, especially when you have a limited amount of time and a wealth of information at your disposal.
For an analysis to be meaningful you must identify the key issues quickly so that you can discuss them in depth. Also, you must present your information in a way that makes sense and is easy to follow.
So, where do you start?
Decide what your basis for analysis is going to be. If you are going to compare your analysis to:
An industry average, make sure it is relevant, current and comparable.
A prior year for the same company, make sure the numbers are comparable based on the product offering etc.
A competitor’s numbers, make sure that you consider their different offerings. If you compare Shoprite and Pick and Pay then you need to take into account that Shoprite sells furniture on credit whereas Pick and Pay does not. Try to isolate the differences that you are aware of and if you can’t (based on the information you have) then at least mention it when comparing ratios (this comes down to making sure that you are comparing “apples with apples”.)
Next, you need to identify the key issues. Personally, I love to do a Du Pont analysis as it gives you insight into whether Profit, Asset Turn Over or Gearing is the issue. Based on your Du Pont analysis if for instance you see that the companies are similarly leveraged and that the difference on Return on Equity is brought about by lower NP Margins and a lower Asset Turnover, you immediately know where to focus your attention.
Once you have identified the key issues, you need to express them in a meaningful way. For example:
“Company X’s labour costs increased because they appointed a lot of extra people” is not meaningful as you are not providing the reader with much insight
Would it be more meaningful to write: “Company X’s labour costs increased by R144 million due to the fact they appointed 500 new employees this year”. Not really... If the company had 50 000 employees, then the labour force only increased by 1%.
It is thus essential to express your analysis in meaningful terms and explain why it is relevant, for instance: “Company X’s labour costs increased by R144mil (28%) as they appointed an additional 500 employees. This increased the total labour force by 40% and was done as the company opened a new factory in George. The factory has only been in operation for four months and has not reached its production targets. The increased labour costs thus had an adverse effect on the current year’s net profit percentage but this should be corrected next year as the factory is expected to produce at full capacity from the beginning of the new financial year”
It is also quite helpful to explain your analysis through tables and figures. Remember to not just use tables and figures without a clear explanation.
A final thought, although you probably have been taught key target ratios such as 2:1 for your current ratio and 1:1 for your quick ratio - it is encouraged to rather avoid this. Target ratios are industry specific, based on the risk of the company’s operations. Say that you are analysing Shoprite. Their operational risk is extremely low as they turn their stock quickly, they are guaranteed of sales (they mainly sell food) and most of their sales are cash. Compare this to a Harley Davidson shop. Although their margin might be higher they do not know when their next sale will take place and when cash will flow into their bank account. Thus, you cannot have a similar target ratio such as the current ratio for both. Shoprite can thus take on more risk through leverage as their cash flows are almost certain. If the Harley Davidson shop takes on too much debt and they don’t make a sale of a couple of months they could be out of business. Ratio targets are thus specific to an industry and text book targets should never be used as a means of comparison.
Remember if you have any questions or if you would like me to focus on an area that you are struggling with then please post it in the comments field.
Until next time,
Francois and the Atcor team