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Financial Statement Items as indexes Relative to a Base Year

The common-size balance sheets and income statements can be supplemented by the expression of items relative to a base year. For Harvey Electronics, the base year is 20X0, and aL financial statement items are 100.0 (percent) for that year. Items for subsequent years ar expressed as an index relative to that year. For example, comparing Harvey Electronic accounts receivable in 20X1 ($85,147,000) with its receivables in the base year, 20X ($70,360,000), the index would be 121.0 (i.e., [$85,147,000/$70,360,000] x 100). We should expect that changes in a number of the firm's current assets and liabilities accounts (e.g., cash, accounts receivable, inventory, and accounts payable - which all support sales activity) would move roughly together with sales for a normal, well-run company.

Therefore, remember for future reference that Harvey Electronics' indexed net sales figure for 20X2 is 148.0, which indicates a 48 percent (148.0 minus 100.0 percent) increase in sales over the base period two years ago.

In Table 6.6 the buildup in cash from the base year is particularly apparent over the pa two years, and agrees with our previous assessment. Also, the 683.7 percent (783.7 minu 100 percent) increase in cash over two years seems way out of proportion when compare with only a 48 percent increase in net sales over the same period.

Also, note the large increase in accounts receivable and inventory from 20X1 to 20X2. Thlatter change was not apparent in the common-size analysis. When we compare the accoum receivable and inventory figures with those for net sales, however, the increases do not seem too much out of line. (We would probably want to follow up on this information, nonetheless, by checking the firm's receivable turnover and inventory turnover to see how well the firm is managing these growing asset accounts.) To a lesser extent, there was a noticeable increase in fixed assets, but the change was accompanied by a somewhat favorable, more than proportionate, change in sales over the past two years.

On the liability portion of the balance sheet, we note the large increase in accounts payable and in other current liabilities that occurred. Only the payables increase, however, seems large relative to the increase in sales, as well as the increases in receivables and inventories. Based on this insight, we would want to take a look at the firm's payable turnover to see whether the firm might not be paying its suppliers in a timely fashion. Finally, increases in long-term debt, common stock, and retained earnings also helped finance the large increase in assets that occurred over the last two years.

The indexed income statements in Table 6.7 give much the same picture as the commonsize income statements - namely, fluctuating behavior. The sharp improvement in 20X2 profitability (earnings before interest and taxes, as well as earnings after taxes) is more easily distinguished - especially when we compare it with the smaller percentage improvemem in sales. Moreover, the indexed income statements give us information on the magnitude of absolute changes in profits and expenses. With common-size statements, we have no information about how the absolute amounts change over time.

In summary, the standardization of balance sheet and income statement items as percentages of totals and as indexes to a base year often gives us insights additional to those obtainec from the analysis of financial ratios. Common-size and index analysis is much easier when a computer spreadsheet program, such as Excel, is employed. The division calculations rows or columns can be done quickly and accurately with such a program - but it is up tc you, the analyst, to interpret the results.