Analysts often adjust the financial statements of a company to improve their comparability with other companies. The core principle is to adjust both the balance sheet and income statement for the potential impact.
In deciding whether to adjust a particular inconsistency, an analyst needs to consider its importance and the source of inconsistency i.e. whether it has resulted from differences in financial reporting frameworks, differences in accounting policies allowed under the same GAAP, and/or differences in estimates.
Typical adjustments include adjustments to investments, inventories, property, plant and equipment, and/or goodwill.
Some companies may choose to value investments at fair value through profit and loss (trading securities under US GAAP) while others may choose to hold them at fair value through other comprehensive income (available for sale securities under US GAAP). If two comparable companies make different choices, an analyst may adjust one to improve comparability.
Cost of goods sold figure on the income statement and inventories balance on the balance sheet depend heavily on the cost flow assumption used. If two companies use different cost flow assumptions, i.e. one uses FIFO while the other uses LIFO, it is important to adjust one company’s financial statements to make them comparable with the other. This is why US GAAP allows companies using LIFO to also disclose FIFO values.
Property, plant and equipment
A company’s net income and its balance sheet are very sensitive to its depreciation method and associated estimates (useful life and salvage value). However, financial statement disclosures are not sufficient in making appropriate adjustments, instead analysts must process the information qualitatively.
Using the fixed assets disclosure, an analyst can find out:
- how much of an asset’s economic benefits have been consumed (by comparing accumulated depreciation with total cost),
- average age of the assets (accumulated depreciation divided by depreciation expense),
- remaining useful life (net book value of fixed assets divided by depreciation expense),
- average initial useful life (gross fixed assets divided by depreciation expense),
- percentage of fixed assets renewed (capex divided by the sum of gross PPE and Capex), and
- growth in fixed assets (capex in relation to asset disposal).
Financial ratios of a company which grow by acquisition differs from a company which engages in organic growth. It is because the company engaging in acquisition is able to capitalize purchase consideration paid in excess of the fair value of the acquiree’s net assets but a company growing internally would expense any amounts paid for marketing and branding. Hence, there is a case for making adjustments to goodwill to improve comparability.