17 Apr Analyzing Financials on a Year-by-Year Basis

Written by: Ally Yan

(5-7 minute read)

To fully understand a company’s performance, each year of the recent historical financials needs to be analyzed, as they could show a steady trend or reveal an extraordinary occurrence that reflects an outlier year. If future cash flows are projected to be similar to current operations going forward, weight would be applied to the historical financials as they would be a reasonable indication of future performance. However, if there are fluctuations in sales and earnings, the appraiser should question and understand the reasoning behind them.

If none of the historical financials represent the company’s operations going forward, sales and expenses will need to be projected to reflect stable cash flows. Accordingly, it is important to analyze the financials in each year to determine which years reflect normal operations and which do not.

Different scenarios are shown below that explain why certain years should be given more weight than others.

Case 1: No Weight to Outlier Year

In the example below, the restaurant was closed for a few months in year 3 as it was being repaired and renovated. Since the company was not open for business for the full year due to renovations, no weight would be applied to year 3. Additionally, there is a steady increase in sales from year 1 to year 4 (excluding year 3). Therefore, all weight is applied to year 4.

Case 2: All Weight to Outlier Year

Example 1: Second Location Closed

This gym opened a second location at the end of year 2, but it was closed due to low traffic in the middle of year 3 (with no plans to reopen). Even though sales are projected to be similar in the interim period of year 4 compared to year 3, all weight would be applied to year 4 as that is a recent year of operations with only one location. Year 2-3 financials include sales from the second location and other expenses that would be incurred to run this location (additional rent, employees, etc.). However, year 4 reflects the current operations of the business and the appropriate expense structure.

Example 2: Cost Structure Changes

The example below shows the sales, cost of goods sold (including labor), and earnings of an IT company. Sales decreased in each year, but the cost of goods sold decreased significantly in year 3, resulting in higher earnings that year. The decrease in sales and costs is due to the company making major business model and staffing changes. Accordingly, the company can operate more efficiently with reduced staffing. Due to the changes in cost structure and the resulting increase in earnings in year 3, all weight is applied to that year.

Example 3: New Major Customer

In this scenario, the company’s sales significantly increased in year 4 due to the company gaining a new customer at the end of year 3. This customer contributes approximately one-third of the company’s business. Orders from this customer increased in year 4 and are expected to remain strong or increase further. Therefore, all weight is placed on year 4.

Case 3: Cyclicality / Blended Weight

Sales are relatively different in each year. However, because the company is project/contract based, sales tend to fluctuate due to the timing, volume, and size of awarded contracts (this is especially normal in the construction industry). Therefore, as sales vary based on projects completed within the year, even weighting is applied to the four years. In these scenarios, having a work in progress or pipeline report of the company’s projects/contracts in each year can help verify that sales fluctuate based on the timing of contracts.

Case 4: Historical Years Not Normalized (DCF)

If the historical financials show fluctuating sales and earnings and do not represent stable operations, the Discounted Cash Flow (DCF) method may be utilized. This method projects future cash flows and discounts them back to their present value. When companies are projecting significant growth (or decline before stabilizing), the appraiser may utilize the DCF method to account for potential sales/earnings growth going forward.

Example 1: Opening a Second Location

In the example below, the restaurant is opening a second location. Preparations are still being made, but it is expected to be open for operations by the beginning of year 2 (projected). The appraiser was provided with financial projections including this second location. As the company’s sales are expected to increase in the near future with the addition of a new location, sales (along with the expenses that will be incurred once the second location is open) are projected to account for this.

Example 2: Second Location Closed

This next example also relates to a second location. However, one out of the two existing retail store locations will be closed at the end of its lease term in year 2 (projected). The location will be closed due to low foot traffic and low profitability (with no plans to open another location). The first location’s operations will not change, but the company will no longer incur the second location’s rent/utility and payroll expenses. Because the historical financials include the operations of both locations, the appraiser will project out sales/expenses of the company after the second location has closed, as that would represent the normalized operations going forward. Sales are projected to decrease before stabilizing; however, earnings are projected to increase as the first location was operating at better margins.

Example 3: Increased Service Offerings

The following graphs show the operations of a medical practice. The company had a change of management, and the current owners added additional services and increased the number of hours the practice is open, which resulted in a significant increase in patient volume. The appraiser was provided with a breakdown of monthly sales, which showed an increase on a monthly basis. Therefore, sales are projected to increase in year 1-2 as a direct result of these changes before stabilizing.

Conclusion

Each year of the company’s financials should be analyzed as there could be certain events in a given year that impact future operations. Changes could be temporary (such as the store closure for renovations, weather-related disruptions, etc.) or there could be more permanent changes (such as opening a new location, adding new services, restructuring of management, etc.). While revenue often reflects these events, all components of the financials must be analyzed, questioned, and understood (along with future plans for the business) to make the determination of which year(s) should be relied on.