As your company prepares for an IPO, your financial statements will be under intense scrutiny from investors. Your ability to intimately understand your financial statements will be critical in your efforts to sell your company to investors and increase your valuation. IPO investors want to invest in companies that can sustain high performance. As a result, they will be particularly interested in changes that occur in your financial performance from period to period. An effective flux analysis can help your company understand those changes and communicate them effectively.
What is a Flux Analysis?
A flux analysis (sometimes called horizontal analysis) is an evaluation of fluctuations in account balances from period to period. The changes are generally expressed both as a dollar amount and as a percentage. An effective flux analysis identifies fluctuations and explains their cause. Being able to explain fluctuations in financial statement line items is critical in three main activities:
- Business Management. An effective flux analysis can help you understand and manage your business more effectively. An awareness of fluctuations in financial statement line items and a knowledge of the causes of those changes can enable you to make better financial and operating decisions by identifying risks, opportunities, and areas for improvement.
- Financial Statement Audits. During yearly financial statement audits and quarterly reviews, your auditors will require explanations for material changes in financial statement accounts. This analysis is designed to help auditors gain an understanding of accounts, identify risks, and corroborate the financial statements as a whole. Therefore, you will need to provide detailed explanations of fluctuations to receive a clean audit report.
- Financial Statement Reporting. The SEC requires public companies to report material fluctuations of certain financial statement line items. The flux analysis is reported in the Results of Operations section of the Management Discussion and Analysis (MD&A). Material changes in financial statement line items are a point of focus for investors; therefore, this portion of your quarterly report can have a significant impact on investor perception and your share price.
While this article will mainly focus on the financial statement reporting aspect of flux analyses, the principles discussed will also help your company manage your business more effectively and prepare for financial statement audits. Additionally, while this article focuses on comparisons of financial data from one period to the next, it can also apply to budget comparisons or comparisons between projections and actual results.
Key Elements of an Effective Flux Analysis
An effective flux analysis will identify the underlying causes of the change and explain the entirety of the change. Your company will need to keep detailed records to have the necessary information to perform the flux analysis.
Identify Underlying Causes of the Change
Any number of factors could cause large fluctuations between periods; therefore, a key element of a flux analysis is to identify the underlying causes of the change. Consider the following example from the Form S-1 of BJ’s Wholesale Club Holdings, Inc. in which the company identifies two specific issues that led to an increase in merchandise margin rate:
The merchandise margin rate increased due to successful assortment optimization and better sales penetration of private label items. Private label penetration increased to 19% in fiscal year 2017 from 18% in fiscal year 2016.
Instead of giving a general explanation, BJ’s identifies and explains the specific causes of the change. Understanding the causes of these changes helps BJ’s to manage its business more effectively and provides more useful information to potential investors.
While your internal flux analysis should include highly detailed information, your financial reporting (which is discussed later in this article) will contain aggregated data that is specific enough for investors’ needs. Each situation will merit a different level of aggregation; however, you should consider how important a particular line item is to investors and how much benefit they would receive from a more disaggregated explanation.
The following best practices will help your company identify the underlying causes of line item changes:
- Give Specific Details. The more specific the explanation, the more useful it can be. For example, your revenue flux analysis could be disaggregated by customer, product line, or region to identify more specific reasons for fluctuations. Decision makers can use this detailed data to develop specific courses of action. However, if you identify privacy issues or if competitors could take advantage of the detail in your flux analysis, then you may need to decrease the level of detail before releasing it to outsiders.
- Consider Relationships Between Accounts. Often, the change in one account is related to the change in another. Therefore, to make fluctuations more meaningful, you may find it useful to create common-size financial statements and express fluctuations as a percentage. For example, if cost of goods sold increased by $10 million but remained stable at 30% of revenue, then the 0% change implies that the underlying cause of the change is the increase in revenue. This conclusion is consistent with expectations considering the relationship between revenue and cost of goods sold.
- Correct Accounting Errors. If you are unable to find the economic cause of a fluctuation, then an accounting error may be the reason for the change. If a fluctuation is due to an accounting error, then accounting personnel should correct the error and identify the reason for the mistake. Controls may need to be put in place to prevent similar errors in the future. In this way, flux analyses can help your company improve internal controls. After the error is corrected, the fluctuation should be reevaluated; if the error does not entirely explain the change, then the fluctuation should be investigated further.
Explain the Entirety of the Change
After considering the reasons for a change, a portion of the difference may remain unexplained. Digging deeper to find the entire cause of the change can reveal additional, valuable insights. For example, suppose a decrease in revenue is mostly due to a discontinued product line. If your flux analysis stops after identifying this more obvious component, then you could miss out on other key factors that influenced the change, such as decreased sales volume in another product segment. With this additional information, management can better determine what actions to take.
Consider the following example in the Form S-1 of At Home Group, Inc.
The [$30.9 million] increase [in net sales] was primarily driven by approximately $28.4 million of incremental revenue from the net addition of 20 new stores opened since May 2, 2015, as well as an approximately $2.5 million increase from comparable store sales, which increased 1.9% during the thirteen weeks ended April 30, 2016, driven primarily by our merchandising initiatives.
By identifying both components of the increase in sales, At Home Group can understand its sales growth is primarily coming from new stores, but also from an increase in sales at stores already in operation. Additionally, At Home identifies the underlying cause of the variation—merchandising initiatives. Understanding the entirety of the change and the underlying cause of the change helps inform At Home’s growth strategy.
Keep Detailed Records
Your ability to identify the underlying causes of a change, explain the entirety of the change, and give the details of those changes depends on your ability to keep detailed records. Without adequate records, finding explanations for financial statement line item changes can be very costly (and potentially inaccurate).
For example, assume you believe that an increase in sales is due to a combination of an increase in the number of customers and upselling existing customers. To test your assumption, you will need specific details about the number of customers over time and details about sales to existing customers. Absent a clear record of those factors, you would need to review thousands of invoices to determine the cause of the fluctuation. Alternatively, if these records are readily available it will take significantly less time to evaluate the fluctuation. To avoid this costly and inaccurate process, your company should immediately begin to keep detailed and organized records, if you are not already doing so.
Hold a Flux Analysis Meeting
To identify fluctuation causes more accurately and to provide greater detail, many companies hold a flux analysis meeting. The purpose of this meeting is to provide executives and other managers with the information they need to manage the business and to gather necessary information for financial reporting. The following steps outline a basic flux analysis meeting:
- Set Expectations. An effective flux analysis begins with an expectation of each variation. This expectation serves as a basis for the analysis and helps prevent hindsight bias. Some companies may choose to set standard thresholds for specific accounts as a starting point.
- Create an Initial Report. A controller or other member of the accounting team will create a basic flux report which shows the fluctuations in each line item compared to the prior period. The report will consider whether the change was in line with expectations and use subledger data to support the change and provide context for later discussions.
- Hold Preliminary Flux Meetings. Preliminary flux analysis meetings will generally be held in each department at lower levels of the company in order to gain insight from employees who work directly with each account. When a company holds meetings with relevant personnel rather than relying on a controller’s best guess, the accuracy and level of detail in the flux analysis will be increased. While the meeting with upper management will discuss all changes, these smaller departmental meetings will only cover fluctuations that are relevant to each department.
- Meet with Upper Management. This meeting will generally include chief executives and managers from the capital markets, operations, legal, accounting, and finance teams. Following the principles outlined in the previous section, the team will consider changes in each line item even if they did not fall outside of the previously established expectations. The information from the preliminary report and from lower-level discussions should provide a basis for discussion.
- Make Decisions. Risks, opportunities and other issues will arise during discussion. The team should decide on specific actions that need to be taken to address these issues. If the focus of the analysis has been on the underlying causes of the fluctuations, relevant decision makers will be able to craft a more effective strategy to address the underlying issues.
- Maintain Detailed Notes. Someone should be assigned to keep detailed notes during each meeting. These notes will assist the financial reporting team by providing more detail and context when they prepare flux explanations in the financial statements. The detailed record can also serve as a useful reference for decision makers.
Flux analyses are reported in the Results of Operations section of the Management Discussion and Analysis (MD&A). The SEC requires companies to discuss the causes of material changes in sales—whether the change is due to increased volume, increased prices, or new products or services1. Discussing increases in sales can be especially advantageous for a pre-IPO company with strong sales growth because it is an opportunity to showcase your growth prospects to investors.
Importance to Investors
While an analysis of every line-item is not expressly required, companies will almost always include an analysis of each line item from top to bottom of the income statement because those changes are a focal point for investors. The flux analysis section of your MD&A is important to investors because it helps to eliminate some of the uncertainty surrounding your company’s performance. Therefore, an effective flux analysis can help increase investor confidence in your company, which can increase your company’s valuation.
For example, if your company has a large increase in general and administrative expenses due to a one-time event, then investors may worry that those expenses will continue to increase at the same rate, which could have a negative impact on future profitability. By explaining that the increase was due to this one-time charge, investors can adjust their future expectations accordingly. In general, the best practice is to assume that investors will expect trends to continue, which means that you need to correct those expectations in the MD&A if that is not the case.
Companies will generally perform a flux analysis for all years that they present in their Form S-1. Either of the following two formats is acceptable:
You may also want to include a table before each line item similar to the following:
Notice that the table also includes cost of goods sold as a percentage of net revenue. While this may not be necessary for every line-item, including an explanation of the change in a line item as a percent of revenue can help investors understand the relationship between accounts, as discussed earlier in the article.
Flux analyses will help your company in business management, financial statement audits, and financial statement reporting. Your flux analysis will be more effective as you identify the specific underlying causes of the fluctuations and explain the entirety of the change. Remember, investors will be paying close attention to changes in your financial performance. Effectively reporting flux analyses in your Form S-1 can help ensure that investors have relevant, useful information as they consider these changes in your financial performance.