Common-Size Analysis of Financial Statements

By the way, I like to use examples with small numbers for simplicity. Feel free to add as many zeroes as you want in your head to make the numbers feel “real” to you. Common size statements are valuable tools for evaluating and comparing the financial health of companies across various sizes and sectors. They reveal the relative percentages of different financial elements, helping to spot trends and support informed decision-making in business. By converting all figures into percentages of net sales, it simplifies comparisons between various companies or time periods.

Financial statements in dollar amounts can easily be converted to common-size statements using a spreadsheet. By showing costs as a percentage of revenue, it helps identify areas where expenses can be reduced. By showing each item as a percentage of revenue, it highlights changes in cost structure and profitability over time.

Using Common-Size Analysis to Evaluate Trends within a Company

Common-size Statements are accounting statements expressed in percentage of some base rather than rupees. My guess is that you understand the relative importance of each line item much more quickly and effectively via this graph than the earlier vertical table of numbers. A graph of common-size amounts can be a powerful way to present common-size data. Let’s take off the training wheels and look at a more complex “real world” example. I’m going to walk through an example common-size analysis that I used many times in my banking career.

1. Let’s say a company looks at its inventory levels and determines there is no way to reduce them.
2. Common size statements help standardize financial data for analysis purposes.
3. While most firms do not report their statements in common size format, it is beneficial for analysts to do so to compare two or more companies of differing size or different sectors of the economy.
4. Income before taxes increased significantly from 28.6 percent in 2009 to 40.4 percent in 2010, again mainly due to a one-time gain of $4,978,000,000 in 2010.
5. For example, you might use it to see what percentage of your income is used to support each business expense.
6. Alternatively, if our DSO ratio is rising, that indicates it is taking us longer to collect our credit sales.
7. By breaking down each component as a percentage of revenue, it offers a transparent view of where money is spent and earned.

In contrast, current liabilities, which are debts due within one year, make up only 30% of the company’s total assets. In addition, the company has more total assets than total liabilities. One item that I want to stress is that interpreting ratios is as much of an art form as a science as there are always exceptions. Often, textbooks imply that once you calculate the ratios, you can easily identify a firm’s strengths and/or weaknesses and take advantage of them and/or fix them. Interpreting the ratios requires context, understanding, and often experience. Explanation of Ratios, in the Appendix B, focuses on explaining and interpreting each of these ratios.

What is Common Size Income Statement?

1. However, this same ratio would not make sense in evaluating the performance of a heavy equipment manufacturer like Caterpillar.
2. This company’s debt-to-asset ratio isn’t too high, but a better test is the ratio of annual operational cash flow divided by annual debt service payments.
3. You can then conclude whether the debt level is too high, if excess cash is being retained on the balance sheet, or if inventories are growing too high.
4. The approach lets you compare your business to your competitors’ businesses, regardless of size differences.
5. All materials are crafted in-house by founder and chief instructor Keith Tan.
6. Another challenge with ratios is that they can be calculated in different ways.

Notice that the $ can be inserted to anchor a cell reference, making it easier to copy and paste the same formula onto many lines or columns. As you can see from Figure 13.6 “Common-Size Balance Sheet Analysis for “, the composition of assets, liabilities, and shareholders’ equity accounts changed from 2009 to 2010. These yields and other data can be used to create a product mix common-size statement based on revenue.

Common Size Income Statement

Each line item on a balance sheet, statement of income, or statement of cash flows is divided by revenue or sales. You might be able to find them on the websites of companies that specialize in financial analysis. A common-size financial statement displays line items as a percentage of one selected or common figure. Creating common-size financial statements makes it easier to analyze a company over time and compare it to its peers. Using common-size financial statements helps spot trends that a raw financial statement may not uncover. There are a large variety of different financial ratios that attempt to evaluate different aspects of a company’s health and performance.

Therefore, you can replace sales with revenues in any formula listed above. The goal of this class is not to make you an expert on ratio analysis, but to introduce it as a tool. This list of ratios will provide a strong foundation to build from if you delve further into ratio analysis. Now that you have covered the basic financial statements and a little bit about how they are used, where do we find them? In this next section we will explore the requirements for what needs to be reported, when, and to whom. Companies in other industries may show their product mix analyses using a base number of total revenue or equity.

The above common size statements are prepared in a vertical analysis, referencing each line on the financial statement to a total value on the statement in a given period. Analysts also use vertical analysis of a single financial statement, such as an income statement. Vertical analysis consists of the study of a single financial statement in which each item is expressed as a percentage of a significant total. Vertical analysis is especially helpful in analyzing income statement data such as the percentage of cost of goods sold to sales.

Link to Learning: Common-Size Assets and Common-Size Liabilities and Equity

The result is a quick overview of where the firm stands in the industry with respect to key items on the financial statements. Another way to make the ratios and common size statements meaningful is to compare them to industry averages or key competitors. For example, common size statement analysis labor intensive industries may have high return on assets numbers while companies in capital (asset) intensive industries may have relatively low return on assets. Also, grocery stores are likely to have higher cost of goods sold values as a percentage of sales than software developers. If you are analyzing a software developer, it is important to compare it to others in the industry to determine if the numbers are “good” or “bad”. If our numbers compare favorably to the industry average that is a good sign, and numbers that compare unfavorably to the industry average indicate potential weaknesses.

Activity Ratios

Coca-Cola’s cost of goods sold is 36.1 percent of net sales compared to 45.9 percent at PepsiCo. Coca-Cola’s gross margin is 63.9 percent of net sales compared to 54.1 percent at PepsiCo. Coca-Cola’s operating income is 24.1 percent of sales compared to 14.4 percent at PepsiCo. Figure 13.8 “Comparison of Common-Size Gross Margin and Operating Income for ” compares common-size gross margin and operating income for Coca-Cola and PepsiCo. In general, managers prefer expenses as a percent of net sales to decrease over time, and profit figures as a percent of net sales to increase over time.