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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.
All three of the primary financial statements can be put into a common-size format. Financial statements in dollar amounts can easily be converted to common-size statements using a spreadsheet.
Key Takeaways
- A common-size financial statement displays items on each report as a percentage of a common base figure.
- Common-size financial statements make it easier to compare a company to its competitors and to identify significant changes in a company’s financials.
- Common-size analysis compares the percentages between two or more years to evaluate financial strength, how income is used, and where cash comes from.
- Many items in the cash flow statement can be stated as a percent of total sales.
Balance Sheet Analysis
The common figure for a common-size balance sheet analysis is total assets. Based on the accounting equation, this also equals total liabilities and shareholders’ equity, making either term interchangeable in the analysis. It’s also possible to use total liabilities to indicate where a company’s obligations lie and whether it’s being conservative or risky in managing its debts.
The common-size strategy from a balance sheet perspective lends insight into a firm’s capital structure and how it compares to its rivals. You can also look to determine an optimal capital structure for a given industry and compare it to the firm being analyzed. 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.
Important
The goodwill level on a balance sheet also helps indicate the extent to which a company has relied on acquisitions for growth.
This common-size balance sheet is a good example. You can see that long-term debt averages around 34% of total assets over the two-year period, which is reasonable. Cash ranges between 5% and 8.5% of total assets and short-term debt accounts for about 5% of total assets over the two years.
It’s important to add short-term and long-term debt together and compare this amount to the total cash on hand in the current assets section. This lets you know how much of a cash cushion is available or if a firm is dependent on the markets to refinance debt when it comes due.
Analyzing the Income Statement
The common figure for an income statement is total top-line sales. This is the same analysis used to calculate a company’s margins. A net profit margin is simply net income divided by sales, which is also a common-size analysis.
The same goes for calculating gross and operating margins. The common-size method is appealing for research-intensive companies because they tend to focus on research and development (R&D) and what it represents as a percent of total sales.
This common-size income statement shows an R&D expense that averages close to 1.5% of revenues.
Common Size and Cash Flow
Many items in the cash flow statement can be stated as a percent of total sales, similar to an income statement analysis. This can give insight into several cash flow items, including capital expenditures (CapEx) as a percent of revenue.
Share repurchase activity can also be considered as a percentage of the total top line. Debt issuance is another important figure in proportion to the amount of annual sales it helps to generate. These items are calculated as a percentage of sales, so they help indicate how much the company uses debt to generate overall revenue.
The cash flow statement in terms of total sales indicates that it generated an impressive level of operating cash flow, averaging 26.9% of sales over three years.
Share repurchase activity as a percentage of total sales in each of the three years was minimal or non-existent.
The first row is net income as a percentage of total sales. It precisely matches the common-size analysis from an income statement perspective. This represents the net profit margin.
Comparison With Regular Financial Statements
The key benefit of a common-size analysis is that it allows for a vertical analysis by line item over a single period, such as quarterly or annually. It also allows you to view a horizontal perspective over a period such as the three years that were analyzed in our example.
Just looking at a raw financial statement makes this more difficult, but looking up and down a financial statement using a vertical analysis allows an investor to catch significant changes at a company. A common-size analysis helps put analysis in context on a percentage basis. It’s the same as a ratio analysis of the profit and loss statement.
What the Common Size Reveals
The most significant benefit of a common-size analysis is that it can let you identify large or drastic changes in a firm’s financials. Rapid increases or decreases will be readily observable, such as a fast drop in reported profits during one quarter or year.
The overall results during the period examined were relatively steady. One item of note is the Treasury stock in the balance sheet, which had grown to more than negative 100% of total assets. But rather than act as an alarm, this indicates that the company had been successful in generating cash to buy back shares, far exceeding what it had retained on its balance sheet.
A common-size analysis can also give insight into companies’ strategies. One company may be willing to sacrifice margins for market share, which would tend to make overall sales larger at the expense of gross, operating, or net profit margins. The company that pursues lower margins will ideally grow faster.
Explain Like I’m Five
Each public company has to disclose certain information about its financial performance, including profits, revenues, assets, and debts. This information is typically expressed in absolute dollar terms, making it difficult to compare the performance of different companies or time periods.
A common-size financial statement expresses these values as percentages, rather than dollars. They state net income as a percentage of total revenues or debt as a percentage of assets. This makes it easy to tell at a glance if a company is becoming more profitable or whether it carries more debt than its competitors.
What Is the Main Purpose of Common-Size Financial Statements?
A common-size financial statement shows a company’s financial accounts as a percentage, rather than in dollar figures. This makes it easy to see at a glance how the company’s profitability and debt ratios have changed from year to year, and in comparison with other companies.
How Do You Find Common-Size Financial Statements?
Each line item on a balance sheet, statement of income, or statement of cash flows is divided by revenue or sales. This can be done using a spreadsheet or calculator. You might be able to find them on the websites of companies that specialize in financial analysis.
What Is Meant by a Common-Size Balance Sheet?
A common-size balance sheet is a comparative analysis of a company’s performance over a period of time. It shows each item as a percentage of the company’s total assets, instead of a dollar figure. This can be used to determine how the company is using its assets.
The Bottom Line
A common-size analysis is unlikely to provide a comprehensive and clear conclusion on a company on its own. It must be done in the context of financial statement analysis.
You should also be aware of temporary versus permanent differences. A short-term drop in profitability could indicate just a speed bump rather than a permanent loss in profit margins.
