Common Size Financial Statement

Common size financial statements are a form of financial analysis that expresses each line item on a financial statement as a percentage of a selected figure. This methodology helps investors, analysts, and managers to understand the financial health and operational efficiency of a company by eliminating the effects of size, making it easier to compare with other firms or look at trends over time. By converting raw numbers into percentages, common size analysis makes it easier to see changes in financial statement line items. This is incredibly useful for benchmarking and trend analysis.

Income Statement

A common size income statement expresses each item as a percentage of total sales. The formula for each line item is calculated as follows:

[ \text{Common Size Percentage} = \left( \frac{\text{Line Item}}{\text{Total Sales}} \right) \times 100 ]

Example

Consider the income statement of an imaginary company, XYZ Corporation:

Item Amount
Total Sales $1,000,000
Cost of Goods Sold (COGS) $400,000
Gross Profit $600,000
Operating Expenses $200,000
Operating Income $400,000
Interest Expense $50,000
Income Before Tax $350,000
Taxes $105,000
Net Income $245,000

The common size income statement would be:

Item Amount Common Size (%)
Total Sales $1,000,000 100%
Cost of Goods Sold (COGS) $400,000 40%
Gross Profit $600,000 60%
Operating Expenses $200,000 20%
Operating Income $400,000 40%
Interest Expense $50,000 5%
Income Before Tax $350,000 35%
Taxes $105,000 10.5%
Net Income $245,000 24.5%

Balance Sheet

A common size balance sheet expresses each item as a percentage of total assets. The formula for each line item is:

[ \text{Common Size Percentage} = \left( \frac{\text{Line Item}}{\text{Total Assets}} \right) \times 100 ]

Example

Consider the balance sheet of an imaginary company, XYZ Corporation:

Asset Amount
Cash and Cash Equivalents $150,000
Accounts Receivable $200,000
Inventory $300,000
Property, Plant, and Equipment $350,000
Total Assets $1,000,000
Liabilities and Equity Amount
Accounts Payable $100,000
Short-Term Debt $50,000
Long-Term Debt $200,000
Total Liabilities $350,000
Total Equity $650,000
Total Liabilities and Equity $1,000,000

The common size balance sheet would be:

Asset Amount Common Size (%)
Cash and Cash Equivalents $150,000 15%
Accounts Receivable $200,000 20%
Inventory $300,000 30%
Property, Plant, and Equipment $350,000 35%
Total Assets $1,000,000 100%
Liabilities and Equity Amount Common Size (%)
Accounts Payable $100,000 10%
Short-Term Debt $50,000 5%
Long-Term Debt $200,000 20%
Total Liabilities $350,000 35%
Total Equity $650,000 65%
Total Liabilities and Equity $1,000,000 100%

Cash Flow Statement

A common size cash flow statement expresses each item as a percentage of total cash inflows. The formula for each line item is:

[ \text{Common Size Percentage} = \left( \frac{\text{Line Item}}{\text{Total Cash Inflows}} \right) \times 100 ]

Example

Consider the cash flow statement of an imaginary company, XYZ Corporation:

Item Amount
Net Cash from Operating Activities $300,000
Net Cash from Investing Activities -$100,000
Net Cash from Financing Activities $50,000
Total Cash Inflows $250,000

The common size cash flow statement would be:

Item Amount Common Size (%)
Net Cash from Operating Activities $300,000 120%
Net Cash from Investing Activities -$100,000 -40%
Net Cash from Financing Activities $50,000 20%
Total Cash Inflows $250,000 100%

Note: The percentages here can exceed 100% or be negative due to the nature of cash flow dynamics.

Benefits of Common Size Financial Statements

Easier Comparison

One of the main advantages of common size financial statements is that they make it easier to compare companies of different sizes, as well as to analyze the financial performance of a company over multiple periods.

Trend Analysis

By converting financial statements into common size format, trend analysis becomes straightforward. Analysts can quickly discern whether certain areas such as cost of goods sold, liabilities, or revenue are increasing or decreasing over time.

Highlighting Changes

Common size statements help in highlighting significant changes that may need management’s attention. For instance, a rising percentage of COGS relative to sales could indicate inefficiencies or increased raw material costs.

Benchmarking Against Industry Standards

Common size financial statements allow for easy benchmarking against industry standards or direct competitors. This comparison can reveal whether a company has higher expenses, revenue, or other line items relative to its peers.

Limitations of Common Size Financial Statements

Limited Information on Absolute Size

While this method standardizes financial data, it doesn’t provide information on the absolute size of the figures. Two companies might both show a 20% operating margin, but if one has significantly higher revenues, the absolute figure matters for deeper analysis.

Doesn’t Address Quality of Earnings

Common size financial statements don’t provide insights into the quality of earnings. A company might show a high percentage of net income, but this could be due to non-recurring gains or aggressive accounting practices.

Ignores External Factors

This analysis method doesn’t consider external economic factors that might influence the percentages. Fluctuations in exchange rates, inflation rates, or changes in market demand could impact the common size percentages but will not be transparent from the statements themselves.

Practical Applications

Equity Analysts

Equity analysts use common size statements to compare firms within the same industry or friends operating in different sectors. This helps in understanding which companies are more efficient or profitable.

Management

Management teams utilize these statements for internal performance reviews. By regularly converting their financial statements to common size format, they can pinpoint operational inefficiencies or areas where they are overspending.

Lenders and Investors

Lenders and investors use common size financial statements to assess a company’s risk and potential returns. These tools are crucial for making informed funding or investment decisions.

Financial Planning and Analysis (FP&A)

FP&A professionals use common size financial statements for budgeting and forecasting. These percentages serve as a baseline to project future financial performance based on historical trends.

Software and Tools for Common Size Financial Statements

Microsoft Excel

Excel is still one of the most commonly used tools for creating common size financial statements. It allows for customization and can easily handle complex computations and graphical presentations.

Financial Analysis Software

There are numerous financial analysis software packages available that automate the creation of common size financial statements. Examples include:

These tools often come with pre-built templates and integration capabilities that make the process seamless and efficient.

Online Platforms

Several online financial analysis platforms offer features for generating common size financial statements, including:

These platforms often include additional features like real-time data, trend analysis, and peer comparison, making them very useful for both professional analysts and individual investors.

Conclusion

Common size financial statements are a valuable tool for simplifying the analysis of financial statements, making it easier to compare companies of different sizes and analyze a company’s financial performance over time. Despite their limitations, they provide insightful data that can help in making informed management, investment, and lending decisions.