Common Size Income Statement

A common size income statement is a financial statement that presents all items of a company’s income statement as a percentage of total revenue. This format allows for easier comparison between different periods and with other companies, regardless of size or currency differences. It is a valuable tool for financial analysis, enabling analysts and investors to identify trends, assess financial health, and make informed decisions.

Structure of a Common Size Income Statement

The common size income statement breaks down each line item on the income statement into a percentage of total revenue. This approach standardizes the financial data, providing a clear picture of how each cost and profit element contributes to the overall financial performance. Below is a general structure of what a common size income statement might look like:

Revenues

• Total Revenue (100%)
  • Often broken down further into segments such as sales, services, and other operating incomes.

Cost of Goods Sold (COGS)

• COGS (% of Total Revenue)
  • Represents the direct costs attributable to the production of the goods sold by a company.

Gross Profit

• Gross Profit (% of Total Revenue)
  • Calculated as Total Revenue minus Cost of Goods Sold.

Operating Expenses

• Selling, General and Administrative Expenses (SG&A) (% of Total Revenue)
  • Includes all costs that are not directly tied to the production process, such as marketing expenses, administrative salaries, and rent.
• Research and Development (R&D) Expenses (% of Total Revenue)
  • Funds allocated towards the creation of new products or improvement of existing ones.

Operating Income

• Operating Income (% of Total Revenue)
  • Derived after subtracting operating expenses from gross profit. This metric is crucial as it indicates the efficiency and profitability of the core business operations.

Other Income and Expenses

• Interest Expense (% of Total Revenue)
  • The cost incurred by an entity for borrowed funds.
• Income Tax Expense (% of Total Revenue)
  • Taxes imposed on the company’s earnings.

Net Income

• Net Income (% of Total Revenue)
  • The final line that indicates the company’s total profit after all expenses have been deducted from total revenue.

Importance and Benefits

Easier Comparisons

• Inter-Company Comparisons: Common size statements enable analysts to compare companies of different sizes by standardizing financial data into percentages. This is valuable for benchmarking financial performance against industry peers.

• Intra-Company Comparisons: They also facilitate comparison across different periods for the same company. By examining changes in specific expense categories as a percentage of revenue, analysts can identify trends and operational efficiency.

Identifying Trends and Problems

• Trend Analysis: Analysts can use common size income statements to track changes in expense ratios over time, allowing them to spot emerging trends that might not be visible in absolute figures.

• Early Warning Signals: Increasing costs as a percentage of total revenue may signal inefficiencies or potential financial distress, prompting deeper investigation.

Simplified Analysis

• Eliminating the Size Factor: Since all values are expressed as a percentage of revenues, it eliminates the impact of company size on the analysis, making it easier to focus on operational efficiency and profitability.

Practical Applications

Financial Analysis for Investors

Investors frequently use common size income statements to compare potential investment opportunities. By examining the expense structure and profitability ratios, they can identify companies with superior operational efficiency and growth potential.

Managerial Insights

Company management can use common size income statements to evaluate the effectiveness of their strategies and operations. It helps in identifying areas where costs can be optimized and revenues can be enhanced.

Investment Banking

Investment bankers often leverage common size income statements during mergers and acquisitions (M&A) to assess the financial health of target companies and identify potential synergies.

Example

To illustrate, let’s consider an example of a hypothetical company, ABC Corp:

This common size income statement shows that ABC Corp spends 60% of its revenue on COGS, resulting in a gross profit margin of 40%. After accounting for operating expenses, the operating income stands at 20%. Ultimately, the net income as a percentage of total revenue is 15%.

Conclusion

The common size income statement is a powerful analytical tool that offers several advantages for comparing financial performance across companies and periods. By converting absolute financial data into percentages of total revenue, it allows for more straightforward analysis and identification of trends and inefficiencies. This tool is indispensable for investors, analysts, and company management seeking to make informed financial decisions.