What are Common Size Financial Statements?
Common size financial statements display items as a percentage of a common base figure, total sales revenue, for example. This type of financial statement allows for easy analysis between companies, or between periods, for the same company. However, if companies use different accounting methods, any comparison may not be accurate.
A common size financial statement displays entries as a percentage of a common base figure rather than as absolute numerical figures. Common size statements let analysts compare companies of different sizes, in different industries, or across time in an apples-to-apples way. Common size financial statements include the income statement, balance sheet, and cash flow statement
- The common size income statement reports revenue and expense amount as percentages of net sales.
- Common size balance sheet reports each asset, liability, and owner equity amount as a percentage of total assets.
- The common size cash flow statement tells how much cash is entering and leaving the business. One approach is to express each line item of cash inflow as a percentage of total cash inflows. And, each cash outflow as a percentage of total cash outflow. Another approach is to express each line item on the cash flow statement as a percentage of net revenue.
Common-size financial statements allow you to compare the financial statements of large companies with the financial statements of smaller companies. This is because you are comparing percentages instead of dollars. For example, a small retailer can compare the cost of goods sold (perhaps 80%) to a much larger retailer’s cost of goods sold, perhaps 76%. Similarly, one company’s inventory might be 34% of total assets while competitors might be lower, say 26%.
Using Common Size Financial Statements
Most firms do not report their statements in common size format. However, it is beneficial for analysts to do so. Then they can compare two or more companies of differing sizes or different sectors of the economy. Formatting financial statements in this way reduce the bias that can occur. It also allows for the analysis of a company over various periods. For example, the analysis can reveal what percentage of sales the cost of goods sold is. Or, how that value has changed over time. Common size financial statements commonly include the income statement, balance sheet, and cash flow statement. Common size financial statements reduce all figures to a comparable figure, such as a percentage of sales or assets. Each financial statement uses a slightly different convention in standardizing figures.
Common size financial statements make it easier to determine what drives a company’s profits and to compare the company to similar businesses.
Common Size Balance Sheet Statement
The balance sheet provides a snapshot overview of the firm’s assets, liabilities, and shareholders’ equity for the reporting period. A common size balance sheet is set up with the same logic as the common size income statement. The balance sheet equation is assets equals liabilities plus stockholders’ equity.
The balance sheet thus represents a percentage of assets. Another version of the common size balance sheet shows asset line items as a percentage of total assets, liabilities as a percentage of total liabilities, and stockholders’ equity as a percentage of total stockholders’ equity.
Common Size Cash Flow Statement
The cash flow statement provides an overview of the firm’s sources and uses of cash. The cash flow statement is divided among cash flows from operations, cash flows from investing, and cash flows from financing. Each section provides additional information about the sources and uses of cash in each business activity.
One version of the common size cash flow statement expresses all line items as a percentage of total cash flow. The more popular version expresses cash flow in terms of total operating cash flow for items in cash flows from operations, total investing cash flows for cash flows from investing activities, and total financing cash flows for cash flows from financing activities.
Common Size Income Statement
The income statement (also referred to as the profit and loss (P&L) statement) provides an overview of the flows of sales, expenses, and net income during the reporting period. The income statement equation is sales minus expenses and adjustments equal net income. This is why the common size income statement defines all items as a percentage of sales. The term “common size” is most often used when analyzing elements of the income statement, but the balance sheet and the cash flow statement can also be expressed as a common size statement.
Common Size Income Statement – Example
For example, if a company has a simple income statement with gross sales of $100,000, the cost of goods sold of $55,000, taxes of $2,000, and a net income of $47,000. The common size statement would list those figures as follows:
- Sales – 1.00
- COGS – .55
- Taxes – 0.02
- Net Income – 0.47
Suppose Company A reports sales of $100 million and operating profits of $25 million. Company B, which is smaller, reports sales of $20 million and operating profits of $15 million. At first glance, it would appear Company A is the better performer because it earns a larger profit. However, a look at the common size financial statement of the two businesses, which restates each company’s figures as a percent of sales, reveals Company B is actually more profitable. The common size income statement for Company A shows operating profits are 25% of sales (25/100). The same calculation for Company B shows operating profits at 75% of sales (15/20). The common size statements make it easy to see that Company B is proportionally more profitable and better at controlling expenses. (Source:investinganswers)
Advantages Using Common Size Financial Statements
Benefits of using common-size analysis include the following:
- Allows investors to identify drastic changes – This mainly applies when the financials are compared over a period of two or three years. Any significant movements in the financials across several years can help investors decide whether to invest in the company. For example, large drops in the company’s profits in two or more consecutive years may indicate that the company is going through financial distress. Similarly, considerable increases in the value of assets may mean that the company is implementing an expansion or acquisition strategy, making the company attractive to investors.
- Comparison of different sized companies – Common size analysis is also an excellent tool to compare companies of different sizes but in the same industry. Looking at their financial data can reveal their strategy and their largest expenses that give them a competitive edge over other comparable companies. For example, some companies may sacrifice margins to gain a large market share, which increases revenues at the expense of profit margins. Such a strategy allows the company to grow faster than comparable companies because they are more preferred by investors.
The Drawbacks of Common Size Financial Statements
Common size financial statements help analysts understand individual businesses at a higher level. However, there are several drawbacks to using them. For example, common size financial statements may give the appearance of fair comparisons across companies. But, they don’t take into account that companies may be using different accounting methods or fiscal year-ends. Another drawback of common size financial statements is that they don’t translate for companies across different industries. What may be considered a favorable ratio in one industry may indicate poor performance in another.
For example, an operating margin of 6% would indicate exceptional performance by a distribution company. However, it would be a poor result from a manufacturing company. Low margins are normal for a distribution company. As a result, they rely on volume rather than profit per unit to drive overall profits. (Source: ibid)
The Bottom Line
By looking at common size financial statements, analysts can more easily compare companies. This can reveal which companies within a given industry are the most cost-effective and profitable. Overall, common size financial statements are widely used and an effective tool for comparison and analysis.
- Common sizing is one way to level the field. This process makes financial statements from different companies comparable, allowing analysts and investors to gain insight into the profitability of each company that might be obscured by raw numbers.
- Common-sized financial statements allow for easier comparisons across groups of companies. Analysts can quickly identify which companies in the group are the most efficient, profitable, and/or financially sound.
- Analysts convert the dollar amount of each line item into a percentage of a common amount. These percentages often convey relevant information that may be hidden by the raw numbers.
Up Next: What Is the Operating Cash Flow Ratio?
The operating cash flow ratio is a measure of how well cash flows generated from a company’s operations are covering current liabilities. The ratio can reveal a company’s liquidity in the short term. Using cash flow as opposed to net income is considered a cleaner or more accurate measure. This is because income and earnings can be more easily manipulated. A high number—greater than one—indicates that a company has generated more cash in a period than what’s needed to pay off current liabilities.
The ratio provides insight into the financial health of the business. If you’re an investor, it may indicate that a business needs more capital. However, it’s always important to look at the operating cash flow coverage ratio alongside other liquidity ratios. Metrics like the cash ratio and quick ratio.