What Is a Common Size Financial Statement?
Common size financial statements represent an essential tool for investors and analysts seeking to compare companies, industries, or periods in an apples-to-apples manner. These statements display financial information as percentages of a common base figure, often total revenue, making it easier to analyze trends and identify the primary drivers behind a company’s financial performance.
By standardizing the data, common size financial statements reduce biases and facilitate side-by-side comparisons. Common size statements usually consist of an income statement, balance sheet, and cash flow statement. Let’s dive deeper into each common size statement.
The Income Statement: A Closer Look
The income statement, also known as the profit and loss (P&L) statement, reveals a company’s revenue and expenses for a specific period. To create a common size income statement, all items are expressed as percentages of total sales. For instance, an expense like cost of goods sold would be shown as a percentage of sales. This format allows analysts to easily identify trends in revenues and costs, as well as evaluate the impact of changes in sales volume or pricing on profitability.
Setting up a Common Size Income Statement:
To create a common size income statement, first, calculate all expenses and revenues as a percentage of total sales. For example, if a company’s revenue is $100,000, its cost of goods sold (COGS) amounts to $60,000, operating expenses are $25,000, interest expense is $3,000, and taxes amount to $4,000, the common size income statement would look as follows:
Sales 1.00 COGS (-) 0.60 Operating Expenses (-) 0.25 Interest Expense (-) 0.03 Taxes (-) 0.04 Total expenses (-) 0.82 Net Income (EBIT) (+) 0.18
The total percentage of expenses should equal 100% to ensure consistency across the income statement. Here, the sum of COGS and operating expenses equals 82%, leaving a net income or earnings before interest and taxes (EBIT) of 18%. This common size format makes it possible to compare various companies in the same industry or the same company over different time periods.
Next: Understanding the Common Size Balance Sheet and Cash Flow Statement…
Why Use Common Size Financial Statements?
Common size financial statements are essential tools for investors and analysts to compare and evaluate a company’s financial performance against its industry peers or over different periods. These statements, which display financial data as percentages of a common base figure – usually total revenues or total assets – help reduce bias and enable more straightforward analysis.
Common size financial statements can be applied to various financial statements such as the income statement, balance sheet, and cash flow statement. By standardizing and comparing each line item to a common base, investors can make apples-to-apples comparisons regardless of the company’s size or industry.
Let us explore the benefits of using common size financial statements for institutional investors:
1. Comparison between companies or periods for the same company: Common size statements enable analysts to compare a company’s performance with industry peers, competitors, or its historical data without being influenced by differences in accounting methods, scales, or industries. This comparison helps investors gain valuable insights into a company’s financial health and growth trajectory.
2. Reduction of bias and easier analysis: Common size statements present financial information in a consistent format, which reduces the impact of various accounting methods and makes it simpler to analyze trends, identify anomalies, and compare performance indicators across companies or over time.
By setting up a common size income statement, for example, we can define all items as a percentage of sales:
– Sales = 100%
– Cost of goods sold = X% (e.g., 50%)
– Operating expenses = Y% (e.g., 30%)
– Net income = 100% – (X + Y)%
Following this example, we can evaluate the profitability and efficiency of a company’s operations based on its percentage of sales allocated to costs of goods sold and operating expenses. This comparison helps investors determine which firms are maximizing their revenue potential while minimizing their costs.
In conclusion, common size financial statements provide numerous benefits for institutional investors by enabling accurate comparisons between companies or time periods, reducing bias, and simplifying the analysis process. These tools offer valuable insights into a company’s profitability, efficiency, and overall financial health, making them an essential resource in any investment research process.
Types of Common Size Financial Statements
Common size financial statements are a powerful tool for institutional investors seeking to make informed decisions about their investments in various companies and industries. This section focuses on the three essential financial statements for common size analysis, namely the income statement, balance sheet, and cash flow statement.
The income statement, commonly known as the profit-and-loss (P&L) statement or statement of revenues and expenses, provides an overview of a company’s sales, expenses, and net income during the reporting period. The common size income statement, as its name suggests, is formatted to display all items as percentages of total sales. This approach enables analysts to compare companies with varying sizes, industries, or time frames by focusing on their profitability drivers.
The equation for a common size income statement is: Sales = Cost of goods sold + Operating expenses + Depreciation and Amortization + Interest expense + Income taxes + Net income. By calculating each line item as a percentage of total sales, the income statement reveals how effectively the company manages its revenue and expenses to generate net income. For instance, analyzing a common size income statement for two companies can provide insights into which firm has a better cost structure or operates more efficiently.
A real-world example of a common size income statement may show that Company A and Company B have sales revenues of $5 million and $10 million, respectively. However, upon examining their common size income statements, it is revealed that Company A generates 65% of its sales revenue as cost of goods sold, while Company B has a lower cost structure with only 58% of sales revenue allocated towards cost of goods sold. This information is essential for an institutional investor looking to make informed investment decisions based on companies’ profitability and efficiency.
The balance sheet provides a snapshot overview of a firm’s assets, liabilities, and shareholders’ equity for the reporting period. Common size financial statements can be prepared by expressing all line items as percentages of total assets or total equity, which simplifies analysis between companies or different periods. The common size balance sheet is based on the accounting equation, Assets = Liabilities + Stockholders’ Equity.
The cash flow statement offers an overview of a company’s sources and uses of cash during a reporting period. It can be presented in a common size format by expressing each line item as a percentage of total cash flows from operations, investing activities, or financing activities. This approach helps investors compare the cash generation abilities and liquidity position of different companies within their investment universe.
In conclusion, the common size financial statements – income statement, balance sheet, and cash flow statement – provide valuable insights for institutional investors when making informed decisions on investments in various industries and markets. Understanding these statements as percentages of a common base figure enables analysts to compare companies with different sizes or across periods in an apples-to-apples way, ultimately leading to more accurate and insightful analysis.
Understanding the Common Size Income Statement
A common size financial statement displays every entry as a percentage of a common base figure, like total sales revenue. This format enables analysts to compare companies of varying sizes or industries and different time periods on an equal footing. The three primary types of common size statements are the income statement, balance sheet, and cash flow statement. In this article, we will discuss the intricacies of a common size income statement.
Overview of the Common Size Income Statement Equation:
A common size income statement is derived from the standard income statement equation: Sales – Cost of goods sold (COGS) = Gross profit; Gross profit – Operating expenses = Operating income; Operating income – Interest expense +/- Preferred dividends = Earnings before taxes (EBIT); EBIT – Income tax = Earnings before interest and taxes (EBITDA); EBITDA – Depreciation = Net income.
To make the income statement common size, all figures are expressed as a percentage of sales. This transformation simplifies analysis by allowing direct comparison of the composition of expenses for various companies.
Setting Up the Common Size Income Statement:
To prepare a common size income statement, follow these steps:
1. Collect financial statements from multiple periods or companies.
2. Calculate the total sales revenue for each period or company.
3. Identify all expense line items on the income statement and calculate their percentage of total sales.
4. Enter the percentages in the common size income statement, with Sales as 100%.
5. Review your common size income statement to compare trends and differences between companies or periods.
For instance, if a company has an income statement showing gross sales of $100,000, cost of goods sold ($50,000), operating expenses ($20,000), interest expense ($3,000), preferred dividends ($500), taxes ($8,000), depreciation ($7,000), and net income of $19,000, the common size statement would appear as follows:
Sales 100.0% | Cost of goods sold (COGS) 50.0%| Operating expenses 20.0%| Interest expense 3.0%| Preferred dividends 1.5%| Earnings before taxes (EBIT) 14.5%| Income tax 8.0%| Earnings before interest and taxes (EBITDA) 23.0%| Depreciation 7.0%| Net income 11.5%
This common size format enables analysts to focus on the percentage composition of a company’s expenses, which can reveal valuable insights into the firm’s financial health and performance.
Real-World Example: Common Size Income Statement
To illustrate how a common size income statement works, let’s examine the financial statements of two companies – Company A and Company B, both from different industries. While their absolute values may differ greatly, using common size statements will enable us to make accurate comparisons between their income structures. For our example, we assume that Company A is a retailer with sales revenue of $1 million, while Company B operates in the technology sector, generating $5 million in annual sales revenue.
First, let’s create a standard income statement for both companies:
Company A:
Sales revenue: $1,000,000
Cost of goods sold (COGS): $600,000
Gross profit: $400,000
Operating expenses: $250,000
Operating income: $150,000
Interest expense: $20,000
EBIT: $130,000
Taxes: $50,000
Net income: $80,000
Company B:
Sales revenue: $5,000,000
Cost of goods sold (COGS): $3,000,000
Gross profit: $2,000,000
Operating expenses: $1,000,000
Operating income: $1,000,000
Interest expense: $500,000
EBIT: $550,000
Taxes: $200,000
Net income: $350,000
To convert these income statements into common size statements, we will express all line items as a percentage of total sales revenue. Company A’s common size statement looks like this:
Company A:
Sales 1.000
COGS 0.600
Gross profit 0.400
Operating expenses 0.250
Operating income 0.150
Interest expense 0.020
EBIT 0.130
Taxes 0.050
Net income 0.080
Company B’s common size statement:
Company B:
Sales 1.000
COGS 0.600
Gross profit 0.400
Operating expenses 0.200
Operating income 0.200
Interest expense 0.010
EBIT 0.110
Taxes 0.004
Net income 0.070
From the common size statements, it becomes apparent that both companies have similar structures for their gross profit (40%) and operating expenses (20%), but differ in their cost of goods sold percentage (60% for Company A vs. 60% for Company B). This comparison is valuable as it enables us to focus on the relationship between line items and total sales revenue instead of simply looking at absolute numbers that may not accurately represent the companies’ profitability or efficiency.
Understanding the Common Size Balance Sheet
A common size balance sheet provides a clear representation of a company’s financial position by presenting all assets, liabilities, and equity items as percentages of total assets. This formatting facilitates comparison between different companies or time periods for the same company. The logic behind a common size balance sheet is similar to that of a common size income statement – it normalizes figures to a common base, enabling a more straightforward analysis.
To create a common size balance sheet, we begin by setting up our starting point: the balance sheet equation, which states that assets equal liabilities and stockholders’ equity (also referred to as shareholders’ equity or owners’ equity). The first step is to express all asset items as percentages of total assets.
Let us consider a hypothetical company XYZ’s common size balance sheet:
| Asset Class | Common Size % |
|————————–|——————-|
| Current Assets | 35% |
| Property, Plant and Equipment (PP&E) | 45% |
| Intangible Assets | 10% |
| Total Assets | 100% |
|————————–|——————-|
| Liabilities and Equity | |
| Current Liabilities | 30% |
| Long-Term Debt | 30% |
| Stockholders’ Equity | 40% |
| Total Liabilities and Equity | 100% |
In the example above, we have shown that current assets represent 35% of XYZ’s total assets, while property, plant, and equipment (PP&E) make up 45%. The remaining assets consist of intangible assets, which represent 10% of total assets. By examining the balance sheet in this format, it becomes easier to understand how each asset class contributes to the company’s overall financial position.
A second version of a common size balance sheet presents liabilities as percentages of total liabilities and stockholders’ equity as a percentage of total equity. This version can be useful for evaluating a company’s liquidity, solvency, and equity structure. By comparing the ratios of different companies or time periods using this format, analysts can identify trends and assess the financial health of each entity more effectively.
Understanding the Common Size Cash Flow Statement
The cash flow statement is a fundamental financial document that illustrates the relationship between inflows and outflows of a company’s cash during an accounting period. A cash flow statement, as its name suggests, offers insight into how cash entered or left the business throughout a specific timeframe. The purpose of analyzing the cash flow statement is to identify the sources of cash generation (operating activities), the uses of cash (investing and financing activities) and assess the overall cash position of the company.
A common size cash flow statement, similar to income statements and balance sheets, presents financial data as a percentage of total cash flow rather than in absolute values. This formatting facilitates easier comparability between companies or industries over different periods since all figures are expressed relative to each other. To understand how the common size cash flow statement works, let’s break down its three primary sections:
1. Cash Flows from Operating Activities:
This section includes net income and adjustments for changes in working capital accounts, such as accounts receivable (AR), inventory, and accounts payable (AP). The formula for cash flows from operating activities is:
Net Income + Adjustments = Cash Flow from Operating Activities
For instance, if a company reports net income of $100,000 and has $5,000 in changes to its AR and $3,000 in changes to its inventory, the cash flow from operating activities would be:
$100,000 + $5,000 + $3,000 = $108,000.
In a common size cash flow statement, all items are expressed as percentages of total cash flow from operating activities. For example:
Net Income 0.62
Adjustments for changes to AR and inventory 0.045 and 0.018 respectively
Total Cash Flow from Operating Activities 1.00
The common size format displays the relationship between net income, adjustments, and total cash flow from operating activities in a clear and concise way.
2. Cash Flows from Investing Activities:
This section of the cash flow statement reveals how cash was spent on investments in long-term assets such as property, plant, equipment (PP&E), or intangible assets. In other words, it shows how much capital a company has invested or disinvested during a given period. The formula for cash flows from investing activities is:
Net Purchase of Long-Term Assets + Proceeds from Sale of Long-Term Assets = Cash Flow from Investing Activities
Assume the company in our example bought $30,000 worth of PP&E and sold $15,000 in long-term assets during the reporting period:
$30,000 – $15,000 = $15,000
In a common size cash flow statement, all investing activities would be expressed as percentages of total cash flow from investing activities. For example:
Net Purchase of Long-Term Assets 0.45
Proceeds from Sale of Long-Term Assets -0.061
Total Cash Flow from Investing Activities 0.391
In this way, investors can easily understand the relationship between net investment and total cash flow from investing activities.
3. Cash Flows from Financing Activities:
The final section of the cash flow statement demonstrates how cash was used for financing purposes through sources such as issuance or repurchase of debt or equity securities, payment of dividends, or changes in cash balances. The formula for cash flows from financing activities is:
Net Proceeds from Issuance and Repayment of Debt + Net Proceeds from Issuance and Repurchase of Equity – Dividend Paid = Cash Flow from Financing Activities
For instance, if the company in our example raised $20,000 by issuing debt, repaid $15,000 in debt, paid dividends amounting to $3,000 and had no changes in cash balances, its common size cash flow statement would look like this:
Net Proceeds from Issuance and Repayment of Debt 0.278
Dividend Paid -0.015
Total Cash Flow from Financing Activities 0.263
A common size cash flow statement can be particularly valuable for institutional investors because it offers a clearer understanding of the relationship between different components of a company’s cash generation, investment, and financing activities over time. Moreover, it provides a foundation for further analysis by enabling easy comparison with competitors or industry benchmarks.
Benefits of Using Common Size Financial Statements for Institutional Investors
Common size financial statements offer numerous benefits for institutional investors, enabling them to compare and analyze companies, industries, or time periods more effectively. The primary advantage lies in the fact that common size financial statements reduce all figures to a comparable base – in most cases, total sales revenue or total assets. This apples-to-apples comparison allows investors to easily identify trends and drivers within a company’s financial statements, making it simpler to understand the underlying business and its performance over time.
By analyzing financial data as percentages of the total revenue (or total assets for balance sheet analysis), common size financial statements enable investors to:
1. Compare companies in different industries or sizes: Common size financial statements allow for a level playing field when comparing companies in various industries, as well as those with vastly different sizes. This comparison helps institutional investors make informed decisions about potential investments and assess the relative performance of each company.
2. Identify trends and drivers: Common size financial statements reveal trends and drivers in a company’s financial performance by presenting figures as percentages of total revenue or assets. For instance, an increasing trend in cost of goods sold (COGS) as a percentage of sales could indicate decreasing profitability, while declining debt-to-equity ratios might indicate improved financial health.
3. Assess the impact of changes: By comparing common size financial statements over multiple periods, investors can evaluate the effects of specific events or business decisions on a company’s financial performance. For example, a significant increase in research and development (R&D) expenses as a percentage of sales might indicate the company’s investment in innovation, while a decline could suggest decreasing focus on long-term growth initiatives.
4. Perform industry analysis: Common size financial statements facilitate comparison between companies within the same industry by revealing similarities and differences in their financial structures, helping investors identify potential opportunities or risks within that sector.
5. Enhance investment research: Institutional investors often use common size financial statements as part of their due diligence process when evaluating potential investments. The standardized format makes it easier to compare multiple companies’ financials at a glance and identify potential investments based on trends, drivers, and overall performance.
However, it is essential for institutional investors to recognize the limitations of common size financial statements. Differences in accounting methods between companies can lead to inaccuracies when comparing financials directly. It is crucial for investors to have a deep understanding of the industry and company context to effectively interpret common size financial statements and make informed investment decisions based on this analysis.
Limitations of Common Size Financial Statements for Institutional Investors
One important thing to note about common size financial statements is that they may not provide a completely accurate representation when comparing companies with significant differences in accounting methods, industries, or company contexts. This discrepancy can be attributed to the different accounting principles and methodologies used by various firms. For instance, some may use different depreciation methods for long-term assets, which will impact the presentation of common size financial statements.
Moreover, a deep understanding of industry norms and company context is crucial when interpreting these financial statements. While common size financial statements make it easier to identify trends and drivers within a company’s financial statements, they do not provide a complete picture without contextual analysis. This can be particularly important for institutional investors with significant capital at stake, as misinterpretation of financial data could lead to erroneous investment decisions.
For instance, in the retail industry, inventory valuation can significantly impact the common size balance sheet and income statement, as inventory accounting methods can vary between firms. A company that uses a Last In, First Out (LIFO) method will report different inventory levels and cost of sales compared to a firm employing the First In, First Out (FIFO) method. These differences could impact an investor’s decision-making process when comparing companies in the retail sector, emphasizing the importance of understanding industry norms and company context.
Additionally, it is essential for institutional investors to maintain a holistic perspective when examining common size financial statements. While these statements can help identify trends within a firm’s financials, they should not be the sole basis for investment decisions. A thorough analysis that includes both qualitative and quantitative factors is crucial to making informed investment choices.
In summary, while common size financial statements offer numerous benefits when comparing companies or analyzing financial data over time, there are limitations to their use for institutional investors. By understanding these constraints and maintaining a deep knowledge of industry norms and company context, investors can effectively leverage common size financial statements in their decision-making process.
FAQs on Common Size Financial Statements
Common size financial statements can offer valuable insights for institutional investors, enabling them to compare companies more effectively. This FAQ addresses some frequently asked questions about common size financial statements.
1. What is the purpose of a common size financial statement?
The primary goal of a common size financial statement is to provide a standardized and comparable format for analyzing financial data across various companies, industries, or time periods. By representing all financial figures as percentages of a common base figure (e.g., total sales revenue), investors can make more accurate comparisons and gain valuable insights into the underlying financial trends of different entities.
2. How does a common size balance sheet differ from a regular balance sheet?
In a common size balance sheet, all line items are expressed as percentages of the total assets instead of their absolute numerical values. This allows for easier comparison between different companies or time periods, as each asset is evaluated in relation to the company’s overall assets.
3. Why use the income statement equation to create a common size income statement?
The income statement equation (Sales – Cost of Goods Sold – Expenses = Net Income) is used to set up a common size income statement because it shows how each line item relates to total sales revenue. This format allows for easy comparison between companies, as well as analysis of the relationship between sales and costs over time.
4. Can the cash flow statement also be presented in a common size format?
Yes, a common size cash flow statement can be created by expressing all line items as percentages of total cash flows from operations, investing activities, or financing activities. This standardized presentation allows for easier comparison between companies and industries, and helps investors understand the sources and uses of cash more effectively.
5. What are some limitations of using common size financial statements?
While common size financial statements offer numerous benefits to institutional investors, they do have their limitations. Differences in accounting methods may lead to discrepancies when comparing companies directly. Additionally, a deep understanding of the industry context and individual company fundamentals is required for accurate interpretation of the data presented.