5 7 Common-Size Statements Principles of Finance

This should help the company’s common size income statement in Year 3. Similar to an income statement analysis, many items in the cash flow statement can be stated as a percent of total sales. This can give insight into several cash flow items, including capital expenditures (CapEx) as a percent of revenue. 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.

1. This common-size balance sheet for technology giant International Business Machines (IBM) is a good example.
2. Operating profit is one of the most important numbers you can analyze because it shows the health of the business firm’s core business.
3. Since we use net sales as the base on the income
   statement, it tells us how every dollar of net sales is spent by
   the company.
4. Financial statements in dollar amounts can easily be converted to common-size statements using a spreadsheet.
5. In Figure 5.21, you can see the formulas used to create Clear Lake Sporting Goods’ common-size income statement in Excel.

In addition, the company has more total assets than total liabilities. IBM’s overall results during the period examined were relatively steady considering the market and the economic conditions of the time. 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 hugely successful in generating cash to buy back shares, far exceeding what it had retained on its balance sheet. Share repurchase activity can also be considered a percent of the total top line.

What a Common Size Income Statement Analysis Does

Common-size financial statements facilitate the analysis of financial performance by converting each element of the statements to a percentage. This makes it easier to compare figures from one period to the next, compare departments within an organization, and compare the firm to other companies of any size as well as industry averages. On the income statement, analysts arrears definition and usage examples can see how much of sales revenue is spent on each type of expense. They can see this breakdown for each firm and compare how different firms function in terms of expenses, proportionally. They can also look at the percentage for each expense over time to see if they are spending more or less on certain areas of the business, such as research and development.

What It Means for Individual Investors

On the balance sheet, analysts commonly look to see the percentage of debt and equity to determine capital structure. They can also quickly see the percentage of current versus noncurrent assets and liabilities. Financial statements that show only
percentages and no absolute dollar amounts are common-size statements. All
percentage figures in a common-size balance sheet are
percentages of total assets while all the items in a
common-size income statement are percentages of net
sales.

The balance sheet equation is assets equals liabilities plus stockholders’ equity. A common-size income statement expresses all revenue and expenses as a percentage of total sales or revenue. Investors may use common-size income statements to help them identify trends or anomalies, either positive or negative. The same process would apply on the balance sheet
but the base is total assets.

An Example of Common Size Income Statement Analysis

A short-term drop in profitability could indicate just a speed bump rather than a permanent loss in profit margins. A common size analysis helps put analysis in context on a percentage basis. One version of the common size cash flow statement expresses all line items as a percentage of total cash flow.

Analysis of Expenses for Company XYZ

The goodwill level on a balance sheet also helps indicate the extent to which a company has relied on acquisitions for growth. Gross profits in the example are steady through the three years, while wages decreased in 2020 from 2019, but increased again in 2021. For example, the information in the chart above may cause this company’s leaders https://simple-accounting.org/ to explore why the cost of goods sold jumped by more than 4.5% in the most recent year, as that can affect profits. In this case, a supply issue may have pushed the cost of materials up temporarily. Or, if the cost of goods sold is expected to remain at that higher level, the company may want to raise the prices of their product.

Expressing the figures on the income statement and balance sheet as percentages rather than raw dollar figures allows for comparison to other companies regardless of size differences. For each line item on this sample income statement, we’ve shown the percentage that it makes up of total revenue. If you just looked at numbers, it might seem like this company did better in 2022 because sales increased from $500,000 to $600,000. However, net income only accounted for 10% of 2022 revenue, whereas net income accounted for more than a quarter of 2021 revenue.

This common size income statement analysis is done on both a vertical and horizontal basis. With a common size horizontal analysis, you can easily see if, for example, your expenses increased as a percentage of revenue, stayed the same or decreased among different time periods. Overall, total operating expenses in this scenario dropped by more than 3 percentage points in 2020 and then increased again in 2021. If this company’s leaders can dig deeper and identify ways to keep expenses closer to the 2020 total in future years, it can potentially increase gross profits. Generally speaking, a common-size financial statement is a type of analysis of an income statement that expresses each line of the statement as a percentage of sales.

The common-size percentages on the
balance sheet explain how our assets are allocated OR how much of
every dollar in assets we owe to others (liabilities) and to owners
(equity). Many computerized accounting systems automatically
calculate common-size percentages on financial statements. The base item in the income statement is usually the total sales or total revenues. Common size analysis is used to calculate net profit margin, as well as gross and operating margins.

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. By looking at this common size income statement, we can see that the company spent 10% of revenues on research and development and 3% on advertising. Common-size analysis enables us to compare companies on equal ground, and as this analysis shows, Coca-Cola is outperforming PepsiCo in terms of income statement information. However, as you will learn in this chapter, there are many other measures to consider before concluding that Coca-Cola is winning the financial performance battle.

This is a significant difference that would be an indicator that Clear Lake and Charlie have key differences in their operations, purchasing policies, or general performance in their core products. The current assets formula determines that the «total current assets,» which are the total of all assets that can be converted to cash within one year, makes up 37% of the company’s total assets. In contrast, current liabilities, which are debts due within one year, make up only 30% of the company’s total assets.

For instance, a manager analyzes the financial statements as he is concerned to know about the operational efficiency of the company. On the other hand, stockholders are keen in knowing the net income and future earnings of the company. Comparing these two income statements reveals two significant red flags. The real value of a common-size income statement comes when you can compare it to other income statements.