When you’re looking at your company’s income statements or balance sheets, you might want to know how each line item compares to the others. That’s where the common size ratio comes in — it tells you the size of items in comparison to the whole.
If you’re looking at your business expenses, for example, you might calculate common size ratios for rent, utilities, and raw materials. The ratios can tell you if one particular expense makes up a very big or very small part of your total costs. Why does that matter? It helps you analyze your finances so you can make smarter business decisions.
How to Calculate the Common Size Ratio
In practice, it’s easy to use the common size ratio in your business. To calculate it, gather your financial statements and use the following process:
- Add all the line items on the financial statement you’re analyzing
- Choose a single line item from the statement
- Take the value of that item and divide it by the total to get a percentage
The result is the common size ratio. You can calculate the ratio for any item on a financial statement. Don’t want to do the calculations? Accounting software such as QuickBooks Online typically offers the option to run a common size financial statement.
How to Use a Common Size Percentage
Once you’ve calculated the common size ratio for a line item, what do you do with it? To start, you can compare it to other items on the same financial statement to get a better understanding of your business.
Imagine your small business makes sales in three ways: through phone calls, in-person visits to prospects, and online sales.
When you look at your sales statement, you find that phone call sales bring in $100,000, in-person sales bring in $50,000, and online sales add up to $200,000. This means you have total sales of $350,000. To find the common size ratio of each sales line item, take the amount and divide it by $350,000. This means your common size ratios are:
- Phone sales: $100,000 / $350,000, or 28.6%
- In-person sales: $50,000 / $350,000, or 14.3%
- Online sales: $200,000 / $350,000, or 57.1%
In this case, the common size ratios tell you online transactions make up the majority of your sales revenue — which means your customers love to shop online. To boost sales in that area, you might decide to invest heavily in digital advertising or streamline your shopping cart system for easier ordering.
Want to improve your weak areas? Since the common-size ratios tell you your business has low in-person sales, you might conduct sales training to help your store employees sell more effectively.
Compare Results Over Time
Another way to use the common size ratio is to compare your results over time. That way, you can see whether your company progresses or moves backwards. More importantly, you can use the ratios to spot opportunities for improvement. Let’s say you’re looking at your current and past expense reports:
Expenses: 2 years ago
- Total expenses: $50,000
- Accounting and payroll outsourcing costs: $4,000, or 8%
- Total expenses: $75,000
- Accounting and payroll outsourcing costs: $16,500, or 22%
These common size ratios tell you that as your company has grown, your costs for outsourcing accounting and payroll increased at a disproportionate rate. That information can guide your business decisions. You might decide to bring accounting and payroll in-house using a program such as QuickBooks Online.
In the long run, the common size ratio is one way to keep tabs on your business finances. When you know how your expenses and income change over time, you can pinpoint strengths and weaknesses and create a more effective strategy. Always know exactly where your business stands. Make smarter business decisions now.