As a business owner, you know that the importance of financial statements lies not in its preparation but in its analysis and interpretation. Analysis and interpretation of financial statements include: (i) understanding the various parts of the financial statements, (ii) comparing one part to the other, (iii) evaluating statements as a whole and (iv) establishing meaningful interpretation out of it.
Different stakeholders including managers, investors, owners and creditors want to analyze and interpret the financial statements. Each of the stakeholders evaluate the statements with a different purpose altogether. 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.
Now, each of the stakeholders use different tools and techniques in order to undertake such financial statement analysis. These techniques are in accordance with their purpose. Therefore, one of commonly used tools and techniques to analyze financial statements is the common-size financial statements. Other techniques include:
This article talks about Common Size Statements. So let’s try to understand what are common size statements. And how can such statements help in financial data analysis and interpretation.
What is Common Size Statement Analysis?
Common size analysis is a technique that is used to analyze and interpret the financial statements. This technique is also termed as vertical analysis. Thus, this technique helps in assessing the financial statements by considering each line item as a percentage of the base amount for that period.
In case of the income statement, the base is taken as the net sales. Whereas in case of balance sheet, the amount of total assets is taken as the base. Then, each line item in the income statement is expressed as a percentage of total sales. While, each item in the balance sheet is appropriated as a percentage of total assets.
Thus, this analysis helps in knowing the effect of each of the items in the financial statements. Furthermore, common size analysis also helps in knowing the contribution made by each of the line items to the final figure.
The technique of common size statement analysis is used to interpret three financial statements including balance sheet, income statement and cash flow statement. However, in this article, we will cover most commonly used statements for common size analysis. That is, balance sheet and income statement.
Common Size Balance Sheet
In common size balance sheet analysis, total assets act as the base value. And each item in the balance sheet represents a fraction of such total assets. As we know, balance sheet reflects the accounting equation:
Assets = Liabilities + Owner’s Equity
This equation showcases the amount business owns in the form of assets. And the amount it owes to the creditors and shareholders in the form of liabilities and owner’s equity respectively. Therefore, business owners or investors can use common size analysis to understand a company’s capital structure vis-a-vis its competitors.
Furthermore, the stakeholders can undertake analysis by evaluating each of the line item in the balance sheet in relation to the total assets. For example, a business owner can know the amount of yearly profit retained in the business by comparing retained earnings to total assets as base. Similarly, if the amount of long-term debt as against the total assets is way too high, it indicates that the business has extremely high level of debt.
Steps to Prepare Common Size Balance Sheet
- Assets are classified into categories such fixed assets, investments, current assets and fictitious assets for two years under consideration. Furthermore, liabilities are classified into categories including proprietor’s fund, long-term loan and current liabilities. Thus, a total of the assets or liabilities is taken as a common base equal to 100. These amounts are specified in Column I and Column II of the common size balance sheet.
- Each item on the asset side is taken as the percentage of total assets. Similarly, each item on the liability side is taken as a percentage of total liabilities.
- The formula used to calculate such a percentage is as follows: Percentage of Base = (Individual Item Amount/Base Item Amount (Total Assets/Total Liabilities in case of Balance Sheet) * 100
- Specify the percentages as calculated above in Column III and IV of the Common Size Balance Sheet.
Common Size Income Statement
In common size income statement analysis, the base is usually taken as total revenue or total sales. This analysis helps the business owner to understand:
- If the profits are increasing in relation to the sales or;
- Percentage change in cost of goods sold during the period;
- If there are any changes that have occurred in various expense items or;
- Whether the increase in retained earnings of the business is more than the proportionate change in the profit of the business or.
Furthermore, the common size income statement does not showcase trends of each of the line items. Rather, it showcases the trends of the relationship of each of the items to the total.
Thus, common size income statement technique helps to:
- Compare income statements of two or more periods or two or more companies in cases where the size of such companies is not the same.
- Recognize substantial changes in the financial statements of the company. Such changes over the years help investors to understand whether to invest in the company or not. For example, substantial fall in the profits of a business over the years may hint towards the fact that the company is undergoing financial distress.
Steps to Prepare Common Size Income Statement
- Specify the absolute figures of each line item of the income statement for two accounting years under consideration. These amounts are specified in Column I and Column II of the common size income statement.
- Choose sales amount as the common base. This is equal to 100.
- Calculate base year percentage for each line item using the formula: Percentage of Base = (Individual Item Amount/Base Item Amount(Sales in case of Income Statement)) * 100
- Specify the percentages as calculated above in Column III and IV of the Common Size Income Statement.