Just as apples can't be compared to oranges, meaningful comparisons can't be made across different-sized companies without first making adjustments to their financial statements that level the playing field.
Why Are Common Size Financial Statements Important?
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.
The two financial statements that analysts common size most often are the income statement and the balance sheet. Analysts study the income statement for insights into a company's historic growth and profitability. The balance sheet provides relevant information about a company's liquidity and financial strength.
Common Size and Income Statements
Analysts common size an income statement by dividing each line item (for example, gross profit, operating income and sales and marketing expenses) by the top line (sales). Each item is then expressed as a percentage of sales.
For example, gross profit as a percent of sales (also known as gross margin) is calculated by dividing gross profit by sales. Assuming sales are $100 million and gross profits are $50 million, the resulting gross margin is 50% (50/100).
Some financial ratios derived from common sizing are considered more useful than others. Analysts are typically most interested in knowing the gross margin, operating margin (operating income/sales) and net margin (net income/sales). In evaluating expense items on the income statement, analysts mainly look at sales and marketing/sales and general and administrative/sales.
Common Size Financial Statement Example
Here is a simple example of useful information revealed by common-sizing income statements. 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.
Common Size and Balance Sheets
To common size a balance sheet, the analyst restates each line item contained in the balance sheet as a percent of total assets. Analysts are generally most interested in ratios that measure liquidity such as cash/total assets and financial strength, which is often measured by long-term debt/assets.
Here is an example of how useful information is revealed by the common size balance sheets.
Assume Company A has long-term debt of $200 million and total assets of $800 million. Company B, which is smaller, has long-term debt of only $100 million and total assets of $300 million.
At first glance, Company A looks more risky because of a larger dollar amount of long-term debt. However, a comparison of the common-size balance sheets reveals it is actually Company B which is more risky.
Long-term debt represents 33% of the capital structure of Company B (100/300) but only 25% of the capital structure of Company A (200/800). Analysts look at percentages of debt and equity in the capital structure to determine if a company is financing its operations by issuing stock or through long-term borrowings. The latter increases leverage and financial risk, while the former is dilutive to existing shareholders.
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 can'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 can't be used to compare 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 but a poor result from a manufacturing company. Low margins are normal for a distribution company, which relies on volume rather than profit per unit to drive overall profits.
The Bottom Line
By looking at common size financial statements, analysts can easily determine 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 comparing companies.