The practice of common sizing financial statements allows you to compare two companies that are of different sizes.
What is a Common Size Income Statement?
A common size income statement occurs when every line item on the income statement is shown as a percentage of sales. This allows for easier comparison to other companies or across specific time periods.
How to Common Size an Income Statement
To common size an income statement, analysts divide each line item (e.g. gross profit, operating income, marketing expenses) by revenue or sales. Each item is then expressed as a percentage of sales.
For example, 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 would be 50% (50/100).
Common Size Income Statement Formula
In order to change an income statement to a common size income statement you must divide each line item by net sales.
Example of Common Size Income Statements
Suppose Company ABC reports sales of $100 million and operating profits of $25 million. Company XYC reports sales of $20 million and operating profits of $15 million. At first glance, it would appear Company ABC is the better performer because it earns a larger profit.
However, a look at the common size financial statement of the two businesses reveals Company XYZ as more profitable:
The common size income statement for Company ABC shows operating profits are 25% of sales (25/100). The same calculation for Company XYZ shows operating profits at 75% of sales (15/20).
|Company ABC||Company XYZ|
|Common Size Operating Profits||25%||75%|
Using common size statements, it's evident that Company XYZ is proportionally more profitable and better at controlling expenses.
How to Common Size a Balance Sheet
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.
Common Size Balance Sheet Formula
The formula for calculating a balance sheet into a common size balance sheet you must divide each line item by total assets.
Example of Common Size Balance Sheet
Here is an example of how useful information is revealed by the common size balance sheets.
Assume Company ABC has long-term debt of $200 million and total assets of $800 million. Company XYZ, which is smaller, has long-term debt of only $100 million and total assets of $300 million.
At first glance, Company ABC may look riskier 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 that is riskier.
Long-term debt represents 33% of the capital structure of Company XYZ (100/300) but only 25% of the capital structure of Company ABC (200/800).
|Company ABC||Company XYZ|
|Common Size Debt Ratios||25%||33%|
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 may be dilutive to existing shareholders.
How to Common Size a Cash Flow Statement
In order to common size a cash flow statement analysts must express each line item of the cash flow statement as a percentage of total cash flow.
It is common practice to common size the investing, operations, and financing cash flow separately, however, using the total cash flow from investing total cash flow from operations, and total cash flow from financing as the base. By computing a cash flow statement into common size you will have more detail about the company's sources and uses of cash.
Common Size Cash Flow Statement Formula
Similar to the Income Statement, to compute a Cash Flow Statement into a Common Size Cash Flow Statement many of the cash flow line items can be divided by total cash flows.
Example of Common Size Cash Flow Statements
Assume Company ABC has a line item for an operating cash flow, e.g., cash paid to suppliers, of $4 million and net operating cash flow of $20,000,000. The smaller Company XYZ has $1.5 million of this cash flow, but cash flow from operations of $6 million.
By common sizing the cash flow statement we can see who is really spending more or less cash to pay suppliers.
|Company ABC||Company XYZ|
|Common Size Expense||20%||25%|
The Pros and Cons of Common Size Statement Analysis
There are both advantages and disadvantages of using common size financial statements.
Common Size Financial Analysis Advantages
- Helps compare a company to its competitors
- Pinpoints significant changes that may have occurred in a company's performance
- Explains whether a company is conservative or risky when managing debts
- Outlines if any one item, such as debt or inventory, is too high
- Showcases drastic changes in a company's performance
Common Size Financial Analysis Disadvantages
Common size financial statements can be extremely helpful to analysts and financial managers, but there are several drawbacks to using them:
- May give the appearance of fair company comparisons, but doesn't take different accounting methods or fiscal year-ends into account.
- Must be used in conjunction with an overall financial statement analysis (to provide a clearer understanding of a company).
- Can't be used to compare companies across different industries. What may be considered a 'favorable' ratio in one industry (e.g. construction) may indicate poor performance in another (e.g. retail).