Common Size Analysis, often referred to as Vertical Analysis, is a method of analyzing financial statements in which each item is expressed as a percentage of a base figure within the statement. This type of analysis helps in understanding the relative proportions of different accounts and in comparing financial statements of different firms in the industry.
Methodology
Income Statement Analysis
In Common Size Analysis of an income statement, every line item is expressed as a percentage of total sales. This allows for easy comparison between companies of different sizes or between different periods for the same company.
- Formula: \( \text{Common Size Percentage} = \left( \frac{\text{Income Statement Item}}{\text{Total Sales}} \right) \times 100 \)
Balance Sheet Analysis
For the balance sheet, each item is expressed as a percentage of total assets. This helps in assessing the composition of assets, liabilities, and equity.
- Formula: \( \text{Common Size Percentage} = \left( \frac{\text{Balance Sheet Item}}{\text{Total Assets}} \right) \times 100 \)
Types of Common Size Analysis
Vertical Analysis
Vertical Analysis is the primary method used in Common Size Analysis. It involves expressing financial statement items as a percentage of a base item within the same statement. For example, on an income statement, items are typically expressed as a percentage of sales.
Horizontal Analysis
While not a part of traditional Common Size Analysis, Horizontal Analysis is often used in conjunction. It involves comparing financial data across multiple periods to identify trends and growth patterns.
Applications and Special Considerations
Financial Statement Comparisons
Common Size Analysis is crucial for comparing financial statements of companies of vastly different sizes. By expressing each item as a percentage of a base figure, this method neutralizes scale differences and provides a level playing field for analysis.
Identifying Trends
By converting financial statements into percentages, analysts can easily spot trends in financial performance over time, such as changes in cost structure or shifts in asset allocation.
Industry Comparisons
When comparing companies within the same industry, Common Size Analysis helps in identifying how different companies allocate their resources and manage their finances relative to their peers.
Examples
Example 1: Income Statement
Suppose a company has total sales of $1,000,000 and a cost of goods sold (COGS) of $600,000. The common size percentage for COGS would be:
Example 2: Balance Sheet
Assume another company has total assets worth $2,000,000 and inventory valued at $300,000. The common size percentage for inventory would be:
Historical Context
Common Size Analysis became widely popular in the early 20th century as businesses sought standardized methods to compare financial performance. It has since been a staple in financial analysis, accounting education, and corporate evaluations.
Related Terms
- Financial Ratios: Financial ratios use common size figures for deeper financial analysis and to understand relationships between different financial statement items.
- Comparative Analysis: Comparative analysis involves comparing common size statements of different companies or the same company over multiple periods to draw meaningful conclusions.
- Trend Analysis: Trend analysis focuses on reviewing financial data to identify patterns and trends, often using common size figures to ensure consistency and comparability.
FAQs
Why use Common Size Analysis?
Common Size Analysis allows for easy comparison of financial data across different companies and periods by converting raw data into percentages.
How does Common Size Analysis help in comparing companies of different sizes?
By leveling the field, it neutralizes the scale differences, allowing for insights into how companies manage operations relative to their size.
Is Common Size Analysis only applicable to Income Statements and Balance Sheets?
While primarily used for Income Statements and Balance Sheets, it can also be applied to other financial statements such as the Cash Flow Statement for a comprehensive financial analysis.
References
- “Financial Statement Analysis,” John J. Wild, K. R. Subramanyam, Robert F. Halsey.
- “Accounting Principles,” Jerry J. Weygandt, Paul D. Kimmel, Donald E. Kieso.
Summary
Common Size Analysis, or Vertical Analysis, serves as a fundamental technique in financial analysis that enhances the comparability and understanding of financial statements by expressing line items as a percentage of a base figure. Whether comparing different companies or tracking performance over time, this method provides invaluable insights and helps in making informed financial decisions.
