The Common Size Standard is a financial analysis tool used to analyze and compare the financial statements of different companies. By expressing each line item on a financial statement as a percentage of a specified base, it allows for a standardized comparison regardless of company size. For the income statement, sales revenues are typically set as 100%, and other account groupings, such as expenses, are expressed as percentages of these sales revenues.
Importance of Common Size Standard
Facilitating Comparisons
One of the main advantages of using the Common Size Standard is that it simplifies comparison across different companies, industries, and periods. It normalizes financial data, making it possible to objectively compare operations and performance.
Simplifying Trend Analysis
Common size analysis is also invaluable for trend analysis within a single company over multiple periods. By converting absolute numbers into percentages, it becomes easier to spot trends, such as rising costs or improving gross margins.
Enhancing Ratio Analysis
This method enhances ratio analysis, such as gross margin, operating margin, and net profit margin by putting all figures in a comparable scale.
Types of Common Size Statements
Common Size Income Statement
In a Common Size Income Statement, each line item is expressed as a percentage of sales revenues (which are set at 100%). This helps in understanding the proportion of revenue consumed by each expense and the portion of revenues that contribute to net income.
Example:
| Income Statement Item | Amount | Percentage of Sales Revenue |
|---|---|---|
| Sales Revenue | $1,000 | 100% |
| Cost of Goods Sold | $400 | 40% |
| Gross Profit | $600 | 60% |
| Operating Expenses | $300 | 30% |
| Net Income | $200 | 20% |
Common Size Balance Sheet
In a Common Size Balance Sheet, each asset, liability, and equity item is shown as a percentage of total assets (or total liabilities and equity).
Example:
| Balance Sheet Item | Amount | Percentage of Total Assets |
|---|---|---|
| Total Assets | $1,000 | 100% |
| Current Assets | $400 | 40% |
| Fixed Assets | $600 | 60% |
| Total Liabilities | $700 | 70% |
| Shareholders’ Equity | $300 | 30% |
Historical Context
The concept of common size analysis dates back several decades and has been widely used by financial analysts and accountants as a way to standardize financial data for comparison purposes. This method became particularly useful with the globalization of economies and the resultant need to compare companies across different markets and currencies.
Applicability and Uses
This tool is crucial for:
- Investment Analysts: To compare potential investment opportunities.
- Management: For internal performance evaluation and strategy adjustment.
- Auditors: To identify unusual trends or discrepancies.
Comparisons with Related Terms
Vertical Analysis
Vertical analysis, synonymous with common size analysis, involves comparing financial statement accounts in terms of a vertical structure.
Horizontal Analysis
Horizontal analysis, in contrast, looks at financial statement data across multiple periods, showing changes and trends over time in absolute dollar terms and percentage changes.
FAQs
What is the primary purpose of common size analysis? The primary purpose is to facilitate easier comparison of financial data across different companies and time periods by standardizing line item representations as percentages of a base figure.
Can common size analysis be used for cash flow statements? While less common, it can be adapted for certain line items on cash flow statements to show percentage relationships to net cash flows from operating activities.
How does common size analysis aid in financial analysis? By normalizing data, it allows analysts to compare the relative proportions of different account categories, making it easier to identify trends, strengths, and weaknesses.
References
- “Financial Statement Analysis and Security Valuation” by Stephen Penman
- “Principles of Accounting” by John J. Wild
- Investopedia’s Guide on Common Size Analysis
Summary
In conclusion, the Common Size Standard is a key analytical tool in finance and accounting that assists in the standardization of financial statements. By expressing components of financial data as percentages of a reference figure, it aids in making meaningful comparisons across different firms and time periods, thereby providing invaluable insights for stakeholders.
