Common Size Analysis

Common Size Analysis, also known as vertical analysis, is a method used in financial statement analysis where each line item is listed as a percentage of a base figure within the statement. This technique allows for an easy analysis of different companies or of one company over different periods. It provides a clear picture of the relative sizes of different line items and their changes over time.

Common Size Analysis is a powerful tool for comparing the financial performance of different companies or the same company over different periods. It allows for the comparison of companies of different sizes, which can be particularly useful when comparing companies within the same industry. This article will provide a comprehensive breakdown of Common Size Analysis, including its purpose, how it is calculated, and how it can be used in financial statement analysis.

Understanding Common Size Analysis

At its core, Common Size Analysis is about making meaningful comparisons. It's a way of standardizing financial statements, making it possible to compare a small company with a large one, or a retail company with a manufacturing one. By converting everything to percentages, it levels the playing field and allows for more meaningful comparisons.

Common Size Analysis is most often used with the income statement and the balance sheet. For the income statement, each line item is expressed as a percentage of total sales. For the balance sheet, each line item is expressed as a percentage of total assets. This allows for easy comparison of different line items over time or between different companies.

Importance of Common Size Analysis

Common Size Analysis is a powerful tool in financial statement analysis. It allows for easy comparison of different companies or of one company over different periods. This can be particularly useful in identifying trends or spotting anomalies. For example, if a company's cost of goods sold is increasing as a percentage of sales, it could indicate a problem with rising costs or falling prices.

Furthermore, Common Size Analysis can help in identifying the structure and trends in a company's sources and uses of capital. It can highlight whether a company is heavily reliant on debt, or if it is generating sufficient profits from its operations. This can provide valuable insights for investors, creditors, and the company's management.

Limitations of Common Size Analysis

While Common Size Analysis is a useful tool, it is not without its limitations. One limitation is that it is based on historical data, which may not be indicative of future performance. Furthermore, it does not take into account differences in accounting methods between different companies, which can impact the comparability of financial statements.

Another limitation is that it does not provide any information about a company's market conditions or competitive position. It is therefore important to use Common Size Analysis in conjunction with other financial statement analysis tools and techniques.

Calculating Common Size Analysis

Common Size Analysis is calculated by dividing each line item in a financial statement by a base figure. For the income statement, the base figure is usually total sales, while for the balance sheet, the base figure is usually total assets. The result is then multiplied by 100 to convert it into a percentage.

The formula for calculating Common Size Analysis is as follows: (Line Item / Base Figure) x 100. This can be calculated for each line item in a financial statement, allowing for easy comparison of different line items over time or between different companies.

Example of Common Size Analysis Calculation

Let's take an example of a company with total sales of $1,000,000 and cost of goods sold of $600,000. The Common Size Analysis for the cost of goods sold would be calculated as follows: ($600,000 / $1,000,000) x 100 = 60%. This means that the cost of goods sold represents 60% of total sales.

Similarly, if the company has total assets of $2,000,000 and total liabilities of $1,000,000, the Common Size Analysis for the total liabilities would be calculated as follows: ($1,000,000 / $2,000,000) x 100 = 50%. This means that the total liabilities represent 50% of total assets.

Interpreting Common Size Analysis

Once the Common Size Analysis has been calculated, the next step is to interpret the results. This involves comparing the percentages for different line items over time or between different companies. For example, if the percentage for cost of goods sold is increasing over time, it could indicate a problem with rising costs or falling prices.

Similarly, if the percentage for total liabilities is higher for one company compared to another, it could indicate that the first company is more heavily reliant on debt. It is important to interpret the results of Common Size Analysis in the context of the company's industry, market conditions, and competitive position.

Using Common Size Analysis in Financial Statement Analysis

Common Size Analysis is a key tool in financial statement analysis. It can be used to compare the financial performance of different companies or the same company over different periods. It can also be used to identify trends or anomalies, and to gain insights into a company's financial health and performance.

Common Size Analysis can be particularly useful in the following areas:

• Comparing companies of different sizes: By converting everything to percentages, Common Size Analysis allows for meaningful comparisons between companies of different sizes.
• Identifying trends: By comparing the percentages for different line items over time, Common Size Analysis can help in identifying trends. For example, an increasing percentage for cost of goods sold could indicate a problem with rising costs or falling prices.
• Spotting anomalies: If a line item's percentage is significantly different from the industry average or from previous periods, it could indicate an anomaly that warrants further investigation.

Common Size Analysis and Ratio Analysis

Common Size Analysis is often used in conjunction with ratio analysis in financial statement analysis. Ratio analysis involves comparing different line items or groups of line items in a company's financial statements. It provides a way of assessing a company's financial health, performance, and financial stability.

Common Size Analysis can enhance ratio analysis by providing a standardized basis for comparison. This can make ratio analysis more meaningful and insightful. For example, by using Common Size Analysis, a company's gross profit margin (gross profit as a percentage of sales) can be compared with that of other companies, regardless of their size.

Common Size Analysis and Trend Analysis

Common Size Analysis can also be used in conjunction with trend analysis in financial statement analysis. Trend analysis involves looking at a company's financial performance over time to identify patterns or trends.

By converting line items to percentages, Common Size Analysis can make trend analysis more meaningful and insightful. It can help in identifying trends in a company's cost structure, profitability, and financial stability. For example, an increasing trend in cost of goods sold as a percentage of sales could indicate a problem with rising costs or falling prices.

Conclusion

Common Size Analysis is a powerful tool in financial statement analysis. It allows for easy comparison of different companies or of one company over different periods. It can help in identifying trends, spotting anomalies, and gaining insights into a company's financial health and performance.

While it has its limitations, when used in conjunction with other financial statement analysis tools and techniques, Common Size Analysis can provide valuable insights for investors, creditors, and the company's management. As such, it is an essential tool for anyone involved in financial statement analysis.