Jun 12, 2010

MBA Finance Topics-Common Size Financial Statements

Common size ratios are used to compare financial statements of different-size companies, or of the same company over different periods. By expressing the items in proportion to some size-related measure, standardized financial statements can be created, revealing trends and providing insight into how the different companies compare.

The common size ratio for each line on the financial statement is calculated as follows:
Common Size Ratio =
Item of Interest
Reference Item
For example, if the item of interest is inventory and it is referenced to total assets (as it normally would be), the common size ratio would be:
Common Size Ratio for Inventory =
Inventory
Total Assets
The ratios often are expressed as percentages of the reference amount. Common size statements usually are prepared for the income statement and balance sheet, expressing information as follows:
  • Income statement items - expressed as a percentage of total revenue
  • Balance sheet items - expressed as a percentage of total assets
The following example income statement shows both the dollar amounts and the common size ratios:

Common Size Income Statement

Income Statement
Common-Size
Income Statement
Revenue
70,134
100%
Cost of Goods Sold
44,221
63.1%
Gross Profit
25,913
36.9%
SG&A Expense
13,531
19.3%
Operating Income
12,382
17.7%
Interest Expense
2,862
4.1%
Provision for Taxes
3,766
5.4%
Net Income
5,754
8.2%


For the balance sheet, the common size percentages are referenced to the total assets. The following sample balance sheet shows both the dollar amounts and the common size ratios:

Common Size Balance Sheet

Balance Sheet
Common-Size
Balance Sheet
ASSETS
Cash & Marketable Securities
6,029
15.1%
Accounts Receivable
14,378
36.0%
Inventory
17,136
42.9%
Total Current Assets
37,543
93.9%
Property, Plant, & Equipment
2,442
6.1%
Total Assets
39,985
100%

LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities
14,251
35.6%
Long-Term Debt
12,624
31.6%
Total Liabilities
26,875
67.2%
Shareholders' Equity
13,110
32.8%
Total Liabilities & Equity
39,985
100%


The above common size statements are prepared in a vertical analysis, referencing each line on the financial statement to a total value on the statement in a given period.
The ratios in common size statements tend to have less variation than the absolute values themselves, and trends in the ratios can reveal important changes in the business. Historical comparisons can be made in a time-series analysis to identify such trends.
Common size statements also can be used to compare the firm to other firms.

Comparisons Between Companies (Cross-Sectional Analysis)

Common size financial statements can be used to compare multiple companies at the same point in time. A common-size analysis is especially useful when comparing companies of different sizes. It often is insightful to compare a firm to the best performing firm in its industry (benchmarking). A firm also can be compared to its industry as a whole. To compare to the industry, the ratios are calculated for each firm in the industry and an average for the industry is calculated. Comparative statements then may be constructed with the company of interest in one column and the industry averages in another. The result is a quick overview of where the firm stands in the industry with respect to key items on the financial statements.

Limitations

As with financial statements in general, the interpretation of common size statements is subject to many of the limitations in the accounting data used to construct them. For example:
  • Different accounting policies may be used by different firms or within the same firm at different points in time. Adjustments should be made for such differences.
  • Different firms may use different accounting calendars, so the accounting periods may not be directly comparable.
Source: www.netmba.com

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