Common size analysis

What Is Common Size Analysis?

Common size analysis is a financial analytical technique that converts every line item on a financial statement into a percentage of a chosen base figure, allowing for easier comparisons. This method is a core component of financial statement analysis, providing insights into the proportional relationships within a company's financials over time or against competitors. By presenting items as percentages rather than absolute dollar amounts, common size analysis helps to standardize statements, making it simpler to identify trends and assess a company's profitability, operational efficiency, and financial structure, regardless of its size³², ³³. It can be applied to the income statement, balance sheet, and cash flow statement.

History and Origin

The evolution of common size analysis is intrinsically linked to the broader development of financial reporting and the need for standardized data to inform investment decisions. As businesses grew in complexity and across different industries, the necessity arose for tools that could compare companies of varying scales on an "apples-to-apples" basis. While specific historical figures for its "invention" are not pinpointed, the practice of converting financial figures to percentages for analytical purposes likely emerged with the increasing sophistication of accounting practices and the rise of organized financial markets.

The establishment of regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC) in 1934, played a crucial role in standardizing financial reporting to protect investors and maintain transparent markets³¹. This regulatory environment encouraged the development and widespread adoption of analytical techniques like common size analysis, as it facilitated the comparison of financial data across diverse public companies. Similarly, international bodies like the International Monetary Fund (IMF), established in 1944, have promoted financial stability and monetary cooperation among nations, implicitly encouraging robust financial analysis methods that can transcend national borders and varying economic scales³⁰.

Key Takeaways

• Common size analysis converts all line items on a financial statement into percentages of a common base figure.
• It simplifies comparisons between companies of different sizes or between different periods for the same company.
• The base for an income statement is typically total revenue, while for a balance sheet, it is total assets.
• This analysis helps identify key trend analysis and structural shifts in a company's financial performance.
• Common size analysis is a valuable tool for assessing operational efficiency, cost management, and overall financial stability.

Formula and Calculation

The calculation for common size analysis is straightforward, involving the division of each line item by a chosen base figure and then multiplying by 100 to express it as a percentage. The base figure depends on the financial statement being analyzed:

For an Income Statement:

Each line item is expressed as a percentage of total revenue.

For example, to calculate the common size percentage for expenses like Cost of Goods Sold, you would divide the Cost of Goods Sold by the total revenue for that period.

For a Balance Sheet:

Each line item (e.g., current assets, total liabilities) is expressed as a percentage of total assets.

In the context of the balance sheet, total assets usually equal total liabilities and shareholders' equity, making either an acceptable base for analysis.

Interpreting the Common Size Analysis

Interpreting common size analysis involves looking at the percentages to understand the relative importance of each line item and how these proportions change over time or compare to other companies. For an income statement, a common size analysis reveals how much of each revenue dollar is consumed by various expenses before arriving at net income²⁹. For instance, a rising percentage of selling, general, and administrative expenses relative to revenue could indicate declining operational efficiency or increased marketing efforts.

On a balance sheet, common size analysis illustrates the composition of a company's assets and how they are financed by liabilities and equity²⁸. A high percentage of current assets might suggest strong liquidity, while a growing percentage of long-term debt could indicate increased financial leverage and impact a company's solvency²⁷. Analysts can use these percentages to identify significant shifts in financial structure that might not be apparent from raw dollar figures alone.

Hypothetical Example

Consider two hypothetical companies, Company A and Company B, operating in the same industry.

Company A - Income Statement (Common Size)

• Revenue: $1,000,000 (100%)
• Cost of Goods Sold: $600,000 (60%)
• Gross Profit: $400,000 (40%)
• Operating Expenses: $250,000 (25%)
• Net Income: $100,000 (10%)

Company B - Income Statement (Common Size)

• Revenue: $500,000 (100%)
• Cost of Goods Sold: $250,000 (50%)
• Gross Profit: $250,000 (50%)
• Operating Expenses: $100,000 (20%)
• Net Income: $75,000 (15%)

By applying common size analysis, even though Company A has significantly higher absolute revenue and net income, Company B shows a higher gross profit margin (50% vs. 40%) and lower operating expenses as a percentage of revenue (20% vs. 25%). This suggests that Company B is more efficient in managing its production costs and overhead, leading to a higher net income margin (15% vs. 10%) relative to its sales. This comparison highlights how common size analysis enables meaningful insights despite differences in company size.

Practical Applications

Common size analysis is widely used across various domains of finance and investing for its ability to normalize financial data.

• Comparative Analysis: Investors and analysts use common size financial statements to compare a company's performance against its competitors, even if they are of vastly different sizes²⁵, ²⁶. This allows for an understanding of relative strengths and weaknesses, such as whether a company spends a higher percentage of its revenue on marketing or research and development compared to industry benchmarks²⁴.
• Trend Analysis: Businesses employ common size analysis internally to track changes in their financial structure and performance over multiple periods²³. For example, by analyzing common size income statement data year-over-year, management can identify whether the proportion of specific expenses to revenue is increasing or decreasing, signaling areas for cost control or efficiency improvements²².
• Financial Health Assessment: Common size analysis of the balance sheet helps in assessing a company's financial structure and its reliance on different sources of funding. It can reveal if a company's level of debt, as a percentage of total assets, is unusually high for its industry, which could indicate higher risk²⁰, ²¹. Insights into financial health are often supported by research and publications from economic institutions like the Federal Reserve Bank of San Francisco, which provide broader economic context and analysis.
• Credit Analysis: Lenders often use common size statements to evaluate a borrower's ability to service debt by looking at the proportion of debt to assets or interest expense to revenue.

Limitations and Criticisms

While common size analysis is a powerful tool, it has several limitations that users should consider for a comprehensive view.

• Lack of Absolute Values: Common size analysis focuses solely on percentages, which means it does not provide insight into the absolute dollar amounts¹⁸, ¹⁹. A small percentage change in a very large company could represent a significant dollar amount, while a large percentage change in a small company might be trivial in absolute terms. Therefore, common size statements should always be reviewed in conjunction with traditional financial statement reports¹⁷.
• Industry Differences: Comparing companies across different industries using common size statements can be misleading due to inherent differences in business models and cost structures¹⁵, ¹⁶. For example, a technology company will likely have a higher percentage of expenses in research and development compared to a retail company, which may have higher cost of goods sold as a percentage of revenue¹⁴.
• Accounting Practices: Differences in accounting practices, such as depreciation methods or inventory valuation, can distort comparisons even between companies in the same industry¹³. Analysts must be aware of these potential discrepancies and make adjustments where possible.
• Historical Data Dependence: Common size analysis is based on historical financial data, which may not always accurately reflect future performance or changes in market conditions¹¹, ¹². Academic research, such as that discussing financial analysis techniques, often highlights the importance of context and forward-looking considerations when interpreting historical data¹⁰.

Common Size Analysis vs. Ratio Analysis

Common size analysis and ratio analysis are both crucial components of financial statement evaluation, but they serve distinct purposes. Common size analysis expresses each line item as a percentage of a single base figure within the same financial statement (e.g., all income statement items as a percentage of revenue). This vertical analysis focuses on the internal structure and composition of a company's financials, helping to understand the relative importance of each account and how it contributes to the whole⁹.

In contrast, ratio analysis involves calculating relationships between two or more different line items, often from different financial statements, to provide specific metrics on aspects like liquidity, profitability, and solvency. For example, the current ratio compares current assets to current liabilities, while the net profit margin relates net income to revenue. While common size analysis shows what percentage of sales is gross profit, ratio analysis provides a single metric like the gross profit margin. Both techniques are complementary, offering different lenses through which to evaluate a company's financial health and performance.

FAQs

What is the primary purpose of common size analysis?

The primary purpose of common size analysis is to facilitate easy and meaningful comparisons of financial statement data. It standardizes figures by converting them into percentages of a base amount, which helps in evaluating trends over time or comparing companies of different sizes or in different industries⁸.

Which financial statements can be common sized?

All three primary financial statements can be common sized: the income statement, the balance sheet, and the cash flow statement⁷. For an income statement, total revenue is typically the base, while for a balance sheet, total assets are usually used as the base⁵, ⁶.

How does common size analysis help identify trends?

By converting dollar amounts to percentages, common size analysis removes the effect of scale and allows analysts to easily spot changes in the relative proportions of financial items over multiple periods. For example, consistently rising expenses as a percentage of revenue can indicate a deteriorating cost structure or inefficiency within the company over time³, ⁴.

Can common size analysis predict future performance?

Common size analysis is based on historical data and provides insights into past and current financial structures and trend analysis. While it can highlight patterns that might continue, it cannot predict future performance directly, as it does not account for changes in the business environment, economic conditions, or management strategies¹, ². It should be used as part of a broader analytical framework.