Common sized analysis

What Is Common-Sized Analysis?

Common-sized analysis is a fundamental technique in financial statement analysis that expresses each line item on a financial statement as a percentage of a base figure within the same statement. This approach, also known as vertical analysis, transforms raw financial data into a standardized format, allowing for easier comparison over time and across different entities. For an income statement, all items are typically presented as a percentage of total sales revenue. On a balance sheet, each asset, liability, and equity component is shown as a percentage of total assets. Common-sized analysis is crucial for evaluating a company's internal structure and identifying shifts in its financial performance or composition, irrespective of its absolute size.

History and Origin

The practice of analyzing financial statements to understand a company's health and operations evolved alongside the growth of complex corporate structures. While the precise origin of common-sized analysis isn't attributed to a single inventor, its widespread adoption grew with the standardization of accounting standards. In the United States, the establishment of the Securities and Exchange Commission (SEC) through acts like the Securities Act of 1933 and the Securities Exchange Act of 1934 significantly bolstered the demand for transparent and comparable financial reporting following the stock market crash of 1929. The SEC was granted statutory authority to establish financial accounting and reporting standards for publicly held companies, which laid a robust foundation for the consistent application of analytical tools, including common-sized analysis.⁸,⁷

This regulatory push, along with the development of frameworks like Generally Accepted Accounting Principles (GAAP) and later International Financial Reporting Standards (IFRS), fostered an environment where such comparative techniques became indispensable for investors, creditors, and management alike.

Key Takeaways

• Common-sized analysis standardizes financial statements by expressing each line item as a percentage of a base figure.
• It facilitates comparison of financial statements over time for a single company and across different companies or industries, regardless of size.
• The technique helps highlight the relative importance of each financial component and reveal proportional changes.
• It is a valuable tool for identifying trends, assessing financial structure, and pinpointing areas for further investigation.
• Common-sized analysis can be applied to income statements, balance sheets, and cash flow statements to gain different perspectives.

Formula and Calculation

The formula for common-sized analysis is straightforward:

Where:

• Specific Line Item refers to any individual account on the balance sheet (e.g., Accounts Receivable, Inventory) or income statement (e.g., Cost of Goods Sold, Selling Expenses).
• Base Figure is the total value chosen for comparison within the same financial statement. For an income statement, this is typically total revenue (or net sales). For a balance sheet, it is usually total assets.

For example, to calculate the common-sized percentage for an expense on the income statement, you would divide the expense amount by the total revenue and multiply by 100.

Interpreting the Common-Sized Analysis

Interpreting common-sized financial statements involves looking beyond the absolute dollar figures to understand the relative proportions and structural relationships within a company's finances. For instance, a common-sized income statement reveals how much of each sales dollar is consumed by various costs and how much remains as profitability. If Cost of Goods Sold represents 60% of sales this year compared to 50% last year, it signals a change in cost structure that warrants further investigation, even if absolute sales have grown.

Similarly, a common-sized balance sheet shows the composition of a company's assets and how those assets are financed through liabilities and equity. An increasing percentage of current assets might indicate improved liquidity, while a growing proportion of debt relative to total assets could signal higher financial risk or reduced solvency. By comparing these percentages over several periods or against industry averages, analysts can identify efficiencies, inefficiencies, or shifts in a company's operational or financial strategy.

Hypothetical Example

Consider a hypothetical company, "GreenTech Solutions," and its simplified income statements for two years:

GreenTech Solutions - Income Statement (in millions)

In this common-sized analysis, Net Sales is the base figure.

• In Year 1, Cost of Goods Sold was 40% of Net Sales. In Year 2, it increased to 46.7%, indicating that a larger proportion of each sales dollar is now going towards the cost of producing goods, despite the increase in total sales.
• Conversely, Operating Expenses decreased as a percentage of sales, from 25% in Year 1 to 20% in Year 2. This suggests GreenTech Solutions managed to control its operating costs more effectively relative to its sales growth.
• As a result, Net Income, while higher in absolute terms ($50M vs. $35M), slightly decreased as a percentage of sales (from 35% to 33.3%). This immediate proportional view helps in understanding the underlying dynamics of the company's financial performance more clearly than just looking at the absolute dollar amounts.

Practical Applications

Common-sized analysis is a versatile tool with numerous practical applications across various financial disciplines:

• Investment Decisions: Investors use common-sized statements to compare the financial structures and operating efficiencies of potential investment targets within the same industry, regardless of their revenue or asset scale. This helps in making more informed investment decisions by identifying companies with desirable cost structures or asset utilization patterns.
• Management Decisions: Company management employs common-sized analysis for internal control and performance monitoring. It assists in identifying areas where costs might be escalating as a percentage of revenue or where certain assets are becoming disproportionately large or small. This insight aids in strategic management decisions regarding operational efficiency, resource allocation, and pricing.
• Credit Analysis: Lenders and creditors rely on common-sized balance sheets to assess a borrower's financial risk. They can evaluate the relative composition of assets, liabilities, and equity to gauge a company's solvency and ability to meet its obligations. For example, a common-sized balance sheet helps credit analysts understand if a company is becoming excessively reliant on debt financing. The Federal Reserve Bank of San Francisco, like other Federal Reserve banks, annually prepares and releases audited financial statements, which can be subject to various forms of financial analysis to ensure transparency and accountability in their operations.⁶,⁵
• Industry Benchmarking: By comparing a company's common-sized statements to industry averages or top-performing competitors, businesses can benchmark their financial structure and operational efficiency. This reveals strengths and weaknesses relative to peers, informing competitive strategy.
• Regulatory Oversight: Regulatory bodies, like the International Monetary Fund (IMF), encourage good governance and transparency in financial reporting among member countries, which implicitly relies on the ability to compare financial data effectively, often facilitated by techniques like common-sized analysis.⁴ The IMF promotes sound fiscal and monetary policies, and transparent financial reporting is a cornerstone of this work.

Limitations and Criticisms

While common-sized analysis offers valuable insights, it also has limitations. One primary criticism is that by focusing solely on percentages, it can obscure the absolute dollar amounts. A small percentage change in a very large number can represent a significant dollar impact, which might be overlooked if only the percentage is considered. Conversely, a large percentage change in a small, immaterial account might seem significant but have little financial consequence.

Another limitation arises when comparing companies that utilize different accounting methods or operate under different accounting standards, such as GAAP versus IFRS. Even with common-sized figures, underlying differences in how certain transactions are recognized, measured, or disclosed can distort comparisons. The International Accounting Standards Board (IASB) has noted that the increasing complexity of business transactions can lead to more elaborate financial reporting standards, which in turn can pose challenges for both preparers and users of financial information seeking simplicity and understandability.³,²,¹ This inherent complexity in modern financial reporting can sometimes limit the comparability common-sized analysis aims to achieve, as varying interpretations or applications of principles-based standards can exist.

Furthermore, common-sized analysis provides a static view of the financial statement at a specific point in time or over a single period. It does not inherently show the growth or decline in absolute terms over multiple periods; for that, horizontal analysis or trend analysis is required.

Common-Sized Analysis vs. Trend Analysis

Common-sized analysis and trend analysis are both crucial components of financial statement analysis, but they serve distinct purposes and offer different perspectives.

Common-Sized Analysis (Vertical Analysis)

• Focus: It focuses on the internal structure and composition of a single financial statement (e.g., income statement, balance sheet, or cash flow statement) at a specific point in time or over a single reporting period.
• Methodology: Each line item is expressed as a percentage of a chosen base figure within the same statement. For example, every expense on an income statement is a percentage of total revenue, and every asset on a balance sheet is a percentage of total assets.
• Insight: It highlights the relative importance of each component and reveals how resources are distributed or how revenues are consumed. This allows for direct comparison of the financial structure between companies of different sizes or for a single company over time, abstracting from absolute dollar changes.

Trend Analysis (Horizontal Analysis)

• Focus: It focuses on changes in financial data over multiple periods for the same company.
• Methodology: Financial data from two or more consecutive periods are compared to a designated base period. The changes are typically expressed both in absolute dollar amounts and as percentages relative to the base period.
• Insight: It reveals the growth patterns, rates of change, and overall trends in financial performance and position. Trend analysis helps identify whether specific line items are growing or shrinking faster or slower than others, pointing to operational efficiencies, expansion, or decline.

While common-sized analysis provides a snapshot of proportional relationships, trend analysis shows the trajectory of financial items over time. Often, financial analysts use both techniques in conjunction to gain a comprehensive understanding of a company's financial health, combining the insights from relative proportions with a view of historical changes.

FAQs

What is the primary purpose of common-sized analysis?

The primary purpose of common-sized analysis is to enable meaningful comparison of financial statements. By converting all line items into percentages of a base, it eliminates the impact of company size, making it easier to compare a company's financial structure over different periods or against competitors and industry averages.

Can common-sized analysis be used for all financial statements?

Yes, common-sized analysis can be applied to the income statement, balance sheet, and cash flow statement. Each statement offers unique insights when common-sized. For example, a common-sized income statement shows the percentage of revenue taken by each expense, while a common-sized balance sheet shows the proportional mix of assets, liabilities, and equity.

How does common-sized analysis help in identifying financial trends?

Common-sized analysis helps identify financial trends by standardizing data over time. When you compare a company's common-sized statements across several years, you can observe shifts in the relative proportions of various accounts. For instance, a consistent increase in the percentage of cost of goods sold relative to sales might indicate declining operational efficiency, even if sales are growing in absolute terms. This allows for quick identification of significant proportional changes that might require further ratio analysis.

Is common-sized analysis suitable for comparing companies of different sizes?

Absolutely. This is one of the key strengths of common-sized analysis. Since all figures are converted to percentages, it removes the scale difference between companies. This allows an analyst to compare the underlying financial structures, operational efficiencies, and resource allocation strategies of a small startup and a large multinational corporation on an equal footing.

What is the difference between vertical analysis and common-sized analysis?

There is no difference; "vertical analysis" and "common-sized analysis" are synonymous terms referring to the same financial statement analysis technique. Both involve expressing each line item on a financial statement as a percentage of a base figure within that same statement.