Common size analysis is a sub-category of financial statement analysis. Often it is also referred to as Vertical Analysis. Without performing common size analysis in conjunction with other pertinent analysis on the financial statements (especially the income statement and balance sheet), it is very difficult to gain insights into changes that have occurred in the business from period to period.
Common Size Analysis
Performing common size analysis is not a difficult task. When they are done simultaneously with other types of analyses, like trend and/or ratio analysis, much can be learned about the changes in financial impact of business activities and business policies. Every stakeholder benefits from the information from these types of analyses. For instance:
- A Business Manager will use the information to control costs and improve profitability.
- Lenders (creditors) are interested in the company’s ability to pay back debt, so certain information from performing various types of financial statement analysis will be used to decide how much money they are willing to lend.
- An investor will use the information in similar ways to ascertain if the company is worth investing in.
Vertical analysis is presented as a percentage (%) out of a base. As far as the income statement goes, the base is always Net Sales and every other line item such as Cost of Goods Sold, Operating Expenses, Operating Income, Interest Expenses, Taxes and eventually Net Income is represented as a % of Net Sales.
This is a simple example of a common size analysis on an income statement.
|Income Statement – Fiscal Year 201X|
|Net Sales||$ 10,000,000||100.00%|
|Cost of Goods Sold||6,000,000||60.00%|
|Earnings Before Tax||850,000||8.50%|
|Net Income||$ 650,000||6.50%|
Observing the ($) column by itself, you’d only be looking at “raw” facts. Adding a “Proportional” or composition based analysis to the statement allows one to ask further penetrating questions. For example, a Business Manager might decide that COGS at 60% is unacceptable and look for ways to reduce those costs. A lender might look at the fact that Interest Expense is only 1.5% of Net Sales and be willing to further extend credit.
While looking at common size analysis for just one period gives a certain level of information, there are certain limitations as most people would want to know more information. One of the primary things that gets asked is: “How are these numbers compared to the prior period?” Looking at a comparative statement with common size analysis will yield more insights. Below is an example.
Common Size Analysis – From One Period To Another
|FY 201X||Vertical||FY 201W||Vertical|
|Net Sales||$ 10,000,000||100.00%||$ 9,000,000||100.00%|
|Cost of Goods Sold||6,000,000||60.00%||5,250,000||58.33%|
|Earnings Before Tax||850,000||8.50%||825,000||9.17%|
By looking at the common size analysis from period to period, it is clear that although revenues increased by $1 million, net income as a total $ figure stayed flat at $650,000. Profitability (i.e., profit margin) declined from 7.22% to 6.50%. The reason for this is because Cost of Goods Sold as a % of Net Sales increased by 1.67% with some partial offsets (% wise ) from OPEX and Interest Expense.
The procedure for performing common size analysis on the balance sheet is more or less the same. Since the balance sheet has a section each for Assets, Liabilities and Shareholders’ Equity, the bases are Total Assets for all asset accounts, Total Liabilities + Total Shareholders’ Equity for all liability and equity accounts. Below is a comparative balance sheet with common size analysis(vertical analysis).
|Comparative Balance Sheet|
|Assets||(in $000′s)||Analysis||(in $000′s)||Analysis|
|Total Cur. Assts.||4,985||65%||4,646||65%|
|Prop. Plant & Equip.|
|Tot. Other Assets||276||4%||260||4%|
|Liabilities & S.H. Equity|
|Income Taxes Payable||255||3%||390||5%|
|Total Current Liabilities||840||11%||969||14%|
|Long Term Liabilities|
|Long Term Debt||2,464||32%||2,150||30%|
|Total Long Term Liabilities||2,464||32%||2,150||30%|
|Additional Paid in Capital||1,953||25%||1,732||24%|
|Total Shareholders’ Equity||4,400||57%||4,027||56%|
|Total Liabilities + S.H. Equity||7,704||100%||7,146||100%|
In looking at the common size analysis of the comparative balance sheet above, you can see that Total Assets and every asset account has pretty much stayed flat (as a % of the base). The biggest changes period to period have occurred in the Liabilities and Shareholders’ Equity section. In this example, the company reduced current liabilities but increased long term borrowing.
The firm also issued more stock, both preferred and common stock. Interestingly enough, Additional paid in capital only rose by about 1% of total Liab. + S.H. Equity while Common Stock rose by 3% of total Liab. + S.H. Equity. This is important because it tells you that the market price of the stock per share is trading relatively close to its par value. It could potentially mean the stock is “undervalued”. In order to make that determination, one would have to do more than the basic common size analysis. One last thing to note is that retained earnings as a % of the total Liab. + S.H. Equity dropped significantly. That means that the company paid a good amount of dividends to its shareholders.