Common Size Analysis

Common Size Analysis

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.

common size analysisCommon Size Analysis – Income Statement

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.

XYZ Company
Income Statement – Fiscal Year 201X
    Vertical
    Analysis
Net Sales  $  10,000,000 100.00%
Cost of Goods Sold        6,000,000 60.00%
Gross Profit      4,000,000 40.00%
Operating Expenses        3,000,000 30.00%
Operating Income      1,000,000 10.00%
Interest Expense            150,000 1.50%
Earnings Before Tax          850,000 8.50%
Income Taxes            200,000 2.00%
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

XYZ Company
Income Statement
  FY 201X Vertical FY 201W Vertical
    Analysis   Analysis
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%
Gross Profit      4,000,000 40.00%    3,750,000 41.67%
Operating Expenses        3,000,000 30.00%      2,750,000 30.56%
Operating Income     1,000,000 10.00%    1,000,000 11.11%
Interest Expense            150,000 1.50%          175,000 1.94%
Earnings Before Tax         850,000 8.50%       825,000 9.17%
Income Taxes            200,000 2.00%          175,000 1.94%
Net Income         650,000 6.50%       650,000 7.22%

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.

common size analysisCommon Size Analysis – Balance Sheet

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).

XYZ Company
Comparative Balance Sheet
    201X Vertical 201W Vertical
Assets (in $000′s) Analysis (in $000′s) Analysis
Current Assets        
Cash 649 8% 603 8%
A/R 1,212 16% 1,045 15%
Inventory 3,035 39% 2,789 39%
Prepaid. Exp 89 1% 209 3%
Total Cur. Assts. 4,985 65% 4,646 65%
Prop. Plant & Equip.        
PP&E 3,115 40% 2,890 40%
Acc. Depreciation 672 9% 650 9%
Net PP&E 2,443 32% 2,240 31%
Other Assets        
Intangible Assets        
Patents 51 1% 44 1%
Trademarks 36 0% 27 0%
Goodwill 189 2% 189 3%
Tot. Other Assets 276 4% 260 4%
Total Assets 7,704 100% 7,146 100%
         
Liabilities & S.H. Equity        
Current Liabilities        
A/P 382 5% 402 6%
Accrued Expenses 203 3% 177 2%
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%
Total Liabilities 3,304 43% 3,119 44%
         
Shareholders’ Equity        
Preferred Stock 541 7% 302 4%
Common Stock 1,090 14% 802 11%
Additional Paid in Capital 1,953 25% 1,732 24%
Retained Earnings 816 11% 1,191 17%
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.

Read the tutorial on Horizontal Analysis (Trend Analysis) or the ones below which you can use to supplement your understanding of Common Size Analysis.

Cash Flow Analysis

Relationship Between Financial Statements

Key Financial Ratios – Profitability

Key Financial Ratios – Asset Productivity

Key Financial Ratios – Liquidity

Key Financial Ratios – Solvency / Financial Leverage

Key Financial Ratios – Market Value

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