Question

How does one common size the income statement and the balance sheet?  What is the purpose(s) of doing so and what types of financial/operational information can be gleaned?

Answer 1

Common Size income statement and balance sheet:

Common-size analysis (also called vertical analysis) converts each line of financial statement data to an easily comparable, or common-size, amount measured as a percent. This is done by stating income statement items as a percent of net sales and balance sheet items as a percent of total assets (or total liabilities and shareholders’ equity).

Examples: (a) One company had net income of $11,809,000,000 and net sales of $35,119,000,000 during the previous year. The common-size percent is simply net income divided by net sales, or 33.6 percent (= $11,809 ÷ $35,119).

(b) Company A has cost of goods sold $10,000 and net sales $40,000, the percentage of the cost of goods sold percentage will be 25%.

Purpose:

There are two reasons to use common-size analysis:

(a) to evaluate information from one period to the next within a company and

(b) to evaluate a company relative to its competitors.

Types of Information can be gleaned:

By using a common size financial statement we can get the following types of financial /operational information

(a) Ratios used to measure profitability (focus is on the income statement) Ex: Gross margin ratio, Profit margin ratio, return on assets.

(b) Ratios used to measure short-term liquidity (focus is on short-term liabilities) Ex: Current ratio, Quick ratio, Inventory turnover ratio.

(c) Ratios used to measure long-term solvency (focus is on long-term liabilities) Ex: Debt to assets ratio, Debt to equity ratio, Times interest earned ratio.

(d) Ratios used to measure market valuation (focus is on market value of the company) Ex: Market capitalization ratio, Price earning ratio.