Common size analysis is a powerful financial tool used by business owners and investors to evaluate the health of a company by comparing line items in financial statements. This type of analysis can uncover influential trends that affect profitability or efficiency and can guide better strategic decisions.
In the following article, our experts at Business2Community will guide you through the nuances of common size analysis so that you can apply this valuable technique to your own financial statements or those of other businesses you may be evaluating.
Common Size Analysis – Key Takeaways
- Common size analysis simplifies the comparison of financial statements from different companies by converting figures to percentages of a common base.
- Using common size analysis can enhance the understanding of financial health and performance trends over time, providing a clear perspective on relative revenue, expenses, and profitability metrics.
- Regularly using common size analysis lets businesses and investors benchmark against industry standards, informing more strategic financial planning and decision-making.
What is Common Size Analysis?
A common size analysis is a financial tool that converts all line item figures on an income statement and balance sheet into percentages of a common base figure. This method allows for easy comparison across different time periods or companies, regardless of size. It can also show you which area of your business is having the largest impact on your financials.
By standardizing financial statements, common size analysis can also reveal trends and provide insight into how each item impacts the overall financial performance. It’s useful when comparing companies of different scales if you’re a stock trader for example, as raw financial data can be difficult to interpret or even misleading due to the sheer size differences.
This analytical approach helps you to quickly ascertain the relative significance of each line item and track performance over time.
Who Needs to Do a Common Size Analysis?
Common size analysis is not exclusively for financial professionals but is essential for a variety of stakeholders:
- Financial analysts and investors use it for company performance evaluation and investment decision-making.
- Managers and executives employ it for strategic planning and managing finances, identifying potential areas for resource allocation or cost savings.
- New or expanding businesses rely on common size analysis to understand market positioning and to outline measurable goals for financial performance and growth strategies.
- Departments within a business can leverage this method for intracompany financial comparison and budget adjustments to enhance departmental efficiency and productivity.
- Stock traders evaluate trends across different sectors and make informed trading decisions based on the comparative financial health of companies using common size analysis.
- Credit analysts and lenders apply it to assess a company’s financial solidity and creditworthiness.
- Academics such as educators and students use this tool in business education to teach and learn financial statement analysis.
How to Perform a Common Size Analysis
Performing a common size analysis is a systematic process that can be broken down into straightforward steps. Below, we outline each step to help you gain deeper insights from your financial statements.
Step 1: Obtain Financial Statements
Before you start, you need to have a company’s income statement and balance sheet on hand. These documents are often found in a company’s annual report or filings with financial regulatory authorities. For analyzing your own business, you should have your financial information on hand or available through your bookkeeper or accountant.
Step 2: Identify the Base Amount
Having a base amount gives you a place to start from. It is the baseline that you will use to see if subsequent calculations give increased or decreased amounts.
For an income statement, the base amount is typically total revenue or sales, while for the balance sheet, it could be total assets, total liabilities, or shareholders’ equity. Which you choose will depend on what you’re interested in measuring the change over time.
Step 3: Convert Figures to Percentages
Each line item on the financial statement is divided by the base amount and then multiplied by 100 to convert it into a percentage. Say you want to understand the makeup of total assets in a business:
The base amount is the total assets so the calculation will look like this:
Step 4: Analyze Trends and Compare
Use the percentages to identify trends within the financial statements and compare them against industry benchmarks or competitor data. You can compare against competitors by looking at their publicly available data or you can make a comparison against previous years’ data in your own business.
Step 5: Interpret the Results
Look at the percentages to assess the financial health of the business. High costs as a percentage of total sales, for example, may indicate inefficiencies.
You may notice more of your assets are being held in stock and consider reducing your warehouse inventory, or you may see a higher percentage of your income is being driven by online sales rather than in-store and plan to improve your ecommerce offering.
In-Depth Example of Common Size Analysis
To illustrate common size analysis in action, let’s consider a hypothetical company that specializes in selling cryptocurrency mining equipment. We will plug in simple numbers to demonstrate the process step by step.
The crypto equipment company’s income statement and balance sheet are obtained from the company’s most recent annual report.
You want to understand revenue drivers for the company, so you identify the base amount of the total reported revenue for 2023, which is reported as $2,000,000.
With this information, you’re ready to convert the absolute numbers to percentages using this formula:
You get the following results, showing you how your revenue is made up.
With data in hand, it’s time to analyze the results you’ve found. Here, you can see that the crypto company’s cost of goods sold makes up 60% of revenue, meaning the majority of revenue is spent on producing the goods it sells. Depending on how this compares with competitors, you will gain insight into the company’s operational efficiency.
Further interpreting the results, you can see the net profit margin is 15% of revenue – learning what the result is for in similar companies will tell you if your profits are healthy or if you need to find ways to improve your outcomes or reduce overheads.
When to Use Common Size Analysis
Common size analysis proves to be highly beneficial in various scenarios, such as:
- When conducting an annual financial review to gain deeper insight into your financial results.
- When making investment decisions, so that you can see how companies that differ in size compare to each other.
- When evaluating merger and acquisition opportunities, helping you to see results in proportion rather than absolute numbers.
- When benchmarking against competitors to see if you need to adjust your strategy to remain competitive in the market.
- When seeking to enhance efficiency, so that you can make valuable and accurate comparisons across the business.
How to Adjust a Common Size Analysis
To enhance the outcomes of a common size analysis, business owners and traders can implement various strategies. Being mindful of the economic levers within your control can lead to more favorable financial ratios and insights. Here are real-world examples of adjustments that can be made:
- Adjust your pricing: If your percentages indicate low profitability, consider testing new pricing strategies to improve margins without sacrificing sales volume. You can try this by increasing the price of a flagship product by 5% and monitoring the change in sales and profit margins.
- Reduce overhead costs: Look for ways to lower fixed costs, such as renegotiating rental agreements or optimizing utilities usage. For instance, a company could transition to a remote work model to reduce office space expenses.
- Streamline operations: Implement process improvements or adopt new technologies to reduce the cost of goods sold (COGS). If the cryptocurrency company mentioned above, for example, upgraded to more efficient mining rigs, it could reduce its electricity consumption and boost the net profit margin in the long term.
- Expand product lines: Diversify offerings to tap into new revenue streams when sales are flagging, such as introducing a line of energy-efficient mining accessories that offer higher margins, for our example scenario above.
- Manage inventory efficiently: Avoid excess stock which ties up capital, and streamline supply chain management. For example, you can apply a just-in-time inventory system to reduce storage costs and minimize unsold inventory percentages.
- Optimize tax strategies: Consult with financial advisors to leverage tax planning opportunities that can improve the bottom line, like taking advantage of tax deductions available for investments in green technologies.
Limitations of Common Size Analysis
No business or financial analysis technique is perfect and common size analysis is no exception, which is why you need to use a myriad of methods, metrics, and models to ensure that you are making intelligent, informed decisions.
One significant shortcoming of common size analysis is that it doesn’t account for the context of the numbers, such as the state of the market or economic conditions that may impact financial performance.
Common size analysis also focuses solely on relative sizes and ignores absolute values, which can be critical for understanding a company’s true financial health.
Lastly, it assumes that sales growth is inherently positive, but this is not always the case if the growth isn’t profitable or sustainable.
To enhance results and understanding, it is essential to perform other forms of financial analysis. Ratio analysis, for example, looks at the relationships between different financial statement items and can provide deeper insights into profitability, liquidity, and solvency.
Trend analysis, which examines financial statement data over multiple periods, can identify longer-term performance trends. It’s also beneficial to look at industry-specific ratios and to benchmark against competitors.
The Value of Common Size Analysis
In sum, common size financial analysis stands as a vital tool for interpreting a company’s performance by stating income statement items and cash flow elements in percentages. This form of analysis, often facilitated by accounting computer programs, enables managers to evaluate financial statement information with clarity.
By converting figures like net sales, gross profit, and net income into common size format, it simplifies comparison across primary financial statements and industry data. Notably, when net sales decrease or expenses such as selling and administrative expenses or income tax expenses rise significantly, this tool swiftly highlights trends and potential issues.
A formal common size analysis report fosters an efficient comparison of financial health between companies, by juxtaposing income statement categories such as operating income and gross margin, and revealing any accounts that have changed over time. This is beneficial for shareholders’ equity analysis by applying ratio analysis to historical data.
Additionally, it addresses cash flow statement concerns by presenting net sales and operating cash flows in a way that accentuates fluctuations, such as whether cash equivalents as a percent of net income reflect an increase.
Ultimately, through comprehensive analysis utilizing the horizontal and vertical analysis techniques, common size analysis answers vital questions about financial performance, revealing whether strategic decisions have caused net income and other operating incomes to increase or decline and laying the groundwork for data-driven improvements in company profits.