Common-size analysis - (also called vertical analysis) expresses each line item on a single year's financial statement as a percent. The base amount for the balance sheet is usually total assets (which is the same number as total liabilities plus stockholders' equity), and for the income statement it is usually net sales or revenues. By comparing two or more years of common-size statements, changes in the mixture of assets, liabilities, and equity become evident. On the income statement, changes in the mix of revenues and in the spending for different types of expenses can be identified The ratios often are expressed as percentages of the reference amount. Common size statements usually are prepared for the income statement and balance sheet, expressing information as follows: * Income statement items - expressed as a percentage of total revenue * Balance sheet items - expressed as a percentage of total assets
Comparisons Between Companies (Cross-Sectional Analysis)
A company may choose to utilize financial statements of this type to present a quick snapshot of how much of the company’s collected or generated revenue is going toward each operational function within the organization. The use of a common-size statement can make it possible to quickly identify areas that may be utilizing more of the operating capital than is practical at the time, and allow budgetary changes to be implemented to correct the situation. The common size statement can also be a helpful tool in comparing the financial structures and operation strategies of two different companies. The use of percentages in the common size statements removes the issue of which company generates more revenue, and brings the focus on how the revenue is utilized within each of the two businesses. Often, the use of a common-size statement in this manner can help to identify areas where each company is utilizing resources efficiently, as well as areas where there is room for improvement.
Common-size statements can be prepared for any review period desired. Companies that choose to make use of financial statements of this type may choose to utilize this format for quarterly, semi-annual, or annual reviews. When there is concern about operational costs, the common-size statement may be prepared on a more frequent basis, such as monthly. Because the common-size statement is very easy to read and does not necessarily contain information that would be considered proprietary, the format can often be employed as part of general information that is released to the public.
Advantages of the common size financial statement:
* One advantage of having the various amounts expressed in percentage is, the percentage assets of any company can be compared to another company or to other companies in the industry. * The size of the companies being compared, is not important. The companies being compared may be small or big. Hence, it is termed as common size. Since size of the company does not matter, it removes any kind of bias, while comparing companies. Analyzing the operational activities of comparing companies can also be obtained. * Changes in different values pertaining to company's performance can also be ascertained during a particular period. For example, if one wishes to know how the cost of goods sold over a span of time has changed, the common size financial statement can be helpful. * A common size financial statement is used for predicting future trends and analyzing prevailing trends in the industry. Limitations
As with financial statements in general, the interpretation of common size statements is subject to many of the limitations in the accounting data used to construct them. For example: * Different accounting policies may be used by different firms or within the same firm at different...