Common Size Analysis
Is used to visualize a company's financial performance
What is Common Size Analysis?
It is an evaluation of the current primary financial statements that compare all the items to a standard figure, also known as a baseline.
The three primary financial statements are known to be the income statement, the cash flow statement, and the balance sheet. All three are publicly available on the websites of publicly traded firms.
Another name for this analysis would be vertical analysis. However, it can also be performed as a horizontal analysis.
In vertical analyses, each line item is expressed as a percentage of the base amount for that period. The research makes it easier to understand the influence of each line item in the financial statement and how it contributes to the final figure.
Typically, this is accomplished by expressing balance sheet items as a percentage of total assets (or total liabilities and shareholders' equity) and income statement items as a percentage of net sales.
On the other hand, when a line item is being analyzed horizontally, it is compared to a similar line item from the current or previous financial period.
It is easier to study a company over time and evaluate it against its competitors when financial statements are standardized. Trends can be identified using financial statements of a typical size that a piece of basic financial information might not reveal.
Hence, there are two reasons for using the typical size analysis:
1. To assess data from one period to the next within a company.
2. To evaluate a company relative to its competitors.
To spot repeating patterns, the financial manager can also examine line-item ratios across many years. Important financial metrics can be measured using vertical and horizontal common-size analyses.
This evaluation method allows financial managers to quickly examine financial accounts, even if it is less thorough than trend analysis, which utilizes ratios.
The formula used for this type of evaluation is as follows:
% of base = ( Amount of Individual Item / Amount of base item ) * 100
Key Takeaways
- Common Size Analysis is used to visualize a company's financial performance. It presents financial information in a standardized format to better understand the relative proportions of different components and their impact on the company's overall financial health.
- Common Size Analysis is applied to the balance sheet, income statement, and cash flow statement to assess components' relative significance within these statements. This technique allows managers to identify strategies and investors to evaluate profitability and make informed investment decisions.
- Common Size Analysis assists in spotting significant changes in financial statements over multiple years, aiding investors and managers in making informed decisions. By analyzing trends, such as capital structure alterations or revenue performance, companies can enhance strategies and adapt to market dynamics.
- Different from Comparative Analysis, which compares ratios between companies, while Common Size focuses on a single company's percentages, revealing its financial structure.
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Understanding Common Size Analysis
Companies and investors use common size analysis to visualize a company's financial performance changes better. This is done by using a formula that finds the fraction of the examined figure of the base.
This type of evaluation is part of both vertical and horizontal analyses. The main difference between the two is that horizontal research involves multiple periods, whereas vertical study compares the data sheets to a base in the current period.
It is usually performed on the three primary financial statements: the balance sheet, income statement, and cash flow statement.
Financial managers and investors can analyze the results. Managers can track the strategies of their competitors, for example, altering capital structures, cost drivers, etc.
Likewise, they can use the identified trend lines to alter strategy, increasing the company's efficiency of resources. Investors can use the analysis to aid their investment decision and determine their profitability.
An alternative to this analysis is the comparative analysis which deals with establishing a base using ratios of similar public companies in the industry and comparing them to the target company to calculate its relative value.
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Common Size Analysis in Financial Statements
As previously mentioned, this method of evaluation can be used to assess multiple financial statements issued by companies, which are:
1. Balance Sheet
A familiar comparative figure used in this joint analysis is total assets. Based on the accounting equation, the total assets should equal total liabilities and shareholder equity, making either term interchangeable in the analysis.
Likewise, it is common to use total liabilities as a comparative figure in the analysis to evaluate how risky or conservative a company is in regard to its obligations.
This evaluation sheds light on a company's capital structure and how it stacks up against its competitors. Additionally, it aids the company in finding the ideal capital structure for a specific industry and contrasting it with the financial arrangements of its competitors.
It can indicate if the debt is too large, if too much cash is retained, or if inventories are increasing too quickly. The goodwill calculated on a balance sheet can also show how valuable a firm's brand name is.
The following table demonstrates a simplified version of how this type of analysis is used in a real-life scenario:
| Company XYZ Balance Sheet | ||
|---|---|---|
| Amount | Percentage | |
| Assets | ||
| Current Assets | 42,000 | 42% |
| Non-current Assets | 58,000 | 58% |
| Total Assets | 100,000 | 100% |
| Current liabilities and shareholder equity | ||
| Current liabilities | 30,000 | 30% |
| Long-term debt | 25,000 | 25% |
| Shareholder equity | 45,000 | 45% |
| Total liabilities and shareholders' equity | 100,000 | 100% |
The analysis results indicate that company XYZ finances its operations mainly through equity instead of debt. That can be attractive for investors because it reduces bankruptcy risk.
2. Income Statement
A standard base item for the income statement is total sales or revenue. This analysis calculates the net-profit margin and gross and operating margins.
The ratios provide information on the company's revenue performance and allow financial managers and investors to forecast future revenue. Businesses can also use this tool to assess their competitors' spending on advertising, R&D, and other vital costs.
The following table will demonstrate how this type of analysis is used in everyday life by investors and managers:
| Company XYZ Income Statement | ||
|---|---|---|
| Amount | Percentage | |
| Total Sales | 100,000 | 100% |
| Cost of goods sold (COGS) | 35,000 | 35% |
| Total Operating expenses | 20,000 | 20% |
| Income before tax | 45,000 | 45% |
| Tax expense | 2,000 | 2% |
| Net Income | 43,000 | 43% |
XYZ’s excess income was 43% of its total revenue/sales. Likewise, its COGS is 35% of its revenue.
This analysis is most beneficial when multiple periods are being compared. That way, trends can be identified, and cost drivers can become more apparent to investors and managers.
3. Cash Flow Statement
A business’s cash flow statement demonstrates how changes to its balance sheet affect an organization's cash and cash equivalents. A cash flow statement assesses how well a company earns money to cover its obligations and fund its operations.
Financial management can use a common-size analysis to contrast the current cash flow with prior years.
Similar to the income statement analysis, the base figure of many items can be total sales. The capital expenditures (CapEx) as a percentage of revenue can be revealed, as well as other cash flow factors.
Repurchase activity on shares can be expressed as a percentage of total revenue. In proportion to the annual sales, it contributes to debt issuance is another crucial figure.
These items show how much the company uses them to generate revenue because they are computed as a portion of sales.
Importance of common size analysis
One advantage of applying standard size analysis is the ability to spot significant changes in a company's financial statement.
When the financials are compared over a two or three-year span, significant alterations in the company’s financial statements apparent over many years can signal to investors whether they should invest in this company or not.
For example, suppose a company’s liabilities are too high compared to its total assets. In that case, it can scare off investors because the company has a higher risk of not being able to pay off its debtors in the event of liquidation.
It is also an excellent tool for comparing businesses operating in the same sector. Analyzing its financial information will help the company understand its business plan and the highest costs that set it apart from other businesses in the industry.
Hence, this analysis makes the strategies of other businesses in the industry more apparent and can help the company evaluate how to deal with its competitors in the future.
For instance, company ABC performs a standard size analysis on company XYZ and uncovers that it is continuously altering its capital structure to take on more debt. ABC evaluates that XYZ is benefiting from this change. Therefore, it decides to take on more debt as well.
Common Size Analysis VS. Comparative Analysis
The comparative analysis looks for ratios of similar public businesses in the industry and compares them to evaluate another company's value.
A comparable company analysis assumes that similar businesses will have relative valuation multiples, such as EV/EBITDA. The available data for the companies under examination is compiled by analysts, who then compute the valuation multiples to compare them.
Establishing a peer group of comparable businesses in the same sector or locale that is similar in size is the first step in performing a comparative company analysis. Investors can then make a relative comparison of a specific company to its rivals.
A firm's enterprise value (EV) can be calculated using this data as well as other ratios used, all of which are used to compare a company to others in its peer group.
The sales, gross profit, EBITDA, net income, or other measures are typically included in the comparative table along with the average or median multiples of the comparable companies.
| Aspect | Common Size Analysis | Comparative Analysis |
|---|---|---|
| Purpose | To analyze the relative proportion of different line items on the income statement or balance sheet. | To compare the financial performance and position of a company over time or against competitors. |
| Focus | Focuses on the percentage of each line item relative to total revenue (income statement) or total assets (balance sheet). | Focuses on comparing financial data between different time periods or companies. |
| Statement used | Typically used with income statements and balance sheets. | Used with income statements, balance sheets, and cash flow statements. |
| Calculation method | All line items are expressed as a percentage of total revenue (income statement) or total assets (balance sheet). | Financial ratios and metrics are calculated and compared between periods or companies. |
| Timeframe | Usually, a single period (e.g., a year or a quarter) is analyzed at a time. | Compares data over multiple periods (e.g., year-to-year) or against industry benchmarks or competitors. |
| Objective | Identifies the relative importance of various components of financial statements, helping identify trends and outliers. | Helps assess changes in financial performance and position, benchmark against industry peers, and make investment decisions. |
| Example | If total revenue is $1 million and salaries expense is $200,000, then salaries expense is represented as 20% in common size analysis. | Comparing a company's current year's net profit margin to the previous year's net profit margin to assess profitability trends. |
| Usefulness | Useful for internal management to identify areas of financial strength or weakness within the company. | Useful for investors, analysts, and external stakeholders to evaluate a company's performance relative to peers or industry standards. |
| Limitations | Does not provide insights into changes over time or comparisons with external benchmarks. | May not account for differences in accounting practices or business models between companies being compared. |
| Interpretation | Provides a snapshot of a company's financial structure in a specific period. | Provides insights into trends, growth rates, and relative performance. |
| Example Software/Tools | Microsoft Excel, accounting software, or financial analysis tools. | Financial modeling software, investment research platforms, and Excel for data comparison. |
Outliers are frequently excluded or omitted, and the figures will continue to be manipulated until they appear pertinent and realistic to arrive at a meaningful average.
The main difference between the two evaluation methods is that the standard size analysis deals with the company's intrinsic value, using only the data from a single business.
However, the comparative analysis deals with the data of multiple companies and evaluates their relative value after establishing a base.
Common Size Analysis FAQs
The difference is that horizontal analysis usually compares data over multiple periods, as opposed to vertical analysis, which deals with comparing figures of one time period.
Both are useful and paint a 3D picture of a company’s financial performance when used together. However, horizontal analysis is crucial in understanding competitor strategy and identifying a business's weaknesses and strengths.
The first step is identifying which figures should be examined for trends and the period relevant to the analysis.
The second step is to chart the data because visualizing it will aid in making trends easier to spot.
Spotting financial patterns can help companies forecast effectively, as the loss period can be more apparent.
As previously mentioned, the joint statement sees all the financial items standardized as a percentage of net revenue, for example.
On the other hand, the comparative financial statement compares the financial information for several companies and conveys this data in absolute figures, percentages, or both.
Comparative financial statements display the financial information for several years in absolute numbers, percentages, or both, which is a notable distinction between them and common-size financial statements.
However, financial statements frequently include all of these components in percentage terms.
You can learn about expected analysis valuation through courses on the WSO website that tackle all kinds of financial valuation that investors and managers use daily.
The most relevant courses for this topic are the Financial Statement modeling course and the Valuation Modeling course.
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