Common Size Ratio
This ratio is used as a tool for analyzing the company's financial statements.
What is the Common Size Ratio?
The Common Size Ratio is used as a tool for analyzing the company's financial statements, such as the statement of profit and loss, balance sheet, and cash flow. This ratio is computed by expressing each line item in the financial reports as a percentage of the base amount.
This ratio eases the understandability and compatibility of the financial information needed by the company's users while making decisions and planning for prospects.
The formula used to get the values for analysis is:
Percentage of base = (Line Item/ Base amount) x 100
Such an analysis is called standard size analysis or vertical analysis of the financial statements; for the word of financial position, we usually take the base amount as total assets and the base amount as revenue for the income statement.
A number on a company's financial statement is expressed as a percentage of another relevant figure on the information by a global standard size ratio. As a result, it is simple to understand and compare each rate to other financial statement line items.
In other words, there are mainly 2 joint-size statements:
- Common size balance sheet
- Common size income statement
Comparing common size ratios across a specific time frame is another great usage of these ratios. This makes it simpler for you to see trends in particular metrics and, as a result, change the company plan to get a more desirable outcome.
This helps investors to make significant decisions just by taking a glance at the analysis of the financial statements and arriving at meaningful conclusions. In addition, it gives insights into the strategies and assumptions of the company while preparing financial statements for a specific period.
It measures how the company performs compared to its market competitors. It also provides insights into the company's capital structure and compares it with its competitors.
Hence, it evaluates the financial strength and performance of the company in any given accounting period.
Key Takeaways
- Common size ratio analysis involves expressing financial statement line items as percentages of a base amount, like total assets for balance sheets and total revenue for income statements.
- Financial managers use common size ratios to spot trends, assess efficiency, and understand a company's performance compared to competitors.
- The formula for common size ratio analysis is (Line Item / Base Amount) x 100. Total assets are often the base for balance sheets, while total revenue serves as the base for income statements.
- Common size analyses are conducted for balance sheets (Statement of Financial Position), income statements (Statement of Profit and Loss), and cash flow statements (Statement of Cash Flows), offering a comprehensive view of a company's financial performance.
What Is a common size Ratio analysis?
This exercise includes analyzing the financial information where each item is expressed as a percentage of the base amount of the financial statement, which may be total assets or revenue for a specific period.
Financial managers usually use this to observe trends, analyze financial statements, and assess the company's efficiency. Understandability and compatibility are the two significant reasons for vertical analysis.
The primary advantage of vertical analysis is that it allows research to be performed quarterly or annually. Common-size balance sheets are advantageous to internal and external stakeholders, even though generally accepted accounting rules (GAAP) do not mandate their use.
The main advantages include quick comparisons between line items, analyzing trends, the ability to spot significant changes in a company's financial statement, and comparing businesses of different sizes operating in the same industry.
The primary disadvantage is that it lacks an approved benchmark, which makes it useless in the company's decision-making process for analyzing financial performance in the long run.
Common Size Ratio Analysis For Financial Statements
Standard size analyses are conducted for financial statements mentioned below:
1. Balance sheet or Statement of Financial Position
The balance sheet involves standard size and ratio analysis by dividing all the line items by a joint base amount, usually the company's total assets.
(Line item/ Total assets) x 100
This shows every line item as a percentage of the company's total assets, making it easier to understand and compare the data with competitors after the analysis.
2. Income statement or statement of profit and loss
Income statement studies involve using vertical analysis and a ratio that divides all the line items by the company's total revenue, as presented in the income statement.
(Line item/ Total revenue) x 100
This shows each line item as a percentage of the business's total revenue and makes it easier for analysts to compare expenses against previous years and determine the business's health.
The financial manager needs this analysis to observe and learn how the company performs to its revenue benchmarks.
3. Cash Flow Statement or Statement of Cash flows
A cash flow statement shows how changes in the company's account of a financial position affect its cash and cash equivalents in one accounting period.
In the analysis, the financial manager can compare each line item with the previous year's item or compare the current cash flow with the last year's cash flow.
This data can then be used to determine if the sales account for a sufficient portion of the entire inflow of cash. Additionally, the company can see how the ratios have changed over time by comparing each line item to prior years' data.
Common Size Ratio Examples
Below are some example questions for analyzing financial data through joint size ratio analysis or vertical analysis.
The following examples display the companies' joint size income statement and balance sheet and briefly discuss the format and procedure for solving the ratio.
1) Prepare a common-size income statement using the following information for the company, XYZ Ltd., for the year ended 31st March 2020.
XYZ Ltd.
Statement of profit and loss for the year ended 31/03/2020
| Particulars | Amount ($) |
|---|---|
| Revenue | $200,000 |
| Less: COGS | ($50,000) |
| Gross profit | $150,000 |
| Less: Operating expenses | ($100,000) |
| Operating Profit | $50,000 |
| Less: tax | ($10,000) |
| Net profit | $40,000 |
Answer: The common size income statement or typical size analysis
XYZ Ltd.
Statement of Profit and Loss for the year ended 31/03/2020
| Particulars | Amount ($) | Common Size % |
|---|---|---|
| Revenue | $200,000 | 100% |
| Less: COGS | ($50,000) | 25% |
| Gross profit | $150,000 | 75% |
| Less: Operating expenses | ($100,000) | 50% |
| Operating Profit | $50,000 | 25% |
| Less: tax | ($10,000) | 5% |
| Net profit | $40,000 | 20% |
As you can see in the solution, different line items are represented as a percentage of the company's total revenue. So, for example, gross profit constitutes 75% of the total revenue, and Operating profit includes 25% of the total revenue.
2) Prepare a common-size balance sheet for the following balance sheet for the company, ABC Ltd. for the year ended 31st March 2020.
ABC Ltd.
Balance sheet as on 31st March 2020
| Particulars | Amount ($) |
|---|---|
| Assets: | |
| Non-current Assets- | |
| Land | $50,000 |
| Building | $40,000 |
| Plant and Machinery | $60,000 |
| Total non-current assets | $150,000 |
| Current Assets- | |
| Inventory | $30,000 |
| Receivables | $10,000 |
| Cash | $20,000 |
| Bank | $40,000 |
| Total current assets | $100,000 |
| Total Assets | $250,000 |
| Liabilities and Equity: | |
| Non-current Liabilities- | |
| 7% Loan | $140,000 |
| Current Liabilities- | |
| Payables | $20,000 |
| Accrued expenses | $20,000 |
| Total current liabilities | $40,000 |
| Equity- | |
| Share capital | $50,000 |
| Retained earnings | $20,000 |
| Total equity | $70,000 |
| Total liabilities and equity | $250,000 |
Answer: The common-size balance sheet for ABC Ltd.
ABC Ltd.
Balance sheet as on 31st March 2020
| Particulars | Amount ($) | Common Size % |
|---|---|---|
| Assets: | ||
| Non-current Assets- | ||
| Land | $50,000 | 20% |
| Building | $40,000 | 16% |
| Plant and Machinery | $60,000 | 24% |
| Total non-current assets | $150,000 | 60% |
| Current Assets- | ||
| Inventory | $30,000 | 12% |
| Receivables | $10,000 | 4% |
| Cash | $20,000 | 8% |
| Bank | $40,000 | 16% |
| Total current assets | $100,000 | 40% |
| Total assets | $250,000 | 100% |
| Liabilities and Equity: | ||
| Non-current Liabilities- | ||
| 7% Loan | $140,000 | 56% |
| Current Liabilities- | ||
| Payables | $20,000 | 8% |
| Accrued expenses | $20,000 | 8% |
| Total current liabilities | $40,000 | 16% |
| Equity- | ||
| Share capital | $50,000 | 20% |
| Retained earnings | $20,000 | 8% |
| Total equity | $70,000 | 28% |
| Total liabilities and equity | $250,000 | 100% |
As you see in the above solution, different line items are represented as a percentage of total assets, which is the base amount. For example, non-current assets constitute 60% of the total assets, and current assets constitute 40% of the total assets.
The above examples perfectly explain the process of vertical analysis for the companies XYZ Ltd. and ABC Ltd.
This shows each item as a percentage of the base amount, revenue in the standard size income statement, and total assets in the typical size balance sheet.
Common Size Ratio FAQs
It should be performed to assist in analyzing and comparing the financial information between the various periods and competitors concerned.
One of the biggest disadvantages of this analysis is not having a proper benchmark which makes it useless during the decision-making process in a company.
Vertical analysis is considered more meaningful as it allows each line item to be considered as a percentage of the base amount over a specific period of time.
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