Common Size Financial Statements express every financial statement item in terms of a percentage of one convenient base parameter. The base item for the common size balance sheet is taken as the total assets (for assets side) and total liabilities (for liabilities side), while for the common size (Profit and Loss Statement), income and expenditure statement; the base parameter is taken as sales or revenue.
The common size financial analysis is also called vertical analysis. Formula to calculate common size ratios:
|Common Size Ratio = Concerned Parameter / Base Parameter|
E.g., if your concerned parameter is inventory, we have
|Common Size Ratio for Inventory||Inventory|
Thus, common ratios are expressed as a percentage of the base parameter. In the above case, inventory being a part of the “Assets side of Balance Sheet” is expressed as a percentage of the total assets.
Use of Common Size Financial Statements
Comparing Two Companies
Although most companies don’t report their financial statements in common ratios, these ratios may help compare two companies that differ in size. By expressing all the parameters in terms of the percentage of sales or assets, they can remove bias. One can use common size ratios to benchmark the company against the best in the business. This will help evaluate where the business stands on various parameters against competitors.
Comparing the Performance of a Company over a Period of Time
Common-size financial statements can also be used to evaluate a company’s performance over different periods of time. One can evaluate what percentage of sales was the cost of goods sold 5 years before compared to the current figure. This can present a fair idea of how the company has fared in respect of various years.
Example Explaining Common Size Financial Statements
It maintains cash in hand at USD 8,000. And it has total assets of USD 100,000. Thus, the
|Common Ratio of Cash in Hand||=||——||=||8%|
It maintains cash in hand at USD 30,000. And it has total assets of USD 150, 000. Thus, the
|Common Ratio of Cash in Hand||=||——||=||20%|
Thus, one can interpret that firm X maintains lesser cash in hand than Y. Going one step further, X manages with less cash in hand and therefore effectively uses financial resources and saves on interest costs. If X and Y are in the same industry, Y can think of improving in the respect of Cash Utilization. Thus, using common-size financial statements, one can compare the performance of two companies.
Limitations of Common Sized Financial Statements
- Different firms may adopt different accounting practices. In that case, the common ratios may not be directly comparable. In that case, adjustments will have to be made in order to compare the common ratios.
- Different firms may adopt different accounting principles. The Even same firm may adopt different accounting standards over a period of time. Thus, adjustments will have to be made in order to compare the ratios.