Common-size financial statement
A definition of a common-size financial statement determines a balance sheet or an income statement in which each line items are represented as a percent of assets or sales, respectively[1].
Vertical analysis
One type of vertical analysis takes advantage of financial statements that contain only percents. Each element of the financial statement is registered as a percent of some amount of some mutual item in the statement. Statements of this model are called common-size financial statements. Common-size financial statements are different from statements prepared for vertical analysis because in that common-size financial statements include only percentages and not dollar amounts. All figures included on a common-size balance sheet are the percent of total liabilities or total assets plus stockholders' equity. The items are percents of net sales on a common-size income statement. In the statement of cash flows, every item is a percent of the decrease or increase in cash inflows for the year. The items always sum to 100% so this type of presentation is "common-size". Common-size statements let the user to better understand:
- the change in cash and the item (on the statement of cash flows),
- the sales (on the income statement),
- the relationship between a particular item or
- between total assets and an item or
- total liabilities plus stockholders' equity (on the balance sheet).
Such statements might give the reader a better understanding which might be gained by only looking at absolute dollar amounts[2].
Example of the common-size financial statement
Moreover, common-size financial statements also let comparisons to be made between corporations of different sizes. One of the examples can be General Motors Corporation which is much bigger than Chrysler Corporation and the comparison is difficult. However, supposing the modification of the financial statements of each company becomes to common-size, so the changes become apparent in the relative size of the elements of the financial statements. These changes can be missed if just absolute dollar amounts are examined, (for example, a company's sales might increase, giving a positive signal, but if gross margin selling or decreased, administrative and general expenses increased as a percent of sales, the benefit of additional sales might be lost). Common-size financial statements expose both types of change[3].
Advantages of Common-size financial statement
Common-size financial statements show the relative size of different accounts within a financial statement by expressing each line item as a percentage of the total asset or sales. This makes it easier to compare line items to each other between different periods or between different companies. The following are some of the advantages of using common-size financial statements:
- It allows for easier comparison of different line items within a financial statement. This makes it easier to identify trends or changes in financial performance from period to period or from company to company.
- It can help identify the relative importance of different accounts within a financial statement.
- It allows for the comparison of different financial statements with different dollar amounts, such as those of different companies or of the same company in different periods.
- It can be used to identify the percentages of different accounts within a financial statement, such as the percentage of total assets that are current assets or the percentage of total sales that are from fixed assets.
- It can be used to identify the relative performance of different accounts within a financial statement, such as the relative performance of sales, expenses, assets, and liabilities.
Limitations of Common-size financial statement
A common-size financial statement is a useful tool for analyzing the financial performance of a business over time, as it allows for comparison of the relative sizes of different line items. However, there are several limitations of this type of financial statement, such as:
- They do not provide absolute values or context of the financial performance. Since all line items are presented as a percentage of the total, it is difficult to determine absolute numbers or to compare the financial performance of different businesses.
- They do not take into account differences in accounting methods or the cost of capital. Therefore, the results may not be an accurate measure of a company's performance.
- Common-size financial statements do not take into account inflation or other external factors that could affect the performance of the business over time. Therefore, these statements may not provide an accurate picture of the company's performance in the long run.
- Common-size financial statements are often used as a tool for comparison, but can be misleading if the items being compared are not of equal value. For example, a company with large amounts of inventory may appear to be more profitable than a company with fewer assets, when in fact both companies may be equally profitable.
- Common-size financial statements do not provide insight into the underlying business operations and can be difficult to interpret. Therefore, they may not be an effective tool for making decisions about the company's future.
A common-size financial statement is a type of financial statement where each line item is expressed as a percentage of total assets or sales, respectively. In addition to this approach, other approaches used in financial statement analysis include:
- Ratio Analysis: This involves calculating various ratios between financial statement items to assess the financial performance of a business. Ratios are used to compare performance of different entities over different time periods and to determine areas of strength and weakness.
- Trend Analysis: This approach involves the examination of financial statement information over a period of time to identify changes in trend and to analyze performance in terms of sales, expenses, profits, and liquidity.
- Comparative Analysis: This approach involves the comparison of financial statement information of different companies or entities to determine the relative performance of an organization.
In summary, common-size financial statement is one of the approaches used in financial statement analysis, along with ratio analysis, trend analysis, and comparative analysis. Each approach provides valuable insights and information that can be used to assess the financial performance of a business.
Footnotes
| Common-size financial statement — recommended articles |
| Horizontal Analysis — Du Pont analysis — Account Analysis — Comparative statements — Activity ratios — Adjusted ebitda — Annual Basis — Earnings Multiplier — Return on net assets |
References
- Albrecht W., Stice J., Stice E., Swain M., (2007)., Accounting: Concepts and Applications, Cengage Learning
- Loughran M.,(2011)., Financial Accounting for Dummies, John Wiley and Sons
- Plewa F. J., George J., Friedlob T., (1995)., Understanding Cash Flow, John Wiley and Sons
- Wahlen J.M., Baginski S.P., Bradshaw M., (2017)., Financial Reporting, Financial Statement Analysis and Valuation, Cengage Learning
Author: Agnieszka Piwowarczyk
