Common Size Analysis - definition & overview

Common Size Analysis, a term often heard in the realm of small businesses, is a financial tool used to evaluate and compare the financial performance of different companies, irrespective of their size. It is a method of financial statement analysis that presents each line item as a percentage of a base figure within the statement. This approach allows for a more straightforward comparison of different sized companies and industries.

Common Size Analysis is a critical tool for small businesses as it provides a detailed perspective on the financial health of the company. It allows businesses to understand their financial position better and make informed decisions. This article aims to provide a comprehensive understanding of Common Size Analysis, its importance, how it is conducted, and its advantages and disadvantages.

Understanding Common Size Analysis

Common Size Analysis, also known as vertical analysis, is a method used in financial statement analysis where each line item is listed as a percentage of a base figure within the statement. Thus, in a balance sheet, every line item is shown as a percentage of total assets, while in an income statement, each item is presented as a percentage of sales revenue.

By converting everything to percentages, businesses can easily compare their financial statements with those of other companies, even if the absolute numbers differ significantly. This method of analysis helps to identify trends, make strategic decisions, and evaluate company performance.

Components of Common Size Analysis

Common Size Analysis primarily involves two financial statements - the Balance Sheet and the Income Statement. The Balance Sheet provides a snapshot of a company's assets, liabilities, and shareholders' equity at a specific point in time. On the other hand, the Income Statement shows a company's revenues, costs, expenses, and net income over a period.

When conducting a Common Size Analysis, each line item in these statements is expressed as a percentage of a base figure. For instance, in the Balance Sheet, each asset, liability, and equity item is expressed as a percentage of total assets. Similarly, in the Income Statement, each revenue and expense item is expressed as a percentage of total revenue.

Base Figures in Common Size Analysis

The base figure in a Common Size Analysis is the number to which all other numbers are compared. In the Balance Sheet, the base figure is usually the total assets, while in the Income Statement, it is the total revenue. By expressing all other numbers as a percentage of this base figure, businesses can easily compare their financial performance with others.

It's important to note that the choice of base figure can significantly impact the results of the analysis. Therefore, businesses must carefully select the base figure that best represents their financial situation and goals.

Importance of Common Size Analysis

Common Size Analysis plays a crucial role in understanding a company's financial health and performance. It provides valuable insights into the company's operational efficiency, financial stability, and profitability. By comparing different financial periods or different companies, businesses can identify trends, strengths, weaknesses, and opportunities.

Moreover, Common Size Analysis simplifies the process of financial statement analysis. By expressing all numbers as percentages, it eliminates the complexities associated with comparing absolute numbers. This makes it easier for businesses, investors, and stakeholders to understand and interpret the financial statements.

Operational Efficiency

Common Size Analysis can reveal a lot about a company's operational efficiency. By comparing the percentage of different expense items to total revenue, businesses can identify areas where they are spending more or less. This can help them identify inefficiencies and take corrective actions.

For instance, if a company's cost of goods sold (COGS) as a percentage of revenue is increasing over time, it may indicate inefficiencies in production or procurement. Similarly, if the percentage of administrative expenses is high compared to industry peers, it may suggest the need for cost-cutting or process improvement.

Financial Stability

Common Size Analysis also helps assess a company's financial stability. By comparing the percentage of different liability items to total assets, businesses can evaluate their debt levels and financial risk. A high percentage of debt may indicate financial instability and could be a red flag for investors and lenders.

Similarly, the percentage of equity to total assets can provide insights into the company's financial structure and risk-bearing capacity. A high percentage of equity suggests that the company is primarily financed by shareholders and has a lower financial risk.

Conducting a Common Size Analysis

Conducting a Common Size Analysis involves several steps, starting with the selection of financial statements and ending with the interpretation of results. It requires a good understanding of financial statements, basic mathematical skills, and analytical thinking.

The first step in conducting a Common Size Analysis is to select the financial statements to be analysed. This could be the Balance Sheet, Income Statement, or both. The next step is to choose the base figure. In the Balance Sheet, the base figure is usually the total assets, while in the Income Statement, it is the total revenue.

Calculating Percentages

Once the base figure is selected, the next step is to calculate the percentage of each line item. This is done by dividing the line item by the base figure and multiplying by 100. The result is the percentage of the line item to the base figure.

For example, if the total assets are �$1,000,000 and the total liabilities are �$500,000, the percentage of liabilities to total assets would be (500,000 / 1,000,000) * 100 = 50%. This means that 50% of the company's assets are financed by liabilities.

Comparing Percentages

After calculating the percentages, the next step is to compare them. This could be a comparison over different financial periods or between different companies. The aim is to identify trends, strengths, weaknesses, and opportunities.

For instance, if a company's COGS as a percentage of revenue is increasing over time, it may indicate inefficiencies in production or procurement. Similarly, if a company's percentage of debt is higher than its industry peers, it may suggest a higher financial risk.

Advantages of Common Size Analysis

Common Size Analysis offers several advantages. It simplifies the process of financial statement analysis, allows for easy comparison of different companies and periods, and provides valuable insights into a company's financial health and performance.

One of the main advantages of Common Size Analysis is its simplicity. By expressing all numbers as percentages, it eliminates the complexities associated with comparing absolute numbers. This makes it easier for businesses, investors, and stakeholders to understand and interpret the financial statements.

Easy Comparison

Another advantage of Common Size Analysis is that it allows for easy comparison. Businesses can compare their financial performance with that of other companies, even if the absolute numbers differ significantly. This can help businesses identify their strengths and weaknesses and benchmark their performance against industry peers.

Similarly, businesses can compare their financial performance over different periods. This can help them identify trends, monitor progress, and make strategic decisions. For instance, if a company's percentage of debt is increasing over time, it may need to reconsider its financing strategy.

Valuable Insights

Common Size Analysis also provides valuable insights into a company's financial health and performance. It can reveal a lot about a company's operational efficiency, financial stability, and profitability. By identifying areas of concern, businesses can take corrective actions and improve their financial performance.

For instance, if a company's percentage of administrative expenses is high compared to industry peers, it may suggest the need for cost-cutting or process improvement. Similarly, if a company's percentage of equity is low, it may indicate a high financial risk and could be a red flag for investors and lenders.

Disadvantages of Common Size Analysis

Despite its many advantages, Common Size Analysis also has some disadvantages. It relies heavily on the accuracy of financial statements, can be influenced by accounting policies, and may not provide a complete picture of a company's financial health and performance.

One of the main disadvantages of Common Size Analysis is that it relies heavily on the accuracy of financial statements. If the financial statements are inaccurate or misleading, the results of the Common Size Analysis will also be inaccurate or misleading. Therefore, businesses must ensure the accuracy and reliability of their financial statements before conducting a Common Size Analysis.

Influence of Accounting Policies

Another disadvantage of Common Size Analysis is that it can be influenced by accounting policies. Different companies may use different accounting policies, which can affect the comparability of financial statements. For instance, one company may use the straight-line method of depreciation, while another may use the reducing balance method. This can lead to differences in the percentages and may distort the comparison.

Therefore, when comparing different companies, businesses must take into account the differences in accounting policies. They may need to adjust the financial statements to ensure a fair comparison.

Incomplete Picture

Common Size Analysis may not provide a complete picture of a company's financial health and performance. It focuses primarily on the percentages and may overlook the absolute numbers. For instance, a company may have a low percentage of debt, but if the absolute amount of debt is high, it may still pose a financial risk.

Moreover, Common Size Analysis does not take into account non-financial factors, such as market conditions, competition, and management quality. These factors can significantly impact a company's financial performance and should not be overlooked. Therefore, businesses should use Common Size Analysis in conjunction with other financial analysis tools and techniques.

In conclusion, Common Size Analysis is a powerful tool for financial statement analysis. It simplifies the process of analysis, allows for easy comparison, and provides valuable insights. However, it also has some limitations and should be used with caution. By understanding the concept, importance, method, advantages, and disadvantages of Common Size Analysis, businesses can make better financial decisions and improve their financial performance.