What are common size financial statements?

Common size financial statements, also known as common size analysis, are a standardized way of presenting financial statements that express each line item as a percentage of a selected base item. This analysis makes it easier to compare the relative proportions of different financial statement components and is particularly useful for evaluating the composition and structure of a company's financial statements. Here's how to create and interpret common size financial statements:

1. Select the Base Item:

• Choose a base item for each financial statement. Common choices include:
  • For the income statement: Total revenue or net sales.
  • For the balance sheet: Total assets or total liabilities and equity.
  • For the cash flow statement: Total cash flows from operating activities.

2. Calculate the Percentages:

• For each line item on the financial statement, divide the line item's value by the value of the selected base item and multiply by 100 to express it as a percentage.

3. Create Common Size Statements:

• Organize the data in a table or spreadsheet, presenting each line item as a percentage of the chosen base item. The common size statements can be created for the income statement, balance sheet, and cash flow statement, depending on the analysis goals.

4. Analyze and Interpret:

• Examine the common size statements to gain insights into the composition of the financial statements and how each component relates to the base item. Here's how to interpret common size financial statements for each type:

• Income Statement: Common size income statements help assess the relative proportions of revenues and expenses. This analysis can highlight cost structures, the impact of specific expense categories on profitability, and trends over time. For example, it can show whether a company's cost of goods sold (COGS) is increasing as a percentage of revenue, potentially affecting gross margins.

• Balance Sheet: Common size balance sheets reveal the composition of assets, liabilities, and equity as a percentage of total assets. This analysis can identify the proportion of current assets to total assets, the debt-to-equity ratio, and changes in the capital structure over time.

• Cash Flow Statement: Common size cash flow statements help assess the composition of cash flows, particularly the relative importance of operating, investing, and financing activities. This analysis can reveal how a company generates and uses cash and whether it relies heavily on external financing.

5. Industry and Peer Comparisons:

• Compare the common size statements to industry averages and peer companies to determine how the company's financial structure and composition compare to others in the same industry or sector.

6. Qualitative Assessment:

• Combine the insights from common size analysis with qualitative information, such as industry dynamics, market conditions, and company-specific factors, to gain a comprehensive understanding of the company's financial structure and performance.

Common size financial statements provide a standardized view of a company's financial statements, making it easier to assess the relative significance of different line items. This analysis can help identify trends, areas of concern, and opportunities for improvement in a company's financial structure and performance. It's a valuable tool for investors, analysts, and financial professionals seeking to understand the composition and dynamics of financial statements.