How to Use Common Size Analysis to Compare Companies to Peers

A deeper dive would require looking at longer periods, such as three to five years, to detect trends. Those longer snapshots can tell you if the company is going through some financial struggles or a rare event. For example, any discernable movements in the income statement can help investors decide whether to invest in Square. Look at the lack of R&D for the last two years, which is surprising, also notice that both costs of goods sold and administration costs have all remained the same over the four years.

Incomplete Picture of Financial Health

By asserting the financial implications of these initiatives, companies can enrich their reporting process and succeed in their sustainability journey. It can provide valuable insights, but it’s most useful when used as part of a broader evaluation that includes other financial indicators and qualitative analysis. When comparing any two common size ratios, it is important to make sure that they are computed by using the same base figure.

The firm did issue additional stock and showed an increase in retained earnings, both totaling a $10,000 increase in equity. However, the equity increase was much smaller than the total increase in liabilities of $40,000. The remainder of that increase is inventory costing methods and inventory valuation methods seen in the 5 percent increase in current liabilities. Vertical Common Size Analysis is a method where each line item on a company’s financial statement is listed as the percentage of a single, reference item.

1. While the absolute cost may seem enormous, scaling it against total expenses will bring comprehensibility.
2. If you’re evaluating the company’s profitability, the income statement would be most pertinent.
3. This tool is especially important if you’re using key performance indicators to measure your business’s performance and profitability.
4. Look at the lack of R&D for the last two years, which is surprising, also notice that both costs of goods sold and administration costs have all remained the same over the four years.

Common size cash flow statement example

Each financial statement uses a slightly different convention in standardizing figures. By comparing these percentages year on year, you can understand if your company’s sustainability efforts are increasing or decreasing. Thus, applying common size analysis might aid in maintaining the right balance between profitability and sustainable operations.

Let’s perform some common size analysis using both the income statement and balance sheet—the company I would like to use Paypal (PYPL) as our guinea pig. For instance, ratio analysis can provide concrete numerical values reflecting a company’s financial performance, while common size analysis offers a view into how income or assets are distributed. Conducting a horizontal analysis requires choosing a base year and then calculating the percentage change of each line item from that base year. So, if a company’s revenue increased from $50,000 in the base year to $75,000 in the current year, then the revenue has increased by 50%.

What Is a Common Size Income Statement?

They can see this breakdown for each firm and compare how different firms function in terms of expenses, proportionally. They can also look at the percentage for each expense over time to see if they are spending more or less on certain areas of the business, such as research and development. On the balance sheet, analysts commonly look to see the percentage of debt and equity to determine capital structure. They can also quickly see the percentage of current versus noncurrent assets and liabilities.

Comparisons in the investing world are not different; we have many forms of comparison, some flattering, some not. Note that although we have compared just two years of data for Charlie and Clear Lake, it is more common to use several years of data to get a more robust view of long-term trends. By using these methods concurrently, you can gain a multidimensional view of financial data, enhancing your understanding of an entity’s fiscal operations. Interpreting these figures requires a good understanding of the company and its context. You may need to take into account factors such as the general state of the economy, the competitive environment, and the company’s operational issues.

Another advantage that appeals to analysts is the simplification of complex financial data. The nature of financial statements can often be dense and difficult to comprehend for those who are not accustomed to them. By scaling the vast array of figures down to percentages, common size analysis can turn intricate and complicated financial data into simpler, more digestible snapshots. This greatly facilitates easier interpretation of the financial health of a company and the identification of any unusual fluctuations that may warrant further investigation. Many items in the cash flow statement can be stated as a percent of total sales, similar to an income statement analysis. This can give insight into several cash flow items, including stage left or right meaning capital expenditures (CapEx) as a percent of revenue.

How This Differs From Regular Financial Statements

The current assets formula determines that the “total current assets,” which are the total of all assets that can be converted to cash within one year, makes up 37% of the company’s total assets. In contrast, current liabilities, which are debts due within one year, make up only 30% of the company’s total assets. You can use it to see how your business stacks up percentage-wise with another business, even if that business is substantially larger. Debt issuance is another important figure in proportion to the amount of annual sales it helps to generate.

The balance sheet equation is assets equals liabilities plus stockholders’ equity. Similarly, combining common size analysis with horizontal or vertical analysis allows for a deeper dive into specific items of the income statement, balance sheet or cash flow statement. The first step in conducting common size analysis is determining which financial statements are most relevant.

That might indicate the company is expanding its operations and taking market share from its peers. The most significant benefit of a common-size analysis is that it can let you identify large or drastic changes in a firm’s financials. Rapid increases or decreases will be readily observable, such as a fast drop in reported profits during one quarter or year. The key benefit of a common-size analysis is that it allows for a vertical analysis by line item over a single period, such as quarterly or annually. It also allows you to view a horizontal perspective over a period such as the three years that were analyzed in our example.

They can make important observations by analyzing specific line items in relation to the total assets. Common size analysis, also referred to as vertical analysis, is a tool that financial managers use to analyze financial statements. It evaluates financial statements by expressing each line item as a percentage of a base amount for that period. The analysis helps to understand the impact of each item in the financial statements and its contribution to the resulting figure. The balance sheet provides a snapshot overview of the firm’s assets, liabilities, and shareholders’ equity for the reporting period. A common size balance sheet is set up with the same logic as the common size income statement.

It provides insights into how a company’s performance and financial health have changed over time, which can be instrumental in predicting future performance. In summary, common size analysis is an invaluable tool for strategic decision-making, performance evaluation, and financial planning across sectors. It not only benchmarks against competitors but also identifies financial trends, making it a foundation of sound economic and financial decisions. Doing so will help you see at a glance which expenses take up the largest percentage of your revenue. For example, large drops in the company’s profits in two or more consecutive years may indicate that the company is going through financial distress. Similarly, considerable increases in the value of assets may mean that the company is implementing an expansion or acquisition strategy, potentially making the company attractive to investors.