3.0. Core application of data analytics


3.1. Financial Accounting And Reporting


3.1.2. Analyse financial statements using ratios, common size statements, trend and cross-sectional analysis, graphs and charts


Common Size Statements:


A common-size statement, also known as a common-size financial statement or a vertical analysis, is a financial statement that expresses each line item as a percentage of a base item within the same financial statement.




The purpose of creating common-size statements is to make it easier to analyze and compare financial data across different companies, industries, or time periods.


KEY TAKEAWAYS


  • Common size financial statements express each line item as a percentage of total revenue (income statement) or total assets (balance sheet).
  • Common size statements help in comparing the composition of financial statements across different time periods or between companies of varying sizes.

Common-size statements are typically used for income statements and balance sheets, and the base item used for calculations can vary depending on the context:


Common-Size Income Statement: In this case, each line item on the income statement (such as revenue, expenses, net income, etc.) is expressed as a percentage of total revenue or sales. This allows for a better understanding of the proportion of each expense or income category relative to total revenue.


Below is an example of a common size income statement for a fictional company:

Company XYZ Income Statement (Common Size) for the Year Ended December 31, 20XX:

Revenue
Cost of Goods Sold(COGS)
Gross Profit
Operating Expenses:
  • Selling & Distribution Expenses
  • General Expenses
  • Research & Development
Operating Income
Interest Expense
Income Before Tax
Income Tax Expense
Net Incomen		 Amount
$1,000,000
$600,000
$400,000

$80,000
$60,000
$20,000
$240,000
$10,000
$230,000
$50,000
$180,000		 % of Total Revenue
100%
60%
40%

8%
6%
2%
24%
1%
23%
5%
18%


In this common size income statement:

  • Each line item is expressed as a percentage of the total revenue (which is set to 100%).
  • This format allows you to see the proportion of each expense or income item in relation to the company's total revenue.
  • It provides a clear picture of how revenue is allocated across different expense categories and how profitable the company is after accounting for expenses and taxes.


This common size income statement is a useful tool for financial analysts, investors, and management to quickly assess the composition of a company's income statement and identify areas that may require further analysis or improvement.


Common-Size Balance Sheet: On a common-size balance sheet, each line item (such as assets, liabilities, and equity) is presented as a percentage of total assets. This helps in analyzing the composition of a company's assets and liabilities in relation to its total asset base.


Company XYZ Balance Sheet (Common Size) for the Year Ended December 31, 20XX:
Assets
Current Assets:
  • Cash and Equivalents
  • Accounts Receivable
  • Inventory
Total Current Assets
Non-Current Assets
Property, Plant & Equipment:
  • Land
  • Buildings
  • Machinery
Total PP&E
Other Assets
Total Assets
Liabilities and Equity:
Current Liabilities:
  • Accounts Payable
  • Short-term Debt
Total Current Liabilities
Long-term Debt
Equity:
  • Common Stock
  • Retained Earnings
Total Equity
Total Liabilities & Equity		 Amount

$50,000
$80,000
$120,000
$250,000


$30,000
$90,000
$60,000
$180,000
$70,000
$500,000


$40,000
$30,000
$70,000
$100,000

$200,000
$130,000
$330,000
$500,000		 % of Total Assets

10%
16%
24%
50%


6%
18%
12%
36%
14%
100%


8%
6%
14%
20%

40%
26%
26%
100%

In this common size balance sheet:
  • Each line item on the balance sheet is expressed as a percentage of either total assets (for assets) or total liabilities and equity (for liabilities and equity).
  • This format allows you to see the relative size of each asset, liability, or equity component in relation to the company's total assets or total liabilities and equity.
  • It provides a clear picture of how the company's assets are allocated among current assets, property, plant & equipment, and other assets, as well as how liabilities and equity are distributed.

A common size balance sheet is a useful tool for financial analysis and provides insights into the composition of a company's balance sheet, helping stakeholders assess its financial structure and liquidity position.


Functions of common size analysis


  1. Comparison Across Companies: Common size statements enable easy comparison of financial data between companies of different sizes or within the same industry. By expressing all line items as percentages of a common base (usually total revenue or total assets), you can assess how various companies allocate their resources and generate income.
  2. Trend Analysis: Common size statements allow for the analysis of financial trends over time within a single company. By creating common size statements for multiple periods, you can identify changes in a company's financial structure and performance. This helps in understanding whether certain expenses are increasing, revenues are growing, or assets are being managed more efficiently.
  3. Identification of Financial Strengths and Weaknesses: They highlight the relative proportions of various components within a financial statement. For example, you can quickly see if a company is heavily reliant on debt (by examining the common size balance sheet) or if its cost of goods sold as a percentage of revenue is increasing (by examining the common size income statement). These insights can help identify financial strengths and weaknesses.
  4. Risk Assessment: Common size statements can assist in assessing financial risks. For instance, if a company's common size income statement shows a declining gross profit margin or a rising interest expense as a percentage of revenue, it may indicate potential profitability and solvency risks. This information is valuable to investors and creditors evaluating the company's risk profile.
  5. Management Decision-Making: Companies use common size statements for internal purposes to make informed decisions. Management can identify areas where cost control is needed, where assets can be better utilized, or where pricing strategies should be adjusted based on the insights provided by these statements.
  6. Investor Communication: Companies may use common size statements in their financial reports to communicate financial information more effectively to investors and stakeholders. These statements can simplify complex financial data and provide a clearer picture of the company's financial position and performance.
  7. Benchmarking: Common size statements can serve as benchmarks for a company's own performance. Companies can compare their current common size statements with historical statements to track progress and set performance targets.
  8. Budgeting and Forecasting: Common size statements can be used as a starting point for budgeting and forecasting. By analyzing historical common size statements, companies can make more accurate projections for future financial performance.

Common size statements play a vital role in financial analysis by standardizing financial data, facilitating comparisons, and providing valuable insights into a company's financial structure and performance. They are valuable tools for investors, creditors, management, and other stakeholders in the decision-making process.





Financial Accounting And Reporting


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