What are Common Size Financial Statements, and why is it essential in Business Valuation?
MediaWhat are Common Size Financial Statements, and why is it essential in Business Valuation?
A common size financial statement is a form of analysis of financial statements - balance sheet and profit and loss statement.
When analyzing the profit and loss statement - the analysis will be called a "Common Size Income Statement Analysis", whereas an analysis of the balance sheet will be called - "Common Size Balance Sheet Analysis".
The name "Common Size" originates from the fact that each section in the balance sheet or in the profit and loss statement is expressed as a percentage of the total. The balance sheet shows each line item as a percentage of total assets. In contrast, on the income statement - each item is expressed as a percentage of revenues.
An Example of a Common Size Balance Sheet Analysis
The following table shows the asset side of a particular liability's balance sheet in millions of US dollars:
Current assets - 800,000
Fixed assets - 200,000
Total assets - 1,000,000
In the common size balance sheet analysis - we will divide each section by the total assets (1,000,000).
The result will be:
Current assets - 0.8
Fixed assets - 0.2
Total assets - 1
According to the common size balance sheet analysis, 80% of the assets are current assets, that is, assets that can be turned into cash within one year, and 20% are fixed assets - that is, assets that are used to produce the firm's products.
To conclude whether it is good or bad - we will have to examine the nature of the firm's activity. The easiest way to do this - would be to compare the results to other companies in the industry in which the company operates.
An Example of a Common Size Financial Statement Analysis
The following table shows part of a company's profit and loss statement.
Sales - 10,000,000 US dollars
Cost of sales - 600,000
Gross profit - 400,000
In the analysis on a single basis, each item in the profit and loss statement is divided by the total sales. The resulting result will show:
Sales - 1 (100%)
Cost of sales - 0.6 (60%)
Gross profit - 0.4 (40%)
The conclusion is that the cost of sales constitutes 60% of sales - that is, the cost to produce the company's products is 60 cents for every $1 of sales, or 60% of sales.
Similar to common size balance sheet analysis - To conclude whether it is good or bad - we will have to examine the nature of the firm's activity. The easiest way to do this - would be to compare the results to other companies in the industry in which the company operates.
The Advantages of the Common Size Analysis
A uniform basis analysis has several advantages. The significant advantage is the possibility to compare two companies of different sizes. Suppose we want to compare two companies - the first has assets equal to 5 million USD, whereas the second - has 1 million USD. The USD compassion of the two might yield wrong conclusions. After all - what can we learn from comparing 5 million with a comparison of 1 million? If we translate the dollars into percentages - we can reach exciting conclusions.
When conducting a company valuation, it is essential to analyze one basis for both the balance sheet and the profit and loss statement and compare the results to the industry average. This can teach us if the company is operating correctly or if it has problems that can affect the value of the company.
