Common Size Statement analysis

Common size statements are also known as ‘Vertical analysis’. Financial statements, when read with absolute figures, can be misleading. Therefore, a vertical analysis of financial information is done by considering the percentage form. The balance sheet items are compared:

• To the total assets in terms of percentage by taking the total assets as 100.
• To the total liabilities in terms of percentage by taking the total liabilities as 100.

Therefore the whole Balance Sheet is converted into percentage form. And such converted Balance Sheet is known as Common-Size Balance Sheet. Similarly profit & loss items are compared:

• To the total incomes in terms of percentage by taking the total incomes as 100.
• To the total expenses in terms of percentage by taking the total expenses as 100.

Therefore the whole Profit & loss account is converted into percentage form. And such converted profit & loss account is known as Common-Size Profit & Loss account. As the numbers are brought to a common base, the percentage can be easily compared with the results of corresponding percentages of the previous year or of some other firms.

Advantages of Common-Size Statement:

(a) Easy to Understand:

Common-size Statement helps the users of financial statement to make clear about the ratio or percentage of each individual item to total assets/liabilities of a firm. For example, if an analyst wants to know the working capital position he may ascertain the percentage of each individual component of current assets against total assets of a firm and also the percentage share of each individual component of current liabilities.

(b) Helpful for Time Series Analysis:

A Common-Size Statement helps an analyst to find out a trend relating to percentage share of each asset in total assets and percentage share of each liability in total liabilities.

(c) Comparison at a Glance:

An analyst can compare the financial performances at a glance since percentage of increase or decrease of each individual component of cost, assets, liabilities etc. are available and he can easily ascertain his required ratio.

(d) Helpful in analysing Structural Composition:

A Common-Size Statement helps the analyst to ascertain the structural relations of various components of cost/expenses/assets/liabilities etc. to the required total of assets/liabilities and capital.

Limitations of Common-Size Statement:

(a) Standard Ratio:

Common-Size Statement does not help to take decisions since there is no standard ratio/percentage regarding the change of percentage in the various component of assets, liabilities, sales etc.

(b) Change in Price-level:

Common-Size statement does riot recognise the change in price level i.e. inflationary effect. So, it supplies misleading information’s since it is based on historical cost.

(c) Following Consistency:

If consistency in the accounting principle, concepts, conventions is not maintained then Common Size Statement becomes useless.

(d) Seasonal Fluctuation:

Common-Size Statement fails to convey proper records during seasonal fluctuations in various components of sales, assets liabilities etc. e.g. sales and closing stock significantly vary. Thus, the statement fails to supply the real information to the users of financial statements.

(e) Window Dressing:

Effect of window dressing in financial statements cannot be ignored and Common-Size Statements fail to supply the real positions of sales, assets, liabilities etc. due to the evil effects of window dressing appearing in the financial statements.

(f) Qualitative Element:

Common-Size Statement fails to recognise the qualitative elements, e.g. quality of works, customer relations etc. while measuring the performance of a firm although the same should not be ignored.

(g) Liquidity and Solvency Position:

Liquidity and solvency position cannot be measured by Common-Size Statement. It considers the percentage of increase or decrease in various components of sales, assets, liabilities etc. In other words it does not help to ascertain the Current Ratio, Liquid Ratio, Debt Equity Capital Ratio, Capital Gearing Ratio etc. which are applied in testing liquidity and solvency position of a firm.

The common-size statements, balance sheet and income statement are shown in analytical percentages. The figures are shown as percentages of total assets, total liabilities and total sales. The total assets are taken as 100 and different assets are expressed as a percentage of the total. Similarly, various liabilities are taken as a part of total liabilities.

These statements are also known as component percentage or 100 per cent statements because every individual item is stated as a percentage of the total 100. The short-comings in comparative statements and trend percentages where changes in items could not be compared with the totals have been covered up. The analyst is able to assess the figures in relation to total values.

The common-size statements may be prepared in the following way:

(1) The totals of assets or liabilities are taken as 100.

(2) The individual assets are expressed as a percentage of total assets, i.e., 100 and different liabilities are calculated in relation to total liabilities. For example, if total assets are Rs 5 lakhs and inventory value is Rs 50,000, then it will be 10% of total assets (50,000×100/5,00,000)

Types of Common-Size Statements:

(i) Common-Size Balance Sheet:

A statement in which balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability is expressed as a ratio of total liabilities is called common-size balance sheet.

For example, following assets are shown in a common-size balance sheet:

The total figure of assets Rs 2,00,000, is taken as 100 and all other assets are expressed as a percentage of total assets. The relation of each asset to total assets is expressed in the statement. The relation of each liability to total liabilities is similarly expressed.

The common-size balance sheet can be used to compare companies of differing size. The comparison of figures in different periods is not useful because total figures may be affected by a number of factors. It is not possible to establish standard norms for various assets. The trends of figures from year to year may not be studied and even they may not give proper results.

(ii) Common Size Income Statement:

The items in income statement can be shown as percentages of sales to show the relation of each item to sales. A significant relationship can be established between items of income statement and volume of sales. The increase in sales will certainly increase selling expenses and not administrative or financial expenses.

In case the volume of sales increases to a considerable extent, administrative and financial expenses may go up. In case the sales are declining, the selling expenses should be reduced at once. So, a relationship is established between sales and other items in income statement and this relationship is helpful in evaluating operational activities of the enterprise.

Importance of Common Size Analysis

One of the benefits of using common size analysis is that it allows investors to identify drastic changes in a company’s financial statement. This mainly applies when the financials are compared over a period of two or three years. Any significant movements in the financials across several years can help investors decide whether to invest in the company. 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, making the company attractive to investors.

Common size analysis is also an excellent tool to compare companies of different sizes but in the same industry. Looking at their financial data can reveal their strategy and their largest expenses that give them a competitive edge over other comparable companies. For example, some companies may sacrifice margins to gain a large market share, which increases revenues at the expense of profit margins. Such a strategy allows the company to grow faster than comparable companies because they are more preferred by investors.