Express The Items In Common-size Percents

Expressing Items in Common-Size Percents: A Comprehensive Guide

Common-size percents are a powerful financial analysis tool that allows you to compare financial statements across different periods or between different companies, regardless of their size. By expressing each line item as a percentage of a base figure, you eliminate the impact of scale and focus on the relative proportions of different accounts. This makes it easier to identify trends, assess performance, and make informed financial decisions. This comprehensive guide will delve deep into the concept, application, and benefits of common-size percents.

Understanding Common-Size Percents

Common-size financial statements present all items as percentages of a common base figure. This allows for easier comparison of financial data, revealing significant trends and relationships that might be obscured by absolute dollar amounts. The base figure used depends on the statement being analyzed.

Common-Size Balance Sheet

On a balance sheet, the total assets are typically used as the base figure. Each asset and liability account is then expressed as a percentage of total assets. For example:

• Cash and Cash Equivalents: (Cash and Cash Equivalents / Total Assets) * 100%
• Accounts Receivable: (Accounts Receivable / Total Assets) * 100%
• Property, Plant, and Equipment: (Property, Plant, and Equipment / Total Assets) * 100%
• Total Liabilities: (Total Liabilities / Total Assets) * 100%
• Equity: (Equity / Total Assets) * 100%

This allows for a direct comparison of the relative proportion of different assets and liabilities over time or between companies. For instance, a consistent increase in the percentage of accounts receivable might indicate potential issues with collections.

Common-Size Income Statement

For the income statement, the net sales (revenue) are used as the base figure. Every item on the income statement is then expressed as a percentage of net sales. This gives a clear picture of the company's profitability and cost structure. Examples include:

• Cost of Goods Sold: (Cost of Goods Sold / Net Sales) * 100%
• Gross Profit: (Gross Profit / Net Sales) * 100%
• Operating Expenses: (Operating Expenses / Net Sales) * 100%
• Net Income: (Net Income / Net Sales) * 100%

By analyzing these common-size percentages, you can readily identify areas where costs are disproportionately high or where profit margins are shrinking.

Common-Size Statement of Cash Flows

While less common than balance sheet and income statement common-size analysis, applying the same principle to the statement of cash flows can also be insightful. The total cash flow can be used as the base figure to express each category (operating, investing, and financing activities) as a percentage of the total. This helps analyze the relative importance of each cash flow source and use.

Benefits of Using Common-Size Percents

The advantages of using common-size percents in financial analysis are numerous:

• Easy Comparison: The most significant benefit is the ability to easily compare companies of different sizes. Absolute figures can be misleading when comparing a large corporation to a small business. Common-size percents normalize the data, allowing for a fair and meaningful comparison.

• Trend Analysis: Tracking common-size percentages over time reveals trends and patterns in a company's financial performance. This is crucial for identifying potential problems or opportunities before they become major issues. For instance, a consistent increase in the percentage of operating expenses could indicate inefficiency.

• Benchmarking: Common-size percentages facilitate benchmarking against industry averages or competitors. This allows a company to assess its financial health relative to its peers and identify areas for improvement.

• Improved Understanding: Common-size analysis improves the understanding of a company's financial structure and performance. It simplifies complex financial statements, making them more accessible to a wider audience, including non-financial stakeholders.

• Early Warning System: Significant changes in common-size percentages can serve as an early warning system for potential financial problems. For example, a sharp decrease in gross profit margin might indicate pricing pressure or rising input costs.

• Focus on Relative Performance: Instead of being distracted by the absolute dollar amounts which are subject to inflation and growth, common-size percents help focus on the relative performance and the proportion of individual items to the whole.

Applying Common-Size Percents in Practice

The practical application of common-size percents involves several steps:

1. Gather Financial Statements: Obtain the balance sheet, income statement, and statement of cash flows for the company or companies you wish to analyze. This data can usually be found in annual reports or SEC filings.

2. Choose the Base Figure: Select the appropriate base figure for each statement: total assets for the balance sheet, net sales for the income statement, and total cash flow for the statement of cash flows.

3. Calculate Percentages: Divide each line item by the base figure and multiply by 100% to express it as a percentage. For example, (Current Assets/Total Assets) * 100%.

4. Analyze the Results: Compare the common-size percentages over time or between different companies. Look for significant trends or deviations from the norm.

5. Draw Conclusions: Based on your analysis, draw conclusions about the company's financial health, performance, and potential risks.

Limitations of Common-Size Percents

While common-size percents are a valuable tool, it's important to acknowledge their limitations:

• Not a Standalone Tool: Common-size analysis should not be used in isolation. It should be combined with other analytical techniques, such as ratio analysis and trend analysis, for a more comprehensive understanding.

• Industry Context: The interpretation of common-size percentages must consider the specific industry. What might be considered normal for one industry could be abnormal for another.

• Qualitative Factors: Common-size analysis focuses solely on quantitative data. It doesn't account for qualitative factors, such as management quality, competitive landscape, or technological advancements, that can significantly impact a company's performance.

• Inflationary Effects: While common-size analysis helps to mitigate the impact of scale, it doesn't account for the effects of inflation. Comparing percentages over many years might need to account for changes in purchasing power.

Combining Common-Size Analysis with Other Techniques

To maximize the insights gained from common-size analysis, it should be used in conjunction with other financial analysis techniques:

• Ratio Analysis: Calculating various financial ratios (liquidity ratios, profitability ratios, solvency ratios, etc.) and comparing them to industry benchmarks provides a more nuanced perspective on a company's financial health.

• Trend Analysis: Tracking common-size percentages over multiple periods helps to identify trends and patterns in a company’s performance. This reveals whether a particular trend is consistent or a one-off occurrence.

• Horizontal and Vertical Analysis: Combining common-size analysis (vertical analysis) with horizontal analysis (comparing figures across different periods) provides a more complete picture of changes in the company's financial performance.

• Industry Benchmarking: Comparing a company's common-size percentages to those of its competitors or industry averages provides a valuable benchmark for assessing its relative performance.

Conclusion

Common-size percents are an indispensable tool for financial analysis. By expressing financial statement items as percentages of a common base, this technique simplifies comparisons between companies of different sizes and reveals important trends and relationships that might otherwise be obscured. However, it is crucial to remember that common-size analysis is most effective when used in conjunction with other analytical methods and contextual information, leading to more informed and insightful financial decision-making. Understanding the limitations and utilizing common-size percents in conjunction with other analytical tools will maximize its effectiveness and contribute significantly to a robust financial analysis.