Common Size
Common size is an analytical tool used in finance to compare financial statements of different companies. This method converts all items on a financial statement, such as income statements or balance sheets, to a percentage of a total, allowing for direct comparisons between companies of different sizes. It helps in identifying trends and understanding the financial health of a company relative to its competitors.
Examples
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Income Statement Common Size Analysis: If a company has sales revenues of $1,000,000 and cost of goods sold (COGS) of $400,000, the COGS would be 40% of sales. If another company has sales revenues of $500,000 and COGS of $200,000, its COGS would also be 40% of sales. Despite different revenues, the cost structure in percentage terms is comparable.
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Balance Sheet Common Size Analysis: A company with total assets of $2,000,000 and cash of $100,000 would show cash as 5% of assets. Another company with total assets of $1,000,000 and cash of $50,000 would also have 5% of its assets in cash. This percentage is useful for liquidity comparison.
Frequently Asked Questions
Q1: How does common size analysis help in financial comparison?
- A1: Common size analysis converts financial statement items to percentages of a key figure, making it easier to compare companies of different sizes on an equal footing.
Q2: What is the most common base figure used in common size income statements?
- A2: Sales revenues are typically used as the base figure, set at 100%, with other items expressed as a percentage of sales.
Q3: Can common size analysis be applied to all financial statements?
- A3: Yes, common size analysis can be applied to income statements, balance sheets, and even cash flow statements.
Q4: What are the benefits of using common size analysis?
- A4: This analysis helps in benchmarking, trend analysis, and highlights relative composition and financial relationships over time.
Q5: Is common size analysis helpful for understanding operational efficiency?
- A5: Yes, by comparing expense ratios, it helps in identifying operational efficiencies or inefficiencies.
- Vertical Analysis: Analyzing financial statement items as a percentage of a base figure within the same period.
- Horizontal Analysis: Comparing financial data across multiple periods to identify trends.
- Financial Ratios: Metrics calculated from financial statement items used for assessing various financial aspects of a company.
Online References
Suggested Books for Further Studies
- “Financial Statement Analysis and Security Valuation” by Stephen H. Penman
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
- “Financial Reporting and Analysis” by Charles H. Gibson
Fundamentals of Common Size: Financial Analysis Basics Quiz
### What primary figure is typically used as the base figure in common size income statement analysis?
- [ ] Total assets
- [x] Sales revenues
- [ ] Net income
- [ ] Cash balance
> **Explanation:** In common size income statement analysis, sales revenues are most commonly used as the base figure, set at 100%.
### If sales revenue is $500,000 and cost of goods sold (COGS) is $200,000, what is the COGS as a percentage of sales?
- [x] 40%
- [ ] 30%
- [ ] 25%
- [ ] 35%
> **Explanation:** COGS of $200,000 divided by sales revenue of $500,000 equals 0.4, or 40%.
### Why is common size analysis useful in benchmarking?
- [ ] It shows gross sales figures.
- [x] It allows comparison of companies of different sizes.
- [ ] It indicates tax compliance.
- [ ] It simplifies accounting entries.
> **Explanation:** Common size analysis allows for comparison between companies of different sizes by converting items to percentages of a base figure, enabling easier benchmarking.
### What typical base figure is used in a common size balance sheet?
- [ ] Net income
- [ ] Sales revenues
- [x] Total assets
- [ ] Total liabilities
> **Explanation:** In a common size balance sheet, total assets are commonly used as the base figure, set at 100%.
### How does a common size financial statement aid in trend analysis?
- [ ] By showing absolute amounts.
- [ ] By calculating annual budgets.
- [x] By converting figures to percentages that can be compared over time.
- [ ] By showing auditor notes.
> **Explanation:** It converts figures to percentages of a base figure, making it easier to compare trends over different periods.
### What is vertical analysis?
- [x] Analyzing each item as a percentage of a base figure within the same period.
- [ ] Comparing same items across different periods.
- [ ] Allocating overhead costs iteratively.
- [ ] Calculating cash flow projections.
> **Explanation:** Vertical analysis involves analyzing each financial statement item as a percentage of a base figure within the same period, similar to common size analysis.
### What common size statement item would indicate liquidity in a balance sheet?
- [x] Cash as a percentage of total assets
- [ ] COGS as a percentage of sales
- [ ] Net income as a percentage of sales
- [ ] Depreciation as a percentage of fixed assets
> **Explanation:** Cash as a percentage of total assets indicates liquidity in a balance sheet.
### Why is comparing expense ratios across companies useful?
- [ ] It identifies revenue gaps.
- [x] It highlights relative operational efficiencies or inefficiencies.
- [ ] It suggests investment opportunities.
- [ ] It determines tax strategies.
> **Explanation:** Comparing expense ratios can highlight operational efficiencies or inefficiencies by showing how much of revenue is spent on different expense categories.
### Which financial statement analysis is focused on temporal comparison?
- [ ] Common size analysis
- [ x ] Horizontal analysis
- [ ] Cost-benefit analysis
- [ ] Vertical analysis
> **Explanation:** Horizontal analysis focuses on comparing financial data across multiple periods to identify trends.
### Which book would you recommend for advanced study in financial analysis?
- [ ] "The Elements of Investing" by Burton Malkiel
- [ ] "The Intelligent Investor" by Benjamin Graham
- [x] "Financial Statement Analysis and Security Valuation" by Stephen H. Penman
- [ ] "Rich Dad Poor Dad" by Robert T. Kiyosaki
> **Explanation:** "Financial Statement Analysis and Security Valuation" by Stephen H. Penman is a recommended resource for advanced study in financial analysis.
Thank you for embarking on this journey through our comprehensive financial analysis lexicon and tackling our challenging quiz questions. Keep striving for excellence in your financial knowledge!
