Common Size Analysis

Now that we have a deeper understanding of the three financial statements and understood how each statement has a different function, we can now move on to see how to use these statements.

Let's start from some basic methods of financial analyses.

Common Size Analysis

Common Size Analysis is a fancy name for calculating the percentage of each item on the financial statement. It is sometimes referred to as Structure Analysis.

Common Size Analysis of Income Statement

For instance, in an income statement the structure means the ratio of each item over revenue. 

We often compare income statement to a funnel, where revenue enters from the top and net profit comes out of the bottom. If we want to know what percentage of the revenue that each following item occupies in this process, we can use the common size analysis to help accomplish that.

This is the income statement we made for our fictional company. Now let's divide all the items on this statement by the revenue and see what the percentages are.

From the common size analysis, we can see that the cost of goods is 31 million dollars and its ratio over total revenue is 72%. The percentages of three major expenses, namely operating expense, administrative expense, and financial expense, are 6%, 5%, and 3% respectively. The percentage of operating profit over the income is 14%. Deducting income tax ratio of 2% further will make our net profit about 12% of the total revenue.

With the common size analysis, we can have a more intuitive view of the structure of the statement, as we as human beings are more inclined to understanding percentages rather than absolute numbers.

Next, let's see how to do common size analysis of balance sheets. 

Common Size Analysis of Balance Sheet

Now let's use the balance sheet of our fictional company to conduct a common size analysis.

What we can find is that cash accounts for 21% of the total asset of the company, inventory 5%, account receivable 13%, and prepaid expenses 2%. As a result, the total current asset accounts for 41% of the total asset. After that, fixed asset accounts for 57% of the total asset, and intangible asset around 2%. 

The industry that a company operates in and the overall industry competitiveness affect how a company allocates resources into different asset items. For our company, fixed assets occupies the largest share of the total asset, close to 60%. It seems that this is a manufacturing company with relatively heavy assets. On top of that, the company has 13% of its total assets tied up in accounts receivable, further illustrating the competitiveness of the industry.

Now let's turn to the right side of the balance sheet.

Here we can see that liabilities account for 63% of the total asset, while the rest 38% are shareholders' equity. Among the liabilities, short-term debts account for 51%, and account payables account for 12% of the total asset. 

In terms of shareholders' equity, the initial capital provided by the shareholders when the company was set up contributed 32% of the total asset, and retained earnings account for about 4%. It is clear that at this point, the company relies MORE on the bank than its shareholders to provide capital.

Other Types of Analyses

Apart from the common size analysis, there are other methods such as ratio analysis and cash flow analysis, etc. Ratio analysis is when we think the original data of the statement are not sufficient to describe the economic activities of the company, and we might need to create new ratios by busing the original data. Ratio analysis is one of the most important financial analysis methods.

Regardless of whatever method we use, the analyses can only help us obtain data, and it is still up to us to interpret them. As what we did for common size analysis, sometimes we not only need to look at the data themselves, but also need to compare these data with something else in order to make sense. For example, if we compare our company's past data with its current data, we are essentially conducting time series analysis. If we compare our data with our competitor's data or the industry average, we are conducting comparative analysis. We will cover more in future episodes.