Understanding Common Size Financial Statements: An Essential Tool for Financial Analysis

Financial statements are a crucial source of information for any individual or organization looking to make informed decisions about investing, lending, or managing finances. Common size financial statements are a type of financial statement analysis that helps to identify trends and patterns in a company's financial data. In this article, we will explore what common size financial statements are, why they are important, and how to create them.

What are Common Size Financial Statements?

Common size financial statements are financial statements that show the relative percentages of each item to a specific base, usually sales or assets. These statements can be created for income statements, balance sheets, or cash flow statements. The purpose of common size financial statements is to provide a way to compare companies of different sizes and in different industries on a more equal basis. Common size financial statements help to identify trends and patterns in a company's financial data, which can be useful in identifying areas of strength or weakness.

Why are Common Size Financial Statements Important?

Common size financial statements are important for several reasons. Firstly, they provide a more accurate picture of a company's financial health and performance by highlighting relative changes in financial data. For example, a company's revenue might have increased over the past year, but if expenses have increased by a larger percentage, then the company's financial health may have actually deteriorated. Common size financial statements help to identify these trends by focusing on relative changes in financial data.

Secondly, common size financial statements help to identify trends and patterns in a company's financial data over time. For example, if a company's expenses have been increasing as a percentage of sales over the past few years, it may indicate that the company is facing cost pressures or inefficiencies. Conversely, if a company's expenses are decreasing as a percentage of sales, it may indicate that the company is becoming more efficient or has implemented cost-cutting measures.

Finally, common size financial statements can be used to compare companies of different sizes and in different industries on a more equal basis. This is because common size financial statements focus on relative changes in financial data, rather than absolute amounts. As a result, common size financial statements can be useful for investors and analysts who are looking to compare companies in different industries or with different revenue or asset levels.

How to Create Common Size Financial Statements?

Creating common size financial statements involves two steps: calculating the percentage of each item on the financial statement and choosing a base to express each item as a percentage of. The most common bases used for common size financial statements are sales and total assets.

To create a common size income statement, each line item is expressed as a percentage of sales. For example, if a company's revenue is $1 million and its cost of goods sold is $500,000, then the cost of goods sold is expressed as 50% of sales. This is calculated by dividing the cost of goods sold by revenue and multiplying by 100.

To create a common size balance sheet, each line item is expressed as a percentage of total assets. For example, if a company has total assets of $10 million and its inventory is valued at $1 million, then inventory is expressed as 10% of total assets. This is calculated by dividing inventory by total assets and multiplying by 100.

In conclusion, common size financial statements are an essential tool for financial analysis. They help to identify trends and patterns in a company's financial data, provide a more accurate picture of a company's financial health and performance, and can be used to compare companies of different sizes and in different industries on a more equal basis. By creating common size financial statements, investors and analysts can make more informed decisions about investing, lending, or managing finances.