If your first question is, what is a common size financial statement, don’t worry I’ll get to it in a bit.
Most people are familiar with the regular financial statements: the balance sheet, income statement, cashflow statement, and statement of owner’s equity. If you’re a business person, you should be aware of how the statements interact with each other: the balance sheet summarizes the current financial position of the company, it’s assets, liabilities and accounts. The income statement summarizes the results of the current operating period, usually at the end but also quarter on quarter giving you all the revenue numbers, expenses, depreciation and profits for the period. The cashflow statement summarizes the inflows and outflows of cash and their sources, and the statement of equity gives a picture of the invested capitals of the shareholders, retained earnings, dividends paid out etc.
Basically, financial accounting 101.
However, for a business, it is sometimes necessary to compare different accounts or categories of statements in order to know how you are performing. These are the essence of financial ratios like gross margin which is gross profits divided by total revenue, or the ratio of debt to equity which gives insight to the capital structure, or liquidity or capital ratio i.e. current assets/current liability which measures how easily a company can pay off it’s current debts. All of these accounts and classification are in the balance sheet and usually, a company’s accountant will pick off the numbers she needs to calculate those ratios. However, it gets cumbersome having to jump from section to section to manually calculate these ratios and that is where the common size financials come in.
The common size financial statement records each financial statement item as a percentage of a base figure it is most often measured against. For instance, most items on a balance sheet are measures as a percentage of total assets. For the income statement and cash flow statement, they are most often measured against total revenues. So when you record current liabilities for instance, you have a column that shows the ratio of common liabilities to total assets.
Here’s an example below.
As you can see, with a quick glance, I can tell that around 2% of my total assets is cash, while at least 30% of all assets are current. That way I can easily tell if I’m going to run into some cash issues soon, and if too much of my assets are tied up in inventory or receivables, which may necessitate a change in my financing policies. From an investor standpoint, it also makes it fairly easy to compare several companies and see which one is more productive and efficient with assets, which one is more liquid and so on.
In the income statement, the same idea holds but I can easily see what my salaries expense is as a percentage of total revenue, what my capex is as a % of total revenue and so on.
It’s a useful presentation tool and personally, it’s my preferred way to analyze a lot of the same companies at once. I simply create a model in excel and then plug in their numbers, and the ratios automatically calculate. Something some of you might find handy for your own analysis.
Hit me with questions or insights or point out anything you don’t get clearly.