The Common-Size Analysis of Financial Statements

A common-size financial statement is displays line items as a percentage of one selected or common figure. Creating common-size financial statements makes it easier to analyze a company over time and compare it with its peers. Using common-size financial statements helps investors spot trends that a raw financial statement may not uncover.

All three of the primary financial statements can be put into a common-size format. Financial statements in dollar amounts can easily be converted to common-size statements using a spreadsheet, or they can be obtained from online resources like Mergent Online. Below is an overview of each statement and a more detailed summary of the benefits, as well as drawbacks, that such an analysis can provide investors.

The common figure for a common-size balance sheet analysis is total assets. Based on the accounting equation, this also equals total liabilities and shareholders’ equity, making either term interchangeable in the analysis. It is also possible to use total liabilities to indicate where a company’s obligations lie and whether it is being conservative or risky in managing its debts.

The common-size strategy from a balance sheet perspective lends insight into a firm’s capital structure and how it compares to rivals. An investor can also look to determine an optimal capital structure for an industry and compare it to the firm being analyzed. Then he or she can conclude whether debt is too high, excess cash is being retained on the balance sheet, or inventories are growing too high. The goodwill level on a balance sheet also helps indicate the extent to which a company has relied on acquisitions for growth.

Below is an example of a common-size balance sheet for technology giant International Business Machines - IBM (NYSE:IBM). Running through some of the examples touched on above, we can see that long-term debt averages around 20% of total assets over the three-year period, which is a reasonable level. It is even more reasonable when observing that cash represents around 10% of total assets, and short-term debt accounts for 6% to 7% of total assets over the past three years.

It is important to add short-term and long-term debt together and compare this amount to total cash on hand in the current assets section. It lets the investor know how much of a cash cushion is available or if a firm is dependent on the markets to refinance debt when it comes due.

The common figure for an income statement is total top-line sales. This is actually the same analysis as calculating a company's margins. For instance, a net profit margin is simply net income divided by sales, which also happens to be a common-size analysis. The same goes for calculating gross and operating margins. The common-size method is appealing for research-intensive companies, for example, because they tend to focus on research and development (R&D) and what it represents as a percent of total sales.

Below is a common-size income statement for IBM. We will cover it in more detail below, but notice the R&D expense that averages close to 6% of revenues. Looking at the peer group and companies overall, according to a Booz & Co. analysis, this puts IBM in the top five among tech giants and the top 20 firms in the world (2013) in terms of total R&D spending as a percent of total sales.

In similar fashion to an income statement analysis, many items in the cash flow statement can be stated as a percent of total sales. This can give insight on a number of cash flow items, including capital expenditures (capex) as a percent of revenue. Share repurchase activity can also be put into context as a percent of the total top line. Debt issuance is another important figure in proportion to the amount of annual sales it helps generate. Because these items are calculated as a percent of sales, they help indicate the extent to which they are being utilized to generate overall revenue.

Below is IBM’s cash flow statement in terms of total sales. It generated an impressive level of operating cash flow that averaged 19% of sales over the three-year period from 2010 to 2012. Share repurchase activity was also impressive at more than 11% of total sales in each of the three years. You may also notice the first row, which is net income as a percent of total sales, which matches exactly with the common-size analysis from an income statement perspective. This represents the net profit margin.

The key benefit of a common-size analysis is it allows for a vertical analysis by line item over a single time period, such as a quarterly or annual period, and also from a horizontal perspective over a time period such as the three years we analyzed for IBM above.

Just looking at a raw financial statement makes this more difficult. But looking up and down a financial statement, using a vertical analysis allows an investor to catch significant changes at a company on his or her own. A common-size analysis helps put an analysis in context (on a percentage basis). It is the same as a ratio analysis when looking at the profit and loss statement.

The biggest benefit of a common-size analysis is that it can let an investor identify large or drastic changes in a firm’s financials. Rapid increases or decreases will be readily observable, such as a rapid drop in reported profits during one quarter or year.

In IBM's case, its results overall have been relatively steady. One item of note is the Treasury stock in the balance sheet, which has grown to more than a negative 100% of total assets. But rather than alarm investors, it indicates the company has been hugely successful in generating cash to buy back shares, which far exceeds what it has retained on its balance sheet.

A common-size analysis can also give insight into the different strategies that companies pursue. For instance, one company may be willing to sacrifice margins for market share, which would tend to make overall sales larger at the expense of gross, operating or net profit margins. Ideally the company that pursues lower margins will grow faster. While we looked at IBM on a stand-alone basis, like the R&D analysis, IBM should also be analyzed by comparing it to key rivals.

As the above scenario highlights, a common-size analysis on its own is unlikely to provide a comprehensive and clear conclusion on a company. It must be done in the context of an overall financial statement analysis, as detailed above.

Investors also need to be aware of temporary versus permanent differences. A short-term drop in profitability could only indicate a short-term blip, rather than a permanent loss in profit margins.