Need Help? Give us a call.
1 (800) 345-3452
Regularly analyzing your financial statements is essential to the health of your business. First off, doing so can help you identify trends that could signify problems in your business, so you can amend them before they become insurmountable. Beyond identifying problems, though, regular financial statement analysis also helps you identify opportunities for growth and profitability improvements. Common size analysis is just one of these crucial methods.
Many business owners focus almost exclusively on the dollar figures on their financial statements. Although these figures are important, they can easily skew your perception of how your business is actually performing, especially over time or in comparison to other businesses in your industry.
One of the most effective tools to accurately analyze your financial statements is common size analysis. Here, we’ll explore this powerful tool, why you should use it (and how it can even help you when applying for a business loan), and how to perform common size analysis on several of your financial statements.
Common size analysis leverages the power of percentages to help you determine how your business is performing. Percentages are a financial analyst’s best friend, because they equalize the analysis of businesses of differing sizes.
Let’s say you have a relatively new—and small—software development firm. You’re seeking investors for your firm, but because you’re new and small, your business’s numbers can’t compare with a larger, more established firm. Or, at least they can’t if you only look at the dollar amounts on your financial statements.
If you use common size analysis, however, you can show how your business stacks up percentage-wise with another business, even if that business is substantially larger.
Even if you aren’t looking for investors for your business, common size analysis can help you analyze your business from a managerial perspective.
When your focus is strictly on dollar amounts, you may be lured into a false sense of security by higher revenues or lower expenses. Likewise, a dip in revenue might cause you undue panic if you’re only focused on the dollar figures on your financial statements.
Common size analysis focuses on the line items on your financial statements as a percentage of a selected (or common) figure. So, you can quickly and easily see the true impact your business’s activities have on your business’s financial well-being, regardless of your business’s size.
Now that you understand the benefits of common size analysis, we’ll show you how to create these reports.
Common size analysis can be done either vertically or horizontally. Each method provides different information and can be used for different purposes, but both are highly effective tools to give you insight on your business’s health and performance.
Common size vertical analysis lets you see how certain figures in your business compare with a selected figure in one given time period.
An example of this is an analysis of your expenses as a percentage of income. Using common size vertical analysis, you can quickly see what percentage of your income is used to support each expense in your business during the month, quarter, or year. You can then use this information to compare your business’s performance to other businesses in your industry.
Common size vertical analysis is important if you’re using key performance indicators (KPIs) to measure your business’s performance and profitability. This “all things being equal” approach lets you compare your business to your competitors’ businesses, regardless of any size differences. In fact, it’s not unheard of for a small, up-and-coming business to outperform larger, well-established businesses in a common size vertical analysis.
Common size horizontal analysis, on the other hand, lets you analyze changes in your financial position over two or more time periods.
Let’s say your business landed a large contract, which resulted in a $50,000 boost in income between the first and second quarter of the year. To support the increased business, you also had to incur additional expenses for payroll, software, rent, and other administrative costs.
If you only considered the dollar amounts on your financial statements, it would be very difficult to determine exactly how your business performed in the second quarter compared to the first quarter. Sure, your numbers grew in size, but did you actually perform better than you did when you had less revenue? Many business owners believe an increase in revenue automatically leads to better business performance, but this isn’t always the case.
With a common size horizontal analysis, you can easily see if your expenses increased as a percentage of revenue, stayed the same, or, ideally, decreased. Decreased expenses as a percentage of revenue can indicate that your business is operating at a higher level of efficiency, which in turn leads to better profitability. Increased expenses as a percentage of revenue, on the other hand, can indicate that you lost some efficiency as your revenue grew. This must be corrected immediately to maintain your business’s profitability.
All three of the primary financial statements—the income statement (or profit and loss statement), balance sheet, and statement of cash flow—can be put through common size analysis. Let’s look at each one of these individually.
Most often, business owners perform common size analysis on their income statements. This is likely because business owners simply review their P&L statements more frequently than they do other financial statements in their arsenals.
To perform a common size income statement analysis, you’ll compare every line on your P&L statement to your total sales. Chances are, you already do at least a partial common size income statement analysis each month: Whenever you analyze your margins—gross profit, net profit, or operating—you’re performing a common size analysis.
But you can perform this analysis on your entire income statement, too. Doing so will help you see at a glance which expenses take up the largest percentage of your revenue. Knowing this percentage, you can then create metrics to track and increase your financial performance, both vertically and horizontally.
Conducting a common size balance sheet analysis can let you quickly see how your assets and liabilities (or debts) stack up. Ideally, you want a low liability-to-asset ratio, as this indicates you will be able to easily pay your business’s obligations.
This low ratio is favorable especially if you’re applying for a business loan, since lenders want to be assured that you’re financially solvent enough to take on and repay additional debt.
As with the common size income statement analysis, the common size cash flow statement analysis largely relies on total sales as the common figure. Here, you’ll render items on your cash flow statement as a percentage of revenue. This analysis lets you see how effectively you’re leveraging the cash in your business, beyond just dollars flowing out of your bank account.
Most commercially available accounting software programs, like QuickBooks Online, actually have at least one common size financial statement available as a standard report. For instance, check out the Profit and Loss Percentage of Total Income report in QuickBooks Online—that’s an example of a vertical common size income statement analysis.
Even if your accounting software doesn’t offer common size analysis of your financial statements as standard reports, you can still use your software to streamline the process. Most accounting software will let you download your financial statements into Excel. Once you’ve downloaded your data, you can simply apply a formula to quickly prepare common size analysis statements.
Most business owners tend to focus primarily—even exclusively—on the dollar figures on their financial statements. But this myopic focus can lead to inaccurate conclusions about the health of the business.
Using common size analysis and the power of percentages can help you gain a deeper understanding of your business. Not only can you use the percentages on common size analysis statements to compare your business to your competitors’, but you can also use them to ensure that your business is growing profitably.
Although a common size analysis can be conducted on any of the primary financial statements, most small business owners will benefit from a common size income statement analysis. If you’re considering applying for a business loan, though, a common size analysis of your balance sheet may help eliminate surprises during the loan approval process, as it can accurately determine your liability-to-asset ratio (in other words, whether you’re able to repay additional debt with your business assets).
Your accounting software probably already has a common size analysis profit and loss statement as part of its standard reports feature. If it doesn’t, though, you can still export your data to Excel and run the analysis yourself.
As always, consider asking your business accountant or bookkeeper for help. Not only can they help you prepare your common size analysis statement, but they can also help you analyze them. That way, you can identify challenges before they spin out of control—and opportunities to maximize your financial growth before you miss them.