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Common size analysis displays each line item of your financial statement as a percentage of a base figure. Common size analysis can help you determine how your company is performing year over year, and compared to competitors. It also allows you see the impact of each line item on the overall revenue, cash flow, or asset figures for your company.
Regularly reviewing your financial statements is essential to the health of your business. 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. Most business accounting software offers the option to run a common size financial analysis. By looking at the overall impact of each line item on your financial statements, you can see, for instance, if rent, utilities, or equipment are contributing to the biggest costs for your business. You can also see how costs are breaking down over time.
Despite the help of accounting software, it’s still a good idea to understand the calculations behind common size financial analysis. Here, we’ll explore this powerful tool, why you should use it, and show you some common size analysis examples.
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. For instance, net profit might make up only 5% of the bigger business’s revenues, but net profit might account for 15% of your revenues. That makes your business a good bet for investors.
Common size analysis is an accounting term that 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.
Here is the common size analysis formula:
There are two different types of common size analysis—vertical and horizontal. Although these are a little different, the formula above is the starting point for both. We’ll explain vertical vs. horizontal common analysis, and then show you how to use this formula with a few common size analysis examples.
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 accounting 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 interim financial statements, it would be very difficult to determine exactly how your business performed in the second quarter compared to the first quarter. 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 revenue. In other words, net revenue will be the overall base figure on your common size analysis formula. 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. Here’s an example of a common size income statement, done on a vertical basis and horizontal basis (since the percentages for two years can be compared).
Cost of Goods Sold
Research and Development Expenses
General and Administrative Expenses
Earnings Before Taxes
For each line item on this sample income statement, we’ve shown the percentage that it makes up of total revenue. If you just looked at numbers, it might seem like this company did better in 2018 because sales increased from $500,000 to $600,000. However, net profit only accounted for 10% of 2018 revenue, whereas net profit accounted for more than a quarter of 2017 revenue. The company should look for ways to cut costs and increase sales in order to boost profitability.
Conducting a common size balance sheet analysis can let you quickly see how your assets and liabilities 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.
Common size balance sheets are similar to common size income statements. The only difference is that each line item on this accounting balance sheet is expressed as a percentage of total assets. Total assets are the overall base figure this time.
Total Current Assets
Property, Plant, and Equipment
Total Non-Current Assets
Total Current Liabilities
Pensions and Benefits
Total Non-Current Liabilities
Total Liabilities and Shareholder’s Equity
The sample company is in a pretty good position. The current assets formula determines the “total current assets” which are the total of all assets that can be converted to cash within one year, make up 37% of the company’s total assets. In contrast, current liabilities, which are debts are due within one year, make up only 30% of the company’s total assets. In addition, the company has more total assets than total liabilities.
As with the common size income statement analysis, the common size cash flow statement analysis largely relies on total revenue as the base figure. Here, you’ll render items on your cash flow statement as a percentage of net revenue. This analysis lets you see how effectively you’re leveraging the cash in your business, beyond just dollars flowing into and out of your bank account.
Here’s a sample common size cash flow statement:
Increase in Accounts Receivable
Increase in Inventory
Increase in Accounts Payable
Net Cash Flow from Operating Activities
Increase in Investments
Increase in Property, Plant, and Equipment
Net Cash Flow from Investing Activities
Repayment of Business Loans
New Business Loan Received
Net Cash Flow from Financing Activities
Net Increase in Cash Flow
The analysis shows that the sample company had a positive influx of cash from operating activities in 2018, but this was overshadowed by a bigger increase in expenditures on investment items. Ultimately, positive cash flow from financing activities left the business with a positive cash position of $13,000. That means the company might be too dependent on financing. In the future, the company can improve by decreasing investment expenditures and increasing revenue from operating activities.
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.
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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 most from a common size income statement analysis. 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.