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Principles of Finance

5.7 Common-Size Statements

Principles of Finance5.7 Common-Size Statements

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Prepare common-size statements.
  • Assess organizational performance using common-size statements.
  • Use industry comparisons to assess organizational performance.

Common-Size Income Statements

A common-size income statement is created by restating each line as a percentage of net sales. Expressing each item on the income statement as a percentage rather than in absolute dollars makes it much easier to make comparisons, particularly to other divisions or competitors of varying sizes. The formula to calculate each item on the income statement is:

Common-Size Item=IncomeStatementLineItemNetSalesCommon-Size Item=IncomeStatementLineItemNetSales

Using Clear Lake Sporting Goods’ current year income statement, we can see how each line item in it is divided by net sales in order to assemble a common-size income statement (see Figure 5.20).

Common-Size Income Statement for Clear Lake Sporting Goods showing the current year's income, current year percentage, and formula. The net income is $35,000 is about 29% of the net sales. This was calculated by dividing 35,000 (net income) by 120,000 (net sales).
Figure 5.20 Common-Size Income Statement

It may seem cumbersome to create a common-size statement. However, a simple tool like Microsoft Excel can be quite handy in making the process easier and faster. The same formula can be copied and replicated in each income statement line, making the calculations much faster. In Figure 5.21, you can see the formulas used to create Clear Lake Sporting Goods’ common-size income statement in Excel. Notice that the $ can be inserted to anchor a cell reference, making it easier to copy and paste the same formula onto many lines or columns.

Clear Lake Sporting Goods Common-Size Balance Sheet with Excel Formulas. The Excel formula used to determine percentages is =B4/B$11. In this formula, the first cell reference after the equals sign represents the dollar amount for the line item you are working with. B$11 represents the total assets.
Figure 5.21 Clear Lake Sporting Goods Common-Size Income Statements with Excel Formulas

Common-Size Balance Sheet

The common-size balance sheet functions much like the common-size income statement. Each line item on the balance sheet is restated as a percentage of total assets.

Common-Size Item=BalanceSheetLineItemTotalAssetsCommon-Size Item=BalanceSheetLineItemTotalAssets

Using Clear Lake Sporting Goods’ current balance sheet, we can see how each line item in its statement is divided by total assets in order to assemble a common-size balance sheet (see Figure 5.22).

Comparative year-end balance sheets for Clear Lake Sporting Good’s shows the current year amounts, current year percentage, and formula for assets, liabilities, and stockholder equity. For example, Accounts receivable ($30,000) is divided by the Total Liabilities and Equity figure ($250,000) to derive 12% of the current year’s total.
Figure 5.22 Common-Size Balance Sheet

Excel can also be used to create a common-size balance sheet. Once the formula is created, it can be copied into each line, making the process to create a common-size statement much easier (see Figure 5.23):

Clear Lake Sporting Good Common-Size Balance Sheet with Excel Formulas. It shows the percentage figures of various assets and liabilities against the total assets and total liabilities.
Figure 5.23 Common-Size Balance Sheet with Excel Formulas

It is important to note that while we have provided two years of data here to explore the process, when performing analysis for a firm or investment, several years of data are commonly used to provide a better view of historical performance.

Analyzing Organizational Performance

Common-size financial statements facilitate the analysis of financial performance by converting each element of the statements to a percentage. This makes it easier to compare figures from one period to the next, compare departments within an organization, and compare the firm to other companies of any size as well as industry averages. On the income statement, analysts can see how much of sales revenue is spent on each type of expense. They can see this breakdown for each firm and compare how different firms function in terms of expenses, proportionally. They can also look at the percentage for each expense over time to see if they are spending more or less on certain areas of the business, such as research and development. On the balance sheet, analysts commonly look to see the percentage of debt and equity to determine capital structure. They can also quickly see the percentage of current versus noncurrent assets and liabilities.

In Clear Lake Sporting Goods’ common-size income statement for the current and prior years, we can see that cost of goods as a percentage of sales remained the same (see Figure 5.24). This means that while sales increased, so did cost of goods sold, but it increased at the same proportion as sales. No improvement or decline occurred in the company’s cost of goods sold. The same is true for rent, depreciation, and utilities expenses. One key item did change slightly as a percentage: salaries expense. The 2 percent decrease in operating income from the prior year’s 38 percent to the current year’s 36 percent was caused by the increase in salaries expense as a percentage of sales.

Net income, however, only declined by 1 percent from 30 percent in the prior year to 29 percent in the current year because interest expense dropped by 1 percent, offsetting the 2 percent increase in salaries expense.

Common-Size income statement for Clear Lake Sporting Good. It shows the percentage figures of various assets and liabilities against the total assets and total liabilities for the prior and current years. The percentage for most items remained the same year over year. However, the salaries expense rose, both in dollars and percentage. In the prior year, salaries expense was $3,000, representing 3% of the prior year. In the current year, salaries expense is $5,400, representing 5%.
Figure 5.24 Common-Size Income Statement

On the Clear Lake Sporting Goods’ common-size balance sheet, we see that current assets remained at 80 percent of total assets from the prior to current year (see Figure 5.25). The mix of current assets that comprise that 80 percent changed only slightly with a 1 percent decrease in cash, 2 percent increase in accounts receivable, 2 percent decrease in inventory, and no change in short-term investments. Noncurrent assets includes only equipment. While the balance in the equipment account did change as a percentage of total assets, equipment remained the same at 20 percent.

On the debt and equity side of the balance sheet, however, there were a few percentage changes worth noting. In the prior year, the balance sheet reflected 55 percent debt and 45 percent equity. In the current year, that balance shifted to 60 percent debt and 40 percent equity. The firm did issue additional stock and showed an increase in retained earnings, both totaling a $10,000 increase in equity. However, the equity increase was much smaller than the total increase in liabilities of $40,000. Long-term debt increased by only $10,000 by issuing additional notes payable. The remainder of that increase is seen in the 5 percent increase in current liabilities. In that increase, most of it was in unearned revenue.

Common-Size Balance Sheet for Clear Lake Sporting Goods. For each line item, it shows what percentage of total assets and total liabilities that line item represents, for the prior and current years. For example, in the prior year, total liabilities were $110,000 or 55%. In the current year, total liabilities were $150,000 or 60%.
Figure 5.25 Common-Size Balance Sheet

Industry Comparison

Recall that a key benefit of common-size analysis is comparing the firm’s performance to the industry. Expressing the figures on the income statement and balance sheet as percentages rather than raw dollar figures allows for comparison to other companies regardless of size differences.

Clear Lake Sporting Goods, for example, might compare their financial performance on their income statement to a key competitor, Charlie’s Camping World. Charlie is a much bigger retailer for outdoor gear, as Charlie has nearly seven times greater sales than Clear Lake. Common-size statements allow Clear Lake to compare their statements in a meaningful way (see Figure 5.26). Notice that Clear Lake spends 50 percent of its sales on cost of goods sold while Charlie spends 59 percent. This is a significant difference that would be an indicator that Clear Lake and Charlie have key differences in their operations, purchasing policies, or general performance in their core products.

We know that Charlie is a bigger retailer, and we see this clearly in the rent expense as a percentage of sales. Charlie spends 11 percent of its sales on building rent, while Clear Lake spends only 5 percent. A clear difference in performance is hinted at here, alluding to Charlie spending more per square foot on rent or using its retail space differently, causing it to rent more space for its product per sales dollar than Clear Lake does. Depreciation expense, though not a large figure, is smaller for Charlie, giving us a hint that Charlie has less capital equipment than Clear Lake, perhaps tied to the higher rent expense. It is possible that Charlie rents some of its equipment, which would help explain the higher rent percentage. Finally, Charlie’s salaries percentage is significantly higher at 12 percent than Clear Lake’s 5 percent. Though the simple percentage does not tell us why, it does provide us a hint and allow for further questions or investigation. Charlie may pay its employees a much higher wage than Clear Lake. They may also have far more sales associates on the floor in their larger spaces than Clear Lake does in their smaller retail spaces.

Note that although we have compared just two years of data for Charlie and Clear Lake, it is more common to use several years of data to get a more robust view of long-term trends.

Charlie’s Camping World and Clear Lake Sporting Good Comparison of Common-Size Income Statements. It shows the percentage figures of various assets and liabilities against the total assets and total liabilities for the prior and current years. Clear Lake spends 50% of its sales on cost of goods sold while Charlie spends 59%. Charlie spends 11% of its sales on building rent, while Clear Lake spends only 5%. Depreciation expense is smaller for Charlie. Charlie’s salaries percentage is higher at 12% than Clear Lake’s 5%.
Figure 5.26 Comparison of Common-Size Income Statements

Now that you have covered the basic financial statements and a little bit about how they are used, where do we find them? How often are they prepared? Who gets them? In this next section we will explore the requirements for what needs to be reported, when, and to whom.

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