The common-size approach is a useful technique for analyzing financial statements that involves expressing each line item as a percentage of a common base, typically total revenue for the income statement and total assets for the balance sheet. This approach allows for easy comparison between different companies, different periods, or different categories within a statement. Here’s how you can analyze the statement of profit or loss (income statement) and the statement of financial position (balance sheet) using the common-size approach:
Statement of Profit or Loss (Income Statement): In the income statement, each line item is presented as a percentage of the total revenue. This helps identify the relative proportion of different expense and income items in relation to the company’s revenue.
For example, let’s assume the following simplified income statement for Company XYZ:
| Income Statement | Amount (Ksh) |
|---|---|
| Revenue | 500,000 |
| Cost of Goods Sold | 300,000 |
| Gross Profit | 200,000 |
| Operating Expenses | 100,000 |
| Net Income | 100,000 |
To convert this income statement into a common-size format, divide each line item by the total revenue and multiply by 100:
| Common-Size Income Statement | Percentage |
|---|---|
| Revenue | 100% |
| Cost of Goods Sold | 60% |
| Gross Profit | 40% |
| Operating Expenses | 20% |
| Net Income | 20% |
Statement of Financial Position (Balance Sheet): In the balance sheet, each line item is expressed as a percentage of total assets. This helps evaluate the composition of the company’s assets and liabilities in relation to its total assets.
For example, let’s assume the following simplified balance sheet for Company XYZ:
| Balance Sheet | Amount (Ksh) |
|---|---|
| Cash | 50,000 |
| Accounts Receivable | 30,000 |
| Inventory | 20,000 |
| Total Current Assets | 100,000 |
| Property, Plant, Equipment | 200,000 |
| Total Assets | 300,000 |
| Accounts Payable | 40,000 |
| Short-Term Debt | 10,000 |
| Total Current Liabilities | 50,000 |
| Long-Term Debt | 150,000 |
| Equity | 100,000 |
| Total Liabilities & Equity | 300,000 |
To convert this balance sheet into a common-size format, divide each line item by the total assets and multiply by 100:
| Common-Size Balance Sheet | Percentage |
|---|---|
| Cash | 16.67% |
| Accounts Receivable | 10.00% |
| Inventory | 6.67% |
| Total Current Assets | 33.33% |
| Property, Plant, Equipment | 66.67% |
| Total Assets | 100% |
| Accounts Payable | 13.33% |
| Short-Term Debt | 3.33% |
| Total Current Liabilities | 16.67% |
| Long-Term Debt | 50.00% |
| Equity | 33.33% |
| Total Liabilities & Equity | 100% |
Using the common-size approach for both the income statement and the balance sheet can provide a clearer understanding of the company’s financial structure, trends, and performance, and it facilitates meaningful comparisons with other companies or industry standards.