Understanding Common Size Statements in Financial Analysis

Common Size Statements are important tools used in financial analysis to compare financial data over different periods or between different companies. They help to show the relative proportion of each item within a statement compared to a base figure. This standardization makes comparisons easier and more meaningful.

Key Features of Common Size Statements

In a Common Size Statement, each line item is expressed as a percentage of a chosen base amount. This base amount is typically a significant figure within the financial statement.

• For the Common Size Income Statement, the base figure is usually the Revenue from Operations (or Sales). Every other item on the Income Statement, such as Cost of Goods Sold, Operating Expenses, and Net Profit, is expressed as a percentage of Revenue from Operations.
• For the Common Size Balance Sheet, the base figure is usually the Total Assets. Alternatively, Total Liabilities and Shareholders' Equity (which equals Total Assets) can also be used as the base. Every item on the Balance Sheet, such as Fixed Assets, Current Assets, Current Liabilities, Long-term Debt, and Share Capital, is expressed as a percentage of Total Assets.

Vertical vs. Horizontal Analysis

There are different ways to analyze financial statements:

• Vertical Analysis: This involves analyzing the relationship between different items within a single financial statement for a specific period. Common Size Statements are a prime example of vertical analysis. You look "down" the statement, comparing each item to the base figure for that period.
• Horizontal Analysis: This involves analyzing the trend of items over multiple periods. It compares the same line item in financial statements across two or more years to identify increases or decreases, usually in absolute amounts and percentages. Comparative Statements are an example of horizontal analysis. You look "across" the statement, comparing figures from one period to another.

Analyzing the Statements about Common Size Statement

Let's examine each statement given in the question in the context of Common Size Statements:

1. (A) Expressed as a percentage on revenue from operation

   This is correct. In a Common Size Income Statement, each item is typically expressed as a percentage of Revenue from Operations. This helps in understanding how much of each sales dollar is used for different expenses or contributes to profit.

2. (B) Horizontal analysis

   This is incorrect. Common Size Statements are a form of Vertical Analysis, not Horizontal Analysis. They show the relationship between items within a single period's statement.

3. (C) Vertical analysis

   This is correct. As explained above, Common Size Statements analyze the proportional relationship of items within a single financial statement using a base figure, which is the definition of Vertical Analysis.

4. (D) Expressed as a percentage on total assets

   This is correct. In a Common Size Balance Sheet, each item is typically expressed as a percentage of Total Assets. This shows the relative proportion of different assets, liabilities, and equity components within the total structure.

Based on the analysis, statements (A), (C), and (D) are correct in connection with Common Size Statements. Statement (B) is incorrect.

Conclusion

Common Size Statements use vertical analysis to express items as percentages of a base figure (Revenue from Operations for Income Statement, Total Assets for Balance Sheet) to facilitate comparison and analysis of financial structure and performance.

Therefore, the correct statements are (A), (C), and (D).

Revision Table: Common Size Statements

Additional Information: Financial Statement Analysis Tools

Besides Common Size Statements, other techniques are used for financial statement analysis:

• Comparative Statements: These show financial data for two or more periods side-by-side, along with the absolute and percentage change from one period to the next. This is a form of horizontal analysis.
• Ratio Analysis: This involves calculating ratios between different financial statement items to assess aspects like liquidity, solvency, profitability, and efficiency. Ratios can be calculated using data from Common Size Statements or raw financial data.
• Trend Analysis: Similar to horizontal analysis, but often involves comparing data over several periods (more than two) relative to a base year, usually expressed as an index number.

Common Size Statements are particularly useful for comparing companies of different sizes, as the percentages remove the impact of scale.