Question: 

How to compare the financial statements of different organizations and what isCommon Size analysis  ?

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BeingSkilled's picture

If investors want to compare the financial statements of different organizations, then there needs to be some commonality so that two totally different businesses from different industries even from different countries can be compared.

This is important because when you want to invest in companies, you need higher returns and therefore investor needs to understand and compare the profit, losses, size, growth and other important parameters of the companies.

One cannot compare financial statements of different organizations directly as that can lead to incorrect judgements due to difference in currency values, size of company. Therefore common size analysis is used for decision making were common size financial statements are preared. In this, all financial statements are reported in form of percentage.

Base figure is taken which is divided with all items in the statement and are reported as percentage of gross sales.

Reasons to use Common Size analysis are:

  1. Comparision can be done between different periods.

  2. Comparison can be done among competitors

  3. Comparing financial statements with global companies where currency is different

Towo types of common size analysis are:

1. Horizontal Common Size Analysis

It uses one type of financial statement at a time. It compares several consecutive years, usually 3 and more to measure long-term trends in the organization’s growth and performance.
Baseline year is compared with following years and we can see the growth pattern.

  page1image15688

Previous Year

Percentage ( 2016 )

page1image18176

Current Year

page1image19392

Percentage ( 2017 )

2016

page1image22880

page1image23200

2017

page1image24976

Net sales

975

100.00%

1200

page1image28888

123.08%

Less: Cost of goods sold

438.75

100.00%

page1image34440

600

page1image35792

136.75%

Gross profit

536.25

100.00%

600

page1image42112

111.89%

Less: Selling and distribution Exp.

140

100.00%

180

128.57%

Operating Profit

page1image49184

396

100.00%

420

106.06%

Less: Interest expenses

page1image55472

101

page1image56720

100.00%

126

124.75%

Earnings before taxes

295

100.00%

294

99.66%

Less: Taxes

118

page1image68536

100.00%

page1image70072

117.6

99.66%

Earnings after taxes

177

page1image75928

100.00%

176.4

99.66%

We perform the calculations as follows:

  1. ((Net Sales in 2017) / (Net Sales in 2016) )* 100 = 123%

  2. ((Cost of Goods Sold in 2017) / (Cost of Goods Sold in 2016) )* 100 = 136%

  3. ((Gross Profit in 2017) / (Gross Profit in 2016) )* 100 = 111.8%

and so on.

In this, we can observe that Net Sales have drastically growth from 975 to 1200 which means net sales has grown to 123% in 1 year. Likewise, COGS has growth to 136%, Gross Profit has grown to 111%, Operating Profit has grown to 106%. The only components which displayed minuscule reduction are Earnings before taxes, Less: Taxes, Earnings after taxes.

2. Vertical Common Size Analysis

It refers to propotional analysis of the financial statements. In Vertical common size analysis, each item is recorded as percentage of base item which is the gross sales ( whenever Income Statement is taken ) and when Balance sheet of the organization is undertaken, total Assets is taken as base and is divided with each of the items in the financial statement.

In the question below,since it is an income statement, we have taken Net Sales as the Base value and each of the items such as COGS, Gross profit, Less: Selling and Distribution expenditure, operating profit, all are divided by the Net Sales to calculate the percentage.

Vertical Common Size Analysis of Income Statement 1:

  page2image12200

Previous Year

Percentage ( 2016 )

page2image14736

page2image15200

2016

Net sales

page2image17800

975

page2image19280

100.00%

Less: Cost of goods sold

page2image22032

438.75

page2image23384

page2image24104

45.00%

page2image25136

Gross profit

536.25

55.00%

Less: Selling and distribution Exp.

page2image29672

140

page2image31448

page2image31744

14.36%

Operating Profit

396

page2image35216

40.62%

page2image36536

Less: Interest expenses

101

10.36%

Earnings before taxes

page2image41032

295

page2image42808

page2image43104

30.26%

Less: Taxes

118

12.10%

Earnings after taxes

page2image49264page2image49424

177

page2image51440

18.15%

Vertical Common Size Analysis of Income Statement 2:

page2image54616

Current Year

Percentage ( 2017 )

page2image58640

2017

Net sales

1200

100.00%

Less: Cost of goods sold

600

50.00%

Gross profit

600

50.00%

Less: Selling and distribution Exp.

page2image72976

180

page2image75048

15.00%

Operating Profit

420

35.00%

Less: Interest expenses

126

10.50%

Earnings before taxes

294

24.50%

Less: Taxes

117.6

9.80%

Earnings after taxes

176.4

14.70%

For deeper analysis, users can also take total liabilities as the base for calculating the liabilities in the balance sheet.

Findings:

  1. Operating Profit has increased in 2017 as compared to 2016.

  2. Earnings after tax with respect to sales have decreased.

  3. Net sales have increased but with respect to Net sales in 2017, comparing with 2016, it has

    decreased.

So, this is how we convert any financial statement into a common size income statement.