Financial Statements: Using Common-Size Analysis to Evaluate Your Company's Health and Performance
It's common practice to produce balance sheets, profit and loss statements, and cash flow statements showing year-to-year comparisons. The figures for the current year appear in one column, the figures for the comparison year in another.
In general, this is an excellent way to asses your company's overall progress, growth, and financial health. However, for companies which are rapidly building their inventory, their sales, or their scale of operations, such year-to-year comparisons are not always as helpful as you might like.
Questions Your Company Financials Cannot Answer
For example, let's imagine that your inventory storage costs have more than doubled in the last two years. Is that a good thing? Or a bad thing?You can't answer this question with a quick scan of your financial statements, even with year-to-year comparisons side by side. Because the comparisons contrast absolute dollars to absolute dollars, they don't tell you whether your costs per unit of sales are remaining within your target range.
Sure, you could find the answer by doing some side calculations. But what if you could answer this question, and dozens like it, with only a glance? How helpful would that be?
The Advantages of Common-Size Analysis
Well, that's precisely the benefit of a tool called "common-size analysis." Its purpose is convert your financial statements from dollars into ratios expressed as percentages.
With this conversion you are now able to evaluate two widely differing financial statements by comparing percentages to percentages rather than dollars to dollars.
In effect, you have reduced the contrasting financial statements to one size. That is, each statement has 100 percentage points to distribute, no matter how much the balances and cash flow differ from statement to statement. Hence the name, "common-size analysis."
Once you have made this conversion, it's a relatively simple matter to answer the inventory storage question which we posed earlier.
If your storage costs have doubled in terms of absolute dollars, but they have dropped significantly as a percentage of total sales, then you are probably doing a fairly good job of inventory management. On the other hand, if your storage costs are rising rapidly as a percentage of total sales, you may need to modify your inventory management system to make it more efficient.
Creating the Analysis
The most common software accounting packages for small businesses do not include common-size analysis. You will need to perform this calculation using a spreadsheet.
First, export your balance sheet, your profit and loss statement, and your cash flow statement in a format that your spreadsheet can read. Usually this means an Excel format, as some of the more popular software packages for accounting offer Excel as the only export option.
Once the statements are in your spreadsheet, you will create a new column. Place it to the immediate right of the column which shows the line-by-line dollar amounts for a given statement. In this new column you will convert each dollar amount from the statement into a percentage.
But a percentage of what? The answer depends on the financial statement. Each statement has a unique denominator for making the percentage conversion.
- The balance sheet uses two different denominators, one for the assets section, the other for the liabilities and equity section. In the asset section, you will divide the amount for each line item by the number for total assets. Similarly, line item amounts in the liabilities and equity section are divided by total liabilities and equity.
- For the profit and loss statement, total income (or total sales) is the denominator throughout.
- You also use total income from the profit and loss statement as the denominator on the cash flow statement.
You generate the percentages in the right column by dividing the dollar amount in the left column by the proper denominator, then multiplying by 100.
Making Year to Year Comparisons
Comparing two years side by side is simply an enlargement of this process. Suppose you produce financial reports which show the current year in one column, the previous year in another. Again you would export the report to a spreadsheet. But this time you would create two columns, one to show the percentage distributions for the current year, the other showing the same distributions for the previous year.
Once you have these percentages in front of you, it's a simple matter to scan the change in percentages for each line item and note the year-to-year change. You can easily ask such questions as, "Are my marketing costs going up or down as a percentage of total revenue?" Or, "Is long-term indebtedness increasing or decreasing as a percentage of total assets?"
This is also a wonderful tool for planning purposes. At the first of January produce financial reports showing figures for the previous year and the one before that. Compare the change in percentages between the two years. Then, for your critical line items, set goals for where you want the percentages to be at the end of the current year.
And let me mention one other situation in which common-size analysis is particularly helpful. Consider a case in which your company is contemplating the purchase of a competitor. You might want to know how well the income and expense ratios of the two companies align with each other.
If one company is much larger than the other, you can't quickly determine these ratios by merely laying their financials alongside one another. Common-size analysis, however, quickly gives you the answers you need.
As you can see, common-size analysis is a very practical tool. You may not need it in your first year of operation. But as your new business grows and matures, it will be of ever-increasing value to you as you assess your company's year-to-year performance.
