The Algorithm Blog

Common Size Financial Statements—It's a Matter of Perspective

Grand Canyon Aerial vs. Ground (1)
As I am flying over the Grand Canyon, it looks completely different than standing on its rim.  Granted, from both perspectives, it is a really big hole. 

But flying over it gives a fuller sense of the enormity of this natural wonder and the events that created it. 

Sometimes a different perspective helps us understand things better.  Looking at comparative financial statements gives us one perspective, but looking at a common-size statement can help us learn something new. 

Some of you may not be familiar with a common-size statement, so let me take a minute to explain. 

A common-size statement replaces the period activity amounts with a percentage value, usually a percent of revenue on income statements and total assets on the balance sheet. 

Let’s examine some of the benefits of common-size statements. 

First, they bring context to account balances. The idea is not to look at an account for a single period alone, but rather observe changes in activity across multiple periods. 

It is easy to see if the amount of an account or subtotal such as cost of goods sold increases or decreases from period to period, but what does that change mean in relation to the rest of the financials? If revenue increases, you might expect direct labor to increase as well, but did it increase faster than revenues? 

By having several periods, you can spot healthy trends as well as those that need further investigation.

Second, common-size statements make it easier to compare detail to budget, especially when revenue doesn’t match the forecast.  By converting absolute values in the budget and actual results to a percentage, you can see if there are expenses that would create unfavorable variances if adjusted for changes in revenue. 

Common Size Financial StatementsExample of a Common-Size Income Statement

An unfavorable variance is easy to spot for revenue, but as you browse the income statement, you may see favorable variances, especially related to cost of goods sold and possibly even selling, general, and administrative expenses (SG&A).  However, when you put them into an apples-to-apples comparison to the budget, you could discover expenses that need investigating, or control measures to put in place.

Third, they can be used for benchmarking exercises.  Comparing activity levels with an industry peer group, a competitor, or a company you want to emulate can be challenging; especially if they are much larger or smaller. 

Converting actual activity numbers to ratios and common-size reports can help.  While you still may need to consider different accounting methods and effects of their individual strategies, again, you have context for the comparison.

While there may not be value in looking at every account in a common-size statement, you know your business and the key value drivers that need to be monitored.  Create a common-size statement and then plot the change to help visualize the trends, and make sure to add your budget line for a quick comparative view.

The more quality information you have, the better the decisions that can be made.  The easier it is to get a clear understanding of what the information is telling you, the faster decisions can be made. 

As competition gets fiercer and the rate of change accelerates, that can mean the difference between succeeding, surviving and becoming a statistic, or worse a case study. 

A change in perspective may be just what you need.

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