Common Size Income Statement
Table of Contents
Introduction
When it comes to analyzing a company's financial performance, one of the most important tools is the income statement. This financial statement provides a snapshot of a company's revenues, expenses, and profits over a specific period of time. However, simply looking at the numbers on an income statement may not always provide a clear understanding of a company's financial health. This is where the common size income statement comes into play.
What is a Common Size Income Statement?
A common size income statement is a financial statement that presents all the line items as a percentage of a chosen base figure. This base figure is typically the company's total revenue. By expressing each line item as a percentage of revenue, the common size income statement allows for easy comparison and analysis of a company's financial performance over time or against its competitors.
For example, let's say Company A has total revenue of $1 million, cost of goods sold (COGS) of $600,000, and operating expenses of $300,000. On a traditional income statement, these numbers may not provide much insight. However, if we convert these numbers into percentages of revenue, we can see that COGS represents 60% of revenue and operating expenses represent 30% of revenue. This allows us to compare Company A's cost structure to industry benchmarks or to its own historical performance.
Why is the Common Size Income Statement Useful?
The common size income statement is a powerful tool for financial analysis for several reasons:
- Comparison: By expressing each line item as a percentage of revenue, the common size income statement allows for easy comparison between companies of different sizes or within the same company over time.
- Trend Analysis: The common size income statement helps identify trends in a company's financial performance. For example, if a company's cost of goods sold as a percentage of revenue is increasing over time, it may indicate inefficiencies in the production process or rising input costs.
- Identifying Financial Red Flags: The common size income statement can help identify potential financial red flags. For instance, if a company's selling and administrative expenses as a percentage of revenue are significantly higher than its competitors, it may indicate poor cost management or excessive overhead.
How to Prepare a Common Size Income Statement
Preparing a common size income statement involves converting each line item into a percentage of revenue. Here's a step-by-step guide:
- Gather the necessary financial statements: Start by gathering the company's income statement for the desired period.
- Calculate the base figure: Determine the base figure to which all other line items will be expressed as a percentage. This is typically the total revenue, but it can also be operating revenue or gross profit.
- Convert each line item into a percentage: Divide each line item by the base figure and multiply by 100 to get the percentage. For example, if the cost of goods sold is $600,000 and the total revenue is $1 million, the cost of goods sold as a percentage of revenue would be 60%.
- Present the common size income statement: Organize the converted percentages in a table format, with each line item and its corresponding percentage.
Example of a Common Size Income Statement
Let's take a look at an example of a common size income statement for Company B:
| Line Item | Amount | Percentage of Revenue |
|---|---|---|
| Revenue | $1,500,000 | 100% |
| Cost of Goods Sold | $900,000 | 60% |
| Gross Profit | $600,000 | 40% |
| Operating Expenses | $300,000 | 20% |
| Net Income | $200,000 | 13.33% |
In this example, we can see that the cost of goods sold represents 60% of revenue, while operating expenses represent 20% of revenue. This allows us to easily compare Company B's cost structure to industry benchmarks or to its own historical performance.
Case Study: Common Size Income Statement Analysis
Let's consider a case study to understand how the common size income statement can provide valuable insights. Company C and Company D are two competitors in the retail industry. We will analyze their common size income statements to identify differences in their cost structures.
Company C:
| Line Item | Amount | Percentage of Revenue |
|---|---|---|
| Revenue | $2,000,000 | 100% |
| Cost of Goods Sold | $1,200,000 | 60% |
| Gross Profit | $800,000 | 40% |
| Operating Expenses | $400,000 | 20% |
| Net Income | $400,000 | 20% |
Company D:
| Line Item | Amount | Percentage of Revenue |
|---|---|---|
| Revenue | $2,500,000 | 100% |
| Cost of Goods Sold | $1,750,000 | 70% |
| Gross Profit | $750,000 | 30% |
| Operating Expenses | $400,000 | 16% |
| Net Income | $350,000 | 14% |
In this case study, we can see that Company C has a lower cost of goods sold as a percentage of revenue (60%) compared to Company D (70%). This indicates that Company C has better control over its production costs or benefits from economies of scale. Additionally, Company C has a higher net income margin (20%) compared to Company D (14%), suggesting better overall profitability.
Conclusion
The common size income statement is a valuable tool for financial analysis. By expressing each line item as a percentage of revenue, it allows for easy comparison, trend analysis, and identification of potential financial red flags. By analyzing common size income statements, investors and analysts can gain valuable insights into a company's cost structure, profitability, and overall financial health. Incorporating this tool into financial analysis can lead to more informed decision-making and better understanding of a company's performance.