What is the Common Size Ratio?
The Common Size Ratio refers to any number on a business’ financial statements that is expressed as a percentage of a base.
Global Common Size Ratios
Global common size ratios express a number on a business’ financial statement as a percentage of a denominating relevant number on the statement. Thus, all the percentages shown can be easily interpreted and compared to other line items in the financial statement.
Consider BCD Cookies Ltd, which is an organization that wants to conduct financial statements analysis. The first step to better understanding the cost breakdown of the enterprise is to convert its statements into the common-size format. Take for instance the income statement – which can be converted to express a common size ratio by dividing all line items by the top line revenue. Below is a snippet of what it would look like:
The same methodology can also be applied to the business’ other financial statements in order to get a different perspective of their composition. For the balance sheet, you can focus on the asset section and divide all line items by the business’ total assets to better understand the company. By doing so, you can examine individual asset accounts and get a better understanding of their respective weights on the balance sheet.
With the cash flow statement, you can divide the statement into its three parts (financing activities, investing activities, and operating activities) and compute the relevant common size ratio by dividing the line items by the net cash flow for the specific section of the statement. Conversely, you can take a broader view of the business’ cash situation by dividing all line items by the net cash flow amount.
Tailored Common Size Ratios
Consider again BCD Cookies, which recently reported a revenue of $5 million. Jack, the business owner, wants to express the figure as a function of a base. First off, he must find a base that is relevant to the analysis that he wants to conduct.
Supposing that Jack wants to gather additional insights about the way that his business costs are laid out, he may use the cost of goods sold (COGS) as a base. Supposing that the business posted a COGS of $2 million, the common size revenue per COGS would be (5 / 2) x 100 = 250%. The number could also be expressed as a multiple such as 2.5x. Thus, Jack is able to conclude that his revenue is 2.5x the business’ COGS.
While the common size approach may be useful in conducting financial statement analysis, it may sometimes be quite difficult to derive meaning from the ratios.
Using Common Size Ratios
Common size ratios can be very useful when trying to get a better understanding of a business, but they need to be examined within a certain context in order to derive meaningful conclusions.
Common size ratios are most effective when compared across multiple companies that operate in the same industry as it will enable us to rank companies based on specific metrics. It can help with the identification of strengths and weaknesses, which can, in turn, encourage changes to the business’ overall strategy.
Common size ratios are also very useful when compared over a certain time period. It will enable us to more easily observe trends in specific metrics and, in turn, adjust the business’ strategy in order to arrive at a more optimal outcome.
When comparing any two common size ratios, it is important to make sure that they are computed by using the same base figure since failure to do so will render the comparison meaningless.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: