Convert Balance Sheets to Common-size Balance Sheets

Converting a company’s balance sheet into a common-size balance sheet is a very useful tool for providing insight into a company’s liquidity as well as its solvency.

Common-sizing the balance sheet can assist with time-series analysis by comparing the company’s balance sheet composition over time. It can also assist with cross-sectional analysis by looking across companies in the same industry or sector. Indeed, the cross-sectional analysis may even highlight differences that exist between two or more companies’ strategies.

Common-sizing the Balance Sheet

There are two primary methods for common-sizing the balance sheet: vertical common-size analysis, and horizontal common-size analysis.

The vertical common-size analysis involves stating each balance sheet item as a percentage of total assets, while the horizontal common-size analysis reflects quantities on the balance sheet in terms of a base-year value of choice. The vertical common-size analysis is, however, the more popular of the two methods.

Example of a Vertical Common-size Analysis

$$ \begin{array}{l|r|r} {} & \bf {\text{Dec }31,2016} & \bf{Common-} \\ \text{} & \bf{($)} & \bf{size} \\ {} & {} & \bf{\text{balance-}} \\ \textbf{Assets} & {} & \bf{\text{sheet }(\%)} \\ \hline \text{Current Assets} & {} & {} \\ \hline {\quad \quad \text{Cash and cash equivalents}} & {100,000} & {0.8} \\ \hline {\quad \quad \text{Short-term marketable securities}} & {1,234,678} & {9.7} \\ \hline {\quad \quad \text{Accounts receivable}} & {52,000} & {0.4} \\ \hline {\quad \quad \text{Inventory}} & {1,170,356} & {9.2} \\ \hline \text{Total current assets} & {2,557,034} & {20.0} \\ \hline \text{Property, plant and equipment} & {6,834,190} & {53.6} \\ \hline \text{Intangible assets} & {3,370,041} & {26.4} \\ \hline \textbf{Total assets} & \bf{12,761,265} & \bf {100.0} \\ \hline \textbf{Liabilities and shareholders’ equity} & {} & {} \\ \hline \text{Current liabilities} & {} & {} \\ \hline {\quad \quad \text{Accounts payable}} & {3,825,396} & {30.0} \\ \hline \text{Total current liabilities} & {3,825,396} & {30.0} \\ \hline \text{Bonds payable} & {3,771,894} & {29.6} \\ \hline \text{Total liabilities} & {7,597,290} & {59.5} \\ \hline \text{Total shareholders’ equity} & {5,163,975} & {40.5} \\ \hline \textbf{Total liabilities and shareholders’ equity} & \bf {12,761,265} & \bf {100.0} \\ \end{array} $$

An analysis of data in the table above reveals that property, plant, and equipment, at 53.6%, make up the lion’s share of the company’s assets. The company does not have much cash and cash equivalents (0.8%), and most of its debt is in the form of accounts payable (30.0%). Also, there is no working capital as current assets (20.0%) is less than current liabilities (30.0%).

Question 1

Which of the following statements is incorrect?

1. In a vertical common-size analysis, each balance sheet item is stated as a percentage of total assets.
2. A common-size analysis can be used to compare a company’s balance sheet composition over time.
3. A common-size analysis cannot assist with making a comparison across companies in the same industry.

Solution

The correct answer is C.

Options A and B are accurate statements. However, option C is inaccurate because common-size analysis can, in fact, assist with making a comparison across companies in the same industry.

Question 2

To convert a regular balance sheet into a common-size balance sheet, each line item is stated as a percentage of:

1. Total assets.
2. Total equity.
3. Total liabilities.

Solution

The correct answer is A.

Making a common-size balance sheet requires stating each line item as a percentage of total assets.