Convert Balance Sheets to Common-size Balance Sheets

Introduction

Converting a company’s balance sheet into a common-size balance sheet is a very useful tool for providing insight into the 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, which 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 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 methods.

Example of a Vertical Common-size Analysis

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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?

A. In a vertical common-size analysis, each balance sheet item is stated as a percentage of total assets.

B. A common-size analysis can be used to compare a company’s balance sheet composition over time.

C. A common-size analysis cannot assist with making a comparison across companies in the same industry.

Solution

The correct answer is C.

Statements A and B are accurate statements, however, statement 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:

A. Total assets.

B. Total equity.

C. 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.

 

Reading 25 LOS 25g:

Convert balance sheets to common-size balance sheets and interpret common size balance sheets

 

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