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
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%).
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.
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.
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.
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