Financial statements are reports that provide information to their users regarding different aspects of the business. All businesses must produce financial statements. Sometimes, businesses prepare financial statements because they are required by relevant rules and regulations. However, some businesses, that are not required by rules and regulations, may also prepare financial statements voluntarily to satisfy the needs of their stakeholders. For example, sole proprietorships, in some jurisdictions are not required to prepare financial statements. However, they may still not choose to do so to provide information regarding the business to banks and other financial institutions to obtain a loan.
There are four main financial statements that businesses must prepare. However, for some businesses, only two main financial statements may be required. These two main financial statements are the Balance Sheet (also known as the Statement of Financial Position) and the Income Statement (also known as Statement of Profit or Loss). The other two financial statements are the Cash Flow Statement (also known as Statement of Cash Flows) and Statement of Owner’s Equity. These financial statements also come with some notes. These notes consist of breakups and details regarding the figures reported in the other financial statements.
These financial statements report different values related to different aspects of the business. These values are reported in monetary terms. However, in some cases, these can also be reported in percentages instead of monetary terms. These are known as common size financial statements.
What is a Common Size Balance Sheet?
As mentioned above, a balance sheet is one of the important financial statements that every business must produce. The balance sheet of business contains information regarding the position of a business at a specific date. The position is reported in the form of account balances and in monetary terms. However, when these account balances are reported in percentages rather than monetary values, it is known as a common size balance sheet.
A common size balance sheet is less frequently used within businesses. In a common size balance sheet, every balance is reported as a proportion of the total assets of a business. The total assets of a business will always be equal to the sum of its equity and total liabilities. Therefore, the total assets and owners’ equity plus total liabilities can be used interchangeably. However, total assets are used as a base more commonly.
The common size balance sheet is not required by any major accounting standards around the world such as IFRS or GAAP. Therefore, there are no specific rules or formats that dictate or require the preparation of this type of balance sheet. However, businesses can voluntarily report the percentages of line items on their balance sheet. It is also often used internally by the management of a business for different purposes. Similarly, external auditors also use a common size balance sheet for better analysis of the position of the business.
The common balance sheet can be presented as two columns with percentages only. However, most commonly, it is presented as an extension of the balance sheet. Two columns are added to the end of the balance sheet representing two years which a balance sheet reports. In these columns, the relative percentages of the balance sheet items are presented. This helps the user easily view both the proportion and monetary value of a balance.
Types of Common Size Balance Sheet
There are two different types of common size balance sheets. The first type, which is the most common type, is known as a vertical common size balance sheet. In this type of a balance sheet, the percentage of each line item of a balance sheet is stated as a proportion of the total assets of the balance sheet. For example, in a vertical analysis the Account Receivable balance will be reported as a percentage of the total assets of the business for the same year.
The second type is a horizontal common size balance. This type of common size balance sheet is not commonly prepared by businesses for reporting purposes. Unlike the vertical type, the horizontal type of common balance sheet reports the percentages of each line items of a balance sheet as a proportion of the previous year balance. This can allow businesses to easily compare different line items and evaluate changes over a period.
How is a Common Size Balance Sheet Used?
A common size balance sheet can be used for several purposes. First of all, it allows for comparison between relative percentages of balance sheet line items. This allows the user of the financial statements to easily identify any drastic changes within the balances for the years reported. However, for the comparison to be possible, the balance sheet should report at least two years of percentages. This can be helpful for different users such as investors and owners who can make decisions regarding their investment in the business based on the comparison.
The common size balance sheet and common size financial statements can provide a great way to compare businesses of different sizes. However, this comparison must be made for businesses that are similar to each other, for example, competitors or businesses within the same industry. Using a common size balance sheet as a comparison tool can give the users of the financial statements some useful information regarding the position of a business as compared to other similar businesses.
It can also give the users of financial statements useful insights into the capital and working capital structure of a business. Using this information, investors and owners of a business can determine an optimal capital and working capital structures of an industry as a whole. Once the optimal structures for the industry are determined, they can use it to compare the information with the specific business.
As mentioned above, it can also be used by the external auditors of a business as a part of analytical procedures. Auditors can compare the common size balance sheet of business with prior year’s information or other businesses to detect any unexpected changes within account balances. If any suspicious changes are detected, auditors can investigate the changes and ascertain that these changes have not occurred due to fraud or error.
A company, ABC Co. prepared the following balance sheet for a year of its business.
|As at December 31, 20XXX|
|Property, plant and equipment||100,000||105,000|
|Cash and Bank||8,000||7,000|
|Equity and Liabilities|
|Total Equity and Liabilities||170,000||168,000|
Using this balance sheet as a base, ABC Co. also prepared a common size balance sheet. The common size balance sheet is as below.
|As at December 31, 20XXX|
|Property, plant and equipment||100,000||105,000||59%||63%|
|Cash and Bank||8,000||7,000||5%||4%|
|Equity and Liabilities|
|Total Equity and Liabilities||170,000||168,000|
ABC Co. based their common size balance sheet calculations on the total assets of the company. Therefore, all the percentages are a proportion of the total assets of the company.
The common size balance sheet has some advantages as follow:
Easy to Understand
The first advantage is that it is easy to understand. The users of financial statements don’t need to have any technical knowledge to understand how common size balance sheets work. Similarly, since the balance sheet line items are reported in percentages, they can be easier to interpret as compared to numbers.
Useful for Analytical Techniques
The common size balance sheet can also be used in different analytical techniques such as time series or trend analysis. This helps the users of the financial statements identify any trends or patterns that exist in the balance sheet of the business. These techniques can be useful for the stakeholders of a business such as potential investors and owners. Similarly, the auditors of a business can also use these techniques as a part of their audit procedures.
Allow for Better Comparison
As mentioned above, common size balance sheets also allow for better comparisons. Users can compare the position of a business with that of other businesses to identify any changes. Not only can it be used for comparisons between two businesses, but can also be used for comparison of a business with its historical positions. Furthermore, the two types of common size balance sheets, vertical and horizontal, allow for different types of useful comparisons to be made.
Useful in Determining Different Structures of a Business
Finally, common size balance sheets are also useful in determining different structures of a business. As mentioned above, users of the financial statements can use it to determine the capital and working capital structure of a business and how they have changed over a period. Similarly, it can help users identify the correlation between different components of a balance sheet.
While common size balance sheets are useful for business as demonstrated above, they may have some disadvantages as well. Below are the advantages of this analysis tool:
No Standard of Preparation
The first disadvantage of common size balance sheet or financial statements is that there is no set standard for their preparation. Therefore, different businesses will prepare it using different basis or may use different types of common size balance sheets. This makes the comparison more difficult with other businesses.
Provides Inconsistent Comparison
Similarly, if a business does not use the same consistent basis and type of common size balance sheet, then it may be difficult for the users of its financial statements to use it comparatively. For example, if a business makes vertical common sized balance sheet one year but switches to a horizontal one the next year, then the users of its financial statements may find it confusing.
Unable to Measure Liquidity and Solvency Position
While a common size balance sheet can help users identify the working capital structure of a business, it cannot measure the liquidity or solvency position of a business. To measure these, users must use other ratios such as Current Ratio or Quick Test Ratio. Similarly, while a common size balance sheet can be used to determine the capital structure of a business, users should use other ratios such as Gearing Ratio for more advanced decisions.
Still Be Manipulated by a Business
Finally, while a common size balance sheet can also be utilized by auditors of a business, it can still be manipulated by the business. This is mainly due to its percentages being based on the monetary value of account balances. Any manipulations to these account balances are also carried over to common size balance sheet. Therefore, auditors cannot fully rely on it for audit procedures.
Businesses prepare financial statements to satisfy the needs of their stakeholders. There are four financial statements that businesses must prepare. These financial statements are prepared in monetary values, however, can also be prepared in percentages or proportions. When financial statements are prepared in percentages rather than monetary value, they are known as common size financial statements. A common size balance sheet is prepared by calculating the proportion of balance sheet line items based on the total assets of the business.