Your business’s income statement is a long list of dollar figures: revenue, production costs, gross profit, overhead expenses, taxes, and finally, net income. To get a better perspective on these dollar amounts you create a parallel list known as a common size income statement.Here’s more on common size income statements and how you can use them in your business.
What is a common size income statement?
A common size income statement is the presentation of a company’s income and expenses in percentage terms instead of dollar amounts. The percentages reflect the size of an income statement line item—such as cost of goods sold (COGS)—compared to revenue, often referred to as the “top line” of the income statement.
A common size income statement is a quick and handy way of understanding each line item’s relationship to the top line. Business managers and investors use this type of financial statement to analyze a company’s cost ratios and profit margins—and to compare them to those of other companies. Common sizing is also sometimes used for other financial statements, such as the balance sheet and cash flow statement.
The common size statement, like the contribution format income statement, is not a substitute for the traditional income statement that publicly traded companies use when presenting financial data.
How is a common size income statement used?
Businesses and financial managers use common size income statements to track and assess financial performance in the following ways:
You can use a common size statement to examine how each component of your income statement contributes to or reduces profitability.
Managers and investors can use common size income statements to analyze a business’s performance over time to see trends in costs and profit margins.
Managers and investors can also use common size income statements to compare a business’s ratios and margins with other businesses, particularly businesses selling similar products or services.
Eliminate size differences
An important feature of common size income statements is that by using ratios rather than dollar figures, it’s possible to compare companies of very different sizes. So a $10 million company’s cost ratio or profit margin can be compared with those of a $100 million company.
Vertical analysis vs. horizontal analysis
Common size income statement analysis falls into two broad categories: vertical and horizontal.
1. Vertical analysis
Vertical analysis refers to “looking down” the column of an income statement. It is often used to compare companies in the same industry.
It starts with total sales or total revenue, also known as the top line of the income statement. The top line is expressed as 100% on a common-size statement. All subsequent amounts, such as expenses and profit, are expressed as lesser percentages because their dollar amounts are less than revenue. In rare cases, however, when expenses exceed revenue, the percentage would top 100%.
For example, a company income statement with $10 million of revenue and $5 million production costs, also known as cost of goods sold (COGS), would express revenue as 100% and COGS as 50% because COGS is equal to half of revenue. Similarly, if net income—what’s left after all expenses are subtracted from revenue—were $2 million, it would be 20% on the common-size statement.
2. Horizontal analysis
Horizontal analysis refers to “looking across” a specific line item. A company typically uses it to detect any changes in its ratios and margins over time.
Imagine a company examining its second-quarter income statements for the past four years. Revenue growth has been fairly steady, but net income is growing slower. Looking across from left to right, managers see, for example, that COGS has been climbing—from 30% of revenue to 50% in the most recent second quarter. This kind of ratio analysis can help managers zero in on inefficiencies and look for ways to boost profitability.
Example of common size income statement—vertical analysis
Here is a hypothetical example of how a common size income statement can be used in vertical analysis. In this case, ABC Inc. creates an annual traditional income statement on the left, along with a common size statement on the right. We can see that total expenses (cost of goods sold and selling, general, administrative expenses) account for 87% of its revenue, its operating income margin is 13%, and its after-tax net income margin is 10%.
|ABC Inc. (millions of dollars)|
|Cost of goods sold||-45.0||56%|
|Selling, general, admin. costs||-25.0||31%|
Vertical analysis also is useful for comparing two or more companies, even if one is much bigger than the other. Let’s compare ABC Inc. to its smaller rival XYZ Corp. A common-size vertical analysis of the companies’ annual income statements might look like this:
|ABC Income Statement||Common Size||XYZ Income Statement||Common Size|
|Revenue||$80 million||100%||$10 million||100%|
|COGS||-$45 million||56%||-$4 million||40%|
|Gross profit||$35 million||44%||$6 million||60%|
|SG&A||-$25 million||31%||-$2 million||20%|
|Operating income||$10 million||13%||$4 million||40%|
|Income tax||-$2 million||3%||-$1 million||10%|
|Net income||$8 million||10%||$3 million||30%|
Although XYZ is much smaller than ABC, its expenses account for a smaller proportion of revenue, and its profit margins (highlighted in green) are higher than ABC’s. The stronger profit performance could prompt XYZ’s managers to plan for expansion, while possibly encouraging lenders and investors to provide capital.
Example of common-size income statement—horizontal analysis
While XYZ may take satisfaction from this vertical analysis and favorable comparison, ABC decides to review its income statements for the past three years through horizontal analysis. It hopes to better understand why its profit margins are lower than XYZ’s. It looks across the rows of its income statement, from Year 1 to Year 3, its most recent year reported above.
|Year 1||Year 2||Year 3|
|Revenue||$70 million (100%)||$75 million (100%)||$80 million (100%)|
|Cost of goods sold||$35 million (50%)||$40million (53%)||$45 million (56%)|
|Gross profit||$35 million (50%)||$35 million (47%)||$40 million (44%)|
|Selling, general, admin. costs||$10 million (14%)||$20 million (27%)||$25 million (31%)|
|Operating income||$25 million (36%)||$15 million (20%)||$10 million (13%)|
|Income tax||$5 million (7%)||$3 million (4%)||$2 million (3%)|
|Net income||$20 million (29%)||$12 million (16%)||$8 million (10%)|
ABC’s managers can readily draw three conclusions from this horizontal analysis:
- Cost of goods sold. These production expenses (highlighted in red) rose steadily, accounting for more than half of revenue by Year 3.
- Selling, general, and administrative. Overhead costs (also highlighted in red) almost doubled as a percentage of revenue in Year 2 and rose further in Year 3.
- Profit profit margins. Because costs rose much faster than revenue, the gross profit margin fell and operating margin and net profit margin in Year 3 were much smaller than two years earlier.
Common-size income statements FAQ
What does a common-size income statement measure?
A common-size income statement measures ratios—the ratio of expenses to revenue or sales, for example, or the ratio of net income to revenue. Cost ratios measure the proportion of a company’s revenue to cover expenses, while profit ratios—typically called profit margins—measure the amount of revenue left after expenses.
What is the difference between an income statement and a common-size statement?
An income statement, sometimes known as a traditional income statement, presents the dollar amounts of a company’s revenue and its various expenses to reach the final result, or net income. A common-size statement expresses the amounts in relative terms, as percentages of sales or revenue that appear on the top line of an income statement.
What are some advantages of common-size income statements?
Common size financial statements allow for easier analysis of a company’s performance because percentages can be more quickly assessed than large dollar amounts. A common size income statement can make it simpler to compare a company’s performance against competitors, and to spot any significant changes in its expenses and profit margins over time.
What are some disadvantages?
A common-size statement’s usefulness may be limited if a company changes some accounting methods or its business experiences seasonal fluctuations. Also, while common-size statements can be used to compare a small company with a large one, size can’t be disregarded: A $1 billion company is a very different thing than a $10 million company.