Which of the following financial statements reports the financial position of a business at a point in time quizlet?

A common size financial statement displays line items as a percentage of one selected or common figure. Creating common size financial statements makes it easier to analyze a company over time and compare it with its peers. Using common size financial statements helps you spot trends that a raw financial statement may not uncover.

All three of the primary financial statements can be put into a common size format. Financial statements in dollar amounts can easily be converted to common size statements using a spreadsheet. Below is an overview of each financial statement and a more detailed summary of the benefits and drawbacks that such an analysis can provide to you.

Key Takeaways

• A common size financial statement displays items on each report as a percentage of a common base figure.
• Common size financial statements are used to make it easier to compare a company to its competitors and to identify significant changes in a company's financials.
• In a common size analysis, you compare the percentages between two or more years to evaluate financial strength, how income is used, and where cash comes from.

Balance Sheet Analysis

The common figure for a common size balance sheet analysis is total assets. Based on the accounting equation, this also equals total liabilities and shareholders’ equity, making either term interchangeable in the analysis. It is also possible to use total liabilities to indicate where a company’s obligations lie and whether it is being conservative or risky in managing its debts.

The common size strategy from a balance sheet perspective lends insight into a firm’s capital structure and how it compares to its rivals. You can also look to determine an optimal capital structure for a given industry and compare it to the firm being analyzed. Then, you can conclude whether the debt level is too high, excess cash is being retained on the balance sheet, or inventories are growing too high. The goodwill level on a balance sheet also helps indicate the extent to which a company has relied on acquisitions for growth.

Below is an example of a common size balance sheet for technology giant International Business Machines (IBM). Running through some of the examples touched on above, we can see that long-term debt averages around 34% of total assets over the two-year period, which reasonable. Cash ranges between 5% and 8.5% of total assets, and short-term debt accounted for about 5% of total assets over the past two years.

It is important to add short-term and long-term debt together and compare this amount to the total cash on hand in the current assets section. This lets you know how much of a cash cushion is available or if a firm is dependent on the markets to refinance debt when it comes due.

Analyzing the Income Statement

The common figure for an income statement is total top-line sales. This is actually the same analysis as calculating a company's margins. For instance, a net profit margin is simply net income divided by sales, which also happens to be a common size analysis.

The same goes for calculating gross and operating margins. The common size method is appealing for research-intensive companies, for example, because they tend to focus on research and development (R&D) and what it represents as a percent of total sales.

Below is a common size income statement for IBM. We will cover it in more detail below, but notice the R&D expense that averages close to 1.5% of revenues in 2020 and 2021.

Common Size and Cash Flow

Similar to an income statement analysis, many items in the cash flow statement can be stated as a percent of total sales. This can give insight into several cash flow items, including capital expenditures (CapEx) as a percent of revenue.

Share repurchase activity can also be considered a percent of the total top line. Debt issuance is another important figure in proportion to the amount of annual sales it helps generate. Because these items are calculated as a percentage of sales, they help indicate how much the company uses them to generate overall revenue.

Below is IBM’s cash flow statement in terms of total sales. It generated an impressive level of operating cash flow that averaged 26.9%% of sales over the three-year period. Share repurchase activity as a percentage of total sales in each of the three years was minimal or non-existent, possibly due to economic and market conditions resulting from the Covid-19 pandemic. You may also notice the first row, which is net income as a percent of total sales—matches precisely with the common size analysis from an income statement perspective. This represents the net profit margin.

How This Differs From Regular Financial Statements

The key benefit of a common size analysis is that it allows for a vertical analysis by line item over a single period, such as quarterly or annually; it also allows you to view a horizontal perspective over a period such as the three years we analyzed for IBM above.

Just looking at a raw financial statement makes this more difficult. But looking up and down a financial statement using a vertical analysis allows an investor to catch significant changes at a company. A common size analysis helps put analysis in context (on a percentage basis). It is the same as a ratio analysis of the profit and loss statement.

What the Common Size Reveals

The most significant benefit of a common size analysis is that it can let you identify large or drastic changes in a firm’s financials. Rapid increases or decreases will be readily observable, such as a rapid drop in reported profits during one quarter or year.

In IBM's case, its results overall during the period examined were relatively steady, considering the market and economic conditions of the time. One item of note is the Treasury stock in the balance sheet, which had grown to more than negative 100% of total assets. But rather than act as an alarm for you, it indicates the company had been hugely successful in generating cash to buy back shares, far exceeding what it had retained on its balance sheet.

A common size analysis can also give insight into companies' different strategies. For instance, one company may be willing to sacrifice margins for market share, which would tend to make overall sales larger at the expense of gross, operating, or net profit margins. Ideally, the company that pursues lower margins will grow faster. While you viewed IBM on a stand-alone basis, like the R&D analysis, IBM should also be analyzed by comparing it to its key rivals.

What Is the Main Purpose of Common Size Financial Statements?

Common size financial analysis lets you see how a company is performing year to year and compare it to its competitors.

How Do You Find Common Size Financial Statements?

Each line item on a balance sheet, statement of income, or statement of cash flows is divided by revenue or sales. This can be done using a spreadsheet or calculator—you might be able to find them on the websites of companies that specialize in financial analysis.

What Is Meant by Common Size Balance Sheet?

A common size balance sheet is a comparative analysis of a company's performance over a period, used to determine how the company is using its assets.

The Bottom Line

As the above scenario highlights, a common size analysis on its own is unlikely to provide a comprehensive and clear conclusion on a company. Instead, it must be done in the context of financial statement analysis, as detailed above.

You should also need to be aware of temporary versus permanent differences. For example, a short-term drop in profitability could only indicate a speed bump rather than a permanent loss in profit margins.

Which of the following financial statement reports the financial position of a business at a point in time?

Which of the following financial statements reports the financial position of a business at a point in time multiple choice question?