Common-size financial statement analysis

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Financial statement analysis can benefit from knowing what proportion of a group or subgroup is made up of a particular account. Specifically, in analyzing a balance sheet, it is common to express total assets (or liabilities plus equity) as 100%. Then, accounts within these groupings are expressed as a percentage of their respective total. In analyzing an income statement, sales are often set at 100% with the remaining income statement accounts expressed as a percentage of sales. Because the sum of individual accounts within groups is 100%, this analysis is said to yield common-size financial statements. This procedure also is called vertical analysis given the up-down (or down-up) evaluation of accounts in common-size statements. Common-size financial statement analysis is useful in understanding the internal makeup of financial statements. For example, in analyzing a balance sheet, a common-size analysis stresses two factors:
1. Sources of financing—including the distribution of financing across current liabilities, noncurrent 

    liabilities, and equity.
2. Composition of assets—including amounts for individual current and noncurrent assets.

Common-size analysis of a balance sheet is often extended to examine the accounts that make up specific subgroups. For example, in assessing liquidity of current assets, it is often important to know what proportion of current assets is composed of inventories, and not simply what proportion inventories are of total assets. Common-size analysis of an income statement is equally important. An income statement readily lends itself to common-size analysis, where each item is related to a key amount such as sales. To varying degrees, sales impact nearly all expenses, and it is useful to know what percentage of sales is represented by each expense item. An exception is income taxes, which are related to pre-tax income and not sales.

Temporal (time) comparisons of a company’s common-size statements are useful in revealing any proportionate changes in accounts within groups of assets, liabilities, expenses, and other categories. Still, we must exercise care in interpreting changes and trends as shown in Illustration 1.3 

Common-size statements are especially useful for intercompany comparisons because financial statements of different companies are recast in common-size format. Comparisons of a company’s common-size statements with those of competitors, or with industry averages, can highlight differences in account makeup and distribution. Reasons for such differences should be explored and understood. One key limitation of common-size statements for intercompany analysis is their failure to reflect the relative sizes of the companies under analysis.

Colgate’s common-size income statements are shown in Exhibit 1.12. In 2011, Colgate earned 14.5 cents per dollar of sales compared with 11.1 cents in 2006, an increase of 3.4 cents per dollar of sales. This increase masks some important trends in.
 

Colgate’s income statement accounts. Examining Colgate’s gross profit indicates that Colgate earned 57.3 cents after cost of sales in 2011, in contrast to 58.9 cents in 2006, a decrease of 1.8 cents per dollar of sales. This decrease in gross profit margin reflects the difficult competitive environment that Colgate faces in the consumer products industry. What accounts for the increase in profit margin despite the decreasing gross profit margin? First, selling, general, and administrative expenses have dropped as a percentage of sales from 35.2 to 34.4 cents per dollar of sales over the 2006–2011 period. Second, other expenses have dropped from 5.5 cents per dollar of sales in 2006 to 0.1 cents in 2011. Items in other expenses include asset impairments, termination benefits, and other one-time charges that are partially related to Colgate’s restructuring efforts initiated in 2004. As Colgate’s charges from its 2004 restructuring effort have declined, the amount of other expenses recognized by Colgate has similarly declined. Together, these cost saving efforts explain the increase in net income despite the slight decline in gross profit margin for Colgate over the period.

Common-size analysis of Colgate’s balance sheets is in Exhibit 1.13. Because Colgate is a manufacturing company, PP&E constitutes 29% of its total assets. The share of PP&E has remained fairly steady at around 30% of total assets since 2006. Intangible assets and goodwill account for 31.4% of its assets, indicating significant acquisitions in the past. In comparison, 34.6% of Colgate’s assets are current, down slightly from 36.1% in 2006. Most of this decrease comes from a decrease in receivables as the largest component of current assets. Receivables decreased as a percent of total assets from 16.7% in 2006 to 13.2% in 2011. An increase in cash holdings by Colgate from 5.4% in 2006 to 6.9% in 2011 partially offsets this decrease in receivables. Current liabilities are 29.2% of assets, which is lower than its current assets. Current portion of long-term debt constitutes 2.7% of its current liabilities.

Colgate’s operating working capital (operating  current assets less operating current  liabilities) is 8% of its assets, suggesting that Colgate has not tied up much money in its working capital. A lion’s share of Colgate’s financing is debt: total liabilities are 80% of assets, of which more than 37% is long-term debt (including current portion). Colgate’s shareholders’ equity makes interesting reading. Just 16.3% of Colgate’s assets have been financed by equity share capital, retained earnings (net of accumulated comprehensive income) are 103.5% of assets, and a whopping 100.7% of its assets are treasury stock,  which suggests significant stock repurchases. Because of the significant stock repurchase activity, Colgate’s share of net equity financing is just 20% of assets. For most companies, such a small share of equity financing may be cause for concern, but in Colgate’s case it just reflects its generous payouts to shareholders.

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