How To Create Common Size Balance Sheet

How to Create a Common-Size Balance Sheet: A Comprehensive Guide

A balance sheet is a crucial financial statement that provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. While a standard balance sheet shows the absolute values of these items, a common-size balance sheet expresses these values as percentages of a base figure, typically total assets. This normalization allows for easy comparison of companies of different sizes, and analysis of trends over time within a single company. This comprehensive guide will walk you through the process of creating a common-size balance sheet, highlighting its uses and benefits.

Understanding the Purpose of a Common-Size Balance Sheet

The primary advantage of a common-size balance sheet lies in its ability to facilitate comparative analysis. By expressing each item as a percentage of total assets, you eliminate the scale difference between companies. A large corporation with billions in assets can be directly compared to a smaller enterprise with millions, allowing for meaningful insights into their relative financial structures.

This comparative feature is beneficial in several scenarios:

• Benchmarking: Compare your company's financial health against industry averages or competitors.
• Trend Analysis: Track changes in your company's financial structure over time. Identifying shifts in asset composition or liability levels can reveal important business trends.
• Financial Health Assessment: Analyze the proportion of assets, liabilities, and equity to gauge the company's financial strength and stability. A high proportion of debt, for example, might indicate higher financial risk.
• Investment Decisions: Investors often use common-size balance sheets to compare potential investment opportunities and assess the financial soundness of companies.

Steps to Create a Common-Size Balance Sheet

Creating a common-size balance sheet is a straightforward process, but accuracy is crucial. Here's a step-by-step guide:

1. Gather the Necessary Data:

You'll need a standard balance sheet containing the following information:

• Assets: Current assets (cash, accounts receivable, inventory), and non-current assets (property, plant, and equipment, intangible assets).
• Liabilities: Current liabilities (accounts payable, short-term debt), and non-current liabilities (long-term debt).
• Equity: This represents the owners' stake in the company.

This data can typically be found in a company's annual report or financial statements.

2. Calculate Total Assets:

Sum up all the individual asset items to arrive at the total assets figure. This will be your base figure for calculating percentages.

Example:

Let's assume the total assets of a company are $1,000,000.

3. Calculate the Percentage for Each Asset Item:

For each asset item, divide its value by the total assets and multiply by 100 to express it as a percentage.

Example:

• Cash: $100,000 / $1,000,000 * 100 = 10%
• Accounts Receivable: $200,000 / $1,000,000 * 100 = 20%
• Inventory: $150,000 / $1,000,000 * 100 = 15%
• Property, Plant, and Equipment: $500,000 / $1,000,000 * 100 = 50%
• Intangible Assets: $50,000 / $1,000,000 * 100 = 5%

4. Calculate the Percentage for Each Liability Item:

Follow the same procedure as above, dividing each liability item's value by the total assets and multiplying by 100.

Example:

• Accounts Payable: $50,000 / $1,000,000 * 100 = 5%
• Short-Term Debt: $100,000 / $1,000,000 * 100 = 10%
• Long-Term Debt: $200,000 / $1,000,000 * 100 = 20%

5. Calculate the Percentage for Equity:

Divide the equity value by the total assets and multiply by 100.

Example:

• Equity: $650,000 / $1,000,000 * 100 = 65%

6. Create the Common-Size Balance Sheet:

Present the data in a tabular format, with each item listed as a percentage of total assets. The sum of all percentages should ideally equal 100% (minor discrepancies may arise due to rounding).

Interpreting the Common-Size Balance Sheet

Once you've constructed your common-size balance sheet, you can begin to analyze the data. Here are some key aspects to consider:

• Asset Composition: Examine the percentage of each asset type. A high percentage of inventory, for example, might indicate slow-moving goods or potential obsolescence. A high proportion of receivables could suggest problems with debt collection.

• Liability Structure: Analyze the proportion of short-term and long-term debt. A high proportion of short-term debt suggests greater financial risk, as these debts need to be repaid quickly.

• Equity Ratio: The equity percentage indicates the proportion of the company's assets funded by equity. A higher equity ratio generally suggests better financial stability.

• Trend Analysis: Compare common-size balance sheets from different periods (e.g., several years) to identify trends in asset and liability composition. This can help uncover potential issues or positive developments within the company.

• Industry Benchmarks: Compare your company's common-size balance sheet to industry averages. This allows you to assess your financial position relative to competitors and identify areas for improvement.

Common Mistakes to Avoid

• Inaccurate Data: Double-check your source data for errors. Even small inaccuracies can significantly impact the percentages.
• Incorrect Calculations: Carefully review your percentage calculations to avoid mathematical mistakes.
• Ignoring Context: Don't interpret the data in isolation. Consider factors like industry norms, economic conditions, and the company's specific business model.
• Overlooking Trend Analysis: A single common-size balance sheet offers a limited view. Analyzing multiple years' worth of data provides a much richer understanding of financial trends.

Advanced Applications of Common-Size Analysis

Beyond simple comparisons, common-size balance sheets can be used for more sophisticated analysis:

• Vertical Analysis: Comparing line items within the same balance sheet to understand their proportions relative to total assets. This can reveal imbalances or areas that need further investigation.
• Horizontal Analysis: Comparing the common-size balance sheets of different periods to analyze changes over time. This can highlight trends in asset allocation, financing, and profitability.
• Combined Analysis: Combining common-size analysis with other financial ratios, such as liquidity ratios and profitability ratios, provides a more comprehensive view of the company's financial health.

Conclusion

The common-size balance sheet is a powerful tool for financial analysis, providing a normalized view of a company's financial structure. By following the steps outlined above, you can create accurate common-size balance sheets that facilitate effective comparative analysis, trend identification, and improved financial decision-making. Remember to always consider the data in context, compare it to industry benchmarks, and combine your analysis with other financial tools for a thorough understanding of a company's financial position. Mastering the creation and interpretation of common-size balance sheets is a valuable skill for anyone involved in financial analysis, investment, or business management. The ability to dissect and understand the financial health of a business based on the relationships between assets, liabilities, and equity will prove invaluable throughout your career.