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How to Do a Common-Size Balance Sheet: Deconstructing Financial Health

Creating a common-size balance sheet is a powerful analytical technique. It transforms a standard balance sheet, which presents absolute dollar amounts, into one that showcases each item as a percentage of a base figure, typically total assets. This normalization allows for easy comparison of financial performance across different periods or between companies of vastly different sizes. To create one, simply divide each line item on the balance sheet by total assets and multiply by 100%. The resulting percentage represents the proportion of total assets financed by that specific item, providing a valuable perspective on a company’s financial structure.

Understanding the Power of Proportions

The standard balance sheet is a snapshot of a company’s assets, liabilities, and equity at a specific point in time. While the absolute dollar values are important, they don’t always tell the full story. A common-size balance sheet, on the other hand, reframes the narrative by highlighting the relative importance of each item. This is crucial for:

Trend Analysis: Comparing common-size balance sheets across multiple periods reveals shifts in a company’s asset allocation, debt structure, and equity composition.
Benchmarking: Comparing a company’s common-size balance sheet to that of its competitors or industry averages provides insights into its relative financial strength and efficiency.

Early Warning Signals: Significant changes in the proportions of certain items can signal potential financial distress or opportunities. For instance, a rapid increase in the proportion of debt might raise concerns about solvency.

Step-by-Step Guide to Creating a Common-Size Balance Sheet

1. Gather Your Data

The first step is to obtain the balance sheet for the period you want to analyze. You can typically find this information in a company’s annual report (Form 10-K for publicly traded companies) or quarterly report (Form 10-Q).

2. Identify Total Assets

Locate the total assets figure on the balance sheet. This will be your base for calculating the percentages. Make sure that it is the total assets figure, inclusive of all assets listed.

3. Calculate Percentages for Each Asset

For each asset line item (e.g., cash, accounts receivable, inventory, property, plant, and equipment), divide the dollar amount by total assets and multiply by 100. The formula is:

(Asset Line Item / Total Assets) * 100 = Percentage of Total Assets

For example, if a company has $500,000 in cash and $5,000,000 in total assets, the cash percentage would be:

($500,000 / $5,000,000) * 100 = 10%

4. Calculate Percentages for Liabilities and Equity

Repeat the process for each liability and equity line item (e.g., accounts payable, short-term debt, long-term debt, common stock, retained earnings). Divide each item by total assets and multiply by 100. The formula is:

(Liability or Equity Line Item / Total Assets) * 100 = Percentage of Total Assets

For example, if a company has $1,000,000 in long-term debt and $5,000,000 in total assets, the long-term debt percentage would be:

($1,000,000 / $5,000,000) * 100 = 20%

5. Verify Your Work

Double-check your calculations to ensure accuracy. A critical verification step is to sum the percentages of all asset line items and all liability and equity line items. Both totals should equal 100% (or very close, allowing for rounding differences). If the totals don’t equal 100%, there is an error in your calculations.

6. Analyze the Results

Once you have created the common-size balance sheet, the real work begins. Analyze the percentages to identify significant trends, compare them to industry averages, and assess the company’s financial health. Look for substantial changes in proportions from period to period, or large differences compared to competitors. These differences are your flags for further investigation.

Tools and Resources

While the calculations are straightforward, spreadsheet software like Microsoft Excel or Google Sheets can significantly streamline the process. You can create templates to automate the calculations and quickly generate common-size balance sheets for multiple periods or companies. Accounting software packages also offer built-in features for generating common-size financial statements.

Example of a Common-Size Balance Sheet

(Simplified Example – Incomplete Balance Sheet)

Item	Year 1 ($)	Year 1 (%)	Year 2 ($)	Year 2 (%)
———————–	————	————	————	————
Cash	$500,000	10%	$600,000	12%
Accounts Receivable	$750,000	15%	$800,000	16%
Inventory	$1,250,000	25%	$1,100,000	22%
Total Assets	$5,000,000	100%	$5,000,000	100%
Accounts Payable	$500,000	10%	$400,000	8%
Short-Term Debt	$250,000	5%	$300,000	6%
Long-Term Debt	$1,000,000	20%	$1,200,000	24%
Common Stock	$2,000,000	40%	$1,800,000	36%
Retained Earnings	$1,250,000	25%	$1,300,000	26%

In this example, we can see that cash increased as a percentage of total assets between Year 1 and Year 2, while inventory decreased. Long-term debt also increased, and common stock decreased, hinting at potential changes in the company’s capital structure.

Frequently Asked Questions (FAQs)

1. What is the primary advantage of using a common-size balance sheet?

The primary advantage is the ability to compare financial data across different time periods or between companies of varying sizes. The percentage-based format normalizes the data, eliminating the distortions caused by scale differences.

2. Can a common-size balance sheet be used for internal analysis only, or is it useful for external stakeholders too?

A common-size balance sheet is beneficial for both internal analysis (e.g., management tracking performance) and external stakeholders (e.g., investors, creditors evaluating a company’s risk profile).

3. Are there any limitations to using a common-size balance sheet?

Yes. While useful for comparisons, common-size balance sheets don’t provide absolute dollar values. This can mask the real magnitude of changes. Always use it in conjunction with other financial statements and analyses. Also, industry averages may not always be relevant for a specific company due to its unique business model or strategy.

4. What does it mean if a company’s current assets are a small percentage of total assets?

It could indicate that the company is not liquid enough to meet its short-term obligations. However, it also depends on the industry. A service-based business might naturally have lower current assets compared to a manufacturing company. Analyze it in the context of the company’s industry and operating cycle.

5. How can a common-size balance sheet help identify potential financial risks?

By highlighting shifts in asset allocation, debt levels, and equity structure. A sudden increase in the proportion of debt relative to equity, for instance, could indicate increasing financial leverage and higher risk. A decrease in cash as a percentage of assets can suggest a liquidity issue.

6. What is the difference between a common-size balance sheet and a common-size income statement?

A common-size balance sheet expresses each item as a percentage of total assets, while a common-size income statement expresses each item as a percentage of total revenue (sales). Both provide insights into a company’s financial performance but from different perspectives.

7. Can you create a common-size balance sheet for a non-profit organization?

Yes, the concept applies to non-profit organizations as well. The same methodology is used, dividing each line item by total assets. It provides insights into how the organization is allocating its resources.

8. Is it always best to use total assets as the base for a common-size balance sheet?

Generally, yes, total assets is the most common and widely accepted base. However, in specific situations, another base might be more relevant. For instance, when analyzing a bank, you might use total deposits as the base. Always choose the base that provides the most meaningful context for your analysis.

9. What factors should I consider when comparing a company’s common-size balance sheet to its competitors?

Consider industry dynamics, business models, company size, and geographical locations. Ensure that the competitors are truly comparable. Significant differences in any of these factors can skew the analysis.

10. How often should a common-size balance sheet be prepared?

The frequency depends on the needs of the user. Public companies usually publish their balance sheet quarterly. Therefore, it is best to prepare it quarterly or annually, coinciding with the standard reporting periods.

11. What does it indicate if a company’s retained earnings are decreasing as a percentage of total assets?

A decreasing percentage of retained earnings can indicate that the company is either experiencing net losses, paying out a large amount of dividends, or repurchasing shares. It could also signify an accounting adjustment that reduced retained earnings. Further investigation is warranted to understand the underlying reason.

12. What are some software applications that can generate common-size balance sheets automatically?

Many accounting software packages like QuickBooks, Xero, and NetSuite have the functionality to generate common-size balance sheets automatically. Spreadsheet software like Microsoft Excel and Google Sheets can also be used with custom templates. Financial analysis software like Bloomberg Terminal or FactSet also include robust tools for generating and analyzing common-size financial statements.