How to Prepare a Common-Size Balance Sheet: A Deep Dive

Preparing a common-size balance sheet is a critical analytical technique that allows you to assess the composition and financial health of a company irrespective of its size. In essence, it transforms the raw numbers of a traditional balance sheet into percentages, facilitating meaningful comparisons across different periods, companies, or even industries. To create one, you express each line item as a percentage of a chosen base figure: total assets for asset accounts and total liabilities and equity for liability and equity accounts. The result is a standardized view that highlights proportional relationships and uncovers significant shifts in asset allocation, debt structure, and equity contributions.

The Step-by-Step Process: From Numbers to Insights

Here’s a comprehensive breakdown of how to prepare a common-size balance sheet:

1. Gather Your Data: The Foundation

Start with a complete traditional balance sheet. Ensure the data is accurate and properly categorized. You’ll need figures for all assets, liabilities, and equity items for the periods you wish to analyze. This could be for a single period, multiple years for trend analysis, or across different companies for benchmarking.

2. Choose Your Base Figure: Anchoring Your Analysis

The cornerstone of the common-size balance sheet is the base figure. For assets, total assets is almost universally used. For liabilities and equity, total liabilities and equity serves as the base. Remember that the accounting equation dictates that total assets must equal total liabilities and equity. This base will always represent 100%.

3. Calculate the Percentages: The Core Transformation

This is where the magic happens. For each line item on the balance sheet, perform the following calculation:

(Line Item Value / Base Figure) * 100

For example, if cash is $100,000 and total assets are $1,000,000, the common-size percentage for cash would be:

($100,000 / $1,000,000) * 100 = 10%

Repeat this calculation for every single line item on both the asset and liabilities and equity sides of the balance sheet.

4. Create Your Common-Size Balance Sheet: Structuring the Data

Organize your results into a clear and easily readable table. The table should include the following columns:

• Line Item: The description of each asset, liability, or equity account (e.g., Cash, Accounts Receivable, Accounts Payable, Retained Earnings).
• Dollar Value: (Optional) The original dollar value from the traditional balance sheet. Useful for reference.
• Common-Size Percentage: The calculated percentage representing the line item’s proportion of the base figure.
• Prior Period Percentage: (If performing trend analysis) The common-size percentage from a previous period for comparison.

5. Analyze the Results: Unveiling the Story

This is where you extract valuable insights from your common-size balance sheet. Look for significant changes in percentages from period to period or differences between companies. Ask yourself:

• Are there shifts in asset allocation? Is the company investing more or less in certain asset classes (e.g., increasing investment in property, plant, and equipment (PP&E) indicating growth, or decreasing investment in inventory indicating better inventory management)?
• How is the company financing its assets? Is the company relying more on debt (higher percentage of liabilities) or equity (higher percentage of equity)?
• Are there any red flags? A significant increase in accounts receivable as a percentage of total assets, coupled with a decrease in sales, could indicate problems with collections.

6. Consider Industry Benchmarks: Putting it in Perspective

To gain a deeper understanding, compare your company’s common-size balance sheet to industry averages or the common-size balance sheets of competitors. This will help you identify areas where the company is performing better or worse than its peers. Tools and databases like those available through financial data providers (e.g., Bloomberg, Reuters) can be invaluable for accessing industry benchmarks.

Common-Size Balance Sheet: Frequently Asked Questions

Here are some frequently asked questions about common-size balance sheets to further refine your understanding:

1. Why is a common-size balance sheet important?

It allows for easy comparison of financial statements across different companies and time periods, regardless of size. It reveals proportional relationships, highlighting potential strengths and weaknesses.

2. Can I use a common-size balance sheet for trend analysis?

Absolutely! Comparing common-size balance sheets across multiple periods allows you to identify trends and significant changes in a company’s financial structure over time.

3. What are some limitations of using a common-size balance sheet?

It doesn’t provide information about the absolute size of the company. You need to consider other financial statements and metrics for a complete picture. It also doesn’t address the quality of assets or the profitability of liabilities.

4. 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 (or total liabilities and equity), while a common-size income statement expresses each item as a percentage of total revenue or net sales.

5. How does the common-size balance sheet help in credit analysis?

It reveals a company’s debt structure and its ability to meet its obligations. A high percentage of liabilities relative to equity might signal higher financial risk.

6. What are the key ratios that can be derived from a common-size balance sheet?

While not ratios per se, the percentages themselves provide valuable insight. For instance, the percentage of cash to total assets indicates liquidity, and the percentage of debt to total assets reflects leverage.

7. How is the common-size balance sheet used in investment analysis?

It helps investors understand how a company allocates its assets and finances its operations, providing insights into its risk profile and growth potential.

8. What does it mean if a company’s inventory percentage is increasing over time in a common-size balance sheet?

It could indicate that the company is having trouble selling its inventory, which could lead to obsolescence and write-offs. However, it could also be a strategic build-up in anticipation of increased demand. Further investigation is needed.

9. What does it mean if a company’s retained earnings percentage is increasing over time in a common-size balance sheet?

It generally indicates that the company is profitable and retaining earnings for reinvestment or future growth. However, it could also indicate a lack of investment opportunities or a conservative dividend policy.

10. How can I use Excel to create a common-size balance sheet?

Excel is your best friend! Use formulas to calculate the percentages. You can easily create a table, link the percentage calculations to the original balance sheet data, and create charts for visual analysis. For example, you can use the formula =B2/$B$10*100 where B2 is the cell with the balance sheet item and B10 is the cell with the total assets. The $ symbols anchor the total asset cell so that when you drag the formula down, the denominator remains the same.

11. Are there any free online templates for common-size balance sheets?

Yes, many websites offer free templates. Search for “common-size balance sheet template Excel” or “financial statement analysis template”. Remember to verify the accuracy and adjust the template to fit your specific needs.

12. What’s the best way to present a common-size balance sheet to stakeholders?

Use clear and concise visuals, such as charts and graphs, to highlight key trends and insights. Avoid overwhelming stakeholders with too much detail. Focus on the key takeaways and their implications for the company’s performance and future prospects. In a report, accompany the common-size balance sheet with a written narrative explaining the observed trends and their potential causes and consequences.

By mastering the common-size balance sheet, you gain a powerful tool for financial analysis, allowing you to compare, contrast, and ultimately, understand the financial health and strategic direction of any company. It’s not just about the numbers; it’s about the story they tell.