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Common Size Balance Sheet Vs Traditional Balance Sheet: Which One is Better?
Want to figure out more effective ways to study your company’s financial statements? If so, look no further than the common size balance sheet. This powerful tool displays financial data as a percentage, making it easier to spot trends and changes over time. This blog explores the advantages and disadvantages of using a common size balance sheet and provides insights into how to utilize it efficiently for financial analysis.
What is a Common Size Balance Sheet?
A common size balance sheet is a financial statement that displays each balance sheet item as a percentage of total assets. As a result, it becomes easier to compare companies of various sizes and track changes within a company over time. To generate a common size balance sheet, divide each asset and liability by total assets and multiply by 100 to get the percentage. For example: If Company A has $1,000 in cash and $5,000 in total assets, this would be presented in a separate column as 20%. Line items in income statements are frequently divided by total revenues or total sales. If Company A has $2,000 in operating expenses and $4,000 in total revenues, the operating expenses are 50%. This produces a standardized view of the balance sheet that emphasizes the relative size of each item and the balance sheet’s overall structure. Commonsize balance sheets are more useful than traditional ones in identifying trends and patterns in a company’s financial performance. They provide a more detailed picture of the company’s financial health. As a result, they can also be used to compare companies in the same industry and benchmark against industry averages.
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How Does a Common Size Balance Sheet Differ From a Traditional Balance Sheet?
The information presented on a common size balance sheet differs from that on a traditional balance sheet. A traditional balance sheet shows a company’s assets, liabilities, and equity in dollar amounts. On the other hand, it shows the same information as a percentage of total assets. This means that in a common size balance sheet, each line item is shown as a percentage of a company’s total assets, making it easier to compare organizations of different sizes and track changes within them. Meanwhile, a traditional balance sheet presents the actual dollar values of each item, which can be difficult to compare between companies or over time. Another distinction between the two types of balance sheets is that this balance sheet provides a clearer understanding of a company’s overall balance sheet structure. Due to this, it may be easier to see what proportion of a company’s assets are in cash versus inventory. Also, to understand how much of a company’s liabilities are in long-term debt versus accounts payable.
How Can a Common Size Balance Sheet Help in Financial Analysis?
Here are a few examples of how a common size balance sheet aids in financial analysis:
Comparison between Companies
The financial position of companies in the same industry can be compared using such a balance sheets. Converting balance sheet items into percentages makes it easier to ascertain their relative size and compare them to other companies in the industry.
Comparison Over Time
Tracking changes in the percentages of each item over time can identify trends and patterns in a company’s financial performance.
Identifying Areas of Concern
Comparing the percentages of different balance sheet items helps identify potential areas of concern or weakness in a company’s financial position. So, if the percentage of long-term debt rapidly increases, it may indicate that the company is incurring excessive debt.
Comparing items in a company’s balance sheet to industry averages or benchmarks makes it possible to identify areas where the company performs well or where it could improve.
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Benefits of a Common Size Balance Sheet
Here are some benefits of using a common size balance sheet:
- Provides a standardized picture of a company’s financial situation
- Allows for easier comparison of companies of various sizes within the same industry
- Gives a better understanding of a company’s overall balance sheet structure
- Identifying trends and patterns becomes easier when the relative size of each item on the balance sheet is highlighted
- Aids in the identification of potential areas of concern or opportunity
- Useful in monitoring the evolution of a company’s financial position over time
- Helps compare the financial position of a company to industry averages or benchmarks
- Provides a more detailed picture of a company’s financial health as compared to a traditional balance sheet
- Assists investors, analysts, and financial professionals in making better investment decisions
Limitations of a Common Size Balance Sheet
Not Enough for Decision-Making
Common size balance sheets alone aren’t sufficient to make investment decisions because they lack an approved benchmark for comparison. Hence, it’s essential to also peruse other financial statements, industry standards, and non-numerical information to make smart decisions.
Seasonality Can be Misleading
Seasonal fluctuations in a company’s business may render common size balance sheets unhelpful and misleading. If a company sells more during Christmas, the balance sheet percentages may be distorted. As a result, they will not reflect the company’s true financial position. Other financial papers and information are necessary to understand the company’s financial situation comprehensively.
Learn to Master a Balance Sheet With Emeritus
The limitations notwithstanding, a such balance sheet is a powerful tool for gaining insights into a company’s financial health. Combining a balance sheet with other financial statements and industry benchmarks can provide a more comprehensive understanding of a company’s financial position. Hence, understanding the advantages and limitations of a common size balance sheet can help you to make informed investment decisions. Learn to master common size balance sheets from industry professionals and academics at home with the online financial courses available on the Emeritus platform. These include certificate and diploma courses tailored to meet your learning needs and schedule.
By Siddhesh Shinde
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