It is often hard to compare the financials of companies that are different in size. Common size financial statements are one way to make them comparable. This guest article explains how to common-size a P&L statement.
Apples and Oranges
Let me ask you a simple question – I am giving you a financials of two companies: Apples and Oranges.
The question is: Which is better?
In absolute values Apples seems to have performed better (higher revenue and higher operating profit must mean a better performance!). But in this world of relative grading, just as apples cannot be compared to oranges, meaningful comparisons cannot be made across different-sized companies without first adjusting their financial statements.
Overcome this problem – create a level playing field?
Common-sizing financials is one way to level the field, as this process makes financial statements of different companies comparable. Thus, it allows investors and other interest stakeholders to gain insight into the performance of each company that may be obscured by the absolute numbers. Simply stated it is nothing big: Instead of comparing absolute numbers, compare ratios, percentages and multiples!
Use Excel to facilitate your calculations
If you have your numbers in Excel, it can make the calculations a breeze! All you need to do: Start with an "=" in the cell, use your UP arrows and use it like a calculator to get the results. If you want to convert them into percentages, simply press CTRL + SHIFT + 5.
The first thing that might make sense: Express each income statement item as a percentage of revenue, i.e. divide each line item by the revenue. This simply states that for each dollar of revenue generated, what was the respective line item and how much money remains after incurring all costs. This makes comparison between Apples and Oranges possible for each dollar of revenue they generate!
In the screenshot below, the sheet Problem contains the original, absolute financials, with D7 being the revenue:
Although not shown in the screenshot - in the case of income tax expense, it may make more sense to express it as a percentage of pre-tax income, as it is not really dependent on how much revenue is generated.
A quick word on analysis
The common size income statement for company Apples shows operating profits are 21% of sales. The same calculation for company Oranges shows operating profits at 56% of sales. Therefore, the common size statements make it easy for us to say that company Oranges is more profitable on a relative basis.
A look at the common size financial statement reveals company Oranges is more profitable. For each dollar of revenue it generates, it is able to retain more for the shareholders! So if it can increase the revenue, at this pace, it would definitely make more money for the shareholders.
Why should I use Excel for learning?
Today, Excel spreadsheets are indispensable in any finance and accounting job. The ability to use excel in financial modeling opens doors to many interesting career opportunities. Therefore learning-by-doing examples and practical applications enhance the practical knowledge and understanding of both finance and Excel.
This guest article was provided by Paramdeep Singh from finance training provider Pristine. Pristine offers general finance and Excel education and is also an authorised exam preparation training provider for programmes like the CFA (Chartered Financial Analyst) programme, the FRM (Financial Risk Manager) programme and the PRM (Professional Risk Manager) programme. You can reach Paramdeep at email@example.com.