A.5 Appendix:  Common Size Analysis

Introduction

 

The major purpose for preparing financial statements is so users can extract useful information from them about a company.  The first step is to understand how financial statements are constructed and what the various line items mean.  This was covered earlier in the introduction to financial statements.  In this topic we explore a technique designed to let users extract additional information from the financial statements.  This technique is referred to as common size analysis.  Common size analysis re-expresses an entire financial statement relative to a single item referred to as the “base item.”  Typical base items are Total Assets and Revenue for general purposes, but the depending upon the purpose many other base items are relevant for specific purposes.  Common size analysis creates a simple ratio between every item on the financial statement and the selected base item.  Ratio analysis provides a refinement of common size analysis designed to extract and summarize additional information relative to key categories such as profitability, risk, solvency and liquidity.

Vertical and Horizontal Common Size Analysis

There are two types of common size analysis, vertical and horizontal.  Vertical analysis restricts common size analysis to one reporting period and typically focuses upon the composition within a report.  For example, vertical analysis provides immediate insight to users regarding asset, financing and cost structures within a firm.  Horizontal analysis applies common size analysis to focus upon trends and changes over time.   For example, how has a firm’s gross margin changed over time? 

Both vertical and horizontal common size analysis can be further extended to comparing across a set of competitors or other firms to tease out additional information.   As a result, common size analysis is an important tool that is immediately applicable to the financial reports.

Valuation Tutor lets you work interactively and visually with the financial statements provided to investors in a 10-K, 10-Q, and 20-F.  This is a powerful tool lets you take common size analysis to new heights permitted by today’s technology.  This tool allows for the common size analysis of any of the latest as well as past interactive statements so that easy comparisons can be made over time and among immediate competitors or other stocks being screened.  This ensures that you are extracting timely information from these reports that can be compared to responses in the stock market after the reports are publicly disclosed such as in “earnings’ season.”

The opening screen appears as follows:

The top LHS of the screen is where you enter the ticker and select the statement you want to apply common size analysis to.  The bottom LHS of the screen is the statement you have selected to apply common size analysis to, the center part of the screen is the base variable that you select to scale by (which can come from another statement) and the RHS of the screen is the results of your graphical analysis.

First we consider the default Consolidated Balance Sheet and scale it by Total Assets.  We then extend this analysis to the Income other statements.

Common size Analysis of the Balance Sheet

The common size analysis of a balance sheet can immediately highlight some important issues such as: 

What is the composition of assets (real versus financial assets)?

What is the financing composition (debt versus equity)?

How does the asset composition change over time?

Has the financing composition changed over time?

What does a strong versus a weak balance sheet look like?

Vertical analysis provides answers to the first two questions and horizontal analysis provides answers to the second pair of questions.  Combined, both forms of analysis provide some relevant information for the last question.

Example:  Common Size Analysis using Total Assets for Apple

In the above screen a common size analysis of the January, 2012 balance sheet for Apple is provided scaled by Total Assets.  The LHS of the screen provides the results of the analysis and the RHS of the screen presents these results graphically.

A few immediate observations jump out.  First, the relative importance of Property, Plant and Equipment to Apple is not large.  This reflects the fact that manufacturing hardware such as the Apple iPhone is outsourced.  The relative importance of Financial Assets is immediately clear.  The big spike is “Long term marketable securities.”  In general the asset composition is a much greater emphasis upon financial as opposed to real assets for Apple. 

Furthermore, this is an increasing trend over time.  For example the relative percentage of total assets for PPE is declining, because Apple’s financial assets are growing.  This is especially the case for investment related financial assets however Apple’s working capital assets, such as inventory and accounts receivable, are also growing.  This reflects the current growth and the expectations for immediate future growth.

The composition f liabilities for Apple also reflect strength.  Apple has no debt and the composition is heavily skewed toward current liabilities (long term liabilities are approximately 10% of total liabilities).   Compared to Total Assets Apples total liabilities are low, less than 40% implying that the stockholders’ equity is relatively large (65%).

The composition can be decomposed to reveal greater detail in a more traditional pie chart

How does Apple compare to Intel, a manufacturer that does not rely heavily on outsourcing?

Immediately the difference for real assets is apparent.  Intel’s PPE has increased from 28% to 33% in contrast to Apples decrease to 5.6% from 6.7%.  This reflects the fact that Intel manufacture in their own plants.

Similarly, on the liability side investment in real assets implies the financing decision is more important to Intel than it is to Apple.

The relative % of Owners Equity has declined for Intel to just over 60% from a very high 78% which is largely due to the additional long term debt financing taken on over the last year – presumably to take advantage of the very low rates currently available to fund its increased investment in real assets.

Example:  Common Size Analysis using Revenue for Apple

Common size analysis applied to Apple’s 2012 10Q reveals the strength in earnings for this company.  First, Gross margin, Operating and Net Income have all increased.  Every cost category has declined with the exception of provision for taxes which understandably increased.

Apple’s Gross Margins are large and growing (45%, 35% respectively for 2011, 2010 December quarters). 

Example:  Common Size Analysis of the Cash Flow Statement for Apple

Common size analysis of the cash flow statement provides additional insights into the Operating, Investing and Financing activities of the firm.  For example, scaling these activities by Net Income reveals that Apple is achieving large amounts of growth without increasing their investments:

However, the Cash Flow from Operations as a % of Net Income is declining which raises the interesting question why:

Graphically you can observe this from the RHS plot relative to the LHS plot (which is Net Income/Net Income = 1).

To clarify this consider scaling both cash flow statements by the net income for the 2010 quarter.  This is achieved by selecting both 2010 statements circled below:

Now all is relative to the 2010 Net Income.   This common size analysis immediately reflects the strong growth Apple is currently experiencing.  That is, the increase in December quarter’s net income was 218%!   Common size analysis immediately reflects how each category has grown relative to Net Income.  This reveals that along with this rapid growth Apple was positioning itself for even stronger growth especially with respect to the working capital items such as Inventory, and accounts payable.  Also reflective of the quarter’s realized growth was the sharp jump in accounts receivable.  Combined these working capital items implied that the rate of increase in net income greater than the rate of increase in cash flow from operations.  The pie chart depicting composition makes this clearer:

In the above scaled by 2010 Net Income the growth in Net Income for the same quarter 2011 was 218% but the growth in cash generated from operations is 2.92/1.63 = 179%.   This is largely driven by Accounts Receivable jumping from -2.80% to -11.28% (i.e., a use of cash), Inventory jumping from 0.90% to -1.46% (a use of cash) and Accounts Payable increasing from 12.7% to 13.7% (a use of cash).  These jumps when growth is strong indicates the expectation of even stronger growth to come.