Common-Size and Ratio Analysis

Common-Size and Ratio Analysis: A Comprehensive Guide | CFA Level I FSA

In this article, we’ll dive into two powerful analytical tools for comparing income statements: common-size analysis and income statement ratios.

Let’s take a look at two competing companies, Mammoth and Tiny.

Mammoth is significantly larger and more profitable than Tiny in absolute terms. For instance, Mammoth’s gross profit is $26 million, while Tiny’s is $4.5 million. So, how can an analyst meaningfully compare the performance of these two companies? By using margin ratios and common-size analysis, of course!

Margin Ratios: Quick Profitability Measures

Margin ratios allow analysts to quickly compare profitability between companies. Key margin ratios include:

Gross profit margin can be increased by raising prices or reducing production costs, while net profit margin measures the profit generated after considering all expenses.

Common-Size Analysis: Comparing Companies of Different Sizes

Common-size analysis involves presenting all income statement items as a percentage of revenue. This makes it easier to compare companies of different sizes. However, income tax expense is more meaningful when expressed as a percentage of pretax income, known as the effective tax rate.

From the common-size income statement, we can see that Tiny has a higher gross profit margin than Mammoth. However, this advantage is diminished by Tiny’s much higher relative rent costs, resulting in similar operating profit margins for both companies.

The common-size statement can also provide insights into a firm’s strategy. Mammoth’s strategy appears to be aggressive price cutting to drive sales, as indicated by its high revenue but lower gross profit margin.

Cross-Sectional and Time-Series Analysis

Common-size analysis can be used in two ways:

For example, using a time-series common-size statement for Mammoth, we observe that its profit margins have increased over the past year, primarily due to lower production costs. An analyst may want to investigate the reasons behind this trend and assess its sustainability in future periods.

We’ve learned how to use ratios and common-size statements to study and compare companies. In our next lesson, we’ll wrap up this topic with a brief discussion on comprehensive income.

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