Common-Size Analysis of Income Statements

Your role may require you to perform an analysis using common-size income statement data and to do this you have to follow a simple process.

1. Take your oldest year and make the revenue or sales figure your baseline.
2. Then show following years as a percentage gain or loss of this baseline.
3. Next, for each of the years under consideration express operating expenses and income as a percentage of revenue.
4. You can then look for trends in the resulting data.

When looking for trends you are hoping to see that revenue growth exceeds or at least keeps pace with the growth of expenses. If you look at the table below you can see that operating income or revenue is declining, but still acceptable.

Performing a common-size analysis using income statements

The figures in the table show that you need to address the growth of operating expenses if your organization wishes to remain within a reasonable range of profitability. Otherwise the decline in profits will continue and could eventually affect the viability of your organization.

The growth of expenses is outpacing revenue growth and by using the common-size analysis you are able to easily identify discrepancies that require further exploration.

You may need to refer to good sources of data such as Dun & Bradstreet and the Risk Management Association to assist your analysis. Both these organizations release an annual study of financial statements for small- and medium-sized organizations (SMEs).

Key profitability indicators

Once you've obtained this data, you can break down the information provided by the income statements. Three of the big profitability indicators you should look at are:

Gross Profit Margin - measures how well an organization is performing at its most base level of activity. Is it making a profit on the product or service that it is selling?

Operating Profit Margin - is calculated by taking the revenue and subtracting all the expenses related to the day-to-day operations of the organization, such as cost of goods sold and labor. This will exclude things like interest expense and one-time charges that are not a core part of the organization's operations. This gives the operating earnings, which are then divided by revenue to get the operating profit margin. The resulting figure provides a good indication of how efficiently the company is operating.

Net Profit Margin - is derived by dividing net income by revenue, measuring the amount of income an organization generated for each dollar of revenue.

Once you have these three figures you will be able to make a judgment on how profitable an organization's growth strategy has been.

This Key Financial Ratios Checklist details the key financial ratios you can use to help you interpret financial information. This Financial Ratio Formulas Checklist provides you with a list of the most popular financial ratios used to assess an organization's performance, solvency, profitability and investment potential. If you need a basic financial accounting principles pdf then download our free eBook now.

You may also be interested in:
Income Statement Definition | Income Statement Format | Multiple-Step Income Statement | Income Statement Explained | Operating Expenses Definition | Income Statement Ratios | Common-Size Income Statements | Income Statement Cash Flow.

Key Points

  • When performing a common-size analysis the profitability indicators you should look at are gross profit margin, operating profit margin, and net profit margin.
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