A common question that comes up in the daily banter between business professionals is "How's Business?". And the answer to this question usually takes the form of; "Great", "OK", "Could be better", "Looking up", etc, etc. One of the ways this question can be answered in a more sophisticated manner is to use financial ratio analysis to develop a more informed judgment as to the financial performance of your company. I've discussed this subject in a previous Blog (see, "Some Tips for Studying Financial Ratios").
Ratio Analysis is a primary analytical tool for evaluating historical financial performance against both internal financial benchmarks and industry standards. However, another financial performance evaluation tool, Common-Size Statement Analysis, can also be used for this purpose, but much more narrowly, to make similar financial performance comparisons. Since the BOK doesn't devote very much discussion to this topic, I think that an exam question designed to test your understanding of it would fall into the category of a "drill-down" question. So I believe that some study of this subject is warranted so that you gain an understanding of how common-size benchmarks are determined and how they are used to evaluate financial performance.
This analytical tool expresses the components of the Income Statement and the Balance Sheet as percentages of their respective totals. In the case of the Income Statement, for example, the components of Cost of Goods Sold and Operating Expense are divided by Net Profit and expressed as a percentage. Also, the various Profit Margins that are discussed in the BOK are calculated this way (see my Blog: "Some Thoughts about Profit Margins").
In the case of the Balance Sheet, for example, the various asset categories are divided by Total Assets and expressed as percentages. The following are the asset categories from the sample Balance Sheet in the BOK expressed as percentages.
Short -Term Investments 8%
Accounts Receivable 11%
Pre-Paid Expense 6%
Net PP&E 48%
The same procedure would also be applied to the components of Total Liabilities and Equity to determine their respective percentages for the purpose of performing Common-Size Statement Analysis.
This financial performance evaluation technique is based on the premise that companies in the same industry will have relatively the same percentages for the components of their financial statements. Given this, these "industry percentages" can serve as financial performance benchmarks for comparison purposes.
Here's an example, let's assume that the 10% Cash percentage mentioned above is an industry benchmark and our company is a member of that industry group. Now, if our Cash is 20% of Total Assets which is above the industry benchmark, investors will question our ability to profitably manage our assets. On the other hand, if our Cash is 5% of Total Assets which is below the benchmark, both investors and lenders will be concerned that we may have liquidity problems.
So, using Common-Size Statement Analysis as one of the techniques to evaluate the financial performance of your company gives you the opportunity to add the following, to your litany of responses, to the almost daily question of, "How's Business?" which is, " We're in the zone"
-George Schilling, CTP