Common size balance sheet : A vertical presentation of the balance sheet
Common size balance sheet is a vertical presentation of the balance sheet wherein each item is presented as a percentage of total assets. This standardizes the balance sheet and allows for better comparison of the company’s results over time and also the comparison of a company’s results with that of another company.(Click here to read the post covering the basics of how to read and interpret a balance sheet)
Common size balance sheet example
Please refer to the below balance sheet and common size balance sheet example.
|Balance sheets of company ABC and DEF as on 31st March 2015|
|Plant and equipment||35000||11000|
|Long term debt||27000||5000|
|Total liabilities & equity||48200||15100|
On viewing the above balance sheet example we see that firm ABC is a much bigger firm than DEF and therefore the two are not so comparable. Converting it to a common size balance sheet allows for much better comparison.
|Common size Balance sheet example of company ABC and DEF as on 31st March 2015|
|Plant and equipment||72.61||72.85|
|Long term debt||56.02||33.11|
|Total liabilities & equity||
Common size analysis: How it allows for better comparison
Common size analysis helps us to do away with the size problem and delve deeper. Now on comparison of the two common size balance sheet example, we can see that current liabilities of firm ABC are much higher than that of DEF. ABC’s working capital position is very weak and it may not be able to service its short term obligations. That is not to say, company DEF has a superior working capital position. Such a large working capital could also indicate productive resources being tied up in current assets.
From the above common size analysis, we can also see that company ABC’s inventory balance is too high which could be indicative of slow moving and obsolete inventory. That means the company’s sales are not doing too well.
Also the long term debt of company ABC is too high at 56% compared to DEF. High debt does not bode well for a company and may suggest the company is having trouble servicing its debt. Hence, we can see from the above how common size analysis has helped us to make a better comparison and find the better managed company.
Balance sheet ratios – Liquidity ratio and Solvency ratio
Liquidity ratio and solvency ratio are balance sheet ratios.
Liquidity ratio measures a firm’s ability to be able to service its short term obligations as they come due. There are three liquidity ratios, current ratio, quick ratio and cash ratio.
Current ratio = current assets / current liabilities
Quick ratio = cash + marketable securities + receivables / current liabilities
Cash ratio = cash +marketable securities / current liabilities
All three liquidity balance sheet ratios should be considered together. For example, the current ratio of company A may be higher and its quick ratio may be lower compared to B. This suggests that inventory forms a large part of current assets of company A.
Quick ratio is also called as the acid test ratio as it is calculated by excluding inventory from current assets and is a more stringent ratio compared to current ratio and gives a truer picture of the liquidity position of the company.
Cash ratio on the other hand considers only cash and cash equivalents available to service the current liabilities, making it the most liquid ratio.
Solvency balance sheet ratios measure the company’s ability to service its long term debt obligations. There are four solvency ratios;
Long term debt to equity ratio = long term debt / equity
Total debt to equity = total debt / equity
Debt ratio = total debt / total assets
Financial leverage ratio = total assets/ total equity
Solvency balance sheet ratios should also be looked at together. A higher long term debt to equity ratio and a lower total debt to equity of company A compared to another company C indicates that C has larger proportion of short term debt.
Debt ratio indicates if the assets are sufficiently covering the liabilities (debt).
Financial leverage ratio calculates what portion of the assets is funded by equity. The remaining portion is obviously being funded by leverage (debt).
With this we come to the end of our discussion on common size balance sheet and balance sheet ratios, in which we have seen a common size balance sheet example and how common size analysis helps in better comparison of financial statements across time periods and also across companies…..I hope the post was useful to you…from the next post we will begin a series of posts covering cash flow statements….check in again later…bye
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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