Common-Size Analysis of the Income Statement
Common-size analysis of the income statement can be performed by stating each line item on the income statement as a percentage of revenue. Common-size statements facilitate comparison across time periods (time series analysis) and across companies (cross-sectional analysis) because the standardisation of each line item removes the effect of size.
The common-size income statement also highlights differences in companies’ strategies. Comparing the two larger companies, Company A reports significantly higher gross profit as a percentage of sales than does Company B (70 percent compared with 25 percent). Given that both companies operate in the same industry, why can Company A generate so much higher gross profit? One possible explanation is found by comparing the operating expenses of the two companies. Company A spends significantly more on research and development and on advertising than Company B. Expenditures on research and development likely result in products with superior technology. Expenditures on advertising likely result in greater brand awareness. So, based on these differences, it is likely that Company A is selling technologically superior products with a better brand image. Company B may be selling its products more cheaply (with a lower gross profit as a percentage of sales) but is saving money by not investing in research and development or advertising. In practice, differences across companies are more subtle, but the concept is similar. An analyst, noting significant differences, would do more research and seek to understand the underlying reasons for the differences and their implications for the future performance of the companies.n-size analysis of the income statement can be performed by stating each line item on the income statement as a percentage of revenue. Common-size statements facilitate comparison across time periods (time series analysis) and across companies (cross-sectional analysis) because the standardisation of each line item removes the effect of size.
Vertical common-size analysis of the income statement is particularly useful in cross-sectional analysis—comparing companies with each other for a particular time period or comparing a company with industry or sector data. The analyst could select individual peer companies for comparison, use industry data from published sources, or compile data from databases based on a selection of peer companies or broader industry data.
Income Statement Ratios
One aspect of financial performance is profitability. One indicator of profitability is net profit margin, also known as profit margin, and return on sales.
Another measure of profitability is the gross profit margin. Gross profit (gross margin) is calculated as revenue minus cost of good sold, and the gross profit margin is calculated as gross profit divided by revenue:
The gross profit margin measures the amount of gross profit that a company has generated for each dollar of revenue. A higher level of gross profit margin indicates higher profitability and thus is generally more desirable, although differences in gross profit margins across companies reflect differences in companies’ strategies.
The net profit margin and gross profit margin described previously are just two of the many subtotals that can be generated from common-size income statements. Other “margins” used by analysts include the operating profit margin (profit from operations divided by revenue) and the pretax margin (profit before tax divided by revenue).
