Explain how common-size balance sheets are used by analysts

Answer 1

COMMON-SIZE BALANCE SHEET

Many analysts use a common-size balance sheet, which expresses each balance sheet item as a percentage of total assets. Comparing firms using a common-size balance sheet rests on the assumption that the size or scale of a business does not affect the relation between a given balance sheet item and total assets. This assumption need not hold. Large firms often achieve economies of scale that affect the proportionality of the components of their business, thus reducing the comparability of their common-size ratios with those of smaller-scale competitors. For example, a large purchaser of goods and services has negotiating power over its suppliers, relative to the negotiating power of a smaller purchaser, such as a single local clothing store. The large purchaser can negotiate better terms, including lower per-unit prices (which, holding quantity constant, implies a lower per-unit recorded amount for inventory), more frequent but proportionately smaller quantities purchased (which reduces the quantity of inventory held by the purchaser), and better payment terms (which increases the time the purchaser retains cash as opposed to paying it to the supplier). More negotiating power would appear on the large purchaser's balance sheet as proportionately smaller amounts reported for inventory and proportionately larger amounts reported for accounts payable, relative to the amounts reported by a smaller purchaser with less negotiating power. Typically, users would not compare the common-size balance sheets of two firms that differed significantly in size.