In addition to financial ratio analysis over time, it is often useful to express balance sheet and income statement items as percentages. The percentages can be related to totals, such as total assets or total net sales, or to some base year. Called common-size analysis and index analysis respectively, the evaluation of levels and trends in financial statement percentages over time affords the analyst insight into the underlying improvement or deterioration in financial condition and performance. Though a good portion of this insight is revealed in the analysis of financial ratios, a broader understanding of the trends is possible when the analysis is extended to include the foregoing considerations. Also, these two new types of analysis are extremely helpful in comparing firms whose data differ significantly in size, because every item on the financial statements gets placed on a relative, or standardized, basis.
In common-size analysis, we express the various components of a balance sheet as percentages of the total assets of the company. In addition, this can be done for the income statement, but here items are related to net sales. The gross and net profit margins, taken up earlier, are examples of this type of expression, and the procedure can be extended to include all the items on the income statement. The expression of individual financial statement items as percentages of total helps the analyst spot trends with respect to the relative importance of these items over time. To illustrate, common-size balance sheets and income statements are shown alongside regular statements in Tables 6.4 and 6.5 for R. B. Harvey Electronics Company for 20X0 through 20X2. In Table 6.4 we see that, over the three-year span, the percentage of current assets increased, and that this was particularly true for cash.
In addition, we see that accountreceivable showed a relative increase from 20X1 to 20X2. On the liability and equity portion of the balance sheet, the total debt of the company declined on a relative (and absolute) basi from 20X0 to 20X1, primarily because of a decline in notes payable. However, with the large absolute increase in assets that occurred in 20X1 and 20X2, the debt ratio increased frorr 20X1 to 20X2. The rebound in the importance of debt financing is particularly apparent in accounts payable, which increased substantially in both absolute and relative terms in 20X2.
The common-size income statements shown in Table 6.5 show the gross profit margin fluctuating from year to year. An improved 20X2 gross profit margin, coupled with better relative control over selling, general, and administrative expenses, caused 20X2 profitability to improve sharply over 20X0 and 20X1.