A Common Size Income Statement Might Just Help!
August 25, 2015
What is a common size income statement and can it help a small business improve operations and increase profits? You're a small business owner or manager and diligently review the income statement every month. Some numbers steadily increase or decrease while others might have erratic jumps or drops. Simply seeing a change in dollars (or other currency) does not give a complete picture of how the business is doing in various categories.
Can you tell by just looking at the numbers if certain categories are out of line? If revenues and expenses are all increasing, do you know if some increases are disproportionate from others? Probably not, but there is an answer.
Convert Dollars to Percentages
Common size financial statements convert all dollars to percentages. This is an excellent way to review trends in a business, compare month-to-month (or quarter-to-quarter or year-to-year) revenue and expenses, and spot any anomalies that appear. When numbers are viewed as percentages, it is much easier to spot categories that are inconsistent with prior accounting periods. This enables you to start asking questions about why a particular category had a significant increase or decrease percentage-wise and take immediate action if needed.
If a category had a positive increase, then efforts can be made to continue the positive trend. On the other hand, if a category had a negative turn, then corrective action can be taken to reverse the trend before the profitability of your business is severely impacted. One advantage of preparing and reviewing income statements monthly rather than quarterly or annually is so operational changes can be made sooner rather than later to improve efficiencies, reduce waste, and increase profits.
Now, how are the percentages calculated? Simply take the actual dollar amount of a particular account category and divide that number by the total revenue number. This gives you the number as a percentage. As an example, if the total revenue line on the income statement is $1 million and rent expense is $240,000, then the rent percentage would be 24% ($240,000 divided by $1,000,000.). In preparing a common size income statement, the amount on the total revenue line continues to remain the same while the numbers will vary for each individual account category.
It is best to enter these numbers on a spreadsheet with the oldest accounting period in the left column moving to the right, as income statements for subsequent accounting periods are prepared. Total revenue and expenses would be listed on the left side of the spreadsheet. When spreadsheets are prepared in this manner, you can review a complete history of your business at a glance and see what numbers look out of the ordinary.
Review Trends and Anomalies
After completion of the common size income statement, it is now easy to review trends and anomalies. As an example, if an expense normally was in the range of 4-5% and jumped in one period to 8%, you would want to investigate the reason for the sharp jump. Likewise, if an expense was normally in the 8-9% range and dropped to 4% in one period, review would also be warranted.
Strictly reviewing "dollar amount" income statements might not have alerted you to these abnormal expense trends. This is the reason common size income statements for comparison purposes are so helpful in detecting anomalies. Out of the ordinary percentages can be an indicator of abnormal expenses, bookkeeping errors, or legitimate expenses. Whatever the reason, anomalies should be reviewed.
Financial knowledge is a powerful tool that enables you to use what happened in the past to improve upon the future. Preparing common size income statements is one of these tools available to any small business owner. Don't just react to the past but use the past to make the future of your business better!