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Common Size Income Statements Industry

1997 1998 1998 Net Sales 100.0% 100.0% 100.0%Costs excluding depreciation 87.6 87.2 87.6

Depreciation 3.2 3.3 2.8Total Operating Costs 90.8 90.5 90.4Earnings before interest & taxes 9.2 9.5 9.6

Less interest 2.1 2.9 1.3Earnings before taxes 7.1 6.5 8.3

Taxes (40%) 2.8 2.6 3.3 Net income before preferred dividends 4.3 3.9 5.0

Preferred dividends 0.1 0.1 0.0 Net income available to common stockholders 4.1 3.8 5.0

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Common Size Balance Sheets Industry

1997 1998 1998 Assets Cash & Marketable securities 4.8% 0.5% 3.2%Accounts receivable 18.8 18.8 17.8Inventories 24.7 30.8 19.8

Total Current Assets 48.2 50.0 40.8 Net plant & equipment 51.8 50.0 59.2

Total Assets 100.0 100.0 100.0Liabilities & Equity Accounts payable 1.8% 3.0% 1.8%

Notes payable 3.6 5.5 4.4Accruals 7.7 7.0 3.6

Total current liabilities 13.1 15.5 9.8Long term bonds 34.5 37.7 30.2

Total Debt 47.6 53.2 40.0Preferred equity 2.4 2.0 0.0Common equity 50.0 44.8 60.0Total Liab. & Equity 100.0 100.0 100.0

Horizontal Common Size Income Statements

A vertical common size income statement expresses expenses in a given year as a percentage of that year’s sales, which allows an investor to evaluate a company’s performance over time. Another approach to this type of analysis is a horizontal common

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size income statement. In this case, each line item on the income statement in a givenyear is pegged to a base year, such as the prior year or some arbitrary starting year.

Consider the following, which is the 3-year income statement presentation for Plantronics, Inc. included in their 10K statement filed June 5, 2006.

In the example of a vertical common size statement we discovered that cost of goods soldrose to 56.5 percent of sales in fiscal year 2006 from 48.5 percent in 2005. Now consider the same income statement expressed in the horizontal common size format. In this case,2004 is used as the base year for each of the subsequent years.

Vertical Common Size Income Statements

Vertical common size financial statements remove the impact of size by expressing eachline item as a percentage of a reference item, usually sales or assets. In a spreadsheet thiscan be done simply by dividing each line item by that year’s net revenues figure.Consider the following, which is the 3-year income statement presentation for Plantronics, Inc. included in their 10K statement filed June 5, 2006.

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We can see right away that in Plantronics’ 2006 fiscal year its net income fell eventhough revenues increased significantly. However, it is not so easy to tell exactly why the

performance deteriorated. Now consider the same statement expressed in a verticalcommon size format.

Presented in this format, it is easy to see that a significant increase in the cost of salesrelative to total sales drove declining profit margins.

Common Size Analysis

Suppose someone told you that a particular company had $1 billion in earnings one year.Is that good or bad? The answer depends on many factors, including:

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• How much revenue did the company book in order to achieve those earnings?• How much did competitors of a similar size earn?• How much did the company earn last year?

How can an investor fairly compare one company’s earnings to another, given that they

cannot be exactly alike in all other respects? How can the firm’s performance becompared to its past performance to determine whether it is improving? Common sizeanalysis is one tool that allows investors to compare companies across time and withother companies.

The following articles explain how to use common size analysis in practice:

1. Vertical Common Size Income Statements shows how to express the incomestatement as a percentage of sales and use this data to analyze a company’s

performance over time.2. Horizontal Common Size Income Statements demonstrates how to express the

financial statements in each year as a percentage of a given base year. This permits an investor to see if certain expenses, assets or liabilities are growingfaster than others.

3. Common Size Balance Sheets can be used to compare companies even when theyuse different currencies.

4. Using Common Size Statements to Forecast Earnings shows how to do just that.

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In this format, the same data can be inferred because we see that sales grew 80 percentfrom 2004 through 2006 while cost of sales grew 111 percent. (In each case taking theending value and subtracting the 100 percent starting value.) Since cost of sales are risingmuch faster than sales themselves, it is clear that profitability is falling.

Using Common Size Financial Statements to ForecastEarnings

We have shown how to prepare vertical common size income statements . This articleaddresses how they can be used to forecast future earnings.

Consider our vertical common size income statement for Plantronics, Inc.

Right away we can see that research and development expense has remained fairly stable between 8.1 and 8.5 percent. This suggests that Plantronics views them at least partiallyas a variable cost. Higher revenues would result in higher expense, and the companymight trim the expense if sales decline. An earnings model might assume that R&D for Plantronics would be 8.3 percent of sales, and the resulting estimate would probably beclose to the actual figure.

Now consider the horizontal common size statement.

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This shows that selling, general and administrative expense is consistently growingslower than revenue, which in turn suggests that there is a fixed cost component to thisexpense. As revenues rise, the fixed part of the expense doesn’t rise but the variable

portion does. By looking at the relative change (the change in SGA divided by the changein revenues) shows a one year relationship of 65 percent and a two year relationship of 75

percent. In other words, in 2005 SGA grew 65 percent as fast as revenue and in from2004-2006 they grew 75 percent as fast. We could assume a 70 percent average rate, butthe two-year trend is probably more accurate than a single year so perhaps an estimatecloser to 75 percent would be more appropriate.

When making this type of estimate, it helps to look into the footnotes to see if there will be any unusual expenses or changes to the historic relationship. An example of this can be found on Stock Market Beat , in a post titled Plantronics Valuation . Plantronics plansto increase both its advertising expense and its capital expenditures (future fixed costs) in2007. Given this data, we will go with an estimate that SGA will grow 75 percent as fastas sales.

The same method can be used to evaluate cost of sales. Again looking at the footnotes wesee that cost of sales is rising due both to increased capital expenditures and to a shift tomore consumer products at lower margins. This shift may continue since the recentacquisition added new consumer lines, which might bring cost of sales up to 60 percentof revenues from the current 56.5 percent.

So now we can design an earnings model:

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Revenues Growth rate to be estimatedCost of sales 60 percent of revenuesResearch and development 8.3 percent of revenuesSelling, general and

administrative

Previous year SGA times (1 + (75 percent of the revenue

growth rate)

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