Common-Size Income Statement

Common-size income statements are very useful when trying to understand a

business’s performance, especially when compared to peers. While they don’t
tell you the whole story at a glance, they do a very good job in identifying
areas of potential interest for further investigation.

A common-size income statement shows every cost and profit item as a

percentage of revenue (simply by dividing each line by total revenue). Profit
items from a common-size income statement are also known as profitability
ratios.

We can see that every dollar ABC earned as revenue in 2020 costs 80 cents
to produce and deliver but then the scale is big enough and the company
efficient enough to support the operation with only 3% of revenue as fixed (or
operating) costs.

Of course, these examples only illustrate the mechanics of how the analysis
begins. A seasoned financial analyst will dig deeper and combine horizontal
and vertical analysis:

What we can infer from the 3-year period common size income statement:
  Strong revenue growth should suggest that operational (fixed) unit costs
should decline; but then operational costs (in this case at just 3% of
revenue) are merely a fraction of total costs and so that won’t make
much difference.
 On the other hand, we have rising production (variable) costs, which
form the bulk of the company’s costs. This doesn’t look good. Perhaps
last year’s acceleration of growth came with certain capacity constraints
that drove production costs up? This needs to be checked.
 We can also see that R&D and depreciation costs nearly doubled last
year, so the firm seems to be investing but the question is, is it investing
efficiently? They spent on PP&E but yet, instead of rising productivity,
production costs went up. Could there be technological constraints
here? A steep learning curve on new machinery?

So, growing revenue, rising costs of production, fairly steady operational costs
but declining profitability (as a percentage of revenue), combined with
investment in R&D and PP&E. Is this good or bad?

What have we here:

 XYZ’s revenue grew slower but at an accelerating pace. They started
with about the same revenues at $35 million; but while XYZ only grew to
$71m in 2020, ABC had $112m!
 Note however that XYZ was the more profitable of the two and as it
happens it had significantly higher operating and net profit margins in
2020.
 One glance at the common-size income statements reveals that ABC’s
direct costs are much higher than those of XYZ and as a result, the
latter has a lot more gross profit, which it can use to cover operational
costs, to invest in R&D or in marketing, or to redirect to capital
expenditures, thus keeping its plant more productive.
 You can compare fixed cost line items and see that XYZ spent more on
R&D and on Marketing (in absolute terms) over the last year (and
slightly less on general and admin expenses). It could well afford it.
 It is also interesting that depreciation expenses for XYZ are staggeringly
higher than ABC’s. Could this be the reason why its gross margins fare
that much better? Because it invested more in more productive
machines and equipment? Or is it just due to different depreciation
methods?