Discussion Question

2.3 Common-Sized Balance Sheets When comparing a large company to a small company, it can be difficult to compare apples to apples. For example, the Best General Company budget committee may want to look at larger companies with similar business models to see how their sales and other benchmarks compare, but this would be hard to do by just looking at the dollar values. While the common-sized balance sheet is not a required format of the SEC, it can be a helpful tool. Few companies provide this information, but anyone can generate this statement.

Creating a common-sized balance sheet makes comparison easier no matter what size the company, because it is based on percentages rather than dollars. A common-sized balance sheet enables users to analyze the balance sheet from a different perspective by calculating each number as a percentage. A common-sized balance sheet therefore presents the information in two ways: both as dollar figures and as percentages. The Asset section of the column shows all assets as a percentage of Total Assets. The Liabilities and Equity section of the column shows all Liabilities and Equity as a percentage of Total Liabilities and Equity.

Figure 2.15 is a sample common-sized balance sheet for Best General Company.

Figure 2.15: Common-sized balance sheet for Best General Company

2.3 Common-Sized Balance Sheets

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A common-sized balance sheet enables easier comparisons of smaller to larger companies. It also gives users a different perspective for comparing financial results from period to period.

Taking a quick look at Best General Company’s common-sized balance sheet in Figure 2.15, the budget committee can see what proportion of the company’s funds is allocated to what line items. For example, the largest portion of current assets is held in inventories: 20.28%. Property, plant and equipment claim 45.64% of assets. Are these percentages common in the industry in which Best General Company operates?

The budget committee could answer this question by looking at industry averages and comparing its common- sized balance sheet to competitors. No matter how large a company is, the percentage allocations for each type of asset should be similar. Looking at only the dollar figures, one cannot do the same comparison for different-sized companies.

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Therefore, common-sized balance sheets can help managers and executives analyze the numbers for three different and critical purposes:

1. To benchmark a company’s financial position to that of other similar companies and industry norms. For example, suppose one company holds 20% of its total assets in inventory, but other companies in the same industry normally hold 15%. Managers may then have questions about how well the company holding a higher percentage of inventory is managing its inventory.

2. To compare two companies in the same industry, regardless of size. By using a common-sized balance sheet, managers can compare the percentage each company has for each line item. Size of the company won’t matter.

3. To find trends in the line items of a balance sheet. If managers prepare a common-sized balance sheet with five years’ worth of data, they can more easily spot a trend for the various line items on the balance sheet. For example, if Accounts Receivable is gradually going up as a percentage of Total Assets, managers can quickly recognize that with a common-sized balance sheet.

The SEC rules do not require companies to prepare a common-sized balance sheet. These are reports generated by companies to spot trends, so there are no SEC rules about how these reports need to be prepared.

Common-sized balance sheets are most often prepared by showing the current year and then the last fiscal year as dollar amounts in the first two columns. Then the same information for the two years of data is shown as percentages. Some analysts prefer to show only the percentages and not the dollar amounts. Both ways are acceptable.

Task Box 2.7: Creating a Common-Sized Balance Sheet for IBM To prepare a common-sized balance sheet, start an Excel worksheet. Copy the information from the IBM balance sheet into the Excel worksheet.

Develop a formula to divide each line item in the Assets section by Total Assets. Next, develop a formula to divide each line item in the Liabilities and Equity section by Total Liabilities and Equity.

To make things easier for you, we have developed a template that includes the most common line items on a balance sheet and the formulas already developed for the percentage columns. You can download that template here (https://ne.edgecastcdn.net/0004BA/constellation/Articulate/OMM622/Financial_Decision_Making_Template.xlsx) .

Figure 2.16 shows a common-sized balance sheet for IBM. To make it easier to compare IBM with other companies, this balance sheet totals all three types of Accounts Receivable into one line item. Also to keep things easy for comparison, it uses only the net numbers for Property, Plant, and Equipment and Intangible Assets.

Figure 2.16: Common-sized balance sheet for IBM

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This common-sized balance sheet was created using IBM’s 2012 Balance Sheet.

Source: IBM. (2013). 2012 annual report. Retrieved from http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf (http://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf)

Viewing this information as percentages makes it easier to analyze the trends. Note that IBM is holding a lower percentage of Cash in 2012 (8.73%) versus 2011 (10.24%). Accounts Receivable is just a slightly higher percentage, 25.65% versus 25.39%. Total Current Assets is lower at 41.47% in 2012 versus 43.74% in 2011.

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Not much can be gleaned from these trends because not a lot of data is presented. To truly determine whether any of this represents a true trend for the company, managers and executives would need to add the numbers for 2010, 2009, and 2008. Those numbers could be found by downloading IBM’s 2010 annual report, which includes the 2010, 2009, and 2008 annual reports.

Task Box 2.8: Creating a Common-Sized Balance Sheet for 3M Use the template (https://ne.edgecastcdn.net/0004BA/constellation/Articulate/OMM622/Financial_Decision_Making_Template.xlsx) provided for a common-sized balance sheet (available here). Prepare a common-sized balance sheet for 3M. Comment on key differences between IBM and 3M for five line items you think are relevant.

Which company is doing a better job of managing these five line items: IBM or 3M? Why do you think that is the case? Use information from the Notes to the Financial Statements to support your argument.

Task Box 2.9: Analyzing Industry Competitors, Part A Pick an industry that interests you. This could be the industry in which you currently work or an industry in which you would like to work. It could be an industry in which you would like to invest. You may even want to compare the company you are currently working for with another in the same industry.

Select two public companies to compare in the selected industry. You can use the Yahoo Finance Industry List to help identify possible candidates: Just click on the industry that interests you to get a list of public companies in that industry.

Prepare a common-sized balance sheet for each company you are comparing. Then discuss how the two companies compare in the five critical areas below. You may want to use the Notes to the Financial Statements to help make your points.

1. Which company does a better job of managing its Inventory and why? 2. Which company does a better job of managing its Accounts Payable and why? 3. Which company does a better job of managing its Long-Term Debt and why? 4. Which company does a better job of managing its Retirement Benefits and why? 5. Is either company buying back stock or have they bought back stock in the past? If so, discuss

their buy-back plans.

Throughout the following chapters, you will have the opportunity to fully analyze the financial reports of these two companies. Each chapter will guide you through the process, step by step, as you learn about the key financial statements. Lastly, we will show you how to use basic financial analysis calculations to complete your analysis.

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OMM622_CH2

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Referencing this week’s readings and lecture, what information is provided in the balance sheet? What is a common-sized balance sheet and how do you create one? For your final project company, does anything stand out on the balance sheet?