Selection of the Tool
When it comes to the balance sheet and statement of equity, creating the statement is only the beginning of the long process of evaluating the health and status of a company. This is why analytical tools are critical for financial statements. Total assets are among the main determinants of the health and status of the company. It is towards the determination of the current total asset that the balance sheet and statement of equity are designed for since total assets are made up of all liabilities added to total shareholder equity (Wahlen, Jones & Pagach, 2017). When selecting an analytical tool it is critical to understand that amounts are just as important as ratios and trends. It is on this basis that the common-size analysis of financial statements is a critical and invaluable tool for analyzing the balance sheet and financial statement.
What the Tool Measures
The common-size analysis of financial statements tool measures trends and ratios relating to financial statements. Number amounts in sales and inventory may be high but the company may still be facing imminent collapse. At the same time, the company might have the lowest numbers in a very long time but be financially healthy based on the trends and ratios within the financial statement. This analytic tool focuses more on ratios which are calculated in percentages than in figures. For example, it can be able to easily assess how specific liabilities in the company compare with each other and also with the total value of the company. At the same time, the tool will enable ease of comparison between the current, past and envisioned future. Finally, the tool can enable the company to easily compare with the competition of related companies on a level playing field since it is about percentages and not figures where exponential variations can exist (Wahlen, Jones & Pagach, 2017).
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Steps in Using the Tool
The common-size analysis of financial statements begins with the preparation of all the three primary financial statements into the common-size format. This is a format where the statements do not reflect amounts but rather percentages. As indicated above, the principal figure for any company is the total assets made up of total liabilities and shareholder’s equity. This can be considered as 100%. Every other figure on the balance sheet and statement of equity will be reduced to a percentage based on the aforementioned total equity. For the purposes of full analysis, it is also critical to have the previous statements and projections reduced to common-size format themselves. Having percentages instead of figures will make it possible to have the statements for three or more years put in the same spreadsheet for comparison. For a relatively small company, a regular computer program such as spreadsheets can be used to create common-size format statements. For larger organizations, there is proprietary software specifically designed to create common-size format statements (Wahlen, Jones & Pagach, 2017). This is followed by the analysis that compares the trends of percentages revealing where the company is improving or in need of improvement. This is based on comparison within the company for the different years evaluated and also externally when compared with other companies.
Pros and Cons
Different tools exist for the analysis of the balance sheet and statement of equity with each tool having its own comprehensive pros and cons. The right tool to use depends on the nature of the company, the perceived current status of the company, and also the reasons why the analysis is being undertaken. Among the main advantages of the tool analyzed herein lies in simplicity and ease of use. The moment the numbers are reduced to percentages, it becomes easier to place a lot of data in a singular spreadsheet for analysis. The analysis itself is also relatively easier more so when comparing a wide array of data. Simplicity, however, also informs the main disadvantage of the tool as it may not be comprehensive enough to the advanced analysis of a larger company (Wahlen, Jones & Pagach, 2017).
Reference
Wahlen, J. M., Jones, J. P., & Pagach, D. P. (2017). Intermediate accounting: reporting and analysis . Boston, MA: Cengage Learning.
