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Build a common-size income statement and explain what it shows

CFA® Level I · Financial Statement Analysis · Analyzing Income Statements · FSA.1.f

The idea

A common-size income statement expresses every line as a percentage of revenue, which removes the effect of size and makes companies of very different scale directly comparable. Read across years it shows where margin is being gained or lost, and read across peers it shows whether a company's cost structure differs from the industry's. The technique is most useful when one line is moving against the others: rising selling costs as a share of revenue while gross margin holds points at a very different problem from the reverse.

A practice question

From the question bank, with the reason each wrong option is wrong.

In a common-size income statement, each line is expressed as a percentage of what?

  1. Total assetsWhy not: That is the base for a common-size *balance sheet*. The income statement has no assets on it.
  2. Revenue — correct
  3. Net incomeWhy not: Net income is one of the lines being expressed, and it is the smallest of them — using it as the base would put revenue at several hundred per cent.

Revenue is the base for the income statement. Total assets is the base for a common-size balance sheet.

A harder one

Gross margin falls while operating margin holds. What does that suggest?

  1. Overheads have been cut — correct
  2. Revenue has fallenWhy not: Both figures are shares of revenue, so a fall in revenue alone leaves the ratios unchanged. Something has to change relative to revenue to move them.
  3. Interest costs have risenWhy not: Interest sits below operating profit and cannot affect either margin.

The reduction was enough to offset a pricing or input cost problem. The two lines moving in opposite directions localises the change: the pressure is above gross profit and the response is below it.

The hardest tier

Gross margin is stable but selling expenses have risen from 12% to 18% of revenue over three years. What does this suggest?

  1. The cost of winning revenue is rising — correct
  2. Production efficiency is deterioratingWhy not: That would compress the gross margin, and the question says it held. Selling expenses sit below gross profit.
  3. The company has changed its inventory methodWhy not: An inventory method change moves cost of goods sold, which would show in the gross margin rather than in selling expenses.

A stable gross margin rules out pricing and input costs. The deterioration is in what it takes to sell, which points at competition, channel change or a weakening brand.

In the app: 12 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.

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