Build a common-size balance sheet and explain what it shows
The idea
A common-size balance sheet expresses each item as a percentage of total assets, exposing the structure of what a company owns and how it is financed. Comparison across years shows whether the asset base is shifting — inventory building faster than sales, receivables growing as a share of assets, goodwill accumulating through acquisition — and comparison across peers shows whether the structure is normal for the industry. Because it is a ratio of stocks rather than flows, it pairs naturally with the activity ratios that measure how quickly those stocks turn.
A practice question
In a common-size balance sheet, what is the base for each item?
- RevenueWhy not: That is the base for a common-size *income statement*. Revenue does not appear on the balance sheet at all.
- Shareholders' equityWhy not: Equity is one of the items being expressed. A highly levered company would show liabilities at several hundred per cent of it.
- Total assets — correct
Expressing everything as a share of total assets shows both what the company holds and how it is funded, on one comparable scale.
A harder one
Inventory has risen from 14% to 22% of total assets over two years while revenue is flat. What does this suggest?
- Inventory is accumulating faster than it is being sold, which raises the prospect of write-downs — correct
- The company has become more efficient at productionWhy not: Producing more efficiently would let the company hold *less* stock for the same sales, not more. Rising inventory against flat revenue is the opposite signal.
- Total assets have declinedWhy not: A fall in total assets would lift every share, not just inventory's. The other lines would have risen too.
Flat revenue with a growing inventory share means goods are not moving. Obsolescence and a lower-of-cost-or-net-realisable-value write-down are the usual consequences.
The hardest tier
A peer's common-size balance sheet shows 60% property and plant against the company's 25%. What should the analyst conclude first?
- The peer is less efficientWhy not: Asset intensity is a structural choice, not a verdict. An owner-operator carries the assets and avoids the rent; a leaser does the reverse.
- The peer is overvaluedWhy not: Valuation is a question about price, and a common-size balance sheet contains no price at all.
- Nothing yet — correct
The peer may own what the company leases or outsources, which is a business model difference rather than a performance one. A structural gap is a question rather than a verdict, and the answer usually lies in how each company chooses to obtain its capacity.
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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