Level 1 CFA® Exam:
Common-Size Analysis & Balance Sheet Ratios
Common-size analysis and balance sheet ratios create a robust framework for analyzing the company’s balance sheet. In combination, they allow us to better understand a company’s liquidity standing and assess the risk of insolvency (or bankruptcy). The primary difference between liquidity and solvency lies within the time frame against which we assess the risk of not being able to meet obligations. Liquidity refers to the inability to settle debts in the short term, while solvency refers to a long-term time frame.
A common-size analysis is based on the premise of analyzing the balance sheet in relative rather than absolute terms.
The analyst needs to present each component of the balance sheet as a percentage of the total assets. Such a presentation method is helpful while tracking the changes in the balance sheet composition across peer companies. It also allows an easy and insightful time-series analysis.
Let’s have an example.
ABC company balance sheet (as of Dec 31, 2021):
|Assets||millions of USD||Liabilities||millions of USD|
|Total current assets||12,976||Total current liabilities||4,592|
|Total non-current assets||7,154||Total non-current liabilities||13,509|
|Total Assets||20,130||Total liabilities and equity||20,130|
Prepare a common-size balance sheet and assess the liquidity and solvency of the company.
The cross-sectional common-size balance sheet analysis should be supplemented with the balance sheet ratios analysis.
Balance sheet ratios show us the relationships between individual assets and liabilities positions that are not visible under the common-size analysis (common-size analysis shows the total assets/liabilities relationship only).
- liquidity ratios, and
- solvency ratios.
It allows assessing how difficult it is for the company to meet its current liabilities.
Like the current ratio, it also shows how easy it is for the company to meet its short-term liabilities. However, as it takes into consideration only the most liquid assets, it is focused on a shorter period.
It’s the most short-term oriented metric as it takes into consideration only very liquid assets like cash, cash equivalents, and marketable securities that the company should be able to liquidate within less than 3 months.
All the solvency ratios are used to analyze the company’s financial risk and financial leverage (use of debt to finance assets). Those ratios are also helpful for a better understanding of how assets are financed.
While both tools – common-size balance sheet and balance sheet ratios – are very useful, they have their limitations:
Level 1 CFA Exam Takeaways for Common-Size Analysis & Balance Sheet Ratiosstar content check off when done
- There are two useful tools that the users of the financial statements can use to better understand the balance sheet of the company throughout time and compare it with the industry peers: common-size analysis and balance sheet ratios. Both of those methods are helpful while analyzing the liquidity and solvency of the company.
- The common-size analysis of the balance sheet is to present the values reported in the balance sheet under assets, liabilities, and equity as a percentage of total assets. It is helpful while analyzing changes to the balance sheet across reporting periods but also informs about the capital structure of the company.
- Balance sheet ratios are divided into the ones that allow a better understanding of the company’s liquidity position and the ones which help to understand the company’s solvency risk.
- Key liquidity ratios are current ratio, quick (acid test) ratio, and cash ratio.
- Key solvency ratios are long-term debt-to-equity ratio, debt-to-equity ratio, total debt ratio, and financial leverage ratio.