# Step-by-Step Solution: **Common-Size Financial Statements** ## 1. **Definition** A **Common-Size Financial Statement** is a financial report where each line item is expressed as a percentage of a base figure (usually total sales for the income statement). This helps compare companies of different sizes or track trends over time. --- ## 2. **Vertical Analysis of Income Statement** ### **Steps:** 1. **Identify the Base Figure:** - For the income statement, **Sales (Revenue)** is typically the base (100%). 2. **Express Each Item as a Percentage of Sales:** - Calculate each item as: \[ \text{Percentage} = \left(\frac{\text{Item Value}}{\text{Sales}}\right) \times 100 \] 3. **Diagram Representation:** - **Sales = 100%** - **Cost of Goods Sold (COGS):** 60% of Sales - **Operating Expenses:** 25% of Sales - **Net Profit:** 15% of Sales --- ### **Diagram Explanation (From Image):** - **Sales:** 100% (Base) - **Cost of Goods Sold (COGS):** 60% - **Operating Expenses:** 25% - **Net Profit:** 15% - **COGS + Operating Expenses = 85%** (Total expenses) - **Net Profit is what remains after expenses (100% - 85% = 15%)** --- ## 3. **Purpose and Usefulness** - **Comparison:** Allows easy comparison between companies and periods, regardless of size. - **Trend Analysis:** Quickly spot changes in cost structure or profitability. --- ## 4. **Final Answer** > **A Common-Size Financial Statement expresses each line item as a percentage of a base figure (usually sales). For example, if Sales = 100%, COGS = 60%, Operating Expenses = 25%, and Net Profit = 15%, it shows how much each item contributes to or reduces from total sales. This vertical analysis helps compare companies and analyze trends effectively.** --- ### **Summary Table (from Diagram)** | Item | % of Sales | |---------------------|------------| | Sales | 100% | | Cost of Goods Sold | 60% | | Operating Expenses | 25% | | Net Profit | 15% | --- **In summary:** A common-size income statement makes it easy to analyze and compare financial performance by expressing all items as a percentage of sales.