Common-size income statements and margin ratios

What is a common-size income statement?

It is an income statement with every line divided by revenue. A common-size income statement turns absolute amounts into percentages, so the statements of a company with revenue of 1,000 and one with revenue of 2,500 can be compared line by line.

Revenue = 100%the base of a common-size statement

• Gross profit Memorize after cost of sales
  • Operating profit Memorize after SG&A, R&D, depreciation
    • Pretax income Memorize after interest

What do the four margins tell you?

Each margin deducts one more kind of cost. Gross margin tells you about pricing and production, operating margin adds overhead, pretax margin adds financing, and net margin adds tax.

$$\text{Gross margin} = \frac{\text{Revenue} - \text{Cost of sales}}{\text{Revenue}}$$

$$\text{Operating margin} = \frac{\text{Operating profit}}{\text{Revenue}}$$

$$\text{Pretax margin} = \frac{\text{Pretax income}}{\text{Revenue}}$$

$$\text{Net margin} = \frac{\text{Net income}}{\text{Revenue}}$$

The names to know: gross profit margin , operating profit margin , pretax margin and net profit margin .

Any margin can be asked from the other side: the profit that a margin implies, or the revenue behind it.

How do you read the differences between companies?

Find the first rung where the margins diverge. The cause sits between that rung and the one above it. Larger companies are not more profitable merely because their profit is larger, which is why you compare percentages.

• Gross margins differ: pricing power or production cost.
• Same gross margin, different operating margin: overheads (SG&A, R&D).
• Same operating margin, different net margin: interest, tax or non-operating items.
• A falling net margin with a stable operating margin points below the operating line.

Exam tip Interest is not an operating cost. If a question changes interest expense, only the pretax and net margins move.

What is the effective tax rate, and what is OCI?

The effective tax rate is tax expense divided by pretax income, not by revenue. Other comprehensive income is the set of gains and losses that go straight to equity and bypass net income.

$$\text{Effective tax rate} = \frac{\text{Income tax expense}}{\text{Pretax income}}$$

$$\text{Comprehensive income} = \text{Net income} + \text{OCI}$$

Other comprehensive incomecomprehensive income = net income + OCI

• Foreign currency translation adjustments Know the idea
• Unrealized gains and losses on certain investments Know the idea
• Cash flow hedge gains and losses Know the idea
• Pension remeasurements Know the idea

Compare companies on comprehensive income where OCI is large, since net income alone can miss swings in currency translation or pension remeasurements.

Go deeper Vertical versus horizontal common-size analysis

Dividing every line by revenue in one year is vertical analysis. Showing each line as a percentage of its value in a base year is horizontal analysis, and reveals which items are growing fastest. Level I also uses common-size balance sheets, where the base is total assets (see the financial analysis techniques module).

Go deeper Why operating margin travels best across capital structures

Operating profit is struck before interest and tax. Two firms with identical businesses but different debt loads have the same operating margin and very different pretax and net margins, so operating margin isolates how well the business itself is run.