Explore how to normalize balance sheet data using common-size statements and evaluate a firm’s long-term financial stability with solvency ratios.
If you’ve ever tried to compare the financial statements of a massive multinational conglomerate to a small local company, you might’ve felt overwhelmed. After all, big companies just have huge numbers everywhere—billions in inventory, billions more in property, and so on. Meanwhile, your neighborhood business has accounts receivable in the thousands. So how on earth are you supposed to do any meaningful comparison?
That’s where common-size balance sheets come in. By expressing every balance sheet line item as a percentage of total assets, you effectively level the playing field. It’s almost like normalizing everyone’s height to 100 inches and then explaining what proportion each person’s arms or legs represent. Common-size analysis helps you see structural differences that absolute figures can hide, such as whether a company relies too heavily on intangible assets or if short-term liabilities are ballooning out of proportion.
In the context of the CFA® 2025 Level 1 curriculum, the ability to look at a firm’s balance sheet in a common-size format is vital. It allows you to detect patterns and red flags and prepares you for deeper analysis, from the intangible assets focus (see Section 3.2) to the impact of liabilities and equity on solvency and capital structure. Let’s dive into the details.
Common-size statements deliver a quick comparative framework between:
• Different firms in the same industry.
• The same firm over multiple periods.
• Benchmarks, such as industry averages or top competitors.
When you have several years of data, you can spot trends like expansions in intangible assets or increased reliance on short-term debt. You can also see how effectively a company manages its working capital—for instance, a rising proportion of inventory might signal strategic stockpiling or, potentially, poor inventory turnover (analyzed more thoroughly in Chapter 5).
In practice, I remember once comparing a tech startup’s balance sheet (80% intangible assets!) with a more traditional manufacturing company. If I had stuck to absolute figures, the intangible items of the manufacturing firm were minuscule, while the startup’s intangible assets were enormous. Common-size analysis helped me see that intangible assets took up a striking portion—over half—of total assets for the tech startup, whereas for the manufacturer, intangibles were negligible. That was a major clue about their future earnings volatility and the potential for intangible asset write-downs. This is precisely the kind of insight you want as an analyst or an investor.
Performing common-size analysis seems straightforward: each balance sheet item is divided by total assets. But the real value emerges when you interpret those percentages in context.
• Identify big movers: Did property, plant, and equipment (PP&E) jump from 30% to 45% of total assets year over year? This could indicate a capital expenditure spree, potentially affecting liquidity if financed by short-term bank debt.
• Watch intangible assets: If intangible assets balloon to 40% of total assets, you’d better check what’s fueling that growth. Are these acquisitions of goodwill, or is the firm capitalizing R&D? Are there possible impairment risks?
• Note trends in payables: If accounts payable consistently hovers around 20% of total assets but suddenly shoots up to 30%, the firm might be stretching its credit or experiencing a cash crunch.
This approach is especially handy for cross-company comparisons. If a retailer holds 45% of assets in inventory while an industry peer carries just 20%, you’ll want to probe management’s inventory strategy. Depending on the sector—manufacturing, retail, or e-commerce—typical line items will differ, so comparing a “like with like” environment (e.g., big-box retailer to big-box retailer) is important for fairness.
Below is a simple Mermaid diagram illustrating how each line item in a balance sheet relates to total assets in a common-size format:
graph LR
A["Total Assets"] --> B["Cash & Equivalents"]
A["Total Assets"] --> C["Accounts Receivable"]
A["Total Assets"] --> D["Inventory"]
A["Total Assets"] --> E["Property, Plant & Equipment"]
A["Total Assets"] --> F["Intangible Assets"]
Each percentage measure (e.g., cash is 10% of total assets, PPE is 35%, etc.) helps you see how the pie is divided.
Solvency ratios measure a firm’s capacity to meet its long-term obligations. Where common-size statements help you see how the firm’s resources are distributed, solvency ratios assess the stability of its capital structure. Three of the most widely used solvency metrics for CFA Level 1 candidates are:
• Debt-to-Equity Ratio (D/E)
• Total Debt Ratio (sometimes just called the debt ratio)
• Interest Coverage Ratio (often EBIT-based)
How do these connect to the balance sheet and income statement? The D/E ratio and total debt ratio come straight from the balance sheet. The interest coverage ratio, on the other hand, ties the Income Statement’s EBIT (earnings before interest and taxes—see Section 2.7) to interest expense.
This ratio shows how much debt a firm uses in relation to the equity financing contributed by shareholders:
(1)
“Total Debt” might be defined differently among firms. Sometimes it includes all interest-bearing obligations. Sometimes short-term lease liabilities are included. As an analyst, be sure you know what’s in that denominator and numerator. If you see a D/E ratio that’s creeping upward over time, it might be a sign the firm is leveraging up—potentially riskier if the business environment worsens.
While the D/E ratio compares debt to equity, the total debt ratio compares total debt to total assets:
(2)
If this ratio is 0.40 (or 40%), it implies that 40% of the assets are financed by debt. The remainder is presumably financed by equity or other forms of capital. Firms with high total debt ratios tend to have more risk, especially if interest rates are rising. On the other hand, some industries (like utilities) commonly carry higher leverage, so properly benchmarking is key.
The interest coverage ratio (or times interest earned) is calculated by dividing EBIT by interest expense:
(3)
A ratio of 5.0 might indicate the firm comfortably covers its interest payments five times over. But a ratio closer to 1.0 could signal potential distress if profitability dips or if interest rates climb. Since the interest coverage ratio uses EBIT—a figure from the income statement—you may want to watch out for nonrecurring items that inflate or deflate EBIT.
By combining common-size balance sheet data with solvency ratios, you can uncover deeper insights:
• If intangible assets are growing as a percent of total assets and the firm’s D/E ratio is also climbing, maybe management has financed a string of acquisitions with debt. You might investigate the synergy assumptions behind those deals.
• If common-size analysis reveals that current liabilities are climbing year over year, a quick look at interest coverage might reveal if the firm has sufficient earnings to cover what’s likely a growing interest burden.
• Benchmarking both common-size data and solvency ratios against peers helps you spot outliers. For example, if your subject firm’s debt ratio is 60% while the industry norm is 30%, that’s a strong sign of high leverage risk.
On more than one occasion, I’ve seen a company’s share price decline sharply when the market realized the firm’s intangible assets were overvalued or that its debt load was unsustainable. This is exactly the sort of scenario you want to anticipate by checking trends in the common-size statements and solvency metrics.
For the most part, the calculation of solvency ratios does not differ dramatically between IFRS and US GAAP, though some balance sheet presentation details can vary. IFRS might allow certain items (like intangible assets or revalued property, plant, and equipment) to appear at an upwardly revalued amount, which can offset debt in the total assets figure. US GAAP typically mandates historical cost minus accumulated depreciation or amortization, except for impairment.
What does this mean for you as an analyst? Be aware of the accounting framework each firm uses. If you compare a UK-based company that revalues its buildings upward every so often under IFRS with a US-based firm that doesn’t, your ratio comparisons might be skewed. You’ll want to adjust the data—where feasible—to create an apples-to-apples scenario.
Additionally, IFRS 16 (and ASC 842 in the US) changed how lease liabilities appear on the balance sheet. That’s relevant for total debt calculations. Many operating leases must now be capitalized, increasing total liabilities. For a company with many leases—say an airline or a retail chain—this can dramatically change its debt metrics overnight. Before you compare year-over-year solvency, double-check that new lease accounting standards didn’t alter the baseline.
• Blindly trusting the definitions: Always verify what each line item includes. “Debt” might include bonds, loans, and lease liabilities, or perhaps only some subset.
• Comparing across different industries: You might see typical D/E ratios around 1.5 for utilities, while technology startups could hover near 0.2. The raw ratio alone doesn’t pass judgment; you need industry context.
• Overreliance on interest coverage: EBIT can sometimes be inflated by nonrecurring items. Consider looking at EBITDA-based coverage or interest coverage after adjusting for one-time gains or losses.
• Neglecting “off-balance-sheet” liabilities: If a firm has plenty of operating leases or structured financing (see Chapter 9 on Off-Balance-Sheet Items and SPEs), you might be underestimating the firm’s true leverage.
Ultimately, you want to blend common-size balance sheet analysis with solvency metrics to paint a rich, 3D picture—comparing not only how the firm’s resources are allocated but also how comfortably it can cover its long-term obligations.
Common-size balance sheets and solvency ratios form the bedrock of long-term financial stability analysis. By transforming raw numbers into percentages of total assets, you gain remarkable clarity across time, firms, and industries. Combine that with solvency ratios, and you’ll quickly identify whether a firm’s capital structure is a ticking time bomb or a stable foundation.
Remember: When intangible assets surge, or when short-term liabilities creep upward, these shifts often leave footprints in both common-size statements and solvency ratios. Don’t shy away from exploring these footprints. Instead, follow them to uncover the company’s true financial story—one that might be more subtle than the highlights in the annual report.
• Subramanyam, K.R. (various editions). Financial Statement Analysis.
• Higgins, R. Analysis for Financial Management.
• CFA Institute, “Financial Statement Analysis” resources: https://www.cfainstitute.org
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