Common-Size Income Statements & Tax Rates

Common-Size Income Statements

• Common-size income statements express each line item (revenue, expenses, profit) as a percentage of total revenue.
• This format reveals the relative size of each item compared to the total revenue.
• Vertical common-size statements analyze one income statement column, expressing every item as a percentage of revenue.
• Useful for:
  • Time-series analysis (comparing company performance over time).
  • Cross-sectional analysis (comparing companies of different sizes in the same industry).
• Example: If revenue is $100 and expenses are $50, expenses are 50% of revenue.

Effective Tax Rate vs. Tax Rate on Revenue

• Tax Rate on Revenue: Income tax expense as a percentage of total revenue. Not ideal as it doesn't account for deductions, losses, and credits.
• Effective Tax Rate: Income tax expense as a percentage of pretax income (EBT). More accurate, as it shows how much tax is paid on actual profits.
• Example: A company with $5,000,000 revenue, $1,300,000 pretax profit and $390,000 tax expense has:
  • Tax rate on revenue: 7.8%.
  • Effective tax rate: 30%.
• Effective tax rates are preferred for assessing a company's tax burden.

Income Statement Ratios

• Gross Profit Margin: Compares gross profit (revenue - COGS) to revenue, measuring profitability.
• Factors to increase gross profit margin:
  • Price increases (if products are differentiated).
  • Lowering production costs.
  • Product differentiation (brand name, quality, technology, patents).
• Net Profit Margin: Measures profit after all expenses (taxes, interest, operating costs) have been deducted from revenue. Shows overall profitability, and should be compared over time and with industry peers.
• Other Margin Ratios:
  • Operating Profit Margin: Operating profit divided by revenue.
  • Pretax Margin: Pretax accounting profit divided by revenue.