Conversion of the value of line items in the cash flow statement into percentages allows for vertical analysis, which is comparison of the value of one line item in the cash flow with another. This provides a better understanding of the relationship among two or more items, such as the relationship between overhead expenses and sales, or between a particular cash flow and the net change in cash.
Another major application of common size cash flows is to determine the quantum of allocation of cash. For instance, converting the sub-totals for net outflows in operations, investing, and financing as a percentage of the total cash allows determining the proportion of cash used for these purposes. Company A with total revenue of $1,000 may reinvest $100, whereas company B with total revenue of $5,000 may reinvest $200. Though apparently company B reinvests more, Company B actually reinvests only 4 percent of revenue, whereas Company A reinvests 10 percent of revenue.
Common size statements also cater to horizontal analysis or comparison of the two different companies for the same period. Common size cash flow statements help in removing bias when comparing operational, investing or financial cash flows of two different companies of different size. It is unit free and ignores the size differentials. Absolute dollar values remain inadequate to gauge the effect of changes in values over time.
Finally, understanding how to common size cash flow statements may help highlight inconsistencies resulting from data entry errors!
The use of common size financial statements extends far beyond providing a standard scale for comparison and analysis. It provides insights regarding the economic characteristics of the business.