8.6 Common size statements – Vertical and horizontal analysis

Common size statements are financial statements in which each line item is expressed as a percentage of a base amount. This allows for easy comparison and analysis of the relative importance of different components within the financial statements. Common size statements can be prepared using both vertical analysis and horizontal analysis techniques.

1. Vertical Analysis: Vertical analysis, also known as common-size vertical analysis, expresses each line item on a financial statement as a percentage of a base amount. The base amount is typically the total of that particular statement. The purpose of vertical analysis is to assess the relative proportion of each line item and identify any significant changes or trends.

For example, in a common size income statement, each revenue and expense item is expressed as a percentage of total revenue. This allows for the evaluation of the composition of expenses and their relationship to revenue. Similarly, in a common size balance sheet, each asset, liability, and equity item is expressed as a percentage of total assets.

Vertical analysis helps to identify the relative significance of different components, such as the proportion of sales revenue devoted to expenses or the relative size of different assets on the balance sheet.

2. Horizontal Analysis: Horizontal analysis, also known as trend analysis, involves comparing financial statement data over multiple periods to identify patterns, trends, and changes. It focuses on the dollar or percentage change in line items over time. The purpose of horizontal analysis is to assess the growth or decline of specific items and to detect any abnormal fluctuations.

For example, in a horizontal analysis of an income statement, the revenues, expenses, and net income of each period are compared to determine the change in performance. In a horizontal analysis of a balance sheet, the assets, liabilities, and equity of each period are compared to identify changes in the financial structure.

Horizontal analysis helps to assess the direction and magnitude of changes in financial statement items over time, enabling the identification of areas of growth, decline, or instability.

Both vertical and horizontal analyses provide valuable insights into a company’s financial performance and position. Vertical analysis helps to assess the composition and proportion of different line items, while horizontal analysis helps to evaluate trends and changes over time. Combining these techniques provides a more comprehensive understanding of a company’s financial statements and aids in decision-making and financial analysis.