# Financial Statement Analysis

<<< Previous COMMON –SIZE AND INDEX ANALYSIS Next >>>

Financial Statement Analysis-FIN621
VU
Lesson-32
COMMON ­SIZE AND INDEX ANALYSIS
Method used by interested parties such as investors, creditors, and management to evaluate the past,
current, and projected conditions and performance of the firm. Ratio analysis is the most common form
of financial analysis. It provides relative measures of the firm's conditions and performance. Horizontal
Analysis and Vertical Analysis are also popular forms. Horizontal analysis is used to evaluate the trend
in the accounts over the years, while vertical analysis, also called a Common Size Financial Statement
discloses the internal structure of the firm. It indicates the existing relationship between sales and each
income statement account. It shows the mix of assets that produce income and the mix of the sources of
capital, whether by current or long-term debt or by equity funding. When using the financial ratios, a
financial analyst makes two types of comparisons:
(a) Industry comparison. The ratios of a firm are compared with those of similar firms or with industry
averages or norms to determine how the company is faring relative to its competitors. Industry average
ratios are available from a number of sources
(b) Trend analysis. A firm's present ratio is compared with its past and expected future ratios to
determine whether the company's financial condition is improving or deteriorating over time.
After completing the financial statement analysis, the firm's financial analyst will consult with
management to discuss plans and prospects, any problem areas identified in the analysis, and possible
solutions. Given below is a list of widely used financial ratios.
2.
Trend percentages/ Horizontal Analysis/ Index Analysis: This analysis considers changes in
items of financial statement from a base year to the following years to show the direction of change.
This is also called horizontal analysis. In this, the figures of various years are placed side by side in
adjacent columns in the form of comparative financial statements.
3. Component percentages/ Vertical Analysis/ Common- Size Analysis: This type of analysis
indicates the relative size of each item in the Financial Statements as a percentage of the total of that
Statement i.e. Total Assets or total Liabilities & Shareholders equity in Balance Sheet and Sales in
Income Statement. Such a statement is then called common-size Financial Statement. This type of
analysis technique is also called Vertical Analysis.
Vertical Analysis
When using vertical analysis, the analyst calculates each item on a single financial statement as a
percentage of a total. The term vertical analysis applies because each year's figures are listed vertically
on a financial statement. The total used by the analyst on the income statement is net sales revenue,
while on the balance sheet it is total assets. This approach to financial statement analysis, also known as
component percentages, produces common-size financial statements. Common-size balance sheets and
income statements can be more easily compared, whether across the years for a single company or
across different companies
Financial statement item that is used as a base value. All other accounts on the financial statement are
compared to it. In the balance sheet, for example, total assets equals 100%. Each asset is stated as a
percentage of total assets. Similarly, total liabilities and stockholders' equity are assigned 100% with a
given liability or equity account stated as a percentage of the total liabilities and stockholders' equity.
For the income statement, 100% is assigned to net sales with all revenue and expense accounts related to
it. Under vertical analysis, the statements showing the percentages are referred to as Common Size
Financial Statements. Common size percentages can be compared from one period to another to identify
areas needing attention. An illustration follows:
128
Financial Statement Analysis-FIN621
VU
Horizontal Analysis
When an analyst compares financial information for two or more years for a single company, the
process is referred to as horizontal analysis, since the analyst is reading across the page to compare any
single line item, such as sales revenues. In addition to comparing dollar amounts, the analyst computes
percentage changes from year to year for all financial statement balances, such as cash and inventory.
Alternatively, in comparing financial statements for a number of years, the analyst may prefer to use a
variation of horizontal analysis called trend analysis. Trend analysis involves calculating each year's
financial statement balances as percentages of the first year, also known as the base year. When
expressed as percentages, the base year figures are always 100 percent, and percentage changes from the
base year can be determined.
Time series analysis of financial statements covering more than one accounting period; also called
Trend Analysis. It looks at the percentage change in an account over time. The percentage change
equals the change over the prior year. For example, if sales in 20X0 are \$100,000 and in 20X1 are
\$300,000, there is a 200% increase (\$200,000/\$100,000). By examining the magnitude of direction of a
financial statement item over time, the analyst can evaluate its reasonableness.
Common Size Financial Statement
A company financial statement that displays all items as percentages of a common base figure. This
type of financial statement allows for easy analysis between companies or between time periods of a
company.
129