2 2: Financial Statements Analysis Business LibreTexts

Conceptually, the premise of horizontal analysis is that tracking a company’s financial performance in real time and comparing those figures to its past performance (and that of its industry peers) can be very practical. Financial Statements are prepared to know the profitability and financial position of the business in the market. The content of a financial statement does not reveal the earning capacity, financial soundness, and liquidity of a company.

What Is Included in a Comparative Balance Sheet

You can also look to determine an optimal capital structure for a given industry and compare it to the firm being analyzed. You can then conclude whether the debt level is too high, if excess cash is being retained on the balance sheet, or if inventories are growing too high. The first step to performing a horizontal analysis is to calculate the net difference — in dollar terms ($) — between the comparable periods. Suppose Company ABC reported a total assets value of $15,000 in the current accounting period and $20,000 in the previous accounting period. It can help you see the variance in how much a line item has changed from one period to another so that you focus on what is causing the increase or decrease in figures in a particular area of the balance sheet. Common size analysis is also an excellent tool to compare companies of different sizes but in the same industry.

1. Is it becoming easier for the company to meet its current liabilities on time and to take advantage of any available cash discounts?
2. Comparative statements are less reliable when companies undergo huge changes.
3. Vertical analysis expresses each line item on a company’s financial statements as a percentage of a base figure, whereas horizontal analysis is more about measuring the percentage change over a specified period.
4. Financial analysts and managers use these financial statements to analyze the company’s activities over the period.
5. For example, managers may compare the ending balance in cash each month over the past two years to determine if the ending cash balance is increasing or declining.

Tips For Better Analysis

In the above example, if the results were presented for a single accounting period, it is a common size statement. Common size statements are useful in comparing results with similar companies. Financial statements are of wide use to a number of stakeholders, especially for shareholders as such statements provide a number of important information. For the estimation of an organisation’s future progress, it is essential to look into its past performance, for which performing a comparative study of two or more years of company financial statements becomes necessary.

Common Size Statement: Definition, Types, Formula & Preparation

The common size percentages help to highlight any consistency in the numbers over time–whether those trends are positive or negative. Large changes in the percentage of revenue as compared to the various expense categories over a given period could be a sign that the business model, sales performance, or manufacturing costs are changing. Generally accepted accounting principles (GAAP) are based on consistency and comparability of financial statements. A common size income statement makes it easier to see what’s driving a company’s profits. Preparing Comparative Financial Statements is the most commonly used technique for analyzing financial statements. This technique determines the profitability and financial position of a business by comparing financial statements for two or more time periods.

1. Comparative statements provide several advantages not included in the standard financial statements.
2. We’ll start by inputting our historical income statement and balance sheet into an Excel spreadsheet.
3. Common size statements are commonly used by investors, analysts, and managers to evaluate companies’ financial health, assess operational efficiency, and benchmark performance against industry peers.
4. These statements include a balance sheet, an income statement, a statement of stockholders’ equity, a statement of cash flows, and the explanatory notes that accompany the financial statements.
5. For example, labor intensive industries may have high return on assets numbers while companies in capital (asset) intensive industries may have relatively low return on assets.

Percentage Change

This method aids in understanding the relative sizes of different components within a company’s financial framework. There are a large variety of different financial ratios that attempt to evaluate different aspects of a company’s health and performance. For example, a popular ratio for brick-and-mortar retailers is sales-per-square-foot as it addresses how well the retailer is using its floor space to generate revenue.

It is an essential tool for internal performance assessment, investment evaluation, credit analysis, and financial planning. By highlighting trends and changes in cash flows, it offers clear insights into a company’s financial health and operational efficiency, making it easier to identify strengths and areas for improvement. Comparative statements can also be used to compare different companies, assuming that they follow the same accounting principles.

In fact, there must be a bare minimum of at least data from two accounting periods for horizontal analysis to even be plausible. In other words, vertical analysis can technically be completed with one column of data, but performing horizontal analysis is not practical unless there is enough historical data to have a useful point of reference. For example, if a company’s current year (2022) revenue is $50 million in 2022 and its revenue in the base period, 2021, was $40 million, the net difference between the two periods is $10 million.

Based on the accounting equation, this also equals total liabilities and shareholders’ equity, making either term interchangeable in the analysis. It’s also possible to use total liabilities to indicate where a company’s obligations lie and whether it’s being conservative or risky in managing its debts. Ratio Analysis – Financial ratio is to derive from the balance sheet items and the comparative balance sheet financial ratio of two years of two companies can be derived and analysis the financial status of the company. Although this brochure discusses each financial statement separately, keep in mind that they are all related.

As in the prior step, we must calculate the dollar value of the year-over-year (YoY) variance and then divide the difference by the base year metric. The accounting period covered could be one-month, a quarter, or a full fiscal year. Business owners use the comparative report to make strategic business decisions. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path.

The use of percentages eliminates the difference in dollar amounts presented in the financial statements of different size companies. A comparative balance sheet presents side-by-side information about an entity’s assets, liabilities, and shareholders’ equity as of multiple points in time. Differentiating between common size financial statements and traditional financial statements is essential. While traditional financial statements present figures in monetary terms, common size statements express each line item as a percentage of a base figure, enabling a more straightforward comparison. The annual report, legally referred to as the Form 10K, contains three of the most important financial reports difference between comparative and common size statement used by investors and analysts to critique business performance.

Normally, revenue is taken as the base in the income statement and total assets or liabilities on the balance sheet. Comparative financial statement is the statement which shows the dollar changes and percentage of the different years by taking a previous year as base. Common size statements include the comparative income statement and comparative balance sheet. Other financial statements turned into a comparison form include the comparative income statement and comparative cash flow statement. A date-to-date comparison within the company helps a business owner or investor identify financial performance trends over time. Investors can also compare companies who use the same accounting principles for reasons such as how organizations in the same business vertical respond to the changes in seasons.

For the purposes of this class, we are going to focus on the following ratios which will be referred to and calculated as follows (using ending values for balance sheet items). Common size analysis, also referred to as vertical analysis, is a tool that financial managers use to analyze financial statements. It evaluates financial statements by expressing each line item as a percentage of a base amount for that period. The analysis helps to understand the impact of each item in the financial statements and its contribution to the resulting figure. A common size statement shows the common size percent of each financial item of the balance sheet or income statement by taking any financial statement item as the base.