Common Size Statements – Horizontal Analysis

Contents of this page are divided into following headings.

  1. What are Common Size Statements?
  2. What are Horizontal Analysis / Method?
  3. Example of Horizontal Analysis
  4. Interpretation of Horizontal Analysis

For readers who have already read the Vertical Analysis, I Will suggest skipping 1. what are / importance of common size statements?

Importance of Common Size Statements

In order to evaluate the position of the company, company’s performance and its assets are compared with other companies operating in the same industry. However these comparisons are worthless since companies operating in the industry can be small, medium or big. This can be better understood by an illustration.

Suppose company A & B have earned profits $500 and $1,000 respectively. Which company is more profitable? Company B seems to be profitable in this simple comparison. However Company A is a small company with $500 total assets; on the other hand Company B is big company with $5,000 total assets. If ratio of earnings with respect to total assets is taken; then Company A’s returns are $1 whereas company B’s return are $0.2. Which company is more profitable? Obviously Company A is more profitable.

Therefore the need to convert the financial statements into Common Size (note words “common size”) is necessary for accurate comparisons. Vertical and Horizontal analysis are the techniques of converting financial statements into common size for comparison purposes. Details of horizontal analysis are provided below, for vertical analysis please see the previous page.

Horizontal Analysis Method

Horizontal analysis is also called the Trend analysis. In horizontal analysis financial statements are converted into common size by taking any one year (numbers) as base and then showing all other years’ corresponding line item numbers as the percentage of that number in horizontal direction.
This way the changes from base year to next year could be determined either in percentages or in amounts.

Since all figures are horizontal to base figure thus the name horizontal analysis or trend analysis is used. This will be more clearly evident from the following example.

Example

The hypothetical Statement of comprehensive income is shown below. Let’s convert this into common size statement.
ABC LIMITED
Statement of Comprehensive Income
For the year ended 31 December 20XX
(This illustrative set of financial statements seeks to provide guidance for financial analysis).

 

20XX

20X0

 

$

$

 

 

 

Revenue

7,468,110

7,016,215

Cost of sales

(3,866,710)

(2,853,835)

Gross Profit


3,601,400


4,162,380

 

 

 

General and

Administrative

Expenses

(2,250,875)

(2,341,339)

Other

operating

expenses

(450,175)

(780,446)

Profit/Loss

from

Operating

Activities


900,350


1,040,595

Finance costs

(3,485)

(13,400)

Other income

385

448

Profit

before tax


897,250


1,027,643

 

 

 

Taxation

(333,150)

(385,048)

 

 

 

Profit after tax


564,100



642,595


Suppose 20X0 is base year. Now calculate all coming years’ numbers (in this example only 20XX but it could be more than one coming years) by dividing that year corresponding line items with the base year line items and then multiplying with 100 to get percentage change e.g. costs of sales (3,866,710 / 2,853,835)*100 = 135%. Means cost of sales has increased by 35% in 20XX from 20X0.

That’s all. Now the statement is common sized and can be compared with its previous years’ financial information. See interpretation of horizontal analysis for more information.

The common size statement will look like this.

ABC LIMITED
Statement of Comprehensive Income
For the year ended 31 December 20XX
Common Sized

 

20XX

20X0

 

$

$

Revenue

106%

100%

Cost of sales

135%

100%

Gross Profit


87%


100%

General and

Administrative

Expenses

96%

100%

Other

operating

expenses

58%

100%

Profit /Loss

from

Operating

Activities


87%


100%

Finance costs

26%

100%

Other income

86%

100%

Profit before tax


87%


100%

Taxation

87%

100%

Profit after tax


88%



100%


common statement of financial analysis horizantal

Interpretation of Horizontal Analysis

Horizontal analysis provides a trend from past to current performance of the company by taking into consideration the respective changes in that years. Horizontal Analysis can be interpreted as internal comparison and external comparison.

Internal Comparison:
In the above example cost of sales were 135% of last year’s cost of sales; meaning the cost of sales has increased by 35%. Similarly, General and Administrative expenses are 90% of last year’s General and Administrative expenses; meaning G&A expenses have decreased by 10% from last year.
Note: If corresponding percentage is more than 100 it means increase if it is below 100 it means decrease.
We know that cost of sales has increased from last year but we are unable to explore the reasons why it has increased. Vertical analysis, to some extent, provides the break up for more insight of why it has increased but ratio analysis is the best technique to study the causes of change. Therefore Vertical & Horizontal analysis has limitations of not providing insight of what are the causes / reasons of change.

External Comparison:
In external comparison the corresponding changes of the company are compared with other companies or industry averages. This might be done by CHARTS showing company changes along with other companies’ changes. Thus decisions maker could identify in which line item they were under or over performing. See the chart below for example.
2.2- Common Size Statments - Horizontal Analysis.jpg
Horizontal Analysis: Line Chart for comparison of different companies and industry average.

Vertical Analysis is discussed on next page.

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