Understanding Financial Statement Analysis: Trend and Common-Size Analysis
In the world of business and finance, understanding a company's financial health is crucial for investors, creditors, and management alike. Two fundamental techniques for dissecting financial statements are Trend Analysis and Common-Size Analysis. These methods help reveal patterns, identify strengths and weaknesses, and facilitate comparisons over time and against industry benchmarks.
Trend Analysis: Spotting the Direction of Change
Trend analysis, also known as horizontal analysis, involves examining financial data over a period of time. It helps to identify patterns and the direction of change in a company's financial performance. By comparing financial statement items from one period to the next, we can see if revenues are growing, expenses are increasing or decreasing, and how profitability is evolving.
Trend analysis tracks changes in financial statement line items over multiple periods.
This is done by calculating the percentage change or absolute change for each item from a base year to subsequent years. It highlights growth or decline in key metrics.
To perform trend analysis, a base year is selected (often the earliest year in the series). Each subsequent year's financial data for a specific line item is then compared to the base year. The calculation typically involves:
- Absolute Change: Current Year Amount - Base Year Amount
- Percentage Change: ((Current Year Amount - Base Year Amount) / Base Year Amount) * 100
This allows for a clear visualization of how a company's financial performance has trended over time, revealing growth, stagnation, or decline in areas like sales, cost of goods sold, operating income, and net income.
Common-Size Analysis: Understanding Proportions
Common-size analysis, also known as vertical analysis, restates each line item on a financial statement as a percentage of a base figure within the same statement. This technique is invaluable for understanding the relative importance of each item and for comparing companies of different sizes or the same company over time, regardless of absolute growth.
Common-size analysis expresses each financial statement item as a percentage of a base figure.
For the income statement, each item is a percentage of total revenue. For the balance sheet, each item is a percentage of total assets.
On the Income Statement, every item (e.g., Cost of Goods Sold, Operating Expenses, Net Income) is expressed as a percentage of Total Revenue. This shows, for instance, what percentage of each sales dollar is consumed by costs or contributes to profit.
On the Balance Sheet, every asset, liability, and equity account is expressed as a percentage of Total Assets. This reveals the composition of the company's assets and how it is financed (e.g., the proportion of debt versus equity).
Imagine a pie chart for the income statement where the entire pie represents total revenue. Each slice would then show the proportion of that revenue consumed by different expenses (like COGS, SG&A) and the portion that becomes net income. Similarly, for the balance sheet, the entire pie represents total assets, with slices showing the proportion of cash, inventory, property, plant, and equipment, and how these assets are funded by liabilities and equity.
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Why These Analyses Matter
By combining trend and common-size analysis, stakeholders gain a comprehensive view of a company's financial performance and position. Trend analysis highlights the direction of change, while common-size analysis reveals the internal structure and proportions. Together, they are powerful tools for:
- Identifying performance improvements or deteriorations.
- Benchmarking against competitors and industry averages.
- Assessing financial risk and stability.
- Supporting investment and lending decisions.
- **Detecting potential financial irregularities.
Think of trend analysis as looking at a car's speedometer over time to see if it's accelerating or decelerating, while common-size analysis is like looking at the car's blueprint to understand the proportion of engine, chassis, and passenger space.
Key Takeaways
To examine financial data over a period of time to identify patterns and the direction of change.
Total Revenue.
Total Assets.
Learning Resources
Provides a comprehensive overview of trend analysis, its applications, and how it's used to identify patterns in financial data.
Explains the concept of common-size statements for both income statements and balance sheets, including calculation methods.
A practical guide to performing horizontal analysis (trend analysis) with clear examples and explanations.
Details on how to conduct vertical analysis (common-size analysis) with illustrative examples.
A resource from CFI that breaks down trend analysis, its importance, and how to calculate it.
An in-depth explanation of common-size analysis, its benefits, and how it's applied to financial statements.
A video tutorial demonstrating the process of performing trend analysis on financial statements.
A visual explanation of common-size analysis, making the concept easier to grasp.
Khan Academy's explanation of both horizontal (trend) and vertical (common-size) analysis as part of financial statement analysis.
While broader, this article on ratio analysis often includes discussions on how trend and common-size analyses inform ratio calculations and interpretations.