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Harrison Harrison
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Horizontal analysis and vertical analysis, including the preparation of common-size financial statements, are important analytical techniques used to evaluate the strength of published financial statements.
Required:
a. Define:
   1. horizontal analysis
   2. vertical analysis
   3. common-size financial statements
b. How is each of these techniques helpful in the analysis of financial statements?
Textbook 
Financial Accounting, Canadian Edition

Financial Accounting, Canadian Edition


Edition: 5th
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TheSinTheSin
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a.
1. Horizontal analysis involves the presentation of the percentage change in reported amounts from year to year. Sometimes the dollar amount of a change and the percentage change are reported together.
2. Vertical analysis involves the presentation of financial statements along with a column showing each item as a percentage of some 100% figure. On the income statement, this 100% figure is generally net sales. On the balance sheet, it is usually total assets or total liabilities plus shareholders' equity.
3. Common-size financial statements represent a form of vertical analysis. They are financial statements prepared reporting only the percentage of each item compared to some 100% figure.

b. The dollar amounts of changes occurring from year to year are important to know, but the calculation of the percentage change improves our ability to use the dollar amounts for analysis. For example, if sales, cost of goods sold, and gross margin have all increased over a three-year period, presentation of the percentage change for each item helps determine whether each of these items is increasing at approximately the same rate.
Likewise, presentation of each financial statement item as a percentage of a total helps determine how relationships change from year to year. It also facilitates comparison with other companies or with industry averages.
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