Common size income statement expresses each income statement item as a percentage of sales, which aloows you to evauate firm performance over time and acrros firms, industries and/or sectors. So what are the limitations and it what circumstances can’t you use them?
common size allows you to do vertical analysis. horizontal analysis is not possible. any imperfection in income statement affects everything else similarly and hence smudges can’t be detected easily.
so what’s the difference between vertical and horizonal anlysis?
vertical is each line item is expressed as a percentage of sales horizontal each item is started at a value, say 1, and as the years go on you can see the change in trends eg. Cash Year 1 Year 2 Year 3 1 1.1 1.21 from this we can see that cash holdings have been increasing by 10% each year
sorry that didnt come out right year 1= 1 year 2= 1.1 year 3= 1.21
Ah okay thanks. However what I was after was the limitations of using vertical analysis? i mean does it always work accross all industries, all time frames etc?
the only limitation I can see is different firm sizes. If you were analyzing 2 companies and you have never heard of them before, sales represents 100% on the vertical analysis but it tells you nothing about what their sales actually were. If you were looking at an oligopoly market (dominant firm) with 2 companies and you were comparing the 2 firms, you probably wouldn’t be able to tell which one was the dominant firm.
Perfect thanks a lot. Makes sense.