Raw financial statements are hard to compare. A company’s revenue may be 9,200 this year and 8,000 last year — but is a cost of 5,980 "high"? Is a receivables balance of 1,450 a problem? Three simple techniques turn the numbers into patterns: horizontal analysis (change over time), vertical analysis (structure within a year) and trend analysis (change over several years using index numbers). Together they are usually the first step of financial statement analysis.
What you will learn
- Calculate absolute and percentage changes between periods
- Prepare common-size income statements and balance sheets
- Build index-number trend series
- Interpret what each technique reveals and where it misleads
Horizontal analysis
Horizontal analysis compares each line item across two or more periods.
Horizontal analysis
Absolute change = Current year − Base year
Percentage change = (Current year − Base year) ÷ Base year × 100%
Worked example: Company A, year on year
Company A (illustrative figures, used throughout ARBIMETRA’s analysis guides):
| Item | Year 1 | Year 2 | Change | % change |
|---|---|---|---|---|
| Revenue | 8,000 | 9,200 | +1,200 | +15.0% |
| Cost of sales | 5,200 | 5,980 | +780 | +15.0% |
| Gross profit | 2,800 | 3,220 | +420 | +15.0% |
| Operating expenses | 1,600 | 1,840 | +240 | +15.0% |
| Operating profit (EBIT) | 1,200 | 1,380 | +180 | +15.0% |
| Interest | 200 | 240 | +40 | +20.0% |
| Net profit | 750 | 855 | +105 | +14.0% |
| Trade receivables | 1,100 | 1,450 | +350 | +31.8% |
| Inventory | 1,300 | 1,700 | +400 | +30.8% |
| Cash | 400 | 350 | −50 | −12.5% |
| Total assets | 7,000 | 8,000 | +1,000 | +14.3% |
What stands out: revenue, costs and operating profit all grew by 15%, so the business scaled smoothly. But receivables and inventory grew roughly twice as fast as sales, and cash fell. Interest rose faster than profit because borrowing increased. Horizontal analysis has pointed straight to working capital as the issue to investigate.
Interpreting percentages carefully: when the base is small, percentages explode — a cost rising from 10 to 30 is +200% but may be immaterial. When the base is negative (a loss), percentage changes are meaningless; report the absolute change instead.
Vertical analysis and common-size statements
Vertical analysis expresses each item as a percentage of a base figure in the same period:
- Income statement: every line as a percentage of revenue.
- Balance sheet: every line as a percentage of total assets (or total liabilities and equity).
The result is a common-size statement, which shows the structure of the business and makes companies of different sizes comparable.
Worked example: Company A common-size income statement
| Item | Year 1 | % of revenue | Year 2 | % of revenue |
|---|---|---|---|---|
| Revenue | 8,000 | 100.0% | 9,200 | 100.0% |
| Cost of sales | 5,200 | 65.0% | 5,980 | 65.0% |
| Gross profit | 2,800 | 35.0% | 3,220 | 35.0% |
| Operating expenses | 1,600 | 20.0% | 1,840 | 20.0% |
| Operating profit | 1,200 | 15.0% | 1,380 | 15.0% |
| Interest | 200 | 2.5% | 240 | 2.6% |
| Net profit | 750 | 9.4% | 855 | 9.3% |
Margins were almost unchanged; the slight fall in net margin comes from higher interest. If a competitor showed cost of sales at 58% of revenue, Company A’s 65% would prompt questions about pricing, purchasing or production efficiency.
A common-size balance sheet answers different questions: What share of assets is tied up in receivables and inventory? How much of the business is funded by debt rather than equity? For Company A, receivables and inventory together rose from 34.3% of total assets (2,400 ÷ 7,000) to 39.4% (3,150 ÷ 8,000).
Trend analysis with index numbers
For longer periods, trend analysis sets a base year to 100 and expresses later years relative to it.
Index number
Index for year t = Value in year t ÷ Value in base year × 100
Company A revenue index (Year 1 = 100)
Show the data
| Revenue index | |
|---|---|
| Year 1 | 100.0 |
| Year 2 | 115.0 |
| Year 3 | 122.5 |
| Year 4 | 136.3 |
| Year 5 | 151.3 |
With revenues of 8,000, 9,200, 9,800, 10,900 and 12,100, the index runs 100.0, 115.0, 122.5, 136.3 and 151.3. Plotting indices for revenue, costs, receivables and headcount on one chart quickly shows which items are growing faster than the business. Over long periods, consider adjusting for inflation, since nominal growth overstates real growth — see inflation and real returns.
Which technique answers which question
| Question | Technique |
|---|---|
| How fast is each item growing? | Horizontal analysis |
| How is the business structured? Are margins changing? | Vertical (common-size) analysis |
| What is the long-run direction? | Trend analysis with indices |
| How efficient, liquid and profitable is the company? | Ratio analysis |
These techniques also feed forecasting: historical growth rates and common-size percentages are often the starting point for revenue and expense forecasts.
Limitations
- Changes in accounting policies, acquisitions or disposals break comparability between years.
- One-off items distort a single year; adjust or exclude them.
- Common-size percentages hide scale: a stable 9% margin on falling sales still means falling profit.
- Inflation and currency changes affect long-term trends.
Common mistakes
- Reporting a large percentage change on a tiny base without context.
- Calculating percentage changes from a negative base.
- Comparing common-size statements of companies with different business models.
- Ignoring acquisitions that inflate year-on-year growth.
Key terms
- Horizontal analysis — comparison of line items across periods.
- Vertical analysis — each item expressed as a percentage of a base figure.
- Common-size statement — a statement with every item shown as a percentage of the base.
- Trend analysis — analysis of changes over several periods, often with index numbers.
- Index number — a value expressed relative to a base period set at 100.
Frequently asked questions
What base should a common-size balance sheet use?
Total assets (equivalently, total liabilities and equity).
Why compare growth in receivables with growth in sales?
If receivables grow much faster than sales, customers are paying more slowly or credit terms have loosened, which ties up cash and may increase bad debts.
How many years should trend analysis cover?
Five years is a common minimum to see a pattern through a business cycle; longer periods help for cyclical industries.
Key takeaways
- Horizontal analysis measures change between periods in amount and percentage.
- Vertical analysis shows structure as a percentage of revenue or total assets.
- Trend analysis uses index numbers to show long-run direction.
- Compare the growth of related items — such as receivables and sales — to spot problems early.