FINANCIAL

STATEMENT
COMPARABILITY
Chapter 4
CHAPTER 4 OBJECTIVES
 Explain the advantage of common size
financial statements compared to those
disclosed on a monetary basis.
 Compute vertical and horizontal common size
income statements and balance sheets.
 Calculate compound annual growth rates and
explain why this method provides better
information than alternative methods of
horizontal analysis.
CHAPTER 4 OBJECTIVES
(CONT.)
 Determine financial statement vertical
profiles and moving averages.
 Use good judgment when reconciling
financial statement inconsistencies,
rounding numbers, computing ratios,
scaling numerical amounts and making
qualitative assessments.
BASIC COMMON SIZE
CONSIDERATIONS
 Enables valid comparisons over time or
against competition
BASIC COMMON SIZE
CONSIDERATIONS (CONT.)
 Vertical common size financial statements
 Disclosures are a percentage of another
account in the same reporting period
 Income statement: accounts reported as a
percentage of revenues (revenues = 100%)
 Balance sheet: accounts reported as a percentage
of total assets (or liabilities plus shareholders’
equity)
VERTICAL COMMON SIZE
EXAMPLE
eXTREMESTUFF.com, Inc.
Income Statements
Vertical Common Size 2003 2002 2001 2000
Sales revenues 100.0% 100.0% 100.0% 100.0%
Cost of goods sold 61.1% 58.0% 55.0% 60.0%
Gross profit 38.9% 42.0% 45.0% 40.0%
Selling expenses 27.1% 25.2% 29.3% 25.0%
Administrative expenses 11.5% 12.1% 11.1% 8.5%
Income from continuing operations 0.4% 4.8% 4.6% 6.5%
Financial expenses 1.5% 1.6% 1.7% 1.0%
Pretax income -1.1% 3.1% 2.9% 5.5%
Income tax expense / benefit -0.5% 1.3% 1.2% 2.2%
Net income -0.7% 1.9% 1.8% 3.3%
BASIC COMMON SIZE
CONSIDERATIONS (CONT.)
 Horizontal common size financial statements
 Disclosures are a percentage of the same
account from a previous reporting period
 Income statement: e.g., this year’s revenues as a
percentage of last year’s revenues
 Balance sheet: e.g., this year’s cash balance as a
percentage of last year’s cash balance
BASIC COMMON SIZE
CONSIDERATIONS (CONT.)
 Alternative disclosures of horizontal
analysis
 Anchoring
 Uses the earliest year’s data as the base
year (100%)
 Subsequent observations are a percentage
of the base year’s amount
HORIZONTAL COMMON SIZE
EXAMPLE
eXTREMESTUFF.com, Inc.
Income Statements
Horizontal Common Size-Base Year 2003 2002 2001 2000
Sales revenues 131.0% 124.0% 120.0% 100.0%
Cost of goods sold 133.3% 119.8% 110.0% 100.0%
Gross profit 127.5% 130.3% 135.0% 100.0%
Selling expenses 142.0% 124.8% 140.8% 100.0%
Administrative expenses 176.5% 176.5% 156.5% 100.0%
Income from continuing operations 7.7% 90.8% 84.6% 100.0%
Financial expenses 200.0% 200.0% 200.0% 100.0%
Pretax income -27.3% 70.9% 63.6% 100.0%
Income tax expense / benefit -27.3% 72.7% 63.6% 100.0%
Net income -27.3% 69.7% 63.6% 100.0%
BASIC COMMON SIZE
CONSIDERATIONS (CONT.)
 Alternative disclosures of horizontal
analysis
 Rolling forward
 Uses the previous year’s observation as
100%
 Subsequent year’s observations are a
percentage of the previous year’s base
amount
HORIZONTAL COMMON SIZE
EXAMPLE
eXTREMESTUFF.com, Inc.
Income Statements
Rolling Forward 2003 2002 2001 2000
Sales revenues 105.6% 103.3% 120.0% 100.0%
Cost of goods sold 111.3% 108.9% 110.0% 100.0%
Gross profit 97.9% 96.5% 135.0% 100.0%
Selling expenses 113.8% 88.6% 140.8% 100.0%
Administrative expenses 100.0% 112.8% 156.5% 100.0%
Income from continuing operations 8.5% 107.3% 84.6% 100.0%
Financial expenses 100.0% 100.0% 200.0% 100.0%
Pretax income -38.5% 111.4% 63.6% 100.0%
Income tax expense / benefit -37.5% 114.3% 63.6% 100.0%
Net income -39.1% 109.5% 63.6% 100.0%
BASIC COMMON SIZE
CONSIDERATIONS (CONT.)
 Types of disclosures: reported as a
 Percentage of the base year amount
 Percentage change from the base year
amount
 Illustrated in Exhibit 4-4 (p. 88)
BASIC COMMON SIZE
CONSIDERATIONS (CONT.)
 Mathematical properties of common
size statements
 Vertical common sizing is appropriate for
intraperiod benchmarks
 Horizontal common sizing is appropriate for
interperiod benchmarks
 Illustrated in Exhibit 4-5 (p. 89)
COMMON SIZE EXTENSIONS
 Compound annual growth rates—
 better method of horizontal analysis than
anchoring or rolling the data forward
 Mathematically valid: considers the affect of
percentage changes on previous periods’ numbers
 Superiority illustrated in Exhibit 4-6 (p. 90)
 Internal rate of return command on spreadsheet
application facilitates computations
COMPOUND ANNUAL
GROWTH RATE EXAMPLE
eXTREMESTUFF.com, Inc.
Income Statements
Compound Annual Growth 2000 2002 2001 2003 Growth
Sales revenues (1000.00) 0 0 1310.00 9.4%
Cost of goods sold (600.00) 0 0 800.00 10.1%
Gross profit (400.00) 0 0 510.00 8.4%
Selling expenses (250.00) 0 0 355.00 12.4%
Administrative expenses (85.00) 0 0 150.00 20.8%
Income from continuing operations (65.00) 0 0 5.00
Financial expenses (10.00) 0 0 20.00 26.0%
Pretax income (55.00) 0 0 (15.00)
Income tax expense / benefit (22.00) 0 0 (6.00)
Net income (33.00) 0 0 (9.00)
COMMON SIZE EXTENSIONS
(CONT.)
 Financial statement profiles
 Condenses a vertical common size
statement into one “average” reporting
period
 Measures variability over time

 See Exhibit 4-7 (p. 91)

COMMON SIZE EXTENSIONS
(CONT.)
 Moving averages
 Condenses three, five, or seven year
vertical common size statements into an
average for that period of time
 Moves the average period forward by
dropping the earliest observation and
replacing with the most recent period’s
data
 See Exhibit 4-8 (p. 93)
DATA CONSIDERATIONS
 Observation quantity
 Analyzing sufficient reporting disclosures to
reach valid conclusions
 Usually between five and 10 years of data
suffice
DATA CONSIDERATIONS
(CONT.)
 Financial statement inconsistencies
 Format of reported data change over time
and differ among companies
 Use judgment to reduce differences in
disclosure sets
 Use most recent data available if options
exist
DATA CONSIDERATIONS
(CONT.)
 Scaling disclosures
 Companies report financial statements in
thousands or millions of dollars
 Be aware of the scale or you will fail to
grasp the entity’s size
DATA CONSIDERATIONS
(CONT.)
 Numerical rounding
 Done to avoid insignificant data disclosures
 Reduces “clutter” of data disclosures

 Should only be done when it does not alter

analysts’ decisions
DATA CONSIDERATIONS
(CONT.)
 Qualitative statements
 Analysts’ opinions about data (e.g. one
company has a better profit margin than
another) should be made with care and
after sufficient analysis