2.4 Common-Size Analysis and Trend Analysis

Common-size analysis and trend analysis are powerful tools for understanding a company's financial health. They help compare companies of different sizes and track performance over time by expressing financial data as percentages or growth rates.

These techniques reveal important insights about a company's financial structure, profitability, and growth trends. They're essential for investors and analysts to assess a company's performance relative to its peers and identify potential strengths or weaknesses in its financial position.

Common-Size Analysis

Vertical Analysis

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• Expresses each line item on a financial statement as a percentage of a base figure
• For the income statement, each line item is stated as a percentage of net sales
  • Allows for evaluating the relative proportions of items such as cost of goods sold, gross profit, operating expenses, and net income
• For the balance sheet, each line item is stated as a percentage of total assets
  • Helps assess the composition of assets (current vs. non-current) and liabilities (short-term vs. long-term) relative to total assets
• Useful for comparing companies of different sizes within the same industry (Walmart vs. Target)
• Identifies trends in the proportions over time (increasing cost of goods sold as a percentage of sales may indicate pricing pressure)

Horizontal Analysis

• Evaluates the change in individual financial statement items over time
• Uses a base year as a benchmark (index year), often the earliest year in the period
• Calculates the percentage change of each line item relative to the base year
• Helps identify growth trends, such as increasing sales or declining profitability
• Reveals changes in the proportions of items over time (increasing inventory relative to sales may indicate slowing demand)
• Can be used to compare growth rates between companies or against industry averages

Industry Comparisons

• Compares a company's financial ratios and common-size percentages to industry averages or peers
• Industry averages provide a benchmark for evaluating a company's financial performance and position relative to its sector
• Identifies areas where a company may be outperforming or underperforming its peers
  • Higher gross profit margin than the industry average may indicate a competitive advantage
  • Lower inventory turnover than peers may suggest inefficient inventory management
• Helps investors and analysts assess a company's relative financial health and competitive position within its industry

Trend Analysis

Year-over-Year Growth Rates

• Calculates the percentage change in a financial statement item from one year to the next
• Provides a measure of a company's short-term growth or decline
• Useful for identifying trends in sales, expenses, profitability, and other key metrics
• Can be used to compare a company's growth rates to its historical performance, competitors, or industry averages
• Positive growth rates indicate expansion, while negative growth rates suggest contraction
  • Consistently high sales growth may reflect strong demand for a company's products (Apple's iPhone sales)
  • Declining net income growth may signal increasing competition or cost pressures (Netflix's slowing subscriber growth)

Compound Annual Growth Rate (CAGR)

• Measures the annual growth rate of a financial statement item over a multi-year period
• Smooths out the effect of short-term fluctuations and provides a long-term growth measure
• Calculated using the formula: $CAGR = (Ending Value / Beginning Value)^{(1/n)} - 1$, where n is the number of years
• Useful for comparing the growth rates of different companies or investments over varying time periods
• Helps investors assess a company's long-term growth potential and sustainability
  • High CAGR in sales and earnings may indicate a rapidly growing company (Amazon's revenue CAGR of 27% from 2010-2020)
  • Declining or inconsistent CAGR may suggest a maturing company or industry (GE's revenue CAGR of -1% from 2010-2020)