Is a technique for evaluating a financial statement item in the current year with other items in the current year?

What Is Vertical Analysis?

Vertical analysis is a method of financial statement analysis in which each line item is listed as a percentage of a base figure within the statement. Thus, line items on an income statement can be stated as a percentage of gross sales, while line items on a balance sheet can be stated as a percentage of total assets or liabilities, and vertical analysis of a cash flow statement shows each cash inflow or outflow as a percentage of the total cash inflows.

Key Takeaways

• Vertical analysis makes it easier to understand the correlation between single items on a balance sheet and the bottom line, expressed in a percentage.
• Vertical analysis can become a more potent tool when used in conjunction with horizontal analysis, which considers the finances of a certain period of time.

How Vertical Analysis Works

Vertical analysis makes it much easier to compare the financial statements of one company with another, and across industries. This is because one can see the relative proportions of account balances. It also makes it easier to compare previous periods for time series analysis, in which quarterly and annual figures are compared over a number of years, in order to gain a picture of whether performance metrics are improving or deteriorating.

For example, by showing the various expense line items in the income statement as a percentage of sales, one can see how these are contributing to profit margins and whether profitability is improving over time. It thus becomes easier to compare the profitability of a company with its peers.

Vertical Analysis

Financial statements that include vertical analysis clearly show line item percentages in a separate column. These types of financial statements, including detailed vertical analysis, are also known as common-size financial statements and are used by many companies to provide greater detail on a company’s financial position.

Common-size financial statements often incorporate comparative financial statements that include columns comparing each line item to a previously reported period.

Vertical analysis is used in order to gain a picture of whether performance metrics are improving or deteriorating.

Vertical vs. Horizontal Analysis

Another form of financial statement analysis used in ratio analysis is horizontal analysis or trend analysis. This is where ratios or line items in a company's financial statements are compared over a certain period of time by choosing one year's worth of entries as a baseline, while every other year represents percentage differences in terms of changes to that baseline.

For example, the amount of cash reported on the balance sheet on December 31 of 2018, 2017, 2016, 2015, and 2014 will be expressed as a percentage of the December 31, 2014, amount. Instead of dollar amounts, you might see 141, 135, 126, 118, and 100.

This shows that the amount of cash at the end of 2018 is 141% of the amount it was at the end of 2014. By doing the same analysis for each item on the balance sheet and income statement, one can see how each item has changed in relationship to the other items.

Example of Vertical Analysis

For example, suppose XYZ Corporation has gross sales of $5 million and cost of goods sold of $1 million and general and administrative expenses of $2 million and a 25% tax rate, its income statement will look like this if vertical analysis is used:

What Is Horizontal Analysis?

Horizontal analysis is used in financial statement analysis to compare historical data, such as ratios, or line items, over a number of accounting periods. Horizontal analysis can either use absolute comparisons or percentage comparisons, where the numbers in each succeeding period are expressed as a percentage of the amount in the baseline year, with the baseline amount being listed as 100%. This is also known as base-year analysis.

Key Takeaways

• Horizontal analysis is used in the review of a company's financial statements over multiple periods.
• It is usually depicted as percentage growth over the same line item in the base year.
• Horizontal analysis allows financial statement users to easily spot trends and growth patterns.
• Horizontal analysis shows a company's growth and financial position versus competitors.
• Horizontal analysis can be manipulated to make the current period look better if specific historical periods of poor performance are chosen as a comparison.

Horizontal Analysis

How Horizontal Analysis Works

Horizontal analysis allows investors and analysts to see what has been driving a company's financial performance over several years and to spot trends and growth patterns. This type of analysis enables analysts to assess relative changes in different line items over time and project them into the future. An analysis of the income statement, balance sheet, and cash flow statement over time gives a complete picture of operational results and reveals what is driving a company’s performance and whether it is operating efficiently and profitably.

The analysis of critical measures of business performance, such as profit margins, inventory turnover, and return on equity, can detect emerging problems and strengths. For example, earnings per share (EPS) may have been rising because the cost of goods sold (COGS) has been falling or because sales have been growing steadily. Coverage ratios, like the cash flow-to-debt ratio and the interest coverage ratio, can reveal how well a company can service its debt through sufficient liquidity and whether that ability is increasing or decreasing. Horizontal analysis also makes it easier to compare growth rates and profitability among multiple companies in the same industry.

Generally accepted accounting principles (GAAP) are based on the consistency and comparability of financial statements. Using consistent accounting principles like GAAP ensures consistency and the ability to accurately review a company's financial statements over time. Comparability is the ability to review two or more different companies' financials as a benchmarking exercise.

Horizontal Analysis vs. Vertical Analysis

The primary difference between vertical analysis and horizontal analysis is that vertical analysis is focused on the relationships between the numbers in a single reporting period, or one moment in time. Vertical analysis is also known as common size financial statement analysis.

For example, the vertical analysis of an income statement results in every income statement amount being restated as a percent of net sales. If a company's net sales were $2 million, they will be presented as 100% ($2 million divided by $2 million). If the cost of goods sold amount is $1 million, it will be presented as 50% ($1 million divided by sales of $2 million).

On the other hand, horizontal analysis looks at amounts from the financial statements over a horizon of many years. Horizontal analysis is also referred to as trend analysis. Assume that the base year for analysis is three years earlier. All of the amounts on the balance sheets and the income statements for analysis will be expressed as a percentage of the base year amounts. The amounts from three years earlier are presented as 100% or simply 100. The amounts from the most recent years will be divided by the base year amounts. For instance, if a most recent year amount was three times as large as the base year, the most recent year will be presented as 300. This type of analysis reveals trends in line items such as cost of goods sold.

Criticism of Horizontal Analysis

Depending on which accounting period an analyst starts from and how many accounting periods are chosen, the current period can be made to appear unusually good or bad. For example, the current period's profits may appear excellent when only compared with those of the previous quarter but are actually quite poor if compared to the results for the same quarter in the preceding year.

Although a change in accounting policy or the occurrence of a one-time event can impact horizontal analysis, these situations should also be disclosed in the footnotes to the financial statements, in keeping with the principle of consistency.

A common problem with horizontal analysis is that the aggregation of information in the financial statements may have changed over time, so that revenues, expenses, assets, or liabilities may shift between different accounts and, therefore, appear to cause variances when comparing account balances from one period to the next. Indeed, sometimes companies change the way they break down their business segments to make the horizontal analysis of growth and profitability trends more difficult to detect. Accurate analysis can be affected by one-off events and accounting charges.

Example of Horizontal Analysis

Horizontal analysis typically shows the changes from the base period in dollar and percentage. For example, a statement that says revenues have increased by 10% this past quarter is based on horizontal analysis. The percentage change is calculated by first dividing the dollar change between the comparison year and the base year by the line item value in the base year, then multiplying the quotient by 100.

For example, assume an investor wishes to invest in company XYZ. The investor may wish to determine how the company grew over the past year. Assume that in company XYZ's base year, it reported net income of $10 million and retained earnings of $50 million. In the current year, company XYZ reported a net income of $20 million and retained earnings of $52 million. Consequently, it has an increase of $10 million in its net income and $2 million in its retained earnings year over year. Therefore, company ABC's net income grew by 100% (($20 million - $10 million) / $10 million * 100) year over year, while its retained earnings only grew by 4% (($52 million - $50 million) / $50 million * 100).

Horizontal Analysis FAQs

How Is Horizontal Analysis Performed?

To perform a horizontal analysis:

1. Choose a line item, account balance, or ratio that you want to analyze.
2. Pick a base year, and compare the dollar and percent change to subsequent years with the base year.
3. Calculate thepercentage change by first dividing the dollar change between the comparison year and the base year by the line item value in the base year, then multiplying the quotient by 100.

What Are the Benefits of Horizontal Analysis?

Horizontal analysis is valuable because analysts assess past performance along with the company’s current financial position or growth. Trends emerge, and these can be used to project future performance. Horizontal analysis can also be used to benchmark a company with competitors in the same industry.

How Can an Investor Use Horizontal Analysis?

Investors can use horizontal analysis to determine the trends in a company's financial position and performance over time to determine whether they want to invest in that company. However, investors should combine horizontal analysis with vertical analysis and other techniques to get a true picture of a company's financial health and trajectory.

What Is the Difference Between Horizontal Analysis and Vertical Analysis?

The primary difference between vertical analysis and horizontal analysis is that vertical analysis is focused on the relationships between the numbers in a single reporting period, or one moment in time. Horizontal analysis looks at certain line items, ratios, or factors over several periods to determine the extent of changes and their trends.

Is a technique used for evaluating a financial statement in the current year with other items in the same year?

What are the techniques used in financial statement analysis?

Is a technique for evaluating a series of financial statement?

Is an analysis by which an item of the financial statement of a particular year is analyzed and interpreted after making comparisons with another years corresponding items?