Analyzing financial statements is critical, yet most find it challenging to interpret the data.
Luckily, there are two straightforward analysis techniques—horizontal and vertical—that provide clarity on financial performance when applied properly.
In this post, we will define horizontal and vertical analysis, walk through mechanics and calculations, examine illustrative examples, and share key takeaways to equip you with actionable financial statement analysis skills.
Introduction to Horizontal and Vertical Analysis
Horizontal and vertical analysis are two important methods used to analyze financial statements. This section will provide an overview of each method and highlight the key differences between them.
Defining Horizontal Analysis
Horizontal analysis, also known as trend analysis, is a technique used to evaluate an account over a period of time. It allows you to see changes in an account from one accounting period to another, expressed as a percentage. This helps identify trends and growth patterns over time.
For example, horizontal analysis of the revenue account on the income statement would calculate the change in revenue from one year to the next as a percentage. If revenue was $100,000 in 2019 and $150,000 in 2020, horizontal analysis would show a 50% [($150,000 - $100,000) / $100,000] increase in revenue from 2019 to 2020.
Understanding Vertical Analysis
Vertical analysis, or common size analysis, analyzes the proportional relationship between line items on a financial statement in a single reporting period. Figures are shown as a percentage of a relevant base figure for that statement.
For example, vertical analysis of the balance sheet means every line item is stated as a percentage of total assets. If cash was $50,000 and total assets were $500,000, cash would be shown as 10% (50,000 / 500,000) of total assets. This allows for easy comparison of the composition of balance sheets over multiple periods.
Contrasting Horizontal and Vertical Analysis
The main difference between the two methods is that horizontal analysis looks at trends over time, while vertical analysis compares line items within a single period.
Horizontal analysis helps spot patterns and growth trends, while vertical analysis allows financial statement items to be compared to each other or to a benchmark figure. Together, they provide greater insight into a company's financial health.
What is the difference between horizontal and vertical analysis of financial statements?
Horizontal analysis and vertical analysis are two important techniques used to analyze financial statements. The key difference between them is the perspective each analysis takes:
Horizontal analysis looks at trends over time, comparing financial data across multiple reporting periods. This allows you to see increases or decreases from one period to the next. For example, you can use horizontal analysis to compare revenue from this year to revenue from last year.
Vertical analysis focuses on relationships within a single reporting period. It compares different line items on a financial statement to a key metric, allowing you to see how each item relates as a percentage. For example, you can use vertical analysis to compare multiple line items from the income statement (revenue, COGS, operating expenses, etc.) as a percentage of total revenue.
In summary:
- Horizontal analysis:
- Compares data across different reporting periods
- Helps identify increases or decreases over time
- Also known as trend analysis
- Vertical analysis:
- Compares relationships within a single reporting period
- Shows items as percentages of a key metric
- Allows analysis of relative proportions and cost structures
Both analyses provide valuable but different insights. Horizontal analysis shows if you are growing or declining. Vertical analysis gives visibility into the composition and relative weightings across your financial levers. Together they make a powerful combination for analyzing financial statements.
What is an example of a horizontal analysis of financial statements?
For example, if a company's current year (2022) revenue is $50 million in 2022 and its revenue in the base period, 2021, was $40 million, the net difference between the two periods is $10 million. By dividing the net difference by the base figure, the percentage change comes out to 25%.
This shows that the company's revenue increased by 25% between 2021 and 2022. This is a simple example of performing a horizontal analysis on the income statement to analyze the trend in revenue over time.
Some key things to note about this horizontal analysis example:
- The base year is 2021 and the current year is 2022
- The base figure is revenue in 2021 ($40 million)
- The current figure is revenue in 2022 ($50 million)
- The net difference is $10 million (current figure minus base figure)
- The percentage change is the net difference divided by the base figure ($10 million/$40 million = 25%)
So in summary, horizontal analysis looks at year-over-year trends by comparing figures from the current period to a base period. This allows financial statement users to see relative changes over time and spot trends.
What is the difference between vertical and horizontal balance sheet format?
A horizontal balance sheet shows assets on the right-hand side, while a vertical balance sheet shows assets below liabilities.
The key differences are:
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Horizontal balance sheet: Assets are shown on the right-hand side, while liabilities and equity are on the left-hand side. This format emphasizes the accounting equation: Assets = Liabilities + Equity.
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Vertical balance sheet: Assets are shown below liabilities and equity. This format lists each financial statement element (assets, liabilities, equity) vertically, making it easier to scan and compare sub-accounts over time.
For example:
Horizontal Balance Sheet
Assets Liabilities & Equity
Cash: $10,000 Accounts Payable: $5,000
Accounts Receivable: Total Liabilities: $5,000
$8,000 Common Stock: $3,000
Retained Earnings: $10,000
Total Equity: $13,000
Total Assets: $18,000 Total Liabilities & Equity: $18,000
Vertical Balance Sheet
Liabilities & Equity
Accounts Payable: $5,000
Total Liabilities: $5,000
Common Stock: $3,000
Retained Earnings: $10,000
Total Equity: $13,000
Total Liabilities & Equity: $18,000
Assets
Cash: $10,000
Accounts Receivable: $8,000
Total Assets: $18,000
In summary, the horizontal format emphasizes the accounting equation, while the vertical format allows easier analysis of sub-accounts over time. Both formats contain the same information but organized differently.
What is the difference between horizontal and vertical analysis of financial statements quizlet?
Horizontal analysis and vertical analysis are two important techniques used to analyze financial statements. The key differences are:
Horizontal Analysis
- Examines trends over time for a single financial statement item (e.g. revenue, expenses)
- Calculates the percentage change from one period to another
- Helps understand growth trends over multiple accounting periods
Vertical Analysis
- Expresses each item on a financial statement as a percentage of a base amount
- The base amount is typically total assets for balance sheets and total revenue for income statements
- Enables comparison of the relative size of items across accounting periods
For example, horizontal analysis of the revenue line on an income statement would calculate the percentage change in revenue from 2020 to 2021. Vertical analysis would express revenue earned in 2021 as a percentage of total revenue earned that year.
So in summary:
- Horizontal analysis: Percentage change over time
- Vertical analysis: Percentage of total in a given year
- Helpful for spotting trends and comparing relative size of items
Using both together provides a more complete picture of a company's financial performance.
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The Mechanics of Horizontal Analysis
Horizontal analysis involves comparing financial data across different periods to identify trends over time. This section outlines the key steps for performing a horizontal analysis.
Selecting a Base Year for Comparison
The first step in horizontal analysis is to select a base year, typically the earliest period presented, to serve as a basis for comparing all future periods. For example, if you have financial statements for the years 2018-2022, you would select 2018 as the base year.
Computing Dollar Changes Over Time
Once the base year has been determined, you can calculate the net dollar change for each line item on the financial statements by subtracting the base year amount from subsequent years.
For example:
Accounts Receivable 2022 - Accounts Receivable 2018 = Dollar Change in Accounts Receivable
This allows you to see how each account on the balance sheet and income statement has increased or decreased in dollar terms over the periods analyzed.
Determining Percentage Changes
To better understand the scale of change over time, horizontal analysis also looks at percentage changes relative to the base year. This is calculated by dividing the dollar change by the base year amount for each line item.
For example:
Dollar Change in Accounts Receivable / Accounts Receivable 2018 = % Change in Accounts Receivable
Percentage changes allow for easier comparison across line items.
Horizontal Analysis Interpretation
Once the dollar and percentage changes have been calculated, the next step is interpreting what these changes mean and what trends they may indicate about the company's financial performance over the periods analyzed.
Key things to look for include:
- Accounts or categories that have changed dramatically in dollar or percentage terms
- Trends of increase or decrease over the periods
- How changes relate to broader economic factors over the same timeframe
Understanding these trends allows inferences about the improving or declining financial health of the company.
Horizontal Analysis Formula Application
The horizontal analysis formula can be applied to any financial statement accounts or line items over time. This includes balance sheet accounts like assets, liabilities, and equity. It also includes entire sections of the income statement, such as revenue, expenses, operating income, EBITDA, net income.
Comparing changes to industry benchmarks provides further context for assessing performance. Overall, horizontal analysis delivers insights into the company's historical performance.
The Process of Vertical Analysis
Vertical analysis expresses each item on a financial statement as a percentage of a base amount. This allows for easy comparison across companies of different sizes or comparison of a company's performance over multiple periods.
Identifying the Base Amount
For the balance sheet, total assets or total liabilities and shareholders' equity are typically used as the base amount. For the income statement, total revenues or total sales are commonly used. Choosing an appropriate base amount allows the vertical analysis to show the composition of key financial statement items.
Converting Financial Figures to Percentages
To perform vertical analysis, divide each line item amount by the base amount. Then multiply the resulting decimal by 100 to convert to a percentage. For example, if total assets were $100,000 and cash was $20,000:
Cash Percentage = Cash / Total Assets x 100<br>
= $20,000 / $100,000 x 100 = 20%
Doing this for every line item shows the percentage composition.
Vertical Analysis of Balance Sheet
Here is an example vertical analysis of a balance sheet with total assets as the base amount:
| Account | Amount | Percentage |
|---|---|---|
| Cash | $20,000 | 20% |
| Accounts Receivable | $15,000 | 15% |
| Inventory | $25,000 | 25% |
| Total Current Assets | $60,000 | 60% |
| Property, Plant & Equipment | $30,000 | 30% |
| Accumulated Depreciation | $(5,000) | (5%) |
| Total Assets | $100,000 | 100% |
This shows the percentage of total assets represented by each item.
Vertical Analysis Formula Utilization
The vertical analysis formula can be applied to any financial statement line item and base amount as follows:
Vertical Analysis Percentage = (Line Item Amount / Base Amount) x 100
Choosing appropriate base amounts and comparing vertical analysis percentages over time lets you analyze changes in the financial structure and performance of a company.
Interpreting Results and Key Differences
Deciphering Horizontal Analysis Outcomes
Horizontal analysis looks at trends over time by comparing financial data across reporting periods. By analyzing dollar and percentage changes, horizontal analysis reveals a company's financial trajectory - whether it is growing, declining, or remaining stable.
Key things to examine in horizontal analysis include:
- Revenue trends - Is revenue increasing or decreasing over time? At what rate? This indicates the company's sales growth.
- Expense trends - Are costs rising or falling from year to year? Faster than revenue? This impacts profitability.
- Asset and liability trends - How quickly are assets or debts growing on the balance sheet? This signals financial health.
- Unusual fluctuations - Are there any outlier changes in the data? These may warrant further investigation.
To interpret horizontal analysis, focus on the trends and growth rates in the financial statements rather than absolute dollar amounts. Shifting percentages indicate changing business conditions.
Understanding Vertical Analysis Results
Vertical analysis looks at financial data as a percentage of a key benchmark figure within the same reporting period. This reveals the proportional contribution of each account and how the financial structure changes over time.
In vertical analysis, look for:
- Increasing percentages - This means the account is making up a larger part of the whole.
- Decreasing percentages - The account is becoming less significant compared to the total.
- Outlier percentages - One account may contribute an unusually large or small portion, which could prompt questions.
For example, if salaries expense as a percentage of total expenses increases over several years, it indicates that salaries are making up a greater portion of total costs. This may signal issues with rising labor expenses.
Strategic Application of Horizontal vs. Vertical Analysis
Horizontal and vertical analysis offer different insights:
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Horizontal shows absolute and relative changes over time to evaluate growth trends and performance. Useful for trend analysis.
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Vertical reveals an account's significance compared to a total. Better for financial structure and composition analysis.
Horizontal analysis is more applicable for studying a company's growth trajectory over multiple periods. Vertical analysis is more useful for benchmarking against industry averages and identifying outliers in period-specific financial data.
Together, they provide comprehensive insights into both a company's directional progress and proportional financial makeup. Using both methods strategically can facilitate smarter and more informed business decisions.
Illustrative Examples of Analysis Techniques
This section will provide numerical examples demonstrating horizontal and vertical analyses using both income statements and balance sheets.
Horizontal and Vertical Analysis Example on an Income Statement
Here is a sample income statement for a fictional company over two years:
| Account | Year 1 | Year 2 |
|---|---|---|
| Revenue | $100,000 | $150,000 |
| Cost of Goods Sold | $60,000 | $80,000 |
| Gross Profit | $40,000 | $70,000 |
| Operating Expenses | $20,000 | $30,000 |
| Operating Income | $20,000 | $40,000 |
To conduct a vertical analysis, we calculate each line item as a percentage of revenue:
| Account | Year 1 | Year 2 |
|---|---|---|
| Revenue | 100% | 100% |
| Cost of Goods Sold | 60% | 53% |
| Gross Profit | 40% | 47% |
| Operating Expenses | 20% | 20% |
| Operating Income | 20% | 27% |
This allows us to see the relative size of each component and compare them over time.
For the horizontal analysis, we use Year 1 as the base year and calculate the dollar and percentage change:
| Account | Change | % Change |
|---|---|---|
| Revenue | $50,000 | 50% |
| Cost of Goods Sold | $20,000 | 33% |
| Gross Profit | $30,000 | 75% |
| Operating Expenses | $10,000 | 50% |
| Operating Income | $20,000 | 100% |
This quantifies how each line item changed between the years. We can see revenue and profits grew substantially while expenses grew at a lower rate.
Vertical Analysis Example on a Balance Sheet
Below is a sample balance sheet:
| Account | Year 1 | Year 2 |
|---|---|---|
| Cash | $10,000 | $20,000 |
| Accounts Receivable | $20,000 | $15,000 |
| Inventory | $30,000 | $25,000 |
| Total Current Assets | $60,000 | $60,000 |
| Property, Plant & Equipment | $100,000 | $150,000 |
| Total Assets | $160,000 | $210,000 |
To conduct a vertical analysis, we calculate each item as a percentage of total assets:
| Account | Year 1 | Year 2 |
|---|---|---|
| Cash | 6% | 10% |
| Accounts Receivable | 13% | 7% |
| Inventory | 19% | 12% |
| Total Current Assets | 38% | 29% |
| Property, Plant & Equipment | 63% | 71% |
| Total Assets | 100% | 100% |
This shows the composition of assets and how it changed between the years. We can see the share of fixed assets increased while current assets declined as a percentage of total assets.
Interpreting a Horizontal Analysis Example
Building on the previous income statement example, the 100% increase in operating income quantifies excellent business performance. However, revenue grew at 50% and expenses grew at 50% and 33%.
This indicates that while profitability improved in absolute terms, there may be an issue with expense control since they grew faster than revenue. The company should investigate why expenses increased at a higher rate and take steps to streamline operations.
The horizontal analysis provides critical insights that can inform decisions around financial management, budgeting, and strategy. Tracking changes over time highlights potential problems and opportunities.
Key Takeaways and Conclusion
Horizontal and vertical analysis are two important techniques for reviewing financial statements. While both methods provide valuable insights, they have key differences:
Deciding When to Use Horizontal vs. Vertical Analysis
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Use horizontal analysis to track performance trends over time. By comparing numbers across past financial statements, horizontal analysis shows increases or decreases in accounts.
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Use vertical analysis to compare accounts across an individual statement. Vertical analysis shows the proportion of each account relative to a key metric like total assets or total revenues.
Combining Horizontal and Vertical Analysis for Comprehensive Insight
Together, these analysis methods provide a more complete picture of financial health:
- Horizontal analysis tracks performance changes over multiple periods.
- Vertical analysis evaluates the composition and structure of the current financial statement.
Integrating both techniques allows deeper analysis of trends alongside present-day account composition.
Final Thoughts on Financial Statement Analysis Techniques
Regularly conducting horizontal and vertical analysis provides vital insight for strategic planning and financial management. As key tools for tracking performance changes and evaluating account proportions, these methods help uncover strengths, weaknesses, and opportunities for improvement over time. Using both analysis techniques can lead to better-informed business decisions.
