Financial statements primarily deal with a period of statements whilst taking into account variations in the analytical system to determine the final result. The analytical system consists of horizontal and vertical analysis of financial statements. In the case of horizontal analysis, one specific aspect of a business is studied through different periods to compare fluctuations.
On the other hand, a vertical analysis takes into account a comprehensive outlook of the financial worksheet for a defined period. Both the analytical systems determine a company's performance over a period.
Both the factors have their pros and cons and determine if the company's graph is increasing in terms of revenue, balance, input, and output and bring out the loopholes that can be worked upon. Businesses focus on improving profit ratio over time, and horizontal and vertical analysis determine the positive and the negative outlook of the similar aspect. Let us read through each of the analytical systems and their differences.
- Trend analysis, also known as horizontal analysis, studies financial analysis over a certain period, usually with the help of a comparison structure.
- The analytical system helps create related decisions and compares financial results line by line horizontally.
- Most importantly, horizontal analysis helps understand how the results are changed over time from one financial period to another. The calculation is usually based on absolute terms as well as in percentage.
- A company's income statement is expressed in percentage to determine the revenue and percentage of working capital employed.
- The horizontal analysis takes a single factor to determine the sequential rise/drop rate. It either considers the overhead or sales of different periods such that a comparison of overhead expense from each quarter of the year with another quarter of another year can be compared.
- For example, the third quarter of 2017 can be compared with the third quarter of 2016 in terms of revenue increased over a period. The financial worksheet includes the cost of sales, gross profit, administrative expenses, selling and marketing expense, operating income, operating profit, tax paid, and the net profit - all of it determined with the variation in the quarters of one financial year to another.
- Usually, the result of one year is taken as the baseline for comparison. For example, if ABC company makes a record of INR 31 crores in profit in the year 2017, standing to be the highest since the date of inception, it may be regarded as the baseline for the next years to come. If the total sales in 2017 were INR 30 lacs and in 2018 it was INR 28.5 lacs, a clear outcome of sales reduction by 2.5% in 2018 can be analysed.
1. Horizontal Analysis = Amount in Year of Comparison – Base Year Amount
2. Horizontal analysis % = [(Amount in Year of Comparison – Base Year Amount) / Base Year Amount] * 100
- The objective of horizontal analysis is to create a pattern of changing trends and predict future performances. A financial analyst observes comparisons between line items or ratios in a financial statement.
- The earliest period analysed is the base period, and the changes so noted depict income either in dollar or in percentage.
Advantages of Horizontal Analysis
- Goal: Financial outcome is analysed in the form of trends related to specific items over several years
- Purpose: It helps organisations understand the growth in terms of each item when measured against financial factors
- Period: Multiple years are taken into consideration
- Comparison: Comparison of one organisation to the other can be made intra firm wise
Disadvantages of Horizontal Analysis
- Base year selection: Organisations adopting a horizontal way of analysis may face difficulty selecting a base year, in case each year generates revenue greater than the previous base year. Fluctuations in determining the base year may lead to un-proportional calculations.
- Consistency: The horizontal analysis is considered difficult, given there are no consistent accounting principles, and the determining factors are ever-changing.
- Inflation: Considering horizontal analysis under inflationary situations is useless. There are chances of producing misleading results as threads of data taken for comparison will have immense data fluctuation.
- The method employed to conduct useful decision making by analysing each line item listed on a financial statement with another item of the same financial statement is vertical analysis.
- Each line item on the income statement is either expressed as a percentage of sales, revenue, or as a percentage of total assets.
- For example, company XYZ made a gross profit margin from the year 2016 and 2017, equal to $3000 million, and gross profit margin from 2015 to 2016 is $2800 million. The comparison of the ratio of two different years taking the same line of the item is the process of vertical analysis.
- Calculating from the above example:
1. For 2016 :
Cost of sales of 2016 = 5000
Revenue of 2016 = 2500
Gross profit margin = Revenue/Cost of sales * 100
2. For 2017
Cost of sales of 2017 = 6100
Revenue of 2017 = 3200
Gross profit margin = Revenue/Cost f sales * 100
- Despite the rise in both the indicating factors, the gross margin of profit has only increased marginally. Usually, vertical analysis is prepared in a vertical format keeping in line with the accounting standards.
- Financial ratios are the primary outcomes to determine the key metrics in evaluating a company's performance via vertical analysis.
- With the help of ratios company, performances can be easily compared with competitor companies for benchmarking purposes.
- All factors in a financial worksheet, for example, profit, overhead, cost of goods sold, sales of a single quarter or a year are taken into account. Companies use the net sales amount as the base amount for calculating the ratio of vertical analysis.
- On the other hand, the cost of total assets employed acts as the base amount while comparing asset figures on the balance sheet. The primary reason for vertical analysis is to help gauge the performance of an organisation with its competitors.
- Just by converting each line of the item in a financial statement into a percentage of an organisation's gross revenue, the ratio of vertical analysis can be put forth to analyse the company's performance in the market.
- Precisely vertical analysis is a more detailed analysis. It brings forth the performance over an entire year, which can thereafter be easily monitored with each item on the statement. The comparison becomes easy as compared to horizontal analysis.
Advantages of Vertical Analysis
- Goal: The goal is to assess a particular item within the current year itself
- Purpose: The purpose of vertical analysis is to portray relative sizes of accounts within the statement
- Period: Vertical analysis calculates ratios based on the current fiscal year
- Comparison: With vertical analysis, comparison can be made intra firm and inter-firm wise
Disadvantages of Vertical Analysis
- Does not follow accounting standards and principles
- Liquidity of a firm cannot be measured
The key difference between horizontal and vertical analysis is the process of extraction of financial data from financial statements. In the case of horizontal analysis, the line by line method is adopted. On the contrary, the vertical analysis focuses on comparing each item over a period in the form of ratios. Both the analysis is conducted using the same financial statements and help in an organisation's critical decision-making.Also read:
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