What analysis expresses each item on the income statement as a percentage of a specified base?

Horizontal analysis is one approach used in financial statement analysis that helps to compare information over a specific time horizon. The approach is used to assist in identifying trends or patterns in a company’s business cycle. Learning how to perform it is easy and particularly useful for analysts.

In this post, we will cover what horizontal analysis is, how it works, how it is different from vertical analysis, and its limitations.

What Is Horizontal Analysis?

When performing financial statement analysis, it is important to compare performance over time.

The component of “time” in financial statement analysis holds a great deal of weight. This is because businesses go through several stages throughout their lives. One of the overall goals of horizontal analysis is to help users gauge what stage the business is in.

For example, growth businesses might exhibit signs of growing sales with initially low-profit margins. As the business matures over time, horizontal analysis helps to illuminate how well the business is maintaining its growth trajectory and whether management is becoming more effective at managing overhead.

How To Perform Horizontal Analysis

The process of comparing data points over time obviously requires at least two data sets to be available. You can perform horizontal analysis on any financial statement metric, financial ratio, or financial statement line item.

Here are the steps to performing horizontal analysis:

1. Identify a line item, ratio, balance, or any other metric you would like to analyze
2. Select your beginning time period. This can be a month, quarter, or year. Using this as your beginning value, compare the next period’s value and continue for each subsequent period
3. Choose to present the information in terms of absolute changes or in percentages

For example, let us assume that we are interested in comparing gross sales of a business quarter-over-quarter for the last year. Using the financial statements, we could take the gross sales from the first quarter as our beginning period’s value.

Then, we would find the difference between the second quarter’s gross sales and the first. We repeat this process for the third quarter, calculating the difference between this and the second quarter until we have compared all four quarters. The change can be expressed in total value or percentages.

Horizontal Analysis Vs Vertical Analysis

Since horizontal analysis is expressed in percentage change over time, it is often confused with vertical analysis. The two are entirely different with the primary difference between them being that horizontal examines the relationship between numbers across various periods and vertical analysis is only concerned with a single period.

This is because vertical analysis expresses each line in the financial statements as a percentage of a base value, like sales. Using this example, vertical analysis takes the income statement and expresses every line item as a percentage of sales, whereas horizontal analysis is concerned with the percentage change in total sales over a period.

Ideally, the horizontal and vertical analysis are combined to paint a comprehensive picture of a company’s financial performance over time.

Pros And Cons of Horizontal Analysis

The most obvious benefit of horizontal analysis is that helps paint a picture of how a business has performed over time. This has several implications, including the ability to identify trends. Trends are used when projecting future performance and analysts use them to identify where they believe the business is within the business cycle.

Additionally, it is useful in determining how well management is using resources to run the business efficiently. The process of comparing performance over time reveals whether the business is growing, managing expenses, or reinvesting its earnings in research and development.

One of the major criticisms of horizontal analysis is that it can at times produce biased results. This is because the beginning period will determine how the growth and trajectory appear. By selecting a beginning period with particularly inferior performance, analysts can sometimes create the impression that the business is doing better than it is.

Finally, because horizontal analysis relies on the financial statements it is subject to the nuances of accounting policies that might not paint an accurate picture of the business’s actual performance over time.

Vertical analysis is a kind of financial statement analysis wherein each item in the financial statement is shown in the percentage of the base figure. It is one of the popular methods of financial statements used as it is simple and also called a common size analysis. Here, all the income statement items are stated as a percentage of gross sales. Likewise, all the items in the balance sheet are stated as a percentage of the total assets. Whereas the opposite of the vertical analysis of financial statements is the Horizontal analysisHorizontal analysis interprets the change in financial statements over two or more accounting periods based on the historical data. It denotes the percentage change in the same line item of the next accounting period compared to the value of the baseline accounting period.read more always looks at the amount from the financial statement over the horizon of many years.

Vertical Analysis formula

In the vertical analysis of financial statements, the percentage is calculated by using the below formula:

Vertical Analysis formula = Individual Item / Base Amount *100

The vertical analysis formula for the Income Statement and Balance Sheet are given below –

Vertical Analysis Formula(Income Statement) = Income Statement Item / Total Sales * 100

Vertical Analysis Formula(Balance Sheet) = Balance Sheet Item / Total Assets (Liabilities) * 100

To increase the effectiveness of vertical analysis, multiple year’s statements or reports can be compared, and comparative analysis of statements can be done. This analysis makes it easier to compare the financial statements of one company with another and across the companies as one can see the relative proportion of accounts.

Example of Vertical Analysis Formula

Example of the vertical analysis of the financial statement, which shows the total amount and percentage.

The total sales are $1000000, and the cost of goods soldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more is $400000. In addition, the salary paid to the workers of the company is $300000, office rent paid is $30000, utilities worth $40000 and other expensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities.read more are $60000.

Vertical Analysis Formula = Individual Item / Total Sales * 100

The above vertical analysis example shows the company’s net profit where we can see the net profit in both amount and percentage. Where the same report can be used to compare with other industries. The income statement can be compared with previous years, and the net income can be compared where it helps to compare and understand the percentage of rising or loss of income.

The below vertical analysis example helps to understand the comparison.

In the above vertical analysis example, we can see that the income decreases from 1st year to 2nd year, and the income increases to 18% in the 3rd year. So by using this method, it is easy to understand the net profit as it is easy to compare between the years. We can easily understand that the total expenses gradually increased from 43% to 52%, and the net income get reduced from 1st year to 2nd year. In the 3rd year, the COGS decreased compared to the previous years, and the income increased.

Let us now calculate the Vertical Analysis of the Balance Sheet with the help of another example.

Vertical Analysis Formula = Individual Item / Total Assets (Liabilities) * 100

The information provided in the balance sheet provides the change in working capitalThe change in net working capital of a firm from one accounting period to the next is referred to as the change in net working capital. It is calculated to ensure that the firm maintains sufficient working capital in each accounting period so that there is no shortage of funds or that funds do not sit idle in the future.read more, fixed income over some time. Where the altered business requires a different amount on the ongoing fund. The same can be done with the income statement, where the previous years can be compared and find out the change in the working capital and fixed assetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more over time.

Advantages of the Vertical Analysis Formula

• It is one of the easiest methods of financial analysis.
• Vertical analysis of financial statements provides a comparable percentage that can be compared with the previous years.
• Different organization statements can be compared as the comparison is made in percentage.
• Vertical analysis is also instrumental in comparing the financial statementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more with the previous year’s statement and analyzing the period’s profit or loss.
• Where it helps to understand the percentage/share of the individual items;
• Where it helps to understand the structural composition of the various components like cost, expenses, assets, and liabilities.

Disadvantages of the Vertical Analysis Formula

• The vertical analysis of financial statements does not help make a firm decision as there is no standard percentage or ratio regarding the change in the income statement components or the balance sheet.
• The accounting conventions are not followed vigilantly in the vertical analysis.
• The liquidity of the organizationLiquidity is the ease of converting assets or securities into cash.read more cannot be measured precisely by using the analysis.
• Quality analysis is not done by using vertical analysis of financial statements as there is no consistency in the ratio of the elements.

Conclusion

This article method is one of the easiest methods of analyzing the financial statement. This method is easy to compare with the previous reports and easy to prepare. But this method is not useful to make firm decisions, and the measurement of the company value cannot be defined.

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Recommended Articles

Guide to Vertical Analysis Formula. Here we discuss how to do a Vertical analysis of Financial Statements (Balance Sheet, Income Statement) using its formula and practical examples and applications. You may learn more about financial statement analysis from the following articles –

• Cost of Goods Manufactured
• Vertical Analysis of Income Statement
• Examples of Common Size Balance Sheet
• How to do Trend Analysis?