Important Differences Between Horizontal and Vertical Analysis

Horizontal Analysis

Horizontal analysis is a financial analysis technique that compares a company’s financial data over time. It is also known as trend analysis. The purpose of horizontal analysis is to identify any significant changes in a company’s financial performance over time.

In this analysis, financial data from different periods is compared to see how the company has changed over time. Typically, two or more years of financial statements are compared side by side to see the percentage change in each line item of the income statement and balance sheet from one year to the next.

The percentage change is calculated as follows:

(Current Year Amount – Base Year Amount) / Base Year Amount x 100%

The base year is the year used as a reference point for comparison. The resulting percentage shows how much the item has increased or decreased compared to the base year. By comparing these percentages, analysts can identify trends in the company’s financial performance and determine if the company’s financial position has improved or deteriorated over time.

Horizontal analysis can be done for any line item in the financial statements, such as revenue, expenses, net income, assets, liabilities, and equity. It is important to note that this analysis should only be conducted if the accounting principles used in each year are the same, as changes in accounting standards can affect the comparability of financial data over time.

Examples of Horizontal Analysis

Here are some examples of horizontal analysis:

Example : Income Statement

ABC Company’s income statement for the years 2020 and 2021 are as follows:

To perform horizontal analysis on this income statement, we will calculate the percentage change in each line item from 2020 to 2021:

From this analysis, we can see that revenue increased by 11.11%, while cost of goods sold and operating expenses increased by 25.00%. Gross profit and net income remained the same.

Forms of Horizontal Analysis

There are two forms of Horizontal Analysis:

1. Percentage Analysis: This form of horizontal analysis compares the change in each item of the financial statement with a base year item. In this method, the percentage change in each item from one year to another year is computed and then analyzed to identify the trends, whether positive or negative.

For example, if sales revenue was $100,000 in the base year and it increased to $120,000 in the current year, then the percentage change in sales revenue is calculated as:

Percentage change in sales revenue = ((Current year sales revenue – Base year sales revenue) / Base year sales revenue) x 100

= (($120,000 – $100,000) / $100,000) x 100 = 20%

2. Absolute Dollar Analysis: This form of horizontal analysis compares the absolute dollar amount of each item in the financial statement with a base year item. In this method, the dollar amount of each item from one year to another year is compared and analyzed to identify the trends, whether positive or negative.

For example, if the cost of goods sold was $50,000 in the base year and it increased to $60,000 in the current year, then the absolute dollar change in cost of goods sold is calculated as:

Absolute dollar change in cost of goods sold = Current year cost of goods sold – Base year cost of goods sold

= $60,000 – $50,000 = $10,000

Characteristics of Horizontal Analysis

The key characteristics of horizontal analysis are as follows:

• Comparison of data: The primary characteristic of horizontal analysis is the comparison of data from one period to another, which helps in identifying the changes in financial performance, trends, and patterns.
• Evaluation of trends: Horizontal analysis enables the evaluation of trends in financial statements over a period of time. The trends can be identified by analyzing the percentage or absolute dollar changes in financial statement items.
• Facilitates decision-making: Horizontal analysis provides essential information to the management for making decisions regarding the future course of action of the organization. It helps in identifying areas where the company needs to focus to improve its financial performance.
• Enables benchmarking: By comparing the financial statements of the organization with that of its peers, horizontal analysis enables benchmarking. This comparison helps in identifying areas where the organization can improve to become more competitive.
• Simplifies financial analysis: Horizontal analysis simplifies financial analysis by providing a clear picture of changes in the financial performance of the organization over time. It facilitates the interpretation and understanding of financial statements, making it easier to communicate the information to stakeholders.

Vertical Analysis

Vertical analysis, also known as common-size analysis, is a financial analysis technique that compares each item in a financial statement to a common base item. The base item is typically a significant item in the statement, such as total assets or net sales, and the other items in the statement are expressed as a percentage of the base item.

For example, in a balance sheet, the base item could be total assets. Each asset account in the balance sheet is then expressed as a percentage of total assets. Similarly, in an income statement, the base item could be net sales. Each item in the income statement is then expressed as a percentage of net sales.

The purpose of vertical analysis is to identify the proportional size of each item in relation to the base item, and to understand how each item contributes to the overall financial performance of the organization. This analysis can also help identify trends and changes in the financial performance of the organization over time.

Vertical analysis is often used by investors and financial analysts to compare the financial performance of different companies in the same industry. By comparing the common-size financial statements of companies, it is possible to identify the relative strengths and weaknesses of each company and to make informed investment decisions.

Examples of Vertical Analysis

Here are a few examples of vertical analysis:

• Balance Sheet: In a balance sheet, the total assets are taken as the base item. Each asset account is then expressed as a percentage of total assets. For example, if total assets are $500,000 and inventory is $100,000, then inventory would be expressed as 20% (100,000 / 500,000) of total assets.
• Income Statement: In an income statement, net sales are taken as the base item. Each expense item is then expressed as a percentage of net sales. For example, if net sales are $1,000,000 and cost of goods sold is $600,000, then cost of goods sold would be expressed as 60% (600,000 / 1,000,000) of net sales.
• Cash Flow Statement: In a cash flow statement, cash inflows and outflows are taken as the base item. Each inflow or outflow item is then expressed as a percentage of total cash inflows or outflows. For example, if total cash inflows are $200,000 and accounts receivable is $40,000, then accounts receivable would be expressed as 20% (40,000 / 200,000) of total cash inflows.

Forms of Vertical Analysis

There are three forms of vertical analysis that are commonly used:

1. Common-Size Balance Sheet: In this form of vertical analysis, each account in the balance sheet is expressed as a percentage of the total assets. For example, if the total assets of a company are $1 million and the accounts receivable are $100,000, then the accounts receivable would be expressed as 10% (100,000 / 1,000,000) of the total assets.
2. Common-Size Income Statement: In this form of vertical analysis, each item on the income statement is expressed as a percentage of the total revenue or sales. For example, if a company has total revenue of $500,000 and the cost of goods sold is $250,000, then the cost of goods sold would be expressed as 50% (250,000 / 500,000) of the total revenue.
3. Common-Size Cash Flow Statement: In this form of vertical analysis, each item in the cash flow statement is expressed as a percentage of the total cash inflows or outflows. For example, if the total cash inflows of a company are $1 million and the cash received from customers is $500,000, then the cash received from customers would be expressed as 50% (500,000 / 1,000,000) of the total cash inflows.

Characteristics of Vertical Analysis

Here are some characteristics of vertical analysis:

• Helps in comparison: Vertical analysis helps in comparing financial statements of different periods or companies of different sizes. By expressing each item as a percentage of a common base item, it becomes easier to compare the relative sizes of different accounts or items within a financial statement.
• Useful for trend analysis: Since each item in a financial statement is expressed as a percentage of a common base item, it becomes easier to identify trends and changes in the financial performance of an organization over time. This can be particularly useful for identifying areas where a company may be experiencing growth or decline.
• Focuses on key items: Vertical analysis helps in identifying the key items that are driving the financial performance of an organization. By expressing each item as a percentage of a common base item, it becomes easier to identify which items are having the biggest impact on the overall financial health of the organization.
• Standardizes financial statements: Since each item is expressed as a percentage of a common base item, vertical analysis helps to standardize financial statements across different periods or companies. This makes it easier to compare financial statements and identify trends or changes in financial performance.
• Complements horizontal analysis: Vertical analysis can be used in conjunction with horizontal analysis to provide a more complete picture of a company’s financial performance. Horizontal analysis looks at changes in financial performance over time, while vertical analysis focuses on the relative size of different accounts or items within a financial statement. Together, these two types of analysis can provide a more comprehensive understanding of a company’s financial health.

Important Difference Between Horizontal and Vertical Analysis

Here’s a table outlining the important features and differences between Horizontal and Vertical Analysis:

Key Difference Between Horizontal and Vertical Analysis

Here are some key differences between Horizontal and Vertical Analysis:

1. Focus: The primary focus of Horizontal Analysis is to track and analyze changes in financial statement items over time. On the other hand, Vertical Analysis is more focused on identifying the relative size of different financial statement items.
2. Basis of Calculation: Horizontal Analysis calculates changes in financial statement items in absolute terms, i.e., by using actual monetary values. In contrast, Vertical Analysis calculates the percentage of each financial statement item in relation to a common base item.
3. Types of Financial Statements: Horizontal Analysis can be applied to all three primary financial statements (i.e., Income Statement, Balance Sheet, and Cash Flow Statement). Whereas, Vertical Analysis is more commonly used for the Balance Sheet and Income Statement.
4. Ease of Interpretation: Horizontal Analysis is relatively easy to interpret as it compares items from different periods using actual monetary values. Conversely, Vertical Analysis can be more difficult to interpret as it uses percentages, which may not provide as clear of a picture of the financial situation.
5. Trend Analysis: Horizontal Analysis is better suited for trend analysis as it tracks changes over time. Vertical Analysis, on the other hand, is more effective in analyzing the composition of financial statements.
6. Comparison of Competitors: Horizontal Analysis is more commonly used to compare a company’s performance against its competitors over time. Whereas, Vertical Analysis is more focused on understanding the composition of financial statements and how different components relate to one another.

Similarities Between Horizontal and Vertical Analysis

Despite the differences between Horizontal and Vertical Analysis, there are also some similarities between these two methods of financial analysis:

1. Comparative Analysis: Both Horizontal and Vertical Analysis are comparative methods of financial analysis. They both compare financial statement items from different periods or different items within the same period.
2. Ratio Analysis: Both Horizontal and Vertical Analysis are used to compute ratios, which can be used to assess a company’s financial health and performance.
3. Standardization: Both Horizontal and Vertical Analysis involve some level of standardization. Horizontal Analysis standardizes financial statement items to a common period, while Vertical Analysis standardizes financial statement items to a common base item.
4. Tool for Decision Making: Both Horizontal and Vertical Analysis are used by investors, creditors, and management to make informed decisions about a company’s financial health and performance.
5. Limitations: Both Horizontal and Vertical Analysis have some limitations, and they should be used in conjunction with other methods of financial analysis to provide a comprehensive view of a company’s financial situation.

Conclusion Between Horizontal and Vertical Analysis

In conclusion, Horizontal and Vertical Analysis are both important methods of financial statement analysis, but they serve different purposes.

Horizontal Analysis focuses on analyzing changes in financial statement items over time, and it is useful for trend analysis and comparing a company’s performance against its past performance. Vertical Analysis, on the other hand, is used to identify the relative size of different financial statement items, and it is useful for understanding the composition of financial statements and how different components relate to one another.

Both methods involve some level of standardization and ratio analysis, and they are useful tools for investors, creditors, and management to make informed decisions about a company’s financial health and performance. However, it’s important to remember that neither method is a comprehensive solution on its own, and they should be used in conjunction with other methods of financial analysis to gain a complete picture of a company’s financial situation.