Horizontal and Vertical Analysis of Financial Statements: Understanding Changes and Trends
Horizontal and Vertical Analysis of Financial Statements are among the most important financial analysis tools that help in understanding an entity’s performance and financial position. Both horizontal and vertical analysis provide insights into changes and trends in the items of the Financial Statements, enabling investors, creditors, and other stakeholders to evaluate the company’s performance and make informed decisions. In this article, we will explain Horizontal and Vertical Analysis of Financial Statements, discuss how to perform them, their importance, and the interpretation of their results, in addition to highlighting their role in evaluating the company’s performance and identifying its strengths and weaknesses.
What is Horizontal Analysis?
Horizontal analysis, also known as trend analysis, is a technique for analyzing Financial Statements that involves comparing the items of the Financial Statements of the same entity across different time periods (two or more years). Horizontal analysis aims to identify trends in the changes in the items of the Financial Statements, such as increases or decreases in revenues, expenses, assets, or liabilities, over a specific period.
How to Perform Horizontal Analysis:
- Select a Base Year: A base year is selected to represent the starting point for comparison. Usually, the base year is the oldest year in the analysis.
- Calculate Changes: The change in each item of the Financial Statements is calculated between the base year and subsequent years by subtracting the value of the item in the base year from its value in the following year.
- Calculate the Percentage Change: The percentage change in each item of the Financial Statements is calculated by dividing the change in the item (the difference between the two years) by the value of the item in the base year, then multiplying the result by 100.
- Analyze the Results: The percentage changes are analyzed to identify positive and negative trends in the entity’s performance and financial position. These percentages are interpreted in light of economic and industry factors and the company’s circumstances.
Example of Horizontal Analysis:
| Statement Item | 2021 | 2022 | 2023 | Change (2022-2021) | Percentage Change (2022) | Change (2023-2022) | Percentage Change (2023) |
|---|---|---|---|---|---|---|---|
| Sales Revenue | 100,000 | 120,000 | 135,000 | 20,000 | 20% | 15,000 | 12.5% |
| Cost of Goods Sold | 60,000 | 70,000 | 75,000 | 10,000 | 16.67% | 5,000 | 7.14% |
| Gross Profit | 40,000 | 50,000 | 60,000 | 10,000 | 25% | 10,000 | 20% |
Analysis:
- Sales revenue increased by 20% in 2022 compared to 2021, and by 12.5% in 2023 compared to 2022.
- Cost of goods sold increased by 16.67% in 2022 compared to 2021, and by 7.14% in 2023 compared to 2022.
- Gross profit increased by 25% in 2022 compared to 2021, and by 20% in 2023 compared to 2022.
Conclusion:
Horizontal and Vertical Analysis of Financial Statements indicates that the company’s performance has generally improved during the period, as sales revenue and gross profit have increased. However, it should be noted that the growth rate of revenue slowed down in 2023, and the percentage increase in the cost of goods sold was lower in 2023. The company should review the reasons for these changes and take the necessary actions to ensure continued growth and profitability.
What is Vertical Analysis?
Vertical analysis, also known as common-size analysis, is a technique for analyzing Financial Statements that involves expressing each item in the financial statement as a percentage of another key item in the same statement. Vertical analysis aims to understand the structure of the Financial Statements and the relative relationships between its various items.
How to Perform Vertical Analysis:
- Income Statement: Each item in the Income Statement is expressed as a percentage of sales revenue.
- Statement of Financial Position: Each item in the Statement of Financial Position is expressed as a percentage of total assets (or total liabilities and equity).
Example of Vertical Analysis (Income Statement):
| Statement Item | Amount (Riyals) | Percentage (%) |
|---|---|---|
| Sales Revenue | 200,000 | 100% |
| Cost of Goods Sold | 120,000 | 60% |
| Gross Profit | 80,000 | 40% |
| Operating Expenses | 40,000 | 20% |
| Net Profit | 40,000 | 20% |
Analysis:
- The cost of goods sold represents 60% of sales revenue.
- Gross profit is 40% of sales revenue.
- Operating expenses represent 20% of sales revenue.
- Net profit is 20% of sales revenue.
Example of Vertical Analysis (Statement of Financial Position):
| Item | Amount (Riyals) | Percentage (%) |
|---|---|---|
| Assets | ||
| Cash | 20,000 | 10% |
| Accounts Receivable | 30,000 | 15% |
| Inventory | 50,000 | 25% |
| Fixed Assets | 100,000 | 50% |
| Total Assets | 200,000 | 100% |
| Liabilities | ||
| Accounts Payable | 40,000 | 20% |
| Long-term Loans | 60,000 | 30% |
| Total Liabilities | 100,000 | 50% |
| Equity | ||
| Capital | 50,000 | 25% |
| Retained Earnings | 50,000 | 25% |
| Total Equity | 100,000 | 50% |
Analysis:
- Fixed assets represent 50% of the company’s total assets.
- The company finances 50% of its assets through liabilities (debt).
- The company finances 50% of its assets through equity.
Importance of Horizontal and Vertical Analysis of Financial Statements:
Both horizontal and vertical analysis are important tools for analyzing Financial Statements, as they help to:
- Understand Performance Trends: Horizontal analysis helps identify trends in changes in the items of the Financial Statements over time, indicating strengths and weaknesses in the entity’s performance.
- Understand the Structure of Financial Statements: Vertical analysis helps understand the structure of the Financial Statements and the relative relationships between its various items.
- Compare the Entity’s Performance with its Competitors: Horizontal and vertical analysis can be used to compare the entity’s performance with its competitors in the same industry. The percentage changes in the items of the Financial Statements and the vertical analysis percentages can be compared with industry averages.
- Assess Management Efficiency: Horizontal and vertical analysis can be used to assess management’s efficiency in generating revenues, controlling expenses, and managing assets and liabilities.
- Make Informed Decisions: Horizontal and vertical analysis provides valuable information that helps investors, creditors, and other stakeholders make informed economic decisions.
- Forecast Future Performance: The results of horizontal and vertical analysis, along with other information, can be used to forecast the entity’s future performance.
How to use Horizontal and Vertical Analysis of Financial Statements together:
Both Horizontal and Vertical Analysis of Financial Statements can be used together in order to have a more holistic view of the performance of the entity, and its financial standing.
Limitations of Horizontal and Vertical Analysis of Financial Statements:
- Affected by Changes in Accounting Policies: Changes in Accounting Policies can make it difficult to compare Financial Statements over time.
- Affected by Inflation: High inflation rates can distort the results of horizontal analysis, as changes in monetary values may not reflect real changes in performance.
- Does Not Consider Qualitative Factors: Horizontal and vertical analysis do not take into account qualitative factors that may affect the entity’s performance, such as changes in market conditions or the quality of management.
- Reliance on Historical Data: Horizontal and vertical analysis rely on historical data, which may not be an accurate indicator of future performance.
Role of Technology in Horizontal and Vertical Analysis of Financial Statements:
Accounting Software and Enterprise Resource Planning (ERP) systems provide advanced analytical tools that help perform horizontal and vertical analysis more efficiently and effectively, by:
- Automating the calculation of percentage changes and vertical percentages.
- Creating graphs and charts that show trends in changes over time.
- Performing comparative analyses with other entities in the same industry.
- Identifying strengths and weaknesses in the entity’s financial performance.
- Forecasting future financial performance based on historical data.
Importance of Horizontal and Vertical Analysis of Financial Statements to users of Financial Statements
Both Horizontal and Vertical Analysis of Financial Statements are essential tools for Financial Statements users, including:
- Investors: They use both analyses to evaluate entity’s performance, profitability, and the investment risks.
- Creditors: They use both analyses to asses the entity’s ability to repay its debts.
- Management: They use both analyses to make operating and strategic decisions and to evaluate management’s efficiency in achieving goals.
- Financial Anylists: They use both analyses to recommend whether to buy, sell or hold the entity’s shares.
Conclusion:
Horizontal and Vertical Analysis of Financial Statements are among the most important financial analysis tools that help in understanding an entity’s performance and financial position. Horizontal analysis provides insights into trends in changes in the items of the Financial Statements over time, while vertical analysis helps understand the structure of the Financial Statements and the relative relationships between its various items.
Mastering the skills of Horizontal and Vertical Analysis of Financial Statements enhances your ability to read Financial Statements more deeply and understand beyond the numbers, helping you make more informed decisions in the world of business and investment. Remember that horizontal and vertical analyses of Financial Statements are part of Financial Statement Analysis tools and should be used in conjunction with other analytical tools, such as ratio analysis and cash flow statement analysis, to obtain a complete picture of the entity’s performance and financial position.