Sometimes it can be difficult to interpret in a meaningful way all the dollar amounts presented in a set of financial statements. For example, if one company has liabilities of $10,000 and another company has liabilities of $10,000,000; is the first company less risky? Maybe or maybe not, it depends in part on the size of the company [how much in assets does each company have?] and the company’s industry.
A useful way to analyze financial statements is to perform either a horizontal analysis or a vertical analysis of the statements. These types of analysis help a financial statement reader compare companies of different sizes, which can be difficult to do when the dollar amounts vary significantly, and evaluate the performance of a company over time.
The horizontal and vertical analysis approaches are similar in that the dollar amounts reported are converted to percentages. However, the approaches differ in the base used to compute the percentages.
Through this post, I will demonstrate how you can prepare horizontal and vertical analysis of a financial statement. Enjoy!
Horizontal analysis focuses on trends and changes in financial statement items over time. Along with the dollar amounts presented in the financial statements, horizontal analysis can help a financial statement user to see relative changes over time and identify positive or perhaps troubling trends.
We will use the income statement shown on below figure to explain how one might prepare a three year horizontal analysis:
In one horizontal analysis approach, a base year is selected and the dollar amount of each financial statement item in subsequent years is converted to a percentage of the base year dollar amount. Assuming 2008 is the base year, 2009 and 2010 revenues were 108% and 120% of the base year amount, as shown in the following calculations:
2010 Revenue, $120,000 / 2008 Revenue, $100,000 = 120%
Similar computations would be made for the remaining income statement items as shown below:
Some interesting trends can be noted from this analysis. The dollar amounts and percentages for each financial statement item increased each year, but the trends for each item differed. For example: in 2010 when revenues were 120% of the base year amounts, cost of goods sold was less—only 115% of the base year amount. Perhaps your company raised its selling prices and/or its inventory cost declined?
Notice that 2010 net income was 187% of the base year amount; even though operating expenses had increased to 123% of the base year amount, this was more than offset by the favorable trends in revenues and cost of goods sold.
In addition to base year comparisons, dollar and percentage changes from one year to the next could also be analyzed. For example: 2009 revenues increased by $8,000 or 8% over the previous year, and 2010 revenues increased by $12,000 or 11.1% over the previous year, as shown in the following calculations:
= Revenue Increase $108,000 – $100,000 / 2008 (previous year) $100,000
= $8,000 / $100,000 = 8.0%
= Revenue Increase $120,000 ?$108,000 / 2009 (previous year) $108,000
= $20,000 / $108,000 = 11.1%
How is the base year selected?
That’s up to the individual performing the analysis. Fraud examiners who are investigating a case of fraudulent financial reporting, for example, probably will select the last year in which they believe no fraud occurred as the base year in order to estimate the extent of the fraud. In other situations, the choice will depend to some degree on the purpose for which the reader is using the financial statements.
Are you trying to decide whether to buy (or sell) stock now that a company has experienced a significant change such as new management or the introduction of a new product line? Then perhaps the base year will be the last year before the change. Essentially, the choice of the base year is up to the individual financial statement user.
Are these proportional increases that we calculated for the above example good? Perhaps the competitors in the same industry are increasing even more.
To interpret the proportional changes, the reader will need additional information, such as the industry averages and/or the changes for a particular company that the financial statement reader also is considering for investment purposes.
Vertical Analysis [Common-size Analysis]
Vertical analysis sometimes is referred to as “common-size analysis” because all of the amounts for a given year are converted into percentages of a key financial statement component.
For example: on the income statement, total revenue is 100% and each item is calculated as a percentage of total revenue. On the balance sheet, total assets are 100% and each asset category is calculated as a percentage of total assets. In the balance sheet equation, total assets are equal to total liabilities plus equity; thus, each liability and/or equity account is also calculated to be a percentage of this total (i.e., total liabilities and equity are 100%).
Vertical or common-size analysis allows one to see the composition of each of the financial statements and determine if significant changes have occurred. We will use the balance sheet information below to explain how one might prepare a three year vertical analysis.
After each year’s total asset amount is set as 100 percent (or total liabilities plus stockholders’ equity, since the amounts must balance), the various account’s dollar amounts are converted to a percentage of the total assets.
When the calculation is complete, the sum of the percentages for the individual asset accounts must equal 100 percent. The sum of the percentages for the various liability and equity accounts also will equal 100 percent (see below figure):
Vertical analysis of a balance sheet will answer questions relating to asset, liability, and equity accounts, such as the following:
- What percentage of total assets is classified as current assets? Current liabilities comprise what percentage of total liabilities and stockholders’ equity?
- Inventory makes up what percentage of total assets? Is this changing significantly over time? If so, is it increasing or decreasing? [These answers could lead to additional questions such as the following: If it is increasing, could this indicate that the company is having trouble selling its inventory? If so, is this because of increased competition in the industry or perhaps obsolescence of this company’s inventory?
- Accounts receivable makes up what percentage of total assets? Is this changing significantly over time? If so, is it increasing or decreasing? (These answers might lead to additional questions such as the following: If it is increasing, could this indicate that the company is having trouble collecting its receivables? If it is decreasing, could this indicate that the company has tightened its credit policy? If so, is it possible that the company is losing sales that it might have made with a less strict credit policy?)
- What is the composition of the capital structure? In other words, total liabilities make up what percentage of total assets and total stockholders’ equity makes up what percentage of total assets?
Vertical analysis of an income statement helps answer questions such as the following:
- What percentage of revenues is cost of goods sold?
- What is the gross profit percentage?
- What is the mix of expenses (in terms of percentages) that the company has incurred in this period?
Since total revenues usually are set at 100 percent, vertical analysis of the income statement essentially shows how many cents of each sales dollar are absorbed by the various expenses. For example, if total revenues were $200,000 and total wage expense was $50,000, total wage expense would equal 25 percent of total revenues. In other words, for every $1 in sales earned, 25 cents goes to employee wages.
In the case of the above example, the organization appears to be fairly stable over the three years of data we have. Again, these percentages won’t provide you with a lot of insight in and of themselves. The analysis is more meaningful when the percentages are compared with competitors’ or industry averages or for a long period of time for one company. However, if some unreasonable fluctuations are noted for one company over time and/or the percentages are significantly different from industry averages, the possibility of fraudulent financial reporting should be considered.
Want more techniques to analyze financial statement? Read: Financial Statement Ratios Analysis [with Interpretations]