Analyzing financial statements is critical, yet many find distinguishing horizontal analysis from vertical analysis confusing.
This post will clearly define both types of analysis and provide easy-to-understand examples so you can utilize these methods confidently.
You'll learn the key differences between horizontal and vertical analysis, see formulas and calculations, and discover how each technique provides valuable - and complementary - insights into financial performance.
Introduction to Financial Statement Analysis
Financial statement analysis is the process of reviewing and evaluating a company's financial statements (income statement, balance sheet, and cash flow statement) to gauge its past performance and current financial health. There are two main methods used:
Horizontal analysis evaluates performance over time by comparing financial data across previous accounting periods, usually years. This shows trends in the business and highlights growth rates from year to year.
Vertical analysis evaluates financial statements by comparing line items to a key metric, typically total revenue. Also called a common-size analysis, this method analyzes the composition of the financial statements and the relative weight of account categories.
Both methods provide valuable insights into a company's financial operations and are useful for assessing historical performance, forecasting future performance, and comparing companies within an industry.
Understanding the Fundamentals of Financial Statements
To conduct horizontal and vertical analyses, a foundational knowledge of the three key financial statements is required:
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Income statement: Reports revenue, expenses, and profit/loss over a period of time. Shows the company's operating performance.
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Balance sheet: Snapshot of assets, liabilities, and shareholders' equity at a single point in time. Shows what the company owns and owes.
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Cash flow statement: Shows the company's cash inflows and outflows from operating, investing, and financing activities. Measures liquidity and solvency.
Understanding these core statements, how they interrelate, and the accounts that compose them is essential for accurate and effective financial analysis.
Defining Horizontal and Vertical Analysis
Horizontal analysis examines the trend in accounts over time, typically from year to year. The data is shown as a percentage change from a base year, allowing easy analysis of growth patterns. The formula is:
(Current Year - Base Year) / Base Year
For example, if 2020 revenue was $1 million and 2021 revenue was $1.2 million, the horizontal analysis would be:
($1.2M - $1M) / $1M = 20%
This shows a 20% increase in revenue from 2020 to 2021. Doing this analysis for all accounts shows where the business is improving or declining over time.
Vertical analysis converts all line items on a financial statement to a percentage of a key figure, typically total revenue. This allows for comparison across companies of different sizes within the same industry. The formula is:
Line Item / Total Revenue
For example, if total revenue was $10 million and the cost of goods sold was $6 million, the vertical analysis would be:
$6M / $10M = 60%
This shows that 60% of revenue comprised cost of goods sold. Comparing this metric across similar companies shows relative financial makeup.
Key Differences Between Horizontal and Vertical Analysis
While both analyses examine financial statements, there are key differences:
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Purpose: Horizontal shows trends over time for a single company. Vertical allows comparison across companies in the same industry.
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Basis of calculation: Horizontal uses dollar and percentage changes over time. Vertical converts all data to percentages of total revenue.
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Data requirements: Horizontal only requires financials from the company over multiple periods. Vertical requires company financials plus industry data.
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Use cases: Horizontal to evaluate past company performance. Vertical to benchmark company against industry standards.
So in summary, horizontal analysis tracks performance trends for a single company, while vertical analysis compares financial composition across companies based on an industry-relative metric.
The Relevance of GAAP and IFRS in Financial Analysis
To accurately compare financial statement data, the underlying accounting standards used to produce the financials must be considered. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) have enough differences that analyses should not mix companies using different standards. Comparing GAAP-based financials to other GAAP-based companies and IFRS to IFRS provides alignment needed for an apples-to-apples comparison. As an analyst, understanding the impacts of accounting standards is vital for drawing accurate conclusions from financial statement analyses.
What is the difference between vertical analysis and horizontal analysis?
Vertical analysis and horizontal analysis are two important techniques used to analyze financial statements. The key differences between them are:
Vertical Analysis
- Focuses on analyzing items as a percentage of a base amount on the financial statement from one reporting period
- Allows you to see relative weightings and proportions of accounts
- Common base amounts are total assets on the balance sheet, total revenues on the income statement, and total cash from operations on the cash flow statement
Horizontal Analysis
- Compares items over multiple reporting periods to spot trends and growth rates
- Shows dollar and percentage changes in accounts over time
- Allows you to see relative increases and decreases in accounts
For example, vertical analysis could show cost of goods sold as 80% of total revenues in the most recent year. This shows its proportional weight.
Horizontal analysis could show that the cost of goods sold increased 10% compared to the previous year. This shows the trend over time.
So in summary, vertical analysis looks at proportional relationships within a reporting period, while horizontal analysis tracks changes over multiple reporting periods. Using both techniques together provides valuable insights into the financial health of a company.
What is an example of a horizontal analysis?
A horizontal analysis looks at how a company's financial performance changes over time. For example:
"For example, a statement that says revenues have increased by 10% this past quarter is based on horizontal analysis. The percentage change is calculated by first dividing the dollar change between the comparison year and the base year by the line item value in the base year, then multiplying the quotient by 100."
To illustrate with a numerical example:
- Company X had $1 million in revenue in 2020 (the base year)
- In 2021, Company X had $1.1 million in revenue.
- The change is $1.1 million - $1 million = $100,000
- The base amount is $1 million
- So the percentage change is $100,000 / $1 million = 10%
Therefore, Company X's revenues increased by 10% from 2020 to 2021. This percentage change figure is calculated through horizontal analysis, comparing the current year to a base year.
Horizontal analysis allows financial statement users to see trends over time and evaluate the performance growth rates of line items like revenue, expenses, assets, and liabilities. It provides insights into areas where the business is improving or declining. Managers use horizontal analysis to track progress on budgets and forecasts. Analysts and investors apply it to assess management effectiveness and operating efficiency.
What is the difference between vertical and horizontal method?
The key difference between horizontal and vertical analysis of financial statements is the perspective from which they examine the data.
Horizontal analysis looks at trends over time, comparing financial data from one period to the next. This allows you to see increases and decreases in accounts over multiple years. For example, horizontal analysis can show whether revenue has been growing steadily from 2020 to 2021 to 2022.
Vertical analysis looks at relationships between numbers in the same reporting period. Typically this involves stating items as a percentage of a key benchmark, allowing you to make comparisons between years. For example, expressing cost of goods sold as a percentage of total revenue.
Some key points:
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Horizontal analysis focuses on year-over-year changes in dollar amounts and percentages - it analyzes trends over time.
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Vertical analysis expresses items as a percentage of a base amount within the same period - it analyzes relationships between numbers in the financial statements.
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Horizontal analysis allows you to spot trends, while vertical analysis allows you to compare items as a percentage, even when absolute numbers differ significantly.
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Using both techniques together provides the most insight into the financial statements. Horizontal analysis spots trends and vertical analysis allows more meaningful comparisons between periods.
In summary, horizontal and vertical analysis offer complementary perspectives for analyzing financial statements. Horizontal looks at trends between reporting periods and vertical examines relationships within a single period. Using both methods together provides the most complete picture of a company's financial health.
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What is an example of a vertical analysis?
Vertical analysis is a method of financial statement analysis where each line item on a financial statement is shown as a percentage of another key item. This allows for easy analysis between companies or between periods for a company.
Here is an example of how to calculate and interpret vertical analysis:
The company ACME Inc. had the following income statement:
Revenue: $100,000
Cost of Goods Sold: $60,000
Gross Profit: $40,000
Operating Expenses: $20,000
Net Income: $20,000
To conduct a vertical analysis, usually the revenue line item is used as the base item. Each subsequent line item is shown as a percentage of revenues, as follows:
Revenue: 100%
Cost of Goods Sold: 60% ($60,000 / $100,000)
Gross Profit: 40% ($40,000 / $100,000)
Operating Expenses: 20% ($20,000 / $100,000)
Net Income: 20% ($20,000 / $100,000)
This shows that for every $1 of revenue, ACME spends $0.60 on costs of goods sold, $0.40 on gross profit, $0.20 on operating expenses, and ultimately has $0.20 left as net income.
Comparing these percentages over time or to industry benchmarks can provide insights into the company's performance. For example, if gross margins declined from 40% to 30% over a few years, it may indicate rising production costs or competitive pressures.
In summary, vertical analysis expresses line items as a percentage of a key base figure, allowing for easy comparison over time or between peers to assess relative performance.
Exploring the Horizontal Analysis Formula
Horizontal analysis is a method of evaluating a company's financial statements over time to detect trends and identify variances in performance. By comparing numbers across consecutive accounting periods, horizontal analysis quantifies increases or decreases as a percentage.
Select the Time Periods for Horizontal Analysis
When performing horizontal analysis, it is important to choose appropriate time periods to facilitate meaningful comparisons. Most commonly, financial statements over 2-5 consecutive years are analyzed to identify performance trends. Comparing quarterly statements can also provide insights on seasonal fluctuations. The key is selecting periods where business operations and accounting policies have remained consistent.
Understanding the Horizontal Analysis Formula
The horizontal analysis formula calculates the change between two periods as a percentage of the earlier period. For each line item, take the difference between the numbers for the two periods, and divide it by the older number. For example:
(Current Year Number - Previous Year Number) / Previous Year Number = Percentage Change
Applying this for every line item quantifies performance increases or decreases over time as a percentage.
Gather Required Financial Statements for Horizontal Analysis
To perform horizontal analysis, comparative financial statements are needed for the periods selected. Typically, an income statement and balance sheet is gathered for each period to analyze both profitability and financial position trends. For accurate calculations, the statements must contain the same line items over each period.
Performing Calculations: A Horizontal Analysis Example
Let's walk through a horizontal analysis example for ACME Company's income statements for 2019 and 2020:
| Income Statement Item | 2019 | 2020 | Change | Percentage Change |
|---|---|---|---|---|
| Revenue | $100,000 | $150,000 | $50,000 | 50% |
| Cost of Goods Sold | $60,000 | $90,000 | $30,000 | 50% |
| Gross Profit | $40,000 | $60,000 | $20,000 | 50% |
Comparing the numbers horizontally and calculating the differences as percentages clearly shows ACME's upward sales and profitability trend year-over-year. This analysis can be extended for more line items and periods to identify variances.
Visualizing Trends: Graphs and Horizontal Analysis
Graphing horizontal analysis outputs visually elucidates financial statement trends. Placing the percentage changes on a line chart over time illustrates whether performance has increased, decreased, or remained consistent. Understanding what business circumstances or strategic changes caused spikes or drops can further inform decision making. Integrating horizontal analysis with other methods like vertical analysis leads to deeper insights.
In summary, horizontal analysis is a straightforward yet powerful way to quantify and track financial statement performance over consecutive periods. Selecting appropriate time intervals, gathering comparative statements, calculating percentage changes, and visualizing trends allows businesses to better understand their numbers.
Unpacking Vertical Analysis
Vertical analysis enables financial statement comparisons by converting amounts to percentages of a key benchmark metric. This common-sizing of financial statements facilitates analysis across companies or reporting periods.
Vertical Analysis: Common Size Financial Statements
Vertical analysis converts all amounts on a financial statement to a percentage of a chosen benchmark figure, often total assets or total revenues. This creates common-size financial statements, where every line item represents a percentage share relative to the whole.
For example, on a common-size income statement, total revenues would equal 100%. If a company had $1 million of revenue and $500,000 of expenses for the period, expenses would show as 50% of total revenues.
Common-sizing removes the impact of company size, enabling performance analysis on a proportional basis. Financial ratios can then be quickly compared across companies or periods.
Vertical Analysis of the Income Statement
To conduct vertical analysis on an income statement:
- Select total revenues as the benchmark figure.
- Divide each income statement line item by total revenues.
- Convert amounts to percentages.
This transforms the income statement into common-size format, with all items showing as a percentage of total revenues. Profitability margins and cost structures can now be easily contrasted across companies or reporting periods on an apples-to-apples basis.
Vertical Analysis of the Balance Sheet
For the balance sheet, total assets are typically used as the base figure. Follow these steps:
- Choose total assets as the benchmark amount.
- Divide each balance sheet line item by total assets.
- Present balances as percentages of total assets.
Converting to percentage form displays how balance sheet accounts compare proportionally. Companies can evaluate financial leverage, working capital management, or liquidity over time using vertical analysis.
Calculating Ratios: Vertical Analysis Formulas
Key vertical analysis ratios derived from common-size financial statements include:
- Gross Profit Margin = (Total Revenue - COGS) / Total Revenue
- Operating Profit Margin = Operating Income / Total Revenue
- Asset Turnover = Total Revenue / Average Total Assets
Benchmarking these ratios facilitates performance comparisons and analysis of trends.
Benchmarking with Vertical Analysis
Industry average ratios serve as benchmarks for vertical analysis. Comparing company percentages to sector averages helps assess relative performance.
For example, an airline with an operating margin of 25% significantly outperforms the industry average of 8%. This signals excellent financial health relative to peers.
Evaluating changes in vertical analysis ratios over time is also key. Consistent margins could indicate stability, while decreasing ratios may signal financial pressures.
Comparative Analysis of Financial Statements
Financial statement analysis is an important part of evaluating a company's financial health and performance. There are two main types of financial statement analysis: horizontal analysis and vertical analysis.
Horizontal analysis looks at trends over time by comparing numbers across previous periods. This allows you to see increases and decreases in accounts over time. Vertical analysis looks at relationships between numbers in the same reporting period by converting all numbers to percentages of a key metric like revenue or total assets. Together, these approaches provide greater insight into a company's financial data.
Horizontal and Vertical Analysis Example in Retail
E-commerce companies can benefit greatly from analyzing financial statements over time using horizontal analysis and benchmarking against industry averages with vertical analysis.
For example, an online retailer saw a 20% year-over-year increase in annual revenue. Horizontal analysis shows this growth rate over time. Meanwhile, their gross profit margin was 45%. Vertical analysis allows comparison to the industry average gross margin of 50% for online retail.
This analysis might lead the e-commerce company to investigate ways to increase margins through pricing optimization or cost reductions in order to reach industry benchmarks.
Vertical Analysis for Profitability Benchmarks in Manufacturing
Vertical analysis enables manufacturing companies to compare their net profit margins over a period of time to detect trends and see how they stack up against competitors.
For instance, a vertical analysis might indicate one automotive parts supplier's net profit margin declined from 8% to 5% over a 5-year period, while direct competitors maintained margins of between 8-12% during that same timeframe.
This vertical analysis signals potential issues with production costs, pricing, or other factors affecting profitability for that supplier over time relative to peers. The company could then drill down into expense details and optimize accordingly.
Supply Chain Analysis Across Regions with Horizontal and Vertical Analysis
Manufacturers can apply both horizontal analysis and vertical analysis to supply chain metrics across regions. This helps assess performance over time and relative to benchmarks.
For example, horizontal analysis might show that production costs for a medical devices supplier in EMEA increased by 15% over the past 3 years. Meanwhile, vertical analysis indicates their APAC locations maintained production costs equal to 58% of revenue – 10 percentage points below the industry benchmark.
This analysis provides visibility into rising production costs in EMEA and highlights an opportunity to investigate process improvements based on practices in APAC facilities that have kept costs below benchmarks. Together, horizontal and vertical analysis deliver actionable insights.
Synthesizing Insights from Horizontal and Vertical Analysis
Horizontal and vertical analysis are two important techniques used to evaluate financial statements over time and relative to industry benchmarks. Each provides unique insights that together offer a more comprehensive assessment of financial performance and position.
The Strategic Value of Horizontal Analysis in Performance Tracking
Horizontal analysis looks at trends in financial statement line items over consecutive time periods, using the earliest period as a baseline. By quantifying changes year-over-year, horizontal analysis enables tracking of metrics like:
- Revenue growth
- Profitability margins
- Liquidity ratios
Presenting these trends visually via graphs makes it easy to spot positive and negative momentum. This aids strategic decisions around growth opportunities, cost management, cash flow, and more.
The Role of Vertical Analysis in Industry Benchmarking
Whereas horizontal analysis evaluates a company over time, vertical analysis compares it to industry peers in the current period. By converting line items to percentages of a key benchmark like total revenue or total assets, vertical analysis normalizes the data for comparison.
Common size financial statements reveal how cost and profitability structures align with competitors. Analyzing working capital and leverage shows if operations and capital decisions fit industry norms. This signals where strategic shifts may be beneficial.
Integrating Analysis Types for Comprehensive Financial Insights
While horizontal and vertical analysis have distinct applications, together they provide a robust picture of financial health and performance. Horizontal trends show internal momentum, while vertical benchmarking contextualizes those metrics externally.
Integrating horizontal and vertical analysis offers crucial insights for both tactical course correction and long-term strategy. This empowers data-driven planning and decision making aligned with financial objectives.
