Question

Explain how horizontal and vertical trend analyses are used to analyze financial statements.

Answer 1

Horizontal analysis:

Horizontal analysis of financial statements refers to comparison of financial ratios to the ratios which has been set as benchmark. It is also known as trend analysis because it is an effective tool to evaluate the trend situations.It is used for two or more periods such as Year over Year or Year till date etc. This analysis can be performed on items of income statement, items of balance sheet and items of cash flow statement. It can also be performed on ratios such as earnings per share (EPS), price earning ratio, dividend payout, and other similar ratio.

For example , PE ratio of Company is calculated as 7 and now this PE ratio will be compared with the PE ratio of industry in which company operates.

Horizontal analysis makes easier to compare growth rate and profitability among different companies.

Vertical analysis:

Vertical analysis is proportional analysis where each item is expressed as percentage of another item. Vertical analysis is also applied on items of income statement, balance sheet and items of cash flow statement. With the help of vertical analysis, we see the changes in the amount of particular account over a period of time.

Say in income statement, sales is taken as 100 and say sales amount is $100000. Cost of goods sold is $60000. Then in vertical analysis, cost of goods sold is expressed as 60000/100000 *100 = 60%. It means that out of 100 in sales, 60 is cost of goods sold. In the same manner other figures are expressed.