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What is the best way to complete a horizontal and vertical analysis? How are the two...

What is the best way to complete a horizontal and vertical analysis? How are the two different?

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Solution:-

What is the best way to complete a horizontal and vertical analysis:-

WHAT IS HORIZONTAL ANALYSIS?

Horizontal analysis, also called time series analysis, focuses on trends and changes in numbers over time. Horizontal allows you to detect growth patterns, cyclicality, etc. and to compare these factors among different companies.

WHAT IS VERTICAL ANALYSIS?

Vertical analysis, also called common-size analysis, focuses on the relative size of different line items so that you can easily compare the income statements and balance sheets of different sized companies.

Let’s go back to our income statement items for Apple and Google. Through our horizontal analysis, we know that Google has been growing at a faster and more sustained rate than Apple… but is it a relatively more profitable company? Do both companies profits seem to be sustainable?

To perform vertical analysis (common-size analysis), we take each line item and calculate it as a percentage of revenue so that we can come up with “common size” results for both companies.

HORIZONTAL AND VERTICAL ANALYSIS OF THE BALANCE SHEET

Just like we performed horizontal and vertical analysis on the income statement, we can also run these calculations on the balance sheet (when performing vertical analysis of the balance sheet, line items are usually taken as a percentage of total assets). The process to calculate these ratios is similar to the examples we went through above and are fairly straight forward.

However, I’ve found that horizontal and vertical analysis of the balance sheet is much less helpful than on the income statement (ratios and YoY growth rates are basically requirements when analyzing any income statement) and can often be distorted by accounting policies (for example, is a debt-to-equity ratio really useful if the equity number used is simply a result of various accounting choices made over the years?).

Rather than calculate a “pure ratio” of the balance sheet, we can instead calculate “mixed ratios” – such as an interest coverage ratio (operating income / interest expense), leverage ratio (debt / EBITDA), or even efficiency ratios like days sales outstanding (DSO) and days payable outstanding (DPO).

How are the two different:-

Vertical analysis reports each amount on a financial statement as a percentage of another item. For example, the vertical analysis of the balance sheet means every amount on the balance sheet is restated to be a percentage of total assets. If inventory is $100,000 and total assets are $400,000 then inventory is presented as 25 ($100,000 divided by $400,000). If cash is $8,000 then it will be presented as 2 ($8,000 divided by $400,000). The total of the assets will now add up to 100. If the accounts payable are $88,000 they will be presented as 22 ($88,000 divided by $400,000). If owner's equity is $240,000 it will be presented as 60 ($240,000 divided by $400,000). The restated amounts from the vertical analysis of the balance sheet will be presented as a common-size balance sheet. A common-size balance sheet allows you to compare your company's balance sheet to another company's balance sheet or to the average for its industry.

Vertical analysis of an income statement results in every income statement amount being presented as a percentage of sales. If sales were $1,000,000 they would be restated to be 100 ($1,000,000 divided by $1,000,000). If the cost of goods sold is $780,000 it will be presented as 78 ($780,000 divided by sales of $1,000,000). If interest expense is $50,000 it will be presented as 5 ($50,000 divided by $1,000,000). The restated amounts are known as a common-size income statement. A common-size income statement allows you to compare your company's income statement to another company's or to the industry average.

Horizontal analysis looks at amounts on the financial statements over the past years. For example, the amount of cash reported on the balance sheet at December 31 of 2012, 2011, 2010, 2009, and 2008 will be expressed as a percentage of the December 31, 2008 amount. Instead of dollar amounts you might see 134, 125, 110, 103, and 100. This shows that the amount of cash at the end of 2012 is 134% of the amount it was at the end of 2008. The same analysis will be done for each item on the balance sheet and for each item on the income statement. This allows you to see how each item has changed in relationship to the changes in other items. Horizontal analysis is also referred to as trend analysis.

Vertical analysis, horizontal analysis and financial ratios are part of financial statement analysis.


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