Question

Describe the main limitations of financial statement analysis, in relation to a horizontal analysis and a vertical analysis?

Answer 1

Horizontal Analysis and Vertical Analysis are the two ways of presenting and analysing a Company's financial statements.

When all items are represented in terms of a % of a past year value, it is known as horizontal analysis, while when all items are represented as % of Some base of the same year, it is known as Vertical Analysis.

For Example, In horizontal analysis, Cash in the Balance Sheet will be represented as a % of Cash of Last year or any other previous year, While in vertical analysis, Cash will be presented as a % of Total Assets.

Benefit of Horizontal analysis is that it helps you compare the growth and trend of assets, income, expenses, and liabilities of a company. All numbers appearing in the Balance Sheet and Income statement reflect the change/pattern over the years, which Vertical Analysis does not. Advantage of Horizontal Analysis becomes the main limitation of Vertical Analysis.

Coming to the Advantages of Vertical Analysis or in other words, limitation of Horizontal Analysis: Vertical Analysis represents every component of Income Statement and Balance Sheet as a % of a commom base such as Totral Assets and Total Revenue, It helps in identifying the % share of each asset/income/expense in the Total Assets/Revenue of the Company. It helps in identifying the major cost/revenue sources of the company, which is not reflected by Horizontal Analysis.