In: Accounting
What provides a better indicator of a firm’s financial status; vertical or horizontal analysis?
Ans.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.