What is the difference between horizontal and vertical analysis of financial statements?
Horizontal and vertical analysis of financial statements deal strictly with the time period in question for analyzing the statements. Horizontal analysis takes a look at a specific aspect of the business throughout different time periods for comparison. For example, a horizontal comparison will look at a single factor, like overhead, cost of goods sold, or sales throughout different time periods. If you are comparing overhead from each quarter of the year or comparing overhead for quarter 3 of 2017 to Quarter 3 of 2016, then you are performing a horizontal analysis. This gives an understanding of how certain elements of the financial worksheet have changed over time.
A vertical analysis looks at the comprehensive view of the financial worksheet for a specific time period. You would analyze all of the different factors—profit, cost of goods sold, overhead, sales, etc, for a single quarter or year. This gives a comprehensive viewpoint of the company's finances as a whole for that time period. A vertical analysis would tell you how much money the company has earned and spent in a certain time period.
Both of these elements are useful for analyzing a company's performance. While either factor individually can be good or bad, a healthy company will have positives for each of them, to show that profit has improved over time and is currently positive.
For horizontal analysis, the company compares the financial statements of different financial periods. Normally, the results of one year act as the baseline for comparison. For example, if a company made record sales or profit in 2017, that year will be the base year. If the total sales made in 2017 were $30 million and in 2018, they were $28.5 million. We say that sales reduced by 5% in 2018. Horizontal analysis is useful because it helps a company identify trends and predict future performance.
For vertical analysis, the firm compares the financial statement figures for a specific period. When comparing the figures in the income statement, the firm will use net sales as the base amount. On the other hand, the company will use total assets as the base amount to compare asset figures on the balance sheet. For example, if a company made net sales worth $30 million in 2017, and the cost of goods sold was $15 million. You can say the cost of goods is 50% of total sales. Vertical analysis helps to gauge the performance of a firm against competitors. Assuming that another company made $50 million in sales in 2017, and the cost of goods is $30 million. On paper, it looks like the company with $50 million in sales is doing better. However, that is far from the truth. This company also incurred expenses that were 60% of the total sales. Since the second company incurred more expenses, the first company has better performance.
Horizontal analysis of financial statements is also known as trend analysis. It involves a financial analyst observing comparisons between line items or ratios in financial statements over the course of two or more specific time frames. In horizontal analysis, the earliest period being analyzed is referred to as the base period. As the name implies, this technique is useful for analyzing trends in financial statements. Usually, the changes noted will be depicted both in dollar values and as percentages.
A vertical analysis, on the other hand, involves analyzing every line on a financial statement as a percentage of another line. On an income statement, in other words, one could conduct a vertical analysis by converting each line on the statement into a percentage of your gross revenue.
The main difference here has to do with the time frame that each method of analysis looks at. A horizontal analysis typically looks at a number of years. By contrast, a vertical analysis looks only at one year.
A horizontal analysis compares financial information for one company with the same types of financial income for the same company in one or more previous years. For example, you could look at the company's inventory and determine the percent change for its inventory over each of the last three years.
By contrast, a vertical analysis is more of a snapshot. It shows all of the firm's financial information for a particular year. Each item on the statement is typically expressed a percentage of some particular statistic. In other words, you might express everything as a percentage of the firm's total assets. This form of analysis allows a firm to compare itself quite easily to other firms in its industry.