Unit 2: Techniques of financial statements analysis

Horizontal Analysis: A Comparative Tool

Horizontal analysis is a financial accounting technique that compares financial data of the
same item across multiple periods (e.g., years). This comparison helps to identify trends,
changes, and patterns in a company's financial performance over time.
How Horizontal Analysis Works
1. Select a base period: This is the period against which all other periods will be
compared.
2. Calculate dollar changes: Subtract the base period amount from the current period
amount for each item.
3. Calculate percentage changes: Divide the dollar change by the base period amount
and multiply by 100.
Benefits of Horizontal Analysis
• Identifies trends: Reveals increasing or decreasing patterns in financial data over time.
• Assesses performance: Compares current performance to historical benchmarks.
• Detects anomalies: Highlights unusual or unexpected fluctuations in financial metrics.
• Forecasts future trends: Provides insights into potential future developments.
Example of Horizontal Analysis

Item Current Year Previous Year Dollar Change Percentage Change

Net Sales $1,000,000 $800,000 $200,000 25%

Cost of Goods Sold $600,000 $500,000 $100,000 20%

Gross Profit $400,000 $300,000 $100,000 33.33%

Operating Expenses $250,000 $200,000 $50,000 25%

Net Income $150,000 $100,000 $50,000 50%

In this example, we can see that:

• Net sales have increased by 25%.
• Cost of goods sold has increased by 20%.
• Gross profit has increased by 33.33%.
 • Operating expenses have increased by 25%.
• Net income has increased by 50%.
Overall, the company's financial performance has improved significantly over the past
year.
By using horizontal analysis, financial analysts can gain valuable insights into a
company's financial health and identify areas for improvement or potential risks.

Vertical Analysis: A Comparative Tool

Vertical analysis is a financial accounting technique that expresses each item on a financial
statement as a percentage of a base amount within the same period. This comparison helps to
evaluate the relative importance of each item and identify relationships between different items.
How Vertical Analysis Works
1. Select a base amount: The base amount for the income statement is typically net sales,
while for the balance sheet, it's total assets.
2. Calculate percentages: Divide each item by the base amount and multiply by 100.
Benefits of Vertical Analysis
• Reveals relative importance: Shows the proportion of each item to the overall
financial statement.
• Compares to industry standards: Allows for benchmarking against industry
averages.
• Identifies trends: Detects changes in the composition of financial statements over
time.
• Analyzes profitability: Evaluates the efficiency of operations and expense control.
Example of Vertical Analysis
Income Statement

Item Current Year Previous Year

Net Sales $1,000,000 (100%) $800,000 (100%)

Cost of Goods Sold $600,000 (60%) $500,000 (62.5%)

Gross Profit $400,000 (40%) $300,000 (37.5%)

Operating Expenses $250,000 (25%) $200,000 (25%)

Net Income $150,000 (15%) $100,000 (12.5%)

Balance Sheet

Item Current Year Previous Year

Total Assets $1,500,000 (100%) $1,200,000 (100%)

Current Assets $800,000 (53.33%) $600,000 (50%)

Fixed Assets $700,000 (46.67%) $600,000 (50%)

Total Liabilities $800,000 (53.33%) $600,000 (50%)

Equity $700,000 (46.67%) $600,000 (50%)

In this example, we can see that:

• The company's gross profit margin has improved from 37.5% to 40%.
• The proportion of current assets to total assets has increased.
• The company's debt-to-equity ratio has remained constant.
By using vertical analysis, financial analysts can gain valuable insights into a company's
financial structure, performance, and risk profile.

Trend Analysis: A Comparative Tool

Trend analysis is a financial accounting technique that examines changes in financial data over
a longer period to identify patterns and long-term trends. This analysis helps to assess the
sustainability of a company's financial performance and predict future outcomes.
How Trend Analysis Works
1. Gather historical data: Collect financial data for multiple periods (e.g., five years).
2. Visualize trends: Create charts or graphs to illustrate changes over time.
3. Identify patterns: Look for consistent increases, decreases, or fluctuations in financial
metrics.
Benefits of Trend Analysis
• Reveals long-term trends: Identifies underlying patterns in financial performance.
• Assesses sustainability: Evaluates the consistency and predictability of results.
• Forecasts future outcomes: Provides insights into potential future developments.
• Identifies early warning signs: Detects emerging issues or opportunities.
Example of Trend Analysis

Year Net Sales Net Income

2019 $800,000 $100,000

2020 $900,000 $120,000

2021 $1,000,000 $150,000

2022 $1,100,000 $180,000

2023 $1,200,000 $200,000

By plotting these data points on a graph, we can see a clear upward trend in both net sales
and net income over the past five years.
This suggests that the company is experiencing steady growth and profitability.
Combining Trend Analysis with Other Techniques
Trend analysis can be combined with horizontal and vertical analysis to gain a more
comprehensive understanding of a company's financial performance. For example, we could
analyze the percentage change in net income over the years (horizontal analysis) and compare
it to the percentage change in net sales (vertical analysis).
By using trend analysis in conjunction with other comparative techniques, financial
analysts can make more informed decisions and develop effective strategies for long-term
success.