There are various types of financial analysis:
- Vertical analysis
- Horizontal analysis
- Leverage analysis
- Ratio analysis (which includes liquidity analysis, profitability analysis etc)
- Sensitivity analysis
- What-if analysis.
Each analysis has its own place and importance in financial analysis; however, the ones we will focus on are vertical analysis (most commonly used), horizontal analysis, ratio analysis and sensitivity analysis.
Before we dive into each of these, we need to review the different components of a financial statement in order to assist us with a financial statement analysis.
It is important to note that the following analysis focuses on financial statements; however, financial analysis has a broader focus and internally there are various different financial metrics that organisations, depending on their focus and departments, may have on hand.
After watching the video in the previous step, you should now have a basic understanding of the components of a financial report by an organisation. Let’s look at how we might perform a horizontal analysis.
- Horizontal analysis is one of the most commonly performed financial analysis techniques, and it allows us to evaluate trends across two chosen periods (e.g. year-on-year, quarter-over-quarter, etc.).
- The purpose of this is to be able to understand the past, and use it as an insight on what the company might do into the future.
- It is important to note that you should only compare like for like line items, for example, cost of sales 2020 vs cost of sales 2019.
See below an example from the Woolworths Annual Report 2019:
The formula for the horizontal analysis is:
- % Change = ((Amount in Comparison Year − Amount in Base Year) / (Amount in Base Year)) x 100
- If you don’t want a percentage, you simply omit the final step (multiply by 100)
(Source: Woolworths Annual Report 2019, pg 68) [1]
Vertical analysis
Another common type of financial analysis is the vertical analysis. Rather than looking horizontally across the financial statement, you analyse it vertically.
You would most commonly use vertical analysis on an income statement, and would use it to show expense line items as a percentage of sales. Thus, you would look at each line item on the income statement and divide it by gross sales to see the percentage of each item as gross sales. You could do the same exercise on the balance sheet, except it would show as a percentage of total assets or similarly as total liabilities.
Unlike horizontal analysis, vertical analysis does not compare the two periods directly (eg, Y1–Y2), instead it breaks down each period separately, allowing you to compare changes in percentages and try to determine why they may have changed. It allows you to see the correlation between single items and the bottom line. It is also extremely effective when comparing companies that might be of different sizes but in the same industry, as it lets you analyse operational differences at the same base.
(Source: Woolworths Annual Report 2019, pg 68) [1]
References
1. Woolworths Group Limited. 2019 Annual Report [Internet]. Available from: https://www.woolworthsgroup.com.au/icms_docs/195582_annual-report-2019.pdf
FAQs
Horizontal analysis usually examines many reporting periods, while vertical analysis typically focuses on one reporting period. Horizontal analysis can help you compare a company's current financial status to its past status, while vertical analysis can help you compare one company's financial status to another's.
What are the three types of financial analysis? ›
Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques are horizontal analysis, vertical analysis, and ratio analysis.
How do you explain the result of horizontal analysis? ›
Horizontal analysis is the comparison of historical financial information over various reporting periods. It helps determine a companies' growth and financial position versus competitors. The horizontal analysis technique uses a base year and a comparison year to determine a company's growth.
What is the difference between vertical and horizontal analysis in Quizlet? ›
Horizontal Analysis looks at the percentage change in a line item from one year to the next. Vertical Analysis looks at the what percentage is one line item from another for the same year.
What is an example of a vertical analysis? ›
Examples of how to use the vertical analysis formula
The company sold a total of 19,304 items, of which 1,543 were children's clothing. Vertical analysis: VA = 1543 / 19304 (100) = Children's clothing represents 8% of all sales.
What is ratio analysis and its formula? ›
Ratio = a : b. Ratio analysis formula = a/b. OR. Ratio Analysis Formula = a/b × 100% Some of the frequently used ratios in accountancy and business are as follows.
What is horizontal analysis also known as? ›
Horizontal analysis is also referred to as trend analysis. Assume that the base year for analysis is three years earlier. All of the amounts on the balance sheets and the income statements for analysis will be expressed as a percentage of the base year amounts.
What are the different types of ratio analysis? ›
What Are the Types of Ratio Analysis? Financial ratio analysis is often broken into six different types: profitability, solvency, liquidity, turnover, coverage, and market prospects ratios.
What is financial analysis in simple words? ›
Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related transactions to determine their performance and suitability. Typically, financial analysis is used to analyze whether an entity is stable, solvent, liquid, or profitable enough to warrant a monetary investment.
Why are ratios useful? ›
Ratio analysis helps people analyze financial factors like profitability, liquidity and efficiency. Ratio analysis helps financial professionals understand company trends and perform competitive analysis. Common ratio analysis includes liquidity, leverage, market value and efficiency ratios.
Vertical analysis helps businesses determine whether certain items consistently increase or decrease over time. Additionally, this method helps businesses identify trends and patterns in their financial statements. These insights can then be used to make informed decisions regarding their financial strategy.
Which of the following is a red flag in financial analysis? ›
Some common red flags that indicate trouble for companies include increasing debt-to-equity (D/E) ratios, consistently decreasing revenues, and fluctuating cash flows. Red flags can be found in the data and in the notes of a financial report.
What is the main difference between horizontal and vertical analysis? ›
Contrasting Horizontal and Vertical Analysis
Horizontal analysis helps spot patterns and growth trends, while vertical analysis allows financial statement items to be compared to each other or to a benchmark figure. Together, they provide greater insight into a company's financial health.
What is the main difference between horizontal and vertical? ›
Horizontal lines are lines that run from left to right and are parallel to the x-axis. Vertical lines are lines that run up and down and are parallel to the y-axis.
Which of the following is the formula for the current ratio? ›
Calculating the current ratio is very straightforward: Simply divide the company's current assets by its current liabilities.
How do vertical and horizontal analysis differ in which of the following ways? ›
Horizontal analysis studies financial data over time to find trends and growth. It looks at how financial numbers change across different periods. Vertical analysis looks at a company's finances in one period.
What is the difference between a vertical and horizontal balance sheet? ›
A horizontal balance sheet shows assets on the right-hand side, while a vertical one shows it below liabilities. The assets of a company may be either tangible or intangible.
What is common size horizontal and vertical analysis? ›
Vertical vs.
For example, a vertical common size analysis may look at an income statement or balance sheet and compare the amounts on each financial document. A horizontal common size analysis looks at the amounts over a longer period, like a trend analysis.
What is vertical and horizontal sales analysis? ›
Horizontal analysis indicates long-term trends and highlights areas of strength and those that need improvement. Vertical analysis indicates the relative importance of each line item in a certain period.
(Source: Woolworths Annual Report 2019, pg 68) [1]
