Horizontal vs Vertical Analysis Explained: Key Tools for Financial Review

Financial analysis is very important in enabling the stakeholder to appreciate the performance as well as the financial position of an organization. Horizontal analysis and vertical analysis can be listed among the most popular methods in this field. They are both basic instruments in financial accountancy, which provide information in respect to trends, structural relationships, and measures of performance. But what are they? What is the way that they are carried out?Why and when are you supposed to use one over the other? 

It is time to deconstruct everything in this in-depth guide.

What Is Horizontal Analysis in Financial Accounting?

Horizontal analysis refers to the trend analysis in financial accounting, which compares financial information across several periods of reporting. It is done to find patterns, increase or decrease in certain line-items over time, most often comparing year to year or quarter to quarter. 

The method will enable you to determine whether revenue, expenses, assets, or liabilities are rising and falling and at what rate. Horizontal analysis offers a clear picture of how a company is changing and is able to act as an alarm sign in case something seems to be out of business. 

In another example, in one company revenue growth has been 10 percent a year during the last three years but only 1 percent during the last year, the horizontal analysis would point toward the decreasing growth rate and an investigation would follow.

How to Perform Horizontal Analysis on Income Statements

It is easy to carry out horizontal analysis on income statements. The first thing you do is to choose a base year after which the other periods are compared to the base year. This is how it is done:

1. Select your time frame: Pick two or more periods of reporting- eg. 2023 vs. 2022.
   
   

2. Calculate the difference: The figure of the base year is subtracted with the comparative one.
   
   

3. Find the percentage change: Take the change and divide it by the base year and multiplying the result by 100.
   
   

As an illustration, when in 2022, the net income was 50 000 dollars and the next year increased to 60 000 dollars the change can be calculated as 10 000 dollars and the percentage growth is 20%.

It is possible to apply this analysis to all the major line items of the income statement including revenue, cost of goods sold (COGS), gross profit, operating expenses, and the net profit.

What Is Vertical Analysis and How Is It Used in Financial Reporting?

In vertical analysis, however, a picture is given of each item line as to its relationship with a base figure in only one line period. As an illustration, in the income statement; the figures on individual lines are usually calculated in terms of percentage of the gross revenue. Usually, it is defined as a portion of total assets in a balance sheet.

This can be used where size is a determining issue, e.g. benchmarking across companies of varying size or benchmarking the performance of one company over two or more years on a proportionate basis. The existence of vertical analysis facilitates easier determination of the structural efficiencies or inefficiencies.

To take an example, marketing expenses comprise 15 percent of the overall company revenue, and 5 per cent in another company vertical analysis makes it out and can be acted upon.

Horizontal Analysis vs Vertical Analysis: Key Differences Explained

Although horizontal and vertical analysis in financial accounting are both useful tools, they are used differently since they are designed to fulfill different purposes:

• Horizontal analysis draws comparisons between data through time. It shows growth patterns, volatility or decrease in financial performance over time.
  
  

• Vertical analysis discusses a period. It aids in assessing proportional implication in a financial statement.
  
  

The two are complementary: one of them reveals more about the historical performance of a company; another balances its budget and makes it possible to evaluate the extent of its internal organization and monetary policy.

Example of Vertical Analysis for Balance Sheet Interpretation

Consider a balance sheet with a total asset of 1,000, 000 dollars. When the accounts receivable stand at $200,000 in the vertical analysis, the receivables are reflected at 20 percent of the total assets value. This indicates the picture of what percentage of your property is in the form of credit given to consumers.

Using vertical analysis for balance sheet interpretation, an analyst may easily determine whether the company is highly dependent on inventory, fixed assets, or short term investment. When 80% of the overall capital structure is composed of liabilities, it could indicate the indication of the overleveraging.

Step-by-Step Guide to Conducting Horizontal and Vertical Analysis

The following is a brief overview and sequential instruction into how to go about the execution of both analyses:

In the case of Horizontal Analysis:

• Find out trouble-free year.
  
  

• Record financial records of various times.
  
  

• Compute values of absolute changes and percentages.
  
  

For Vertical Analysis:

• Select the base item (e.g. Total revenue or total assets).
  
  

• Convert every line item relative to that base as a percentage.
  
  

• Make crossperiod or interfirm comparison.
  
  

When vertical and horizontal analyses are applied in combination, their power becomes even greater. Vertical analysis should demonstrate where a certain expenditure goes and in which context, whereas horizontal analysis should demonstrate how this expenditure has changed during some time frame.

Benefits of Using Vertical Analysis in Ratio Interpretation

Among the most common advantages of vertical analysis, there is a possibility to interpret ratios more effectively. With the help of defining financial data in percentages, vertical analysis adds simplicity in calculating, and determining key financial ratios such as:

• Gross profit margin: Gross profit divided by sales expressed as a percentage.
  
  

• Operating expense ratio: Operating expenses / Revenue.
  
  

• Debt-to-asset ratio: Liabilities % of total assets.
  
  

Vertical analysis provides a convenient structure to financial comparisons and adds to ratio analysis by providing a uniform structure to benchmarking and financial diagnostics

Conclusion

Knowledge of what horizontal and vertical analysis is and how to apply them in financial accounting is vital to every business owner, accountant or an investor. These instruments aid in the identification of the trends, unraveling the structural performance, and the ratios becoming a lot clearer.

Whereas horizontal analysis presents the growth codes and performance over the period, vertical analysis presents proportional relationship, which is essential in internal benchmarking and competitive analysis.

When properly employed, these techniques have significant insights into financial statements and thus assist companies in making the right decisions and also in facing any audits and future planning.