Financial Statement Analysis Guide: Horizontal and Vertical Approaches

Financial analysis technique is vertical analysis of the balance sheet as a percentage of total assets, which converts every balance sheet item into percentage of total assets. This process enables analysts to comprehend the arrangement of the financial position of a company in the sense that it indicates how the assets are financed and distributed. Riverstone Training says that vertical analysis of balance sheet as a percentage of total assets facilitates the standardization of the financial statements, thus it is easy to compare companies of various sizes or to compare the changes in the same company across time.

In practice, a vertical balance sheet analysis as the percentage of the total assets allows noting the dependence of the company on the debt or equity financing and the efficiency of the allocation of the resources. As an illustration, a high ratio of current assets can be used to suggest high levels of liquidity and large percentage of fixed assets can be used to suggest capital intensive operation. Whether the decision-makers have a better understanding of the financial structure and risk exposure by using vertical analysis of balance sheet as a percentage of total assets.

Importance of horizontal and vertical analysis in financial analysis

Horizontal and vertical analysis are important in the financial analysis because they can give trend-based and structural information. Horizontal analysis is concerned with changes of financial statement items with time whereas the vertical analysis indicates relative proportions at a given period. The significance of the horizontal and vertical analysis in financial analysis enables users to compare performance, growth and financial stability in a broader manner.

In addition, the importance of horizontal and vertical analysis in financial analysis is realized when it comes to determining the initial signs of financial distress or operational inefficient practices. The horizontal analysis can indicate the poor increase in revenue or the increasing costs whereas the vertical analysis can indicate the cost structures that are becoming less efficient. Combined, the significance of a horizontal and vertical analysis in financial analysis is that the raw financial data is converted into insightful materials that can be used to make superior choices.

How analysts apply horizontal and vertical analysis in practice

The practice of horizontal and vertical analysis by analysts differs depending on the use of analysis, e.g., investment analysis, credit analysis, or internal management analysis. Horizontal analysis is commonly employed to monitor the increase or decrease in revenue, expense, and profitability across many periods. Meanwhile, cost structures, asset composition, and allocation of capital are evaluated through vertical analysis. The practical application of horizontal and vertical analysis by analysts will help understand how both of these tools are complementary.

In practical application, the use of horizontal and vertical analysis by the analysts in the real world may consist of benchmarking the industry participants. An example is that an analyst can employ horizontal analysis to analyze year-over-year growth rates and vertical analysis to analyze expense ratios versus the competitors. Through the knowledge of the application of horizontal and vertical analysis by the analyst in practical environment, organizations will be able to align their financial performance with the industry benchmarks and their strategic objectives.

Limitations of horizontal and vertical analysis explained

The limitations of the discussed horizontal and vertical analysis are significant to make sure that these two are not the only preferred ways that can be used by the users. Horizontal analysis may be deceptive in the sense that inflation may cause distortions in trends, changes in accounting policies, or one time phenomenon. On the same note, vertical analysis uses relative proportions but fails to give the causes of changes. Knowledge of limitations of horizontal and vertical analysis elucidated assist the analysts to be careful of the results interpretation.

Moreover, such drawbacks of horizontal and vertical analysis as reliance on historical data are also described. Such analyses are not future performance predictors, and can ignore qualitative variables like the quality of management, or the climate in the market. Since these tools have limitations as described by the horizontal and vertical analysis, analysts can complement them with alternative financial and strategic analyses to give them a more balanced perspective.

Vertical analysis example for expense structure evaluation

An example of a vertical analysis to evaluate the expense structure shows the manner in which the costs are allocated in comparison with the revenue. In an income statement, any category of expenses is computed as a percentage of total sales, and this enables the analysts to observe which expenses will take the highest portion of revenue. An example of a vertical analysis used to assess the structure of expenses will allow identifying those areas where the cost control can be enhanced.

As an example, when the percentage of selling and management costs relative to revenue is significantly higher than that of other companies in the industry, management might have to consider operational effectiveness. The budgeting and performance monitoring also use the example of vertical analysis as a means of evaluating the expense structure. Using this approach on a regular basis, organizations can be able to monitor the progress of cost structures as getting better or worse over time.

Combining horizontal and vertical analysis for deeper insights

By considering the horizontal and vertical analysis to get an in-depth analysis, analysts can see the trends and the structure at the same time. Horizontal analysis can indicate that the expenses are on the rise with each passing year, whereas vertical analysis can indicate that the share of the expenses is getting bigger. When horizontal and vertical analysis are combined to gain more insights there is a more refined explanation regarding financial performance.

Moreover, horizontal and vertical analysis are combined to make deeper insights and contribute to strategic decision-making. The management can see whether the growth is based on sustainable revenue growth or due to the increase in the costs and leverage. Through the integration of horizontal and vertical analysis to gain further understanding of it, organizations are able to establish better financial strategies and to be proactive in reacting to emerging risks.

Role of horizontal and vertical analysis in financial planning

The significance of horizontal and vertical analysis of the financial analysis is spilled over to the financial planning and forecasting. The historical trends that are determined using horizontal analysis inform the future projections and the vertical analysis aids in maintaining a balanced financial structure based on the projections. Knowing the use of horizontal and vertical analysis by the analysts in real life makes budgeting and long term planning more robust.

Meanwhile, the awareness of the limitations of horizontal and vertical analysis elucidated guarantees that the planners do not overestimate previous trends. The most effective use of financial planning is with the use of the tools combined with ratio analysis, cash flow analysis, and qualitative evaluation.

Conclusion

Analogy of balance sheet as a percentage of total assets is a useful analysis in understanding the financial structure of a company; however, the relevance of the horizontal and vertical analysis in financial analysis is that they help in exposing patterns and relationships in the financial statements. A practical perspective of how analysts use horizontal and vertical analysis would reveal the role of the tools in the real-life financial decision-making.

Meanwhile, considering the shortcomings of horizontal and vertical analysis explained will be more careful and precise interpretation. An example of a vertical analysis as a tool of expense structure evaluation focuses on how cost efficiency can be measured and a further insight of the horizontal and vertical analysis will result in a more complex perspective of performance. Combination of both horizontal and vertical analysis provides a strong base in the financial analysis, strategic planning and sound business decisions.