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Respond to... Horizontal analysis of a financial statement is used to compare historical data such as line items or ratios throughout multiple accounting periods. This type of analysis can use either
Horizontal analysis of a financial statement is used to compare historical data such as line items or ratios throughout multiple accounting periods. This type of analysis can use either absolute comparisons or percentage comparisons. Horizontal analysis makes it easy for financial statement users to spot growth patterns and trends. This type of analysis allows individuals to successfully assess relative changes in different line items over time as well as project what they will be in the future. Looking at the balance sheet, income statement, and cash flow statement over time, can allow for individuals to observe a complete picture of operational results. This allows individuals to determine what drives a company’s performance and whether or not the company is operating profitably and efficiently. Vertical analysis observes each line item within a current period as a percentage of a base figure. Therefore, line items on an income statement can be stated as a percentage of net sales (Kimmel, Weygandt, & Kieso, 2019).In regards to a financial analysis, the horizontal analysis can be considered to be a broader view whereas the vertical analysis is a narrower view. Liquidity ratios determine a company’s ability to take care of short-term obligations. Current, quick, cash, and defensive interval ratios are all examples of liquidity ratios. In contrast, solvency ratios determine a company’s ability to take care of long-term obligations. Solvency ratios measure the adequacy of cash flow and earnings to pay for interest expenses obtained from current debts. Debt and coverage ratios are examples of solvency ratios. Profitability ratios determine a company’s ability to generate profits from its assets. Return-on-sales and return-on-investment are examples of profitability ratios. These ratios are used to analyze the financial strength of a company.
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2019). Financial accounting: Tools for business decision making (8th ed.). Retrieved from https://www.vitalsource.com
There are two ways to breakdown financial statements to analyze a company. The broader view is the horizontal analysis, and the narrower view is the vertical analysis. Kimmel defined horizontal analysis as, "A technique for evaluating a series of financial statement data over a period of time to determine the increase (decrease) that has taken place, expressed as either an amount or a percentages" .
Using the horizontal analysis to note key percentages can help identify the grand scheme of a company. In other words the horizontal analysis can help gauge a company's potential by measure its growth and/or its diminishment over time. Ideally, taking note of a company's gross profits over the years is the key. It can display a steady progression, which can be used to estimate growing. However, noting a company's liabilities over time is important too For example, assessing a company's diminishment over time through their long-term liabilities.
In order to take a more refined look into financial statements the vertical analysis is used. Kimmel defined vertical analysis as, "A technique for evaluating financial statement data that expresses each item in a financial statement as a percentage of a base amount". Looking closer at the Changes from the base to current amount (in percentages) will identify smaller growth and diminishment of specific assets, liabilities, and stockholders' equity--from base to current.
Kimmel defined the three types of classification for ratio analysis of the primary financial statements:
- Liquidity Ratios - Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
- Solvency Ratios - Measures of the ability of the company to survive over a long period of time.
- Profitability Ratios - Measures of the income or operating success of a company for a given period of time .
In short the Liquidity Ratios will measure the short-term ability of a company to pay its maturing obligations/meet any unexpected needs for cash. The Solvency Ratios measure the ability of a company to survive over a long-term, and the Profitability Ratios measure income/operating success of a company per period. Individually the ratios are not necessarily ideal for analyzing, but all three together are ideal for uncovering conditions unseen at the individual component basis.