There are different methods for analyzing financial statements, the choice of which depends on the specific tasks that have been set and on the amount of information. The most used are horizontal and vertical analysis. They are used by many companies to analyze financial statements and increase profits.
Horizontal analysis of financial statements can be defined as a comparative analysis of financial ratios, benchmarks, items in financial statements, or as an estimate of the growth or decline of the Balance sheet indicators for a certain period.
This method of analysis allows studying absolute indicators of the items of the organization’s reports for several previous periods, as well as calculate and assess the tendencies of their changes. To make a better analysis, it is recommended to take reports for several periods. The purpose of a horizontal analysis of financial statements is to visually show the changes that have occurred. For example, changes in cash flows and profits.
Several approaches are used in the horizontal analysis:
- comparison of changes in absolute values (for example, in dollars)
- comparison of changes in relative value (as a percentage).
For the report, it is necessary to use these two approaches together, although the changes expressed as a percentage provide for more practical and useful analysis.
The horizontal analysis is done with the help of tables that allow absolute indicators to be converted into percentages. In the course of the analysis, financial indicators are entered into the table after which the relative growth or decline rates of these indicators are calculated. Thanks to the horizontal analysis tables, you can determine changes in any financial item, as well as predict the future activities of the organization.
Using tables to perform the analysis is time-consuming. It is necessary to collect data from various sources, bring them to a unified format, and often manually copy some of them into the required table cells. The calculation of horizontal analysis indicators should be automated. If the calculation of all indicators is automated, then it takes minutes to obtain the analysis data, and you can perform it regularly. You will be able to notice negative trends and make decisions based on the data, rather than perform analysis to ascertain events that have already happened.
Advantages and disadvantages
First, let’s define the benefits:
- comparison of organizations that differ in size and scope of activity
- ability to identify trends in indicators.
Please note that in order to fully benefit from the horizontal analysis of the financial statements, it is necessary to analyze all their components.
The disadvantages of this analysis method include:
- changes in accounts and financial reporting standards lead to the fact that the data cannot be compared, the consequence of which will be incorrect data compared for accounting periods – this distorts the results of the analysis;
- sensitivity of the horizontal analysis to the choice of the base period can be used to manipulate the analysis results, embellishing or underestimating the assessment of the financial condition of the organization.
Vertical vs Horizontal Analysis
Horizontal analysis is an analysis technique that calculates the change in an account balance from one period to the next and expresses that change in both dollar and percentage terms. Vertical analysis, on the other hand, is an analysis technique that states each account balance on a financial statement as a percentage of a base amount on the statement.
The purpose of the vertical analysis is to find out and predict the relative proportion of each item to the base amount for the same accounting period. The horizontal analysis helps to determine the change in an item during an accounting period.
Horizontal analysis, like vertical analysis, can be used when studying the main forms of financial statements of an enterprise. In addition, in the process of analysis, one should compare the changes of indicators from various forms of financial statements because this will allow the formation of additional conclusions and recommendations.