Question

What is horizontal analysis and ratio analysis in accounting?

Answer 1

HORIZONTAL ANALYSIS

Horizontal analysis in accounting refers to comparison of financial statement figures of comparative accounting periods. Here figures could refer to a financial statement line item, financial ratio or any other benchmark. This is also known as variance or trend analysis and it is usually performed to analyse the behavior of revenue, costs, assets, liabilities etc. over the years. Comparison can be of 2 or more accounting periods. Also period can be a month or a year but it should be consistent across all the data.

There are 2 methods of performing horizontal analysis :

a) Percentage comparison method of horizontal analysis : Here the differences between accounting periods is analysed and presented in terms of % terms. For example : If revenue for 2019 was 2 Million $ and revenue for 2020 is 3 Million $, variance of revenue between 2019 and 2020 would be expressed as "50%", which has been calculated as : (3-2)/2 = 50%.

b) Absolute comparison method of horizontal analysis : Here the differences between accounting periods is analysed and presented in terms of absolute figures. For example : If revenue for 2019 was 2 Million $ and revenue for 2020 is 3 Million $, variance of revenue between 2019 and 2020 would be expressed as "1 Million $", which has been calculated as : (3-2) = 1 Million $.

RATIO ANALYSIS

Ratio analysis refers to making a comparison of financial statements of 2 businesses using certain financial metrics. It can also be used to evaluate a number of important measures of an entity such as liquidity, profitability etc. There are several different types of ratios which are used to evaluate the performance and other measures of an entity. Four of the most common type of ratios are described below :

1. Turnover Ratios : It indicates the effectiveness of a company's management in generating revenue using the company's assets. Examples include Inventory Turnover ratio, Accounts Receivable turnover ratio, Total assets turnover ratio etc.

2. Profitability Ratios : These ratios calculate the overall financial performance of a company by evaluating the ability of a company to generate revenue against its expenses. Examples include Gross Profit Ratio, Return on Equity, Earnings per share, Return on capital employed etc.

3. Liquidity Ratios : These ratios are used to evaluate the ability of a company to meet it's current short-term obligations. Examples include Current Ratio, Quick Ratio etc.

4. Solvency Ratios : These ratios are used to judge the ability of a company to pay it's long-term debt obligations. Examples include Debt to Equity Ratio, Debt to Assets ratio etc.