Question

Explain horizontal and vertical analysis and how they are prepared to analyze comparative income statements and balance sheets.

Answer 1

A useful approach to analyze financial statements is to perform either a vertical analysis or horizontal analysis of the statements. Both analysis approaches are similar in that the dollar amounts reported are converted to percentages. But the approaches differ in the base used for the computation of the percentages.

Horizontal analysis is a technique for the evaluation of a series of financial statement data over a period of time to determine the rise or fall that has taken place, expressed as either an amount or a percentage. Horizontal analysis compares account balances and ratios over different time periods. The main benefit of using horizontal financial analysis is that it allows for making a comparison of company's financial statement for two more accounting periods. For example, when comparing the sales of company in 2014 to its sales in 2015

Vertical analysis is also known as "common-size analysis"; because all the amounts for a specific year are converted into percentages for a key component in the financial statement. Vertical analysis expresses each item within a financial statement as a percent of a base amount. The main benefit of using vertical financial analysis is that the company's income statements and balance sheets that differ in sizes can be compared. The absolute amounts comparison of companies of different sizes does not lead to accurate conclusions in regard to company's financial performance and financial position. For example, in vertical analysis, gross margin and cost of goods sold are typically listed as a percentage of sales