Review the horizontal, vertical, and ratio analysis

There are various types of financial analysis:

• Vertical analysis
• Horizontal analysis
• Leverage analysis
• Ratio analysis (which includes liquidity analysis, profitability analysis etc)
• Sensitivity analysis
• What-if analysis.

Each analysis has its own place and importance in financial analysis; however, the ones we will focus on are vertical analysis (most commonly used), horizontal analysis, ratio analysis and sensitivity analysis.

Before we dive into each of these, we need to review the different components of a financial statement in order to assist us with a financial statement analysis.

It is important to note that the following analysis focuses on financial statements; however, financial analysis has a broader focus and internally there are various different financial metrics that organisations, depending on their focus and departments, may have on hand.

After watching the video in the previous step, you should now have a basic understanding of the components of a financial report by an organisation. Let’s look at how we might perform a horizontal analysis.

• Horizontal analysis is one of the most commonly performed financial analysis techniques, and it allows us to evaluate trends across two chosen periods (e.g. year-on-year, quarter-over-quarter, etc.).
• The purpose of this is to be able to understand the past, and use it as an insight on what the company might do into the future.
• It is important to note that you should only compare like for like line items, for example, cost of sales 2020 vs cost of sales 2019.

See below an example from the Woolworths Annual Report 2019:

The formula for the horizontal analysis is:

• % Change = ((Amount in Comparison Year − Amount in Base Year) / (Amount in Base Year)) x 100
  • If you don’t want a percentage, you simply omit the final step (multiply by 100)

(Source: Woolworths Annual Report 2019, pg 68) [1]

Vertical analysis

Another common type of financial analysis is the vertical analysis. Rather than looking horizontally across the financial statement, you analyse it vertically.

You would most commonly use vertical analysis on an income statement, and would use it to show expense line items as a percentage of sales. Thus, you would look at each line item on the income statement and divide it by gross sales to see the percentage of each item as gross sales. You could do the same exercise on the balance sheet, except it would show as a percentage of total assets or similarly as total liabilities.

Unlike horizontal analysis, vertical analysis does not compare the two periods directly (eg, Y1–Y2), instead it breaks down each period separately, allowing you to compare changes in percentages and try to determine why they may have changed. It allows you to see the correlation between single items and the bottom line. It is also extremely effective when comparing companies that might be of different sizes but in the same industry, as it lets you analyse operational differences at the same base.

(Source: Woolworths Annual Report 2019, pg 68) [1]

References

_{1. Woolworths Group Limited. 2019 Annual Report [Internet]. Available from: https://www.woolworthsgroup.com.au/icms_docs/195582_annual-report-2019.pdf}