CFO Service Finance & Accounting

Financial Analysis – Horizontal and Vertical Analysis

Analysing the financial health of an organization is a key component that has been of great value. It is a vital process that has helped in assessing the financial health of an organization. This article provides you rich information on the meaning of financial analysis and also on horizontal and vertical analysis. 

What is Financial Analysis?

A company’s data has huge amounts of information, thereby allowing financial analysts to derive conclusions on the past and present and also to try and predict the future. Financial analysis is best described as the process of utilizing financial data to assess a company’s performance and make recommendations regarding how it may improve going forward.

Financial analysis is typically used to assess the status of an organization by determining how stable, solvent, liquid, or profitable it is. It is used internally within an organization as a tool for monitoring and managing finances, while external investors use it to understand the health of an organization and to evaluate financial performance and business value.  

Significance of financial analysis

The significance of financial analysis can be best understood by knowing how it helps different institutions. Analysis of financial statements helps finance manager to assess the operational efficiency and managerial effectiveness of the company.

Financial analysis helps top management to assess whether the firm resources are utilized in an efficient manner and also helps in investigating future prospects of the enterprise.

Investors who have invested their hard-earned money in a firm’s shares would want to know firms’ earnings and future profitability. The analysis of financial statements allows them to predict bankruptcy and potential failure probability of the business enterprise. When investors are aware of the probable failure, it allows them to take preventive measures that help them to minimize loss.

Objective of Financial Analysis

Main objectives of financial analysis are as follows:

• Reviewing company’s past records

In order to predict the future, past is analysed. Past performance is analysed by conducting a review of the trend of past sales, profitability, cash flows, operating expenses, etc.

• Assessment of the current position and operational efficiency

Another objective is to examine the present profitability and operational efficiency of the enterprise to determine the financial health of the company. Analysis helps in knowing the earning capacity and operating performance of the company.

• Predicting growth and prospects of profitability

The top management of any organization is concerned with the future prospects of the company. With financial analysis, investment alternatives can be reviewed to judge the earning potential of the enterprise.

• Taking loan decisions by banks

With financial analysis, financial institutions and loan agencies decide if a loan can be provided to the company or not. It helps them to determine the credit risk, deciding the terms and conditions of a loan, interest rate, etc.

Financial Analysis: Horizontal and Vertical Analysis

This can be of two types- Horizontal and Vertical Analysis. What differentiates them is that horizontal analysis considers the comparison between a % amount of an item in the financial statement with base year’s corresponding item. In case of Vertical analysis, it talks about each amount separately in the financial statement as a % for another amount in the similar financial period.

Horizontal Analysis-

Horizontal analysis considers all amount in financial statements in many years. The amounts from financial statements shall be considered as the percentage of amounts for the base.

One tool used in horizontal analysis is the financial ratios which is useful to gauge the trend and direction over a period. It is often called as trend analysis^[1], effectively permitting the assessment of the relative changes in different items over time. Analysts tend to compare these ratios to industry averages, industry standards, and also against internal trends.

The five major categories in the financial ratio list include:

• Liquidity ratios;
• Activity ratios;
• Debt ratios;
• Market ratios; and
• Profitability ratios.

Vertical Analysis-

Vertical analysis considers each amount on the financial statement listed as % of another amount. For instance- in case of vertical analyses, the line of items on a balance sheet may be expressed as a proportion or percentage of the total assets, liabilities, or equity, but in case of income statement, the same can be indicated as a percentage of gross sales whereas in cash flow statement, the cash inflows and outflows are denoted as the proportion of total cash inflow.

With the help of vertical analysis, the percentages may be directly compared to the result of the equivalent percentages of the past years or other companies functioning in the same industry regardless of their size. Therefore, common size financial statement not only helps in intra-firm comparison but it also helps in inter-firm comparison.

Conclusion

Although both horizontal and vertical analysis have several differences, they are equally important when it comes to business decisions based on performance. The significance of financial analysis can never be undermined as it forms the basis on which many crucial decisions are made.

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