Segment 12.1 – Horizontal & Vertical Analysis

Financial Statement Analysis

  • Purpose of Analysis:

    • Enables comparisons:

    • Between companies of varying size

    • Over different periods of time (trends)

    • Against industry standards

  • Methods of Analysis:

    • Horizontal Analysis:

    • Analyzes trends over time for a specific company.

    • Vertical Analysis:

    • Expresses each item in a financial statement as a percentage of a base amount for the same period.

    • Ratios:

    • Uses financial ratios to assess a company's performance.

Vertical Analysis

  • Definition:

    • Vertical analysis is performed by expressing each item in a financial statement as a percentage of the same base amount.

    • This approach allows for straightforward comparison of financial statements.

  • Examples of Vertical Analysis:

    • Income Statement:

    • Items expressed as a percentage of net sales.

    • Balance Sheet:

    • Items expressed as a percentage of total assets.

Common-Size Financial Statements

  • Common-Size Income Statements:

    • All dollar amounts are transformed into percentages of net sales, making it easy to analyze proportional relationships between different income items.

    • Illustration 12-2:

    • Directions indicated by a red arrow.

  • Common-Size Balance Sheets:

    • All dollar amounts expressed as a percentage of total assets, providing a useful comparison tool across different companies or time periods.

    • Illustration 12-3:

    • Directions indicated by a red arrow.

Horizontal Analysis

  • Definition:

    • Horizontal analysis involves analyzing trends in financial statement data for a single company over multiple periods.

  • Calculation:

    • Percentage Increase or Decrease is calculated using the formula:
      Percentage Increase (Decrease)=Current-year amount−Prior-year amountPrior-year amount\text{Percentage Increase (Decrease)} = \frac{\text{Current-year amount} - \text{Prior-year amount}}{\text{Prior-year amount}}

Practical Applications of Horizontal Analysis

  • Illustrations:

    • Horizontal Analysis of VF’s Income Statements (Illustration 12-4):

    • Analysis shown indicates the trends and changes in income items over time.

    • Horizontal Analysis of VF’s Balance Sheets (Illustration 12-5):

    • Analysis displayed helps in understanding asset and liability trends over the specified periods.

Key Financial Ratios

  • Return on Equity (ROE):

    • Definition:

    • Measures the income earned for each dollar of stockholders’ equity.

    • Application:

    • Relates net income to the investment made by the owners of the business.

  • Current Ratio:

    • Definition:

    • Compares current assets to current liabilities.

    • Interpretation:

    • A higher current ratio usually indicates less liquidity risk, meaning the company is more capable of covering its short-term obligations.

  • Debt to Equity Ratio:

    • Definition:

    • Indicates the risk of bankruptcy by measuring the company’s total liabilities against its stockholders’ equity.

    • Interpretation:

    • Higher debt to equity ratios suggest higher bankruptcy risk; more debt increases risk but could also lead to higher potential returns for investors.

    • Other factors remaining constant, a higher ratio indicates higher risk.

Conclusion

  • Financial analysis, including both horizontal and vertical methods, is essential for effective decision-making in accounting practices.

  • Understanding and applying these concepts allows analysts to gain insights into company performance over time and in comparison with industry standards or competitors.