The Best Use of Your Financial Statements – Vertical and Horizontal Analysis
The two simplest ways to analyze your financial statements are vertically and horizontally. A vertical analysis shows you the relationships among components of one financial statement, measured as percentages. On your balance sheet, each asset is shown as a percentage of total assets; each liability or equity item is shown as a percentage of total liabilities and equity. On your statement of profit and loss, each line item is shown as a percent- age of net sales.
FACT
Some companies use a sort of combination vertical and horizontal analysis in one. These reports contain financial data from more than one period, with a vertical analysis applied to each one. This way you can tell at a glance how statement components have changed in their proportions from one period to the next, without any extra math.
A horizontal analysis provides you with a way to compare your numbers from one period to the next, using financial statements from at least two distinct periods. Each line item has an entry in a current period column and a prior period column. Those two entries are compared to show both the dollar difference and percentage change between the two periods.
Performing a Vertical Analysis
For a fledgling business, vertical analysis of the statement of profit and loss can be particularly enlightening. Looking at every item on the statement as a percentage of sales tells you exactly where each penny of your revenues is going. Once you know that, it’s easy to see which items are eating up too much of your profits. Those are the areas where you can try to cut back. In the two-year version of this analysis, you can see how components have changed, which may not be apparent until you see them expressed in this manner.
The following example shows you what a vertical analysis looks like for both a statement of profit and loss and a balance sheet.
Vertical Analysis
Joan’s Colorful Kites Statement of Profit and Loss for the Year Ended December 31, 2005
| Amount | Percent | |
|---|---|---|
| Sales | $ 18,000 | 100.00 % |
| Cost of Goods Sold | 7,000 | 38.89 % |
| Gross Profit | $ 11,000 | 61.11 % |
| Selling Expenses | ||
| Advertising | $ 500 | 2.78 % |
| Commissions | 750 | 4.17 % |
| Delivery Fees | 1,200 | 6.67 % |
| Salaries | 5,000 | 27.78 % |
| Total Selling Expenses | $ 7,450 | 41.39 % |
| General & Administrative Expenses | ||
| Insurance | $ 800 | 4.44 % |
| Rent | 1,200 | 6.67 % |
| Depreciation | 200 | 1.11 % |
| Utilities | 400 | 2.22 % |
| Total General & Administrative Expenses | $ 2,600 | 14.44 % |
| Net Profit | $ 950 | 5.28 % |
Vertical Analysis
Joan’s Colorful Kites Balance Sheet December 31, 2005
| Assets | ||
|---|---|---|
| Current Assets: | Amount | Percent |
| Cash | $ 600 | 14.12 % |
| Inventory | 2,000 | 47.06 % |
| Prepaid Insurance | 250 | 5.88 % |
| Total Current Assets | $ 2,850 | 67.06 % |
| Fixed Assets: | ||
| Office Equipment | $ 1,800 | 42.35 % |
| Less: Accumulated Depreciation | -400 | -9.41 % |
| Total Fixed Assets | $ 1,400 | 32.94 % |
| Total Assets | $ 4,250 | 100.00 % |
| Liabilities & Owner’s Equity | ||
| Current Liabilities: | ||
| Accounts Payable | $ 1,800 | 42.35 % |
| Taxes Payable | 500 | 11.76 % |
| Total Liabilities | $ 2,300 | 54.12 % |
| Owner’s Equity | $ 1,950 | 45.88 % |
| Total Liabilities & Owner’s Equity | $ 4,250 | 100.00 % |
As you can see in the statement of profit and loss, Joan’s gross profit is sizable, at 61 percent. The selling expenses, though, are eating up a huge chunk of the revenues, even more than product costs; that could be an area in which to cut back. General operating expenses take up a reasonable percentage of sales, leaving Joan with about a 5 percent bottom-line profit. As for the company’s balance sheet, inventory makes up the lion’s share of her current assets, which could translate into cash-flow problems down the line. Also, her company is financed with more debt than equity. That’s not uncommon for new businesses, but all of this debt is current, which could suck up all the current assets of the company.
Horizontal Analysis
The main point of performing a horizontal analysis on your financial statements is to see how things have changed from one period to the next. These changes are called trends in accounting lingo, and you can tell a lot about your company by the trends in its financial statements. In addition to that, it will help shine a light on numbers that should have changed by a certain amount but didn’t. For example, if your sales increased by 20 percent you would expect your gross profit to change by a similar amount.
The following example uses a two-year comparative statement of profit and loss. Look for the important trends and potential trouble spots.
Horizontal Analysis
Joan’s Colorful Kites Statement of Profit and Loss for the Years Ended 12/31/2004 and 12/31/2005
| 2005 Amount | 2004 Amount | Change in Dollars | Percent Change | |
|---|---|---|---|---|
| Sales | $ 18,000 | $ 15,000 | $ 3,000 | 16.67 % |
| Cost of Goods Sold | 7,000 | 6,000 | $ 1,000 | 14.29 % |
| Gross Profit | $ 11,000 | $ 9,000 | $ 2,000 | 18.18 % |
| Selling Expenses | ||||
| Advertising | $ 500 | $ 200 | $ 300 | 60.00 % |
| Commissions | 750 | 400 | $ 350 | 46.67 % |
| Delivery Fees | 1200 | 720 | $ 480 | 40.00 % |
| Salaries | 5000 | 5000 | $ - | 0.00 % |
| Total Selling Expenses | $ 7,450 | $ 6,320 | $ 1,130 | 15.17 % |
| General & Administrative Expenses | ||||
| Insurance | $ 800 | $ 800 | $ - | 0.00 % |
| Rent | 1200 | 1200 | $ - | 0.00 % |
| Depreciation | 200 | 200 | $ - | 0.00 % |
| Utilities | 400 | 280 | $ 120 | 30.00 % |
| Total General & Administrative Expenses | $ 2,600 | $ 2,480 | $ 120 | 4.62 % |
| Net Profit | $ 950 | $ 200 | $ 750 | 78.95 % |
First, Joan’s sales went up by about 17 percent, while her product costs went up by only around 14 percent. That helps add to her profitability on both sides—increased revenues and decreased costs. Most of her selling expenses increased as well, but that seems to have contributed to additional sales without increasing as much as sales did. Joan was also able to keep most of her general operating expenses under control, leading to much greater profits in 2005 than the company saw the prior year.