Let's begin today's lesson by discussing vertical analysis, which is used to evaluate financial statement items by expressing those items as a percent of a base amount.
Vertical analysis involves analyzing the relationship of each item on the financial statement to some base amount. So, for the balance sheet, for example, we will be expressing each item as a percentage of total assets. For the income statement, we will be expressing each item as a percent of net revenue.
We can use vertical analysis to evaluate how the percentages change over time:
Now let's look at an example of how we perform vertical analysis.
Note, the base amount is going to be our net sales, and we have two years to compare.
We're going to express all of these line items--sales returns and allowances, sales discounts, operating expenses, etc.--as a percentage of our base amount, which again, for the income statement, is our net sales.
Once we drop those figures in, below, if you look at the percentage column, you'll see that our base amount is our net sales, which represents 100%.
We're expressing all of these individual line items as a percentage of that base amount so that we can understand the relationship between these specific line items and that base amount.
For example, you can see that in 2011, our salaries expense was 25.9% of our net sales. In 2012, salaries expense went down slightly to 25.4% of net sales. Therefore, not only can we look at the relationship within one year, but we can also look at that changing relationship over time.
So, if we express all of these financial statement line items as a percentage of our total assets, we can understand the relationship between these individual lines and our base amount.
For instance, you can see that our inventory represents 21% of our total assets, and that our notes payable represents 38% of our total assets. Then, if you look at the next year, you can see that notes payable only represents 34%. Therefore, that composition is changing, which helps us to understand the relationship of that individual line item to our base amount.
Now that we've seen how to perform vertical analysis, let's turn our attention to horizontal analysis, which is used to evaluate percentage changes in financial statements from one period to another.
We are looking at the percentage changes within these individual financial statement items across periods, which helps us to analyze changes from one period to another. Now, not only can we express changes in percentages, but we can also express these changes in dollars, meaning we can see the percentage change of each line item as well as the dollar change of each of those financial statement items.
Again, this helps us to perform both internal and external comparisons, evaluating any internal changes within the company structure, or externally comparing ourselves to competitors, as well as industry standards.
Let's look at an example of performing horizontal analysis.
The first thing we can do is express those changes in dollar amounts so that we can see what the dollar increase or decrease is in these individual financial statement lines.
Now we can convert that increase or decrease amount to a percentage, to show us the percentage increase or decrease of these individual financial statement lines, to better understand how they are changing over time.
We can see, for instance, that our sales increased 10% from 2011 to 2012, and rent expense went up 20%. Again, this helps us to understand the changes that are taking place at the individual financial statement line item.
The first thing we do is express the change in dollar amounts, in this case, from 2011 to 2012. We want to know, from a dollar perspective, how these individual financial statement line items are changing.
As you can see, for example, cash increased $10,000 and notes payable went down $25,000.
Next we can convert increase or decrease in dollars to a percentage, to increase our understanding of what changes are taking place.
For instance, supplies went up 20% and unearned revenues also went up by 33%. Sales tax payable went up 10%, which makes sense if you think back to our income statement, because our sales were increasing.
Source: Adapted from Sophia instructor Evan McLaughlin.