When preparing financial projections a start-up business needs to undertake horizontal and vertical financial statement analysis of competitors and make common size comparisons of industry data in order to confirm the reliability of assumptions on which the projections are based.
In addition when the business starts to trade and produce its own financial statements the ability to undertake an analysis of the numbers will help management to understand and gain control of the business allowing appropriate decisions to be made about the future direction of the venture.
Horizontal Analysis of Financial Statements
Horizontal financial statement analysis is used to identify trends such as whether revenue is increasing or decreasing each year.
The analysis can be carried out over any number of successive accounting periods and shows changes in both the monetary amount and percentage of each line item of the financial statement. The percentages are normally calculated in relation to the earliest year known as the base year.
The horizontal analysis or trend analysis formula can be stated as follows.
Percentage change = Change in monetary amount / Base year monetary amount
So for example if revenue for year 1 was 120,000 and revenue for year 2 was 145,000, then the percentage change using year 1 as the base year is calculated as follows.
Revenue year 1 = 120,000 (base year) Revenue year 2 = 150,000 Change in amount = 150,000 - 120,000 = 30,000 Base year amount = 120,000 (year 1) Percentage change = Change in amount / Base year amount Percentage change = 30,000 / 120,000 = 25%
Revenue for year 2 has increased by 30,000 or 25% in relation to the revenue of year 1.
It should be noted that horizontal financial statement analysis compares changes between accounting periods.
Horizontal Analysis Example
Horizontal analysis can be applied to any of the three financial statements but is more often seen applied to the income statement as shown in the example below.
| Year 2 | Year 1 | Change | % | |
|---|---|---|---|---|
| Revenue | 65,000 | 50,000 | 15,000 | 30 |
| Cost of sales | 24,800 | 20,000 | 4,800 | 24 |
| Gross profit | 40,200 | 30,000 | 10,200 | 34 |
| Expenses | 24,000 | 15,000 | 9,000 | 60 |
| Net income | 16,200 | 15,000 | 1,200 | 8 |
In this example year 1 is used as the base year and changes between year 1 and year 2 are shown in terms of monetary amounts and percentages for each line item. The percentages are calculated using the horizontal analysis formula, for example the cost of sales line item is calculated as follow.
Cost of sales year 1 = 20,000 Cost of sales year 2 = 24,800 Change in amount = 24,800 - 20,000 = 4,800 Base year amount = 20,000 (year 1) Percentage change = Change in amount / Base year amount Percentage change = 4,800 / 20,000 = 24%
Between year 1 and year 2 cost of sales increased by 4,800 or 24%.
This horizontal analysis example shows that revenue has increased by 30% but a smaller increase in cost of sales of 24% results in the gross profit increasing by 34%. A significant increase in operating expenses of 60% reduces the overall increase in net income to 8%.
By adding additional successive years (year 3, year 4 etc.) to the analysis and comparing these to the same base year (year 1) a trend will emerge which allows management to identity the problem areas of the business and to take action to correct them. In addition the trend identified can be used as a basis for updating the financial projections.
Vertical Analysis of Financial Statements
Vertical financial statement analysis is used to show the relationship each line item has to a selected base line item. For example operating expenses might be expressed as a percentage of revenue.
The vertical analysis formula can be stated as follows.
Percentage = Monetary amount / Base line item monetary amount
So for example if for year 1 revenue was 145,000 and wage expenses were 29,000, then the vertical analysis percentage using revenue as the base line item is calculated as follows.
Revenue = 145,000 (base line item) Wages expenses = 29,000 Percentage = Amount / Base line item amount Percentage = 29,000 / 145,000 = 20%
Wages for year 1 are 20% of the revenue for the same year.
It should be noted that the vertical analysis calculations are carried out on information from one accounting period.
By representing each line item relative to a common base vertical analysis can be used to compare the financial statements of the business to those of competitor businesses and industry average data. For this reason vertical financial statement analysis is sometimes referred to as common size analysis.
By repeating the calculations vertical analysis can be used to compare the financial statements of the business for different accounting periods allowing trends to be identified.
Vertical analysis compares information to a common base line item. For this reason is also known as common size analysis.
Vertical Analysis Example
Vertical financial analysis can be applied to any of the three financial statements but again is more often seen applied to the income statement on which the example below is based.
Year 2
Using the same information from the horizontal financial statement analysis shown above, the vertical financial statement analysis for year 2 would be shown as follows.
| Year 2 | % | |
|---|---|---|
| Revenue | 65,000 | 100 |
| Cost of sales | 24,800 | 38 |
| Gross profit | 40,200 | 62 |
| Expenses | 24,000 | 37 |
| Net income | 16,200 | 25 |
In this example revenue is used as the base line item and all other line items are expressed as a percentage of revenue. For example the vertical financial statement analysis for the cost of sales line item is calculated using the formula as follow.
Revenue = 65,000 (base line item) Cost of sales = 24,800 Percentage = Amount / Base line item amount Percentage = 24,800 / 65,000 = 38.2%
In year 2 cost of sales represents 38% of revenue.
The vertical analysis in this example shows that after cost of sales of 38% the gross profit of the business is 62% of revenue which after deducting operating expenses of 37% leaves the business with a net income of 25% of revenue.
Year 1
By undertaking a similar vertical analysis for additional years the business can spot trends in each line item. For example an analysis for year 1 shows the following.
| Year 1 | % | |
|---|---|---|
| Revenue | 50,000 | 100 |
| Cost of sales | 20,000 | 40 |
| Gross profit | 30,000 | 60 |
| Expenses | 15,000 | 30 |
| Net income | 15,000 | 30 |
Clearly the gross profit as a percentage of revenue has improved from year 1 (60%) to year 2 (62%). However, the rise in operating expenses from 30% of revenue to 37% of revenue results in a fall in the net income from 30% down to 25% of revenue.
Similar comparisons can now be made with competitor financial statements and industry averages to identify corrective actions that need to be made.
In addition information gleaned from the vertical financial statement analysis such as the gross profit margin can now be used to update the financial projections.
Financial Statement Analysis Summary
Financial statement analysis is an important part of the management of a business. Both vertical and horizontal analysis allow a business to spot trends in the numbers and to make common size comparisons to competitor businesses and industry averages. The process gives advance warnings to management that corrective action may be needed and helps identify changes in the important drivers of the business allowing the financial projections to be updated.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.