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# Vertical and Horizontal Analysis by Michele Cagan, C.P.A.

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 percentage of net sales.

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.

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.

## 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.

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#### THE EVERYTHING ACCOUNTING BOOK

By Michele Cagan, C.P.A.

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