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 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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