Session 1: Vertical and Horizontal Analysis Technique

Session Learning Outcomes
Learners will understand and be appreciative on the use of the horizontal and vertical analysis technique while analyzing the financial statements information, its application and interpretation.

Important Learning Terms

• Financial analysis
• Horizontal financial statements analysis
• Vertical financial statements analysis
• Cross sectional financial statement analysis

Introduction

Financial analysis: is a process which involves reclassification and summarization of information through the establishment of ratios and trends.

Analysis of financial statement: Refers to the examination of the statements for the purpose of acquiring additional information regarding the activities of the business.
The users of the financial information often find analysis desirable for the interpretation of the firm’s activities.

Note: The financial statement to be used for the purpose of analysis should be the audited ones. The audited financial statements give the analyst the auditor’s statement as to whether the records represent a fair view of the company’s affairs.

The Objectives of Financial Statement Analysis
The overall objective of financial statement analysis is the examination of a firm’s financial position and returns in relation to risk. This must be done with a view to forecasting the firm’s future prospective.
For the purpose of understanding, the following financial statements will be used.

A: Horizontal Financial Statement Analysis
This technique is also known as comparative analysis.
It is conducted by setting consecutive balance sheet, income statement or statement of cash flow side-by-side and reviewing changes in individual categories on a year-to-year or multiyear basis. The most important item revealed by comparative financial statement analysis is trend.
A comparison of statements over several years reveals direction, speed and extent of a trend(s). The horizontal financial statements analysis is done by restating amount of each item or group of items as a percentage.

Such percentages are calculated by selecting a base year and assign a weight of 100 to the amount of each item in the base year statement. Thereafter, the amounts of similar items or groups of items in prior or subsequent financial statements are expressed as a percentage of the base year amount. The resulting figures are called index numbers or trend ratios. From the balance sheet statement in exhibit 1. The following indexed balance sheet can be established.

As basis of Analysis, the analyst may seek variables which seem to improve or deteriorate and bring a challenge to the stakeholders in their various decisions. Example from the previous table one can ask the following questions?

• Why is there an increase in the stock of the company? Has the company changed its inventory policy?
• Why did taxation increase so tremendously? Were there any changes in taxation? Is it reflected by the increase in sales? Profit?
• Why is there an increase in the fixed assets and at the same time decrease in the long-term debt? How were these assets financed?
• And many more question which can be elaborated by the management or which can be used as the basis for discussions.

Individual Assignment 1:
From the Exhibit 1, prepare horizontal analysis for the income statement of TeleTalk (T) Ltd and comment on the relevant changes. Associate the comments from the balance sheet and income statement you have established, what is your general comment on the company undertakings in the past three years of operation.

B: Vertical/Cross-Sectional/Common Size Analysis Techniques
Vertical/Cross-sectional/Common size statements came from the problems in comparing the financial statements of firms that differ in size.

• In the balance sheet, for example, the assets as well as the liabilities and equity are each expressed as a 100% and each item in these categories is expressed as a percentage of the respective totals.
• In the common size income statement, turnover is expressed as 100% and every item in the income statement is expressed as a percentage of turnover (sales).

From the vertical analysis above, an analyst can compare the percentage mark-up of asset items and how they have been financed. The strategies may include increase/decrease the holding of certain assets. The analyst may as well observe the trend of the increase in the assets and liabilities over several years.

Example: It can be observed that there is an increase in the holding of the current assets of the company. The management can seek the reasons of why the holding of these assets is continuing increasing.

Exercise 2:

From the Exhibit 1, prepare vertical analysis for the income statement of TeleTalk (T) Ltd and comment on the relevant changes. Associate the comments from the balance sheet and income statement you have established, what is your general comment on the company undertakings in the past three years of operation.