This lesson introduces the fundamental analytical techniques used to evaluate financial statements. It covers horizontal analysis (trend analysis) and vertical analysis (common-size analysis), explaining their application and limitations.

 

  • Horizontal Analysis (Trend Analysis): Horizontal analysis involves comparing financial data across multiple periods to identify trends and growth patterns. It calculates the percentage change in each line item from a base year or period . This technique helps answer questions such as: “Is revenue growing?”, “Are expenses increasing faster than revenue?”, and “Are there significant changes in asset or liability composition over time?” Horizontal analysis can also be applied to ratios and other metrics.

  • Application of Horizontal Analysis: A horizontal common-size balance sheet divides the quantity of each item by a base year quantity of the same item to yield a percentage change in that item from the base year . Trend data generated by horizontal analysis can be compared across financial statements to identify patterns.

  • Vertical Analysis (Common-Size Analysis): Vertical analysis expresses each line item of a financial statement as a percentage of a single base item in the same period. This standardises the data, allowing for meaningful comparisons between companies of different sizes and for a single company over time.

    • Vertical Common-Size Balance Sheet: Each balance sheet item is divided by total assets, showing the composition of the company’s resources and financing sources.

    • Vertical Common-Size Income Statement: Each income statement item is divided by revenue (or total assets), showing the relative proportion of each expense and the profit margins.

  • Uses and Limitations of Horizontal and Vertical Analysis: These techniques are essential tools for financial analysis. They:

    • Provide insights into the underlying structure and trends of a business.

    • Enable comparison across companies and industries.

    • Help identify unusual items or red flags that warrant further investigation .

 
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