For instance, a large increase in Sales returns and allowances coupled with a decrease in Sales over two years would be cause for concern. If this is the case, you need to address and solve the problem or the company’s reputation and future may be at stake. Besides analyzing the past performance, analysis helps determine the strategy of a company moving forward. Peggy James is a CPA with over 9 years of experience in accounting and finance, including corporate, nonprofit, and personal finance environments.

Likewise, a high percentage rate indicates the need to improve the use of Assets. Horizontal Analysis – analyzes the trend of the company’s financials over a period of time.

Horizontal Analysis

The amount and percentage differences for each line are listed in the final two columns, respectively. A total of $560 million in selling and operating expenses, and $293 million in general and administrative expenses, were subtracted from that profit, leaving an operating income of $765 million. To this, additional gains were added and losses were subtracted, including $257 million in income tax. To perform vertical analysis (common-size analysis), we take each line item and calculate it as a percentage of revenue so that we can come up with “common size” results for both companies. Studying the percentages in Column could lead to several other observations. For instance, the 6.9 per cent decrease in long-term debt indicates that interest charges will be lower in the future, having a positive effect on future net income.

• This enables you to easily spot growth trends as well as any red flags that may need to be addressed.
• In order to perform a reasoned analysis and interpretation, it is imperative that the user is aware of the limitations of the financial information that he/she is analysing.
• A good way to do some ratio and trend analysis work is to prepare both horizontal and vertical analyses of the income statement.
• Keeping a higher level of inventory on hand involves higher storage costs and insurance costs and, statistically, there is a higher risk of theft.
• This makes it easier to spot inefficiencies and specific areas of underperformance.

For instance, a manager might compare cost of goods sold and profit margin over a two or three-year span to see how efficient the company is becoming. This comparison of income statements will give the manager not only a benchmark for future performance; it will also help him understand what needs to be changed in the future. Since, any line item in a financial statement or financial ratio can be compared across a period of time, it makes the horizontal analysis extremely useful for anyone trying to track a company’s performance over time. Vertical analysis, also called common-size analysis, focuses on the relative size of different line items so that you can easily compare the income statements and balance sheets of different sized companies. You can carry out the analysis of financial statements using many methods. Two popular methods that cover different needs are horizontal and vertical analysis. Vertical analysis, on the other hand, focuses on a specific period of time and studies the proportions of the total amount represented by the different variables for that period.

Company Financial Statement Analysis & Interpretation of Financial Statements

Financial analysis of an income statement can reveal that the costs of goods sold are falling, or that sales have been improving, while return on equity is rising. Income statements are also carefully reviewed when a business wants to cut spending or determine strategies for growth. Because of this, horizontal analysis is important to investors and analysts. By conducting a horizontal analysis, you can tell what’s been driving an organization’s financial performance over the years and spot trends and horizontal analysis growth patterns, line item by line item. Ultimately, horizontal analysis is used to identify trends over time—comparisons from Q1 to Q2, for example—instead of revealing how individual line items relate to others. Vertical analysis refers to the method of financial analysis where each line item is listed as a percentage of a base figure within the statement. This means line items on income statements are stated in percentages of gross sales, instead of in exact amounts of money, such as dollars.

Horizontal, or trend, analysis is used to spot and evaluate trends over a specific period of time. For example, an analyst may get excellent results when the current period’s income is compared with that of the previous quarter. However, the same results may be below par when the base year is changed to the same quarter for the previous year. No company lives in a bubble, so it is also helpful to compare these results with those of competitors to determine whether the problem is industry-wide, or just within the company itself.

What’s the Purpose of an Income Statement?

Columns and in Exhibit 134 show the dollar amounts for the years 2010 and 2009, respectively. Then examine Columns and which show the horizontal analysis that would be performed on the company’s comparative statements of income and retained earnings. Columns and show the absolute and percentage increase or decrease in each item from 2009 to 2010. The absolute change is determined by deducting the 2009 amount from the 2010 amount. If the change between two dates is an increase from 2009 to 2010, the change is a positive figure.