Financial Statement Analysis Methods: Horizontal vs. Vertical Analysis
Introduction
Financial statement information is used by both external and internal users, including investors,
creditors, managers, and executives. These users must analyze the information in order to
make business decisions, so understanding financial statements is of great importance. Several
methods of performing financial statement analysis exist. This article discusses two of these
methods: horizontal analysis and vertical analysis.
Horizontal Analysis
Methods of financial statement analysis generally involve comparing certain information. The
horizontal analysis compares specific items over a number of accounting periods. For example,
accounts payable may be compared over a period of months within a fiscal year, or revenue
may be compared over a period of several years. These comparisons are performed in one of
two different ways.
Absolute Dollars
One method of performing a horizontal financial statement analysis compares the absolute
dollar amounts of certain items over a period of time. For example, this method would compare
the actual dollar amount of operating expenses over a period of several accounting periods.
This method is valuable when trying to determine whether a company is conservative or
excessive in spending on certain items. This method also aids in determining the effects of
outside influences on the company, such as increasing gas prices or a reduction in the cost of
materials.
Percentage
The other method of performing horizontal financial statement analysis compares the
percentage difference in certain items over a period of time. The dollar amount of the change is
converted to a percentage change. For example, a change in operating expenses from $1,000 in
period one to $1,050 in period two would be reported as a 5% increase. This method is
particularly useful when comparing small companies to large companies.
(1050 – 1000)/1000 X 100 = 5%
Vertical Analysis
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The vertical analysis compares each separate figure to one specific figure in the financial

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.
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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.
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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).
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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.
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Financial Analysis revised
Page 8 of 54 pages. Chapter: 17: Module 3.4: Sensitivity Analysis of ICT Invest
Session 1: Building a Financial Analysis Model for ICT
Session Learning Outcome
The purpose of this session is to show how the different variables studied in this
course and other courses can affect the analysis of a project. In actual undertakings
of projects, there are micro and micro variables which affect overall project analysis.
Introduction
Sensitivity Analysis (SA) is the study of how the variation in the output of a model

4. Calculating the Overall risk index
Some projects may call for the calculation of the overall risk index for various
project components. These cutoff points may be based on sales, prices,
operating cots, etc.
The company may vary all the items by 62% favorable, given the risks index
consideration.
5. Judgment on Three point estimation
Telecommunication companies may judge their operations on three point
estimation based on the hours of access as follows:
o Business (peak) hours
E.g. From 0800hrs – 1800hrs
o Evening/Morning (off-peak) hours
E.g. from 0600hrs – 0800 hrs and from 1800hrs – 2200hrs.
o Night Hours
E.g 2200hrs-0600hrs
Various interconnection and charging rates are considered between three
different times as indicated above. Reasons may be due to the fact that the use
of bandwidth (which is paid even if not consumed) varies from the three time
zones indicated above.
Other considerations may be backed on the market responses and returns. The
returns for this case may be classified as:
• Most pessimistic
• Most likely
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Session 2: Ratio Analysis Techniques
Session Learning Outcome
Learners will understand and be appreciative on the use of the time series
analysis technique while analysing the financial statements information, its
application and interpretation
Important Learning Terms

3. It is compared with a standard of performance (industry average).
Such a standard may be either the ratio which represents the typical
performance of the trade or industry, or the ratio which represents the
target set by management as desirable for the business.
Types of Ratios
Note that throughout this section, ratios are derived from Exhibit one in
Session 1 of this chapter
A: Liquidity Ratios
• Liquidity refers to the ability of a firm to meet its short-term financial
obligations when and as they fall due.
• The main concern of liquidity ratio is to measure the ability of the firms
to meet their short-term maturing obligations. Failure to do this will
result in the total failure of the business, as it would be forced into
liquidation.
Current Ratio
The Current Ratio expresses the relationship between the firm’s current
assets and its current liabilities.
Current assets normally includes cash, marketable securities, accounts
receivable and inventories. Current liabilities consist of accounts payable,
short term notes payable, short-term loans, current maturities of long term
debt, accrued income taxes and other accrued expenses (wages).
The rule of thumb says that the current ratio should be at least 2, that is the
current assets should meet current liabilities at least twice.
What does the calculated ratio tells us? In 2000, the company only had 85
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cents worth of current assets for every dollar of liabilities. This grew to 92
cents in 2002 indicating increasing trend on liquidity, however the company
is still unable to support its short-term debt from its currents assets.
Quick Ratio
Measures assets that are quickly converted into cash and they are compared

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• An excessively long collection period implies a very liberal and
inefficient credit and collection performance.
• The delay in collection of cash impairs the firm’s liquidity. On the other
hand, too low a collection period is not necessarily favourable, rather it
may indicate a very restrictive credit and collection policy which may
curtail sales and hence adversely affect profit.
Inventory Turnover
This ratio measures the stock in relation to turnover in order to determine
how often the stock turns over in the business.
It indicates the efficiency of the firm in selling its product. It is calculated by
dividing he cost of goods sold by the average inventory.
The ratio shows a relatively high stock turnover which would seem to
suggest that the business deals in fast moving consumer goods.
• The company turned over stock every 24 days in 2000 and every 28
days in 2002.
• The trend shows a marginal increase in days which indicates a slow
down of stock turnover.
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• The high stock turnover ratio would also tend to indicate that there
was little chance of the firm holding damaged or obsolete stock.
Total Assets Turnover
Asset turnover is the relationship between sales and assets
• The firm should manage its assets efficiently to maximise sales.
• The total asset turnover indicates the efficiency with which the firm
uses all its assets to generate sales.
• It is calculated by dividing the firm’s sales by its total assets.
• Generally, the higher the firm’s total asset turnover, the more
efficiently its assets have been utilised.
Fixed Asset Turnover

The equity ratio is calculated as follows:
This indicates that only 32.1% of the total assets in 2002 is supplied by the
ordinary stockholders and this has shown a slight decrease from 32.8% in
2000.
• A high equity ratio reflects a strong financial structure of the company.
A relatively low equity ratio reflects a more speculative situation
because of the effect of high leverage and the greater possibility of
financial difficulty arising from excessive debt burden.
Debt Ratio
This is the measure of financial strength that reflects the proportion of
capital which has been funded by debt, including preference shares.
This ratio is calculated as follows:
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With higher debt ratio (low equity ratio), a very small cushion has developed
thus not giving creditors the security they require. The company would
therefore find it relatively difficult to raise additional financial support from
external sources if it wished to take that route. The higher the debt ratio the
more difficult it becomes for the firm to raise debt.
Debt to Equity ratio
This ratio indicates the extent to which debt is covered by shareholders’
funds. It reflects the relative position of the equity holders and the lenders
and indicates the company’s policy on the mix of capital funds. The debt to
equity ratio is calculated as follows:
• The debt to equity ratio shows that for every 1 dollar of shareholders
funds in 2002 there was 2.12 dollars of debt. This compares to 2.05
dollars in 2000. This ratio is extremely high and indicates the financial
weakness of the business.
Times Interest Earned Ratio
This ratio measure the extent to which earnings can decline without causing
financial losses to the firm and creating an inability to meet the interest cost.

(activity) and debt management (gearing) on operating results. The overall
measure of success of a business is the profitability which results from the
effective use of its resources.
Gross Profit Margin
• Normally the gross profit has to rise proportionately with sales.
• It can also be useful to compare the gross profit margin across similar
businesses although there will often be good reasons for any disparity.
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• The ratio above shows the increasing trend in the gross profit since the
ratio has improved from 15.2% in 2000 to 20.3% on 2002. This
indicates that the rate in increase in cost of goods sold are less than
rate of increase in sales, hence the increased efficiency.
Net Profit Margin
This is a widely used measure of performance and is comparable across
companies in similar industries. The fact that a business works on a very low
margin need not cause alarm because there are some sectors in the industry
that work on a basis of high turnover and low margins, for examples
supermarkets and motorcar dealers.
What is more important in any trend is the margin and whether it compares
well with similar businesses.
The net margin ratio shows that the margin is fairly stable over time with
slight improvement to 1.73% in 2001. However, to know how well the firm
is performing one has to compare this ratio with the industry average or a
firm dealing in a similar business.
Return on Investment (ROI)
Income is earned by using the assets of a business productively. The more
efficient the production, the more profitable the business. The rate of return
on total assets indicates the degree of efficiency with which management
has used the assets of the enterprise during an accounting period. This is an
important ratio for all readers of financial statements.

profitability. In your own words, analyse the trends in these ratios
and discuss the linkage between ROI and ROE.
2. How will the gross margin ratio assist you in determining the
profitability of a business?
3. In your own words, explain the calculation used for ROI.
4. When calculating EPS, explain how we should deal with
preference shares dividends.
E: Market Value Ratios
These ratios indicate the relationship of the firm’s share price to dividends
and earnings. Note that when we refer to the share price, we are talking
about the Market value and not the Nominal value as indicated by the par
value.
For this reason, it is difficult to perform these ratios on unlisted companies
as the market price for their shares is not freely available. One would first
have to value the shares of the business before calculating the ratios. Market
value ratios are strong indicators of what investors think of the firm’s past
performance and future prospects.
Dividend Yield Ratio
The dividend yield ratio indicates the return that investors are obtaining on
their investment in the form of dividends. This yield is usually fairly low as
the investors are also receiving capital growth on their investment in the
form of an increased share price. It is interesting to note that there is strong
correlation between dividend yields and market prices. Invariably, the higher
the dividend, the higher the market value of the share. The dividend yield
ratio compares the dividend per share against the price of the share and is
calculated as:
Notice a healthy increase in the yield from 2000 to 2002. The main reason
for this is that the dividend per share increased while at the same time, the
price of a share dropped.
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Dividend pay-out ratio
This ratio looks at the dividend payment in relation to net income and can be
calculated as follows:
Note: Even though the dividend yield has increased, the dividend payout
ratio has reduced, showing that a lower proportion of earnings was paid out
as dividend. The ratio has only reduced slightly, however, from 50.7% in
2000 to 49.4% in 2002. Generally, the low growth companies have higher
dividends payouts and high growth companies have lower dividend payouts.
Exercise:
1. In your own words, comment on the market value ratios in our
example. In your answer, assume the following industry average for
2002
Dividend yield: 3.2%
P/E Ratio: 12.8 times.
2. What is the purpose of calculating the market value ratio?
3. What actions can directors take to ensure a stable dividend yield
growth over time?
4. The P/E ratio indicates the premium an investor is prepared to
pay for a share. Discuss?
5. Explain what activities can cause the dividend payout ratio to
change.
Relationship Among Ratios
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