Financial Analysis Definition

Financial analysis refers to an analysis of finance-related

projects/activities or a company’s financial statements, which includes a
balance sheet, income statement, and notes to accounts or financial
ratios to evaluate the company’s results, performance, and its trend,
which will be useful for taking significant decisions like investment and
planning projects and financing activities. After assessing the company’s
performance using financial data, a person presents findings to the top
management of a company with recommendations about how it can
improve in the future.
Top 15 Most commonly used financial analysis techniques are listed
below –

 #1 – Vertical Analysis
 #2 – Horizontal Analysis
 #3 – Trend Analysis
 #4 – Liquidity Analysis
 #5 – Turnover Ratio Analysis
 #6 – Profitability Analysis
 #7 – Business Risk Analysis
 #8 – Financial Risk Analysis
 #9  – Stability Ratios
 #10 – Coverage Analysis
 #11 – Control Analysis
 #12 – Valuation Analysis
 #13 – Variance Analysis
 #14 – Scenario & Sensitivity Analysis
 #15 – Rate of Return Analysis
#1 – Vertical Analysis

Vertical Analysis is a technique to identify how the company has

applied its resources and in what proportion its resources are
distributed across the income statement and the balance sheet. In the
case of the Income Statement, each element of income and
expenditure is defined as a percentage of total sales. The assets,
liabilities, and shareholder’s equity are represented as a percentage of
total assets.

Vertical Analysis of Colgate’s Income

Statement
Let us see the example of vertical analysis of Colgate’s Income
Statement. In the below snapshot, we have divided each income
statement line item by Net Sales from 2007 to 2015.

Interpretation

 The cost of Sales has been in the range of 41%-44% historically.

It implies that Colgate’s gross profit margin has been around
56% to 59%.
 There has been a decreasing trend in Selling General and
administrative expenses from 36.1% in 2007 to 34.1% in the
year ending 2015.
 We also note that Operating income dropped significantly in
2015 to 17.4%.
 The corresponding net income also decreased to 8.6% in 2015.
 Effective tax rates jumped to 44% in 2015.
Examples of Vertical Analysis of Income Statement

Let’s see some examples of vertical analysis of an income statement to

understand it better.

Example #1
Consider the following example of an income statement of the XYZ
Company:

Year 1 Year 2 Year 3

Sales $3,50,000 $4,25,000 $5,00,000

Cost of Goods Sold $1,00,000 $1,35,000 $1,70,000

Gross Profit $2,50,000 $2,90,000 $3,30,000

Salaries $95,000 $98,000 $1,00,000

Rent and Utilities $30,000 $35,000 $40,000

Marketing $20,000 $25,000 $30,000

Other Expenses $10,000 $12,000 $15,000

Total Expenses $1,55,000 $1,70,000 $1,85,000

Net Income $95,000 $1,20,000 $1,45,000

If we divide each line item for the year by the sales for that year, the
common size analysis of the income statement of the Company will
look like this:
Year 1 Year 2 Year 3

Sales 100% 100% 100%

Cost of Goods Sold 29% 32% 34%

Gross Profit 71% 68% 66%

Salaries 27% 23% 20%

Rent and Utilities 9% 8% 8%

Marketing 6% 6% 6%

Other Expenses 3% 3% 3%

Total Expenses 44% 40% 37%

Net Income 27% 28% 29%

Interpretation

By converting each number by the sales number for the year,

comparing the line items over the years is easy.

 The Company’s Gross Profit grew in dollar terms, but the gross
profit % dropped over the years. It shows that the cost of the raw
 materials and goods has increased and is not in line with the
increase in sales.
 The salaries of the employees have decreased over the years.
 Rent and utilities, marketing, and other expenses have remained
more or less constant as a percentage of the sales.
 The net income has increased by about 1% every year.

Example #2
Let us look at another example: the income statement of Apple Inc.
Source: Apple SEC filings

If we convert the above into common size analysis of income

statement, it will look like the following:

Vertical Analysis of Income Statement Interpretation

 All the numbers are more or less the same, with a difference of
1%-2% over the years.
 The net income of the Company has increased from 2016 to
2018 by 1.5%
  The Company’s expense on research and development has
increased by nearly 1% as a percentage of net sales

Advantages
 Easy to Understand and Interpret: Vertical analysis of income
statements is easy to understand and interpret. After converting
the numbers on each line item into a percentage of sales, the
analyst can compare them and analyze the performance of the
Company better.
 Time Series Analysis: It helps in doing a time series analysis of
the various line items like the expenses, employee salary, gross
profit, operating profit, and net profit.
 Analysis can be done by looking at the common size sheet in
one go. Since all the numbers are available as a percentage of
the sales, the analysts can easily analyze the details of the
Company’s performance.
 Help in Analyzing Structural Composition: A common size
analysis of the income statement helps in analyzing and
ascertaining changes to any structural components of the
income statement, i.e., the salary expense, marketing expense,
depreciation, and amortization expense.

Limitations
 No standard ratios: Since all the line items are divided by the
common sales number, there is no standard financial
ratio (except for profit margins) in the vertical analysis of the
income statement. Hence, it may not be easy to make any
decision based on such analysis and looking at the change in the
percentage of various income statement components.
  Change in price-level/inflation: Vertical analysis of income
statements does not consider the change in the price level or
inflation effects. Sales numbers may be inflated every year due to
inflation, but this is not considered as the numbers are not
adjusted for inflation costs.
 Accounting principle consistency: If the accounting principles
used are not the same year on year, then the income statement’s
vertical analysis is useless until it is adjusted for the changes and
made comparable year on year.
 Seasonal fluctuation: If the Company is involved in the sales of
items that are seasonal, then the vertical analysis may not be
helpful. The seasonal fluctuations cause variation in the
sales cost of goods sold; thus, the numbers may not be
comparable from one period to another.
 Window dressing: Window dressing or using accounting
principles in favor of the Company cannot be recognized easily in
the vertical analysis of the income statement. Such effects render
the analysis useless.
 Qualitative analysis: It provides only quantitative analysis and
does not consider qualitative measures taken by the Company
like new marketing techniques etc.

Conclusion
Vertical Analysis of the income statement shows the revenue or sales
number as 100% and all other line items as a percentage of sales. All
the line items in a vertical analysis are compared with another line
item on the same statement; in the case of an income statement, it is
revenue/net sales.

The common size or vertical analysis of the income statement is the

statement where each line item is expressed as a percentage of sales.
Comparing each number becomes easier when compared as a
percentage of sales/revenue. While such an analysis is helpful for the
analysts to compare the company’s performance over the years or two
Companies in the same sector and line of business, it has its
limitations. Thus, the analysis should consider the limitations of the
vertical analysis of the income statement while comparing and
inferring the results.

#2 – Horizontal Analysis

In Horizontal Analysis, the company’s financial statements are made to

review for several years, and it is also called a long-term analysis. It is
useful for long-term planning and compares figures of two or more
years. Here we find out the current year’s growth rate compared to the
previous year to identify opportunities and problems.
 Horizontal Analysis Example
Let us assume that we are provided with the income statement data of
ABC Co. We need to perform a horizontal analysis of the income
statement of this company.

Details 2016 (In US $) 2015 (In US $) Amount Percentage

Sales 30,00,000 28,00,000 200,000 * 7.14% **

(-) Cost of Goods Sold(COGS) (21,00,000) (20,00,000) 100,000 5%

Gross Profit 900,000 800,000 100,000 12.50%

General Expenses 180,000 120,000 60,000 50%

Selling Expenses 220,000 230,000 (10,000) (4.35%)

Total Operating Expenses (400,000) (350,000) 50,000 14.29%

Operating Income 500,000 450,000 50,000 11.11%

Interest expenses (50,000) (50,000) § §

Profit before Income Tax 450,000 400,000 50,000 12.50%

Income Tax (125,000) (100,000) 25,000 25%

Details 2016 (In US $) 2015 (In US $) Amount Percentage

Net Income 325,000 300,000 25,000 8.33%

The following is a basic example of dividing our approach into two

parts. First, we found the absolute difference between the comparative
years.

 For example, change in sales = (30,00,000 – 28,00,000) = 200,000

 We find the percentage change = 200,000/28,00,000 * 100 =
7.14%.

Likewise, we can do the same for all the other entries in the income
statement.

Uses in Financial Modeling

Horizontal analysis is very useful for Financial Modeling and
Forecasting. The approach used here is pretty simple.

 Step 1 – Perform the horizontal analysis of the income statement

and balance sheet historical data.
 Step 2 – You can assume future growth rates based on the YoY
or QoQ growth rates.
#3 – Trend Analysis

Trend analysis involves collecting the information from multiple

periods and plotting the collected information on the horizontal line
to find actionable patterns from the given information.