MEANING:-

Analysis and interpretation of financial statements are an attempt to determine the

significance and meaning of the financial statement data so that a forecast may be
made of the prospects for future earnings, ability to pay interest, debt maturities, both
current as well as long term, and profitability of sound dividend policy.
The main function of financial analysis is the pinpointing of the strength and
weaknesses of a business undertaking by regrouping and analysis of figures
contained in financial statements, by making comparisons of various components
and by examining their content. The analysis and interpretation of financial
statements represent the last of the four major steps of accounting.

A business owner can use several methods to check the financial health of the
business. Three of the most used methods are:

Horizontal Analysis – analyzes the trend of the company’s financials over a period of
time.
Each line item shows the percentage change from the previous period.

Analysis of Financial Statements determines the strength of a business and where

there is room for improvement.

Without analysis, a business owner may make mistakes understanding the firm’s
financial condition. Resulting in poor rather than strong decision- making. For
example, an Assets to Sales ratio is a measure of a firm’s productive use of Assets.
Whereas a low percentage rate compared to the average for the industry usually
indicates an efficient use of Assets. Likewise, a high percentage rate indicates the
need to improve the use of Assets. Check out our blog post on Ratio Analysis.

The following sections give a detail explanation of Vertical and Horizontal analysis:
Horizontal Company Financial Statement Analysis
With a Horizontal Analysis, also, known as a “trend analysis,” you can spot trends in
your financial data over time.

For example, a $2 million profit year looks impressive following a $0.25 million profit
year, but not after a $10 million profit year.
Horizontal analysis stresses the trends in:
Earnings Assets Liabilities
1. Financial Statements often contain current data and the data of a previous period.
This way, the reader of the financial statement can compare to see where there was
change, either up or down.
2. Horizontal Analysis takes this comparison goes one step further. It depicts the
amount of change as a percentage to show the difference over time as well as the
dollar amount.
3. The following illustration depicts a Horizontal Analysis:
4. Note that the line-items are a condensed Balance Sheet and that the amounts are
shown as dollar amounts and as percentages and the first
year is established as a baseline.
5. A baseline is established because a financial analysis covering a span
of many years may become cumbersome. It would require the arrangement and
calculation of interlinked numbers and dates.

Particularly, interlinks among the numbers make financial analysis tiresome and
complex for a typical businessperson. A solution is to create Comparative Financial
Statements, which depicts the results of Horizontal Analysis and show the trends
relative to only one base year. The baseline acts as a peg for the other figures while
calculating percentages.

1. For example, in this illustration, the year 2012 is chosen as a representative year
of the firm’s activity and is therefore chosen as the base. Each account of the
baseline year is assigned an index of 100%.
Once the baseline is established, the percentage of each respective account is
found by:

1. Subtracting the previous year amount from the current year amount
2. Dividing the account’s amount by the previous year amount
3. Multiplying by 100 to derive the percentage.

For example, if we let 2012 be the base year in the Balance Sheet of Learning
Company, Current Assets would be given an index of 100%.
Then for 2013, to derive the percentage of change, we look at each line item: In this
case,
Current Assets for 2013 are $210,000 subtract the baseline amount of $100,000:
$210,000 – $100,000 = $110,000
Determines the difference of $110,000.
Divide this difference by the baseline amount, so $110,000 / $100,000 = 1.1
Multiply by 100 to calculate the percentage: 1.1*100 = 110%
And we can see that Current Assets grew by 110% from 2012 to 2013.
To calculate 2014, we DO NOT go back to the baseline to do the calculations;
instead, 2013 becomes the new baseline so that we can see percentage growth from
year-to-year.
In our illustration,
The calculation to determine the Current Assets 2014 percentage change becomes:
$463,000 – $210,000 = $253,000
Determines the difference of 253,000.
Divide this difference by the baseline amount, so
$253,000 / $210,000 = 1.2
Multiply by 100 to calculate the percentage:
1.1*100 = 120%
And we can see that Current Assets grew by 120% from 2013 to 2014.
We need to perform 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%

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

Vertical Analysis – compares the relationship between a single item on the Financial
Statements to the total transactions within one given period.
It also shows the percentage of change since the last period.
You can perform a Vertical Analysis on both an Income Statement and a Balance
Sheet.
The following illustration depicts a Vertical Analysis of an balanced Sheet::-
Table

The following illustration depicts a Vertical Analysis of an Income statement::-

Table

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 with the sales for that year,
the common size analysis of the income statement of the
Company will look like:
Year 1 Year 2 Year 3

Sales 100% 100% 100%

Cost of Goods Sold 29% 32% 34%

Gross Profit 71% 68% 66%

 Year 1 Year 2 Year 3

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, the
comparison between the line items over the years is easy.

 The Gross Profit of the Company grew in dollar terms, but the gross
profit % dropped over the years. This 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.