Principles of Financial Accounting: Financial Statement Analysis Horizontal Analysis YearoverYear and Vertical Analysis CommonSize Statements

What It Is

Horizontal analysis and vertical analysis are two financial statement analysis techniques used to evaluate a company's performance over time and in relation to industry benchmarks. Horizontal analysis involves comparing financial statement items from one year to the next, while vertical analysis involves expressing each item as a percentage of a base item, such as sales. For example, if a company's sales increased from $100,000 to $120,000 from one year to the next, the horizontal analysis would show a 20% increase in sales.

Key Concepts & Formulas

• Horizontal Analysis: A method of comparing financial statement items from one year to the next to evaluate a company's performance over time.
  Example: If a company's sales increased from $100,000 to $120,000, the horizontal analysis would show a 20% increase in sales.
• Vertical Analysis: A method of expressing each item on a financial statement as a percentage of a base item, such as sales.
  Example: If a company's sales are $100,000 and its cost of goods sold is $60,000, the vertical analysis would express cost of goods sold as 60% of sales.
• Common-Size Statements: Financial statements that express each item as a percentage of a base item, such as sales.
  Example: A common-size income statement would express each item as a percentage of sales.
• Gross Profit: Gross profit = Sales – Cost of Goods Sold (COGS) Example: If sales are $100,000 and COGS is $60,000, the gross profit would be $40,000.
• Gross Margin Ratio: Gross margin ratio = Gross profit / Sales Example: If gross profit is $40,000 and sales are $100,000, the gross margin ratio would be 40%.
• Debt-to-Equity Ratio: Debt-to-equity ratio = Total debt / Total equity Example: If total debt is $50,000 and total equity is $100,000, the debt-to-equity ratio would be 0.5.
• Return on Equity (ROE): ROE = Net income / Total equity Example: If net income is $20,000 and total equity is $100,000, the ROE would be 20%.

Journal Entry Examples

1. Horizontal Analysis: Increase in Sales

Dr. Sales $10,000
Cr. Cash $10,000

Explanation: The company sold $10,000 worth of merchandise, increasing sales.

1. Vertical Analysis: Increase in Cost of Goods Sold

Dr. Cost of Goods Sold $5,000
Cr. Inventory $5,000

Explanation: The company purchased $5,000 worth of inventory, increasing cost of goods sold.

1. Common-Size Statement: Increase in Net Income

Dr. Net Income $5,000
Cr. Retained Earnings $5,000

Explanation: The company earned $5,000 in net income, increasing retained earnings.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts.
   Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity.
2. Mistake: Not considering the normal balance of an account.
   Correction: Remember that assets have a normal debit balance, liabilities have a normal credit balance, equity has a normal credit balance, revenues have a normal credit balance, and expenses have a normal debit balance.
3. Mistake: Not using the correct formula for a ratio.
   Correction: Remember to use the correct formula for each ratio, such as gross profit = sales – COGS.

Exam Tips

1. Tip: When analyzing financial statements, remember to consider the normal balance of each account.
2. Tip: When calculating ratios, remember to use the correct formula and consider the normal balance of each account.
3. Tip: When preparing common-size statements, remember to express each item as a percentage of a base item, such as sales.

Quick Practice

1. Problem: A company's sales increased from $50,000 to $60,000 from one year to the next. What is the horizontal analysis of sales?

Answer: 20% increase in sales.
Explanation: The horizontal analysis involves comparing financial statement items from one year to the next.

1. Problem: A company's cost of goods sold is $30,000 and its sales are $100,000. What is the vertical analysis of cost of goods sold?

Answer: 30% of sales.
Explanation: The vertical analysis involves expressing each item as a percentage of a base item, such as sales.

1. Problem: A company's net income is $10,000 and its total equity is $50,000. What is the return on equity (ROE)?

Answer: 20%.
Explanation: The ROE is calculated by dividing net income by total equity.

Last-Minute Cram Sheet

1. Assets have a normal debit balance.
2. Liabilities have a normal credit balance.
3. Equity has a normal credit balance.
4. Revenues have a normal credit balance.
5. Expenses have a normal debit balance.
6. Gross profit = Sales – COGS.
7. Gross margin ratio = Gross profit / Sales.
8. Debt-to-equity ratio = Total debt / Total equity.
9. Return on Equity (ROE) = Net income / Total equity.
10. ⚠️ Dividends are NOT an expense – they go directly to retained earnings.