Financial analysis seeks to read between the lines of companies’ financial statements. Every company is legally obliged to make their financial statements publicly available, but they can choose to bury bad news in different categories of data. The financial statements contain two important documents called the Balance Sheet and the Profit and Loss Account. Analysts pick the data from these documents to form the basis of their assessment. The techniques they use fall into two categories: vertical and horizontal.
The figures on the Balance Sheet show the company’s accumulated value. It includes the amount of money the shareholders have invested in the company and shows the amount of cash it holds. The Profit and Loss Account details the company’s turnover and what its costs were in a year. All of these are interesting figures, but the information in any given year has to be mixed together and compared in order to get a true picture. For example, a company that made two million pounds in a year looks good, but if it invested three million pounds to get that result then something has gone wrong within the company. Vertical analysis compares the figures in the results of a company against each other.
A company’s performance cannot be judged by one year’s data. Its current profit may have been a fluke. It is necessary to compare the current year’s performance with that of previous years in order to forecast where the company’s results will head next year. This is important because it enables analysts to predict future share prices and find companies that look like good investments. This is a horizontal analysis – the same figures from several years appearing on the company’s financial statements are compared to see if a trend in performance is developing.
A key purpose in horizontal analysis is the use of historical data to predict future performance. This will affect the share price because investors buy into a company on the basis of the profit they expect to make in the future. The forecast formed by horizontal analysis is also a good yardstick by which to measure a company’s management. If a company’s board of directors fails to achieve the projected profits, the shareholders may choose to vote them off the board. Profit projections are also used to set the bonuses of directors. Vertical analysis identifies how well a company is using its resources. It shows the return on investment and can highlight problems with costs and margins.
Vertical analysis is more useful to a company’s management team. The horizontal analysis can set a goal for profitability, but the vertical analysis can highlight areas where performance could be improved. Both horizontal and vertical analysis can be further enhanced by comparing the company’s performance to the same metrics derived from the financial statements of other companies in the same industry sector. This shows the management team what results are achievable and which factors could attract investors away to rival companies.