25 Vertical Vs Horizontal and Internal Vs External Financial Analysis

Deepika Gautam

LEARNING OBJECTIVES:

The primary objective of financial analysis is to assess the performance of a firm. This module outlines a comprehensive framework for financial statement analysis because financial statements provides the most widely data on public corporations’, economic activities, investors and other stakeholders rely on financial reports to access the plans and performance of firms and corporate managers. The objective of this module is to extract the information relating to financial statements and to know how the various techniques like trend analysis, common size statements and comparative statements used to determine the financial position and results of operations. An effort is made to brief various tools which helps in analyzing the position of an enterprise. After studying this module a student may able to distinction between income statement and the balance sheet that the income statement is for a period and the balance sheet indicates the financial position on a particular date.

INTRODUCTION:

The goal of financial analysis is to use financial data to evaluate the current and past performance of a firm and to access is sustainability. There are two important skills related to financial analysis. First, the analysis should be systematic and efficient. Second, the analysis should allow the analyst to use financial data to explore business issues. There are various methods or techniques used to study the relationship between different statements. The two methods of analyzing financial statements depending upon following factors like:

(i)                 The material used

(ii)               The method of operation

TOOLS AND TECHNIQUES USED IN FINANCIAL STATEMENT ANALYSIS

Very few numbers in financial statements are significant in themselves. But we can draw meaningful inferences from their relationship to other amounts or their change from one period to another. The various tools of financial statement analysis help in establishing significant relationships and changes. Financial Statements indicate certain absolute information about assets, liabilities, equity, revenue and expenses of an organization. They are not readily understandable to the external users so analyst need to adopt various tools and techniques to make it useful to the third parties. A financial analyst can adopt the following tools and techniques for analysis of the financial statements:

(i)                 Comparison of Financial Statements

(ii)               Common Size Financial Statements

(iii)             Trend percentages

(iv)             Ratio Analysis

(v)               Fund Flow Statement

(vi)             Cash Flow Statement

Types of Financial Analysis

   When Criteria is: Material

When Criteria is modus operandi

     External Analysis

Horizontal Analysis

    Internal Analysis

Vertical Analysis

When Criteria is: Material

According to material used, financial analysis can be of two types which are discussed as follows:

Ø  External Analysis: This analysis is done on the basis of data published by outsiders such as, stock holders, banks, creditors, and the general public. The external analysis serves only a limited purpose. However, the recent changes in the company regulations in which it is mandatory as per company act1956 to makes available more detailed information to the public through audited published accounts have considerably improved the position of the external analysis.

Ø  Internal Analysis: This analysis is operated by the persons of the organization within. In other words internal analysis is done by persons who have access to the internal accounting records of a business firm. Such analysis can, therefore, be performed by executives and employees of the organization as well as government agencies which have statutory power vested in them. The objective of such analysis is to provide the information to the top management so that effective decision can be taken and financial position of the firm can be improved.

When Criteria is: Modus Operandi

The financial analysis can also be of two types when the criteria are Modus Operandi:

1.  Horizontal Analysis: Comparison of financial data of a company for several years is the concept of Horizontal Analysis refers. It is also considered as a simple approach to financial statement analysis. Horizontal analysis spotlights trends and establishes relationships between items that appear on the same row of a comparative statement thereby disclosing changes on items in financial statements over time. Horizontal analysis can also be considered as Dynamic Analysis because dynamic analysis is based on the data from year to year rather than on data of any one year. This analysis makes it possible to focus attention on items that have changed significantly during the period under review. The best examples of horizontal analysis are comparative financial statements and trend percentages, as it involves analysis of financial statements for a number of years.

(i) Comparative Financial Statements: These statements for different period of time are known as comparative financial statement. It is an important to compare the financial statement of two years to draw conclusion and this statement serve the purpose. Being a technique of horizontal analysis and applicable to both financial statements, income statement and balance sheet, it provides meaningful information when compared to the similar data of prior periods. The comparative statement of income statements enables to review the operational performance and to draw conclusions, whereas the balance sheets, presenting a change in the financial position during the period, show the effects of operations on the assets and liabilities. Thus, the absolute change from one period to another may be determined. The comparative statement may show:

a.      Absolute figures (rupee amounts): the true values

b.      Changes in absolute figures: It may be positive or negative

c.       Absolute data in terms of percentages: degree of percentage

d.      Increase or decrease in terms of percentages :positive or negative

Note: (The financial data will be comparative only when same accounting principles are used in preparing these statements so therefore it is important that analyst should follow proper accounting policy)

The types of comparative statements can be classified in to two forms, which are discussed as follows:

Ø   Comparison of Balance Sheet

Ø   Comparison of Income Statements

Comparison of Balance Sheet: Studying the trend of the same items, group of items and computed items of the same business enterprise on different dates is the concept of comparative balance sheet. The changes in periodic balance sheet items reflect the conduct of a business that whether the business is rising or falling and changes can be observed by comparison of the balance sheet at the beginning and at the end of a period and these changes can help in decision making.

(The comparative balance sheet has two columns for the data of original balance sheets and third column is used to show increase in figures)

While interpretation of the information contained in the company’s balance sheet certain guidelines need to be followed. The following aspects are expected to study while interpreting the comparative balance sheet.

(i)   A student should see the working capital (Working capital is the capital which is required to meet the daily expenses) in both the years while studying financial position of a concern this will enable them to analyze the current financial position.

(ii) The second aspect in order to understand the financial position of the company is to study the liquidity position of the concern.

(iii)  To frame wise policies to finance fixed assets it is important to study the long term financial position of the concern.

(iv)  The next important aspect is to study the profitability of the concerns all the dividend related decision taken by the company depends upon the profitability position of the concern The study of increase or decrease in retained earnings, various resources and surpluses, etc. will enable the interpreter to see whether the profitability has improved or not.

(v)The nature of the assets which have increased or decreased should also be considered as it may help in the future production possibilities.

(vi)   The study of increase or decrease in retained earnings will also to be considering as it help the company in framing various policies related to dividend.

Comparison of Income Statement: The income statement of the company provides information about a company’s performance over a certain period of time. Although it does not reveal much about the company’s current financial condition, it does provide indications of its future viability. The main elements of the income statement are revenues earned; expenses incurred, and net profit or loss. Revenues consist mainly of sales, though financial analysts may also note the inclusion of royalties, interest, and extraordinary items. The income statement, having been termed as profit and loss account is the most useful financial statement as profit and loss account is prepared to know the net profit earned by the company during a particular period or net loss bear by the company during a specified period.

(The figures of various item for two years is to be shown on first two columns, third and fourth column are used to show increase or decrease in figures in terms of absolute amounts and percentages respectively)

There are certain guidelines which helps in interpretation of data contained in Income Statement of the company. The following aspects are required to study while interpreting the comparative Income Statement.

(i)  The increase or decrease in sales should be compared with the increase or decrease in cost of sale (Cost of Sale can be calculated by deducting Gross Profit from Net Sales)

(ii) The next step of analyses is to study the concept of operational profits.

(iii) The increase or decrease in net profit will give an idea about the overall profitability of the concern as it help in deciding the dividend (the part of the profit distributed among the shareholders) policy for the concern.

(iv) To calculate the figure of net profit all the non-operating expenses are to be excluded from operating profit.

(v) It is important to put opinion about profitability of the concern and it should be given at the end to conclude whether overall profitability of the firm is good or bad.

(ii) Trend Analysis: It is also one of the important tools of horizontal analysis. Trend analysis as it is clear from the name only, it is a useful to check whether the financial position of a business entity is improving in the course of time or it is deteriorating. It involves calculation of percentage changes in financial statement items for a number of successive years. This method determines the direction upwards or downwards and involves the computation of the percentage relationship that each statement item bears to the same item in base year. Generally the first year is taken as base year and figures of the base year are usually taken as 100 and trend ratios for other years are calculated on the bases of base year. The caution is required to be taken by the analyst while interpretation of trend analysis as mere increase or decrease in trend percentage may give misleading results.

Procedure for calculating Trends:

(i)  Generally the first year is taken as base year.

(ii)    The figures of base year are taken as 100.

(iii)    Trend percentages are calculated in relation to base year.

Note: (It should be remembered that the base period should be and if base year is a normal period because the entire results are based on the base year only as all the other years data is divided by the base year only and if base year is not normal then result will come insignificant)

For instance: If sales figures for the year 2010 to 2015 are to be studied, then the sales of 2010 will be taken as 100 and the percentage of sales for all other years will be calculated in relation to the base year, i.e., 2010. Suppose the following trends are determined.

2010      100

2011      120

2012      110

2013      125

2014      135

2015      140

The trends of sales show that sales have been more in all the years since 2010. The sales have shown as upward trend except in 2012 when sales were less than the previous year i.e., 2011. A minute study of trends shows that rate of increase in sales is less in the years 2014 and 2015. The increase in sales is 15% in 2013 as compared to 2012 and increase is 10% in 2014 as compared to 2013 and 5% in 2015 as compared to 2014. Though the sales are more as compared to the base year but still the rate of increase has not been constant.

2.      Vertical Analysis: The study of the relationship of the various items of only one accounting period is the concept of vertical analysis. In this type of analysis financial ratios are to be calculated for one year only. It is also called as static analysis. The two tools employed in this analysis are Common size financial statements and financial ratios. It is not very conducive to a proper analysis of financial statement because it considers the data only for one time period. However, it may be used along with horizontal analysis to make it more effective and meaningful as alone it considers the data of one year only. Vertical analysis involves the conversion of items appearing in statement columns into terms of percentages of a base figure to show the relative significance of the items and to facilitate comparisons. For example, individual items appearing on the income statement can be expressed as percentages of sales. On the balance sheet, individual assets can be expressed as a percentage of total assets. Liabilities and owners’ equity accounts can be expressed in terms of their relationship to total liabilities and owners’ equity.

The two common tools employed in vertical Analysis generally are:

Ø   Common –Size financial statements

Ø   Financial Ratios ( To be discussed in the next module)

Common –Size financial statements

The common size statements, balance sheet and income statements are shown in analytical percentages. The figures of financial statements are converted to percentages.

a.      It is performed by taking the total balance sheet as 100.

b.      The balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability to total liabilities.

Thus, it shows the relation of each component to the whole – Hence, the name common size.

The common-size financial statements are of two types which are discussed s follows:

Ø        Common size Balance Sheet

Ø        Common size Income Statement

Common size balance Sheet: A statement in which balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability is expressed as a ratio of total liabilities is called common size balance sheet. It can be used by different companies of different size for comparison. The comparison of figures in different periods is not useful because total figures may be affected by a number of factors.

Example:

PARTICULARS	RUPEES	%
Cash in Hand	5,000	2.08
Debtors	15,000	6.25
Prepaid expenses	25,000	10.42
Machinery	45,000	18.75
Freehold Premises	1,50,000	62.5
Total Assets	2,40,000	100

The total figures of assets Rs 2,40,000, is taken as 100 and all the other assets are expressed as a percentage of total assets. The relation of each asset to total assets is expressed in the statement. The relation of each liability to total liabilities is similarly expressed.

The Common size balance sheet can be used in any organization to compare companies of different size. The comparison of figures in different period may not be useful because total figures may be affected by a number of factors and it is not possible to establish standard norms for various assets. The trends of figures from year to year may not give proper results.

Common size Income Statement: The items in income statement of common statement can be shown as percentages of sales to show the relation of each item to sales. A significantly relationship can be established between items of income statement and volume of sales and is helpful in evaluating operational activities of the enterprise.

SUMMARY:

Financial statements provide the most widely available data on public corporations’, economic activities and other stakeholders to access the plans and performance of firms and corporate managers. Horizontal analysis and vertical analysis of financial statements are additional techniques that can be used effectively when evaluating a company. After studying the various types of financial analysis an opinion can be formed about the financial position of the concern as one cannot say if short term financial position is good then long term financial position will also be good and vice-versa. While using the trend analysis it should be keep in mind that the accounting procedures and conventions used for collecting data and preparation of financial statements should be similar, otherwise the figures will not be comparable.

Few Suggested Readings:

• Grewal’s T.S, Analysis of Financial Statements, Gayatri Enterprises, Noida
• Hawawini Gabriel A, Finances for Executives: managing for value creation/Gabriel Hawawini, Claude Viallet-2nd ed. Thomson Learning, Inc., South-Western.
• Palepu, G.Krishna, Healy. M Paul and Victor L. Bernard (2004), Business Analysis & Valuation, Cengage Learning India Pvt. Ltd.

Points to Ponder

1.      There are various methods or techniques used to study the relationship between different statements.

2.      Financial statements indicate certain absolute information about assets, liabilities, equity, revenue and expenses of an enterprise.

3.      External Analysis is done on the basis of published financial statements by outsiders who do not have access to the detailed internal accounting records of the business firm.

4.      Internal Analysis conducted by persons who have access to the internal accounting records of a business firm.

5.      Horizontal analysis is also regarded as Dynamic Analysis as it is based on the data from year to year rather than on data of any one year.

6.      Vertical Analysis refers to the study of relationship of the various items in the financial statements of one accounting period.

7.      Trend Analysis determines the direction upwards or downwards and involves the computation of the percentage relationship that each statement item bears to the same items in base year.