Updated: Oct 12, 2021
We find many of our small business clients get their financial statements and taxes filed by their accountant every year, but in many cases are not sure what their statements are telling them about their business. They do not spend the time with their accountant to explain the statements and how their business is performing as well as how they are doing versus other businesses in their industry.
Financial Analysis is not a topic that most are interested in finding out about until such time they apply for a loan or investment and find out that they are turned down. It really would have been more advantageous for the business to understand the results before applying for a loan or providing their financials to an investor. A lender or investor will do their financial due diligence on the statements that have been submitted to them. They want to see how you are performing year over year, which is horizontal analysis.
HORIZONTAL ANALYSIS Horizontal analysis will compare the current year to the previous year. Each item in the income statement and balance sheet will be looked at against the past year to see if there is an increase or a decrease and by what % is the change. This will help you answer underlying questions you might have. In the case of your Income Statement, you notice that your margins (or the profit you make) are becoming lower and lower each year. This could be a sign of a couple of things. Your costs have gone up, so what your business is making is less than it was before. You might investigate other suppliers for lower costs, or you might have to increase your price if you want to make the same margin. In the case of your Balance Sheet, you notice that your accounts receivables and accounts payables increased significantly from the previous year. For your account receivables, you may find out that your outstanding balances are not being collected on time, and no one is following up on this within your business. In the case of account payables, you find out that your accounts payable clerk is having to juggle who they are paying. VERTICAL ANALYSIS
Vertical analysis, instead of looking across, is looking up and down the income statement and balance sheet. In many cases, this type of analysis is looked at to compare a business to competitors/other firms in the same industry. On the income statement, you can look at each revenue item, cost of sales/cost of goods item, operating expenses, income tax, and profit as a percentage of the overall revenue. Also, you can look at individual operating expenses as a percentage of the total of all operating costs. In the case of the balance sheet, asset items are viewed as a percentage of total assets and liabilities and shareholder’s equity are seen as a percentage of the total liabilities and equity.
Vertical analysis needs information from others in your industry in most cases to compare it to make it relevant. Some of this information for Canadian businesses can be found on the Industry Canada website under Financial Performance. In other cases, this information can be provided by industry associations, and the worst case can be purchased.
Unfortunately for those who are not fond of math, ratio analysis uses information from your income statement and balance sheet to calculate different ratios within your business which helps you measure the financial performance of your business. You may have heard your banker talk about your Debt to E