Most analysts start their analysis of financial statements with the income statement. Intuitively, this is usually the first thing we think about with a business…we often ask questions such as, “how much revenue does it have, is it profitable, what are the margins like?”
In order to answer these questions, and much more, we will dive into the income statement to get started.
There are two main types of analysis we will perform: vertical analysis and horizontal analysis.
With this method of analysis of financial statements, we will look up and down the income statement (hence, “vertical” analysis) to see how every line item compares to revenue, as a percentage.
For example, in the income statement shown below, we have the total dollar amounts and the percentages, which make up the vertical analysis.
As you see in the above example, we do a thorough analysis of the income statement by seeing each line item as a proportion of revenue.
The key metrics we look at are:
- Cost of Goods Sold (COGS) as a percent of revenue
- Gross profit as a percent of revenue
- Depreciation as a percent of revenue
- Selling General & Administrative (SG&A) as a percent of revenue
- Interest as a percent of revenue
- Earnings Before Tax (EBT) as a percent of revenue
- Tax as a percent of revenue
- Net earnings as a percent of revenue
Now it’s time to look at a different way to evaluate the income statement. With horizontal analysis, we look across the income statement at the year-over-year (YoY) change in each line item.
In order to perform this exercise, you need to take the value in Period N and divide it by the value in Period N-1 and then subtract 1 from that number to get the percent change.