There are two basic approaches to view the progress: one is to view the trends of each component such as revenues, expenses, or profi ts over time; and the other is to view the effi ciency of each activity by comparing expenses and profi t over the revenues. The former is called the horizontal analysis and the latter is called the vertical analysis. Both views focus on the changes of the same item from two different perspectives. By analyz- ing them this way, we can identify the initial growth patterns of the busi- ness. The analyses can be conducted both on the Income Statements and the Balance Sheets. Let’s try this fi rst with the Balance Sheet information of R&B Grill. The balance sheet records can be displayed as follows:
Figure 4.4 Analysis of the balance sheets – R&B Grill.
Figure 4.4 shows the two different ways of viewing the balance sheet records. The top half shows the changes of the amount of each component and presents the changes in percentage. The assets of R&B Grill have grown from $800,000 in the beginning to $1,128,300 after 1 month. This is growth by 42%. After 1 year, they grew by 0.56%
to $1,135,705. During the fi rst month, its liabilities grew by $325,500, which is 217% growth. This huge growth of liabilities was caused by the internal investing (or resource allocation) activities. Then, the next year, the liabilities grew only by 7% to $442,667. Finally, the equity grew, during the fi rst month from $650,000 by 0.43% to $652,800, then it grew during the next year by 6.17% to 692,058. It is clear that this company has grown its assets mostly by taking large amount of debt.
The increase of its liabilities shows it clearly. The horizontal analysis this way calculates each component’s growth over time by comparing its change. The following formula shows how to calculate the growth percentage (or growth rate):
Growth rate (%) = ((Current amount – Previous amount)/(Previous amount)) × 100
The lower half of Figure 4.4 shows the structural changes of the fi nancial position of R&B Grill by vertical comparison. Because the company’s total assets are made of liabilities and equity, the total amount of liabilities is divided by that of the total assets to determine the pro- portion of the liabilities in the total assets. Then, the result is presented in percentage by multiplying 100. The proportion of the equity is deter- mined in the same way. The amount of total equity is divided by that of the total assets and converted to the percentage by multiplying 100. The following is the formula to determine the proportion of each component for a horizontal analysis:
Liability percentage (%) over Total Assets = (Total Liabilities/Total Assets)
× 100
Equity percentage (%) over Total Assets = (Total Equity/Total Assets) × 100 The vertical analysis of R&B Grill’s Balance Sheets reveals the changes of its fi nancial positions over time. When it started, its assets were contributed by less than 19% of the liabilities and the rest have been contributed by its owners. The proportion of the liabilities has grown to
almost 42% after the fi rst month. Then, it decreased to slightly about 39% after the operations of Y-1.
The same techniques can be applied to the income statements as dis- played in the following Figure 4.5 “Horizontal Analysis of the Income Statements – R&B Grill.”
Figure 4.5(A) Horizontal analysis of the income statements – R&B Grill.
The horizontal analysis of R&B Grill’s operational results through its Income Statements is meaningless due to the nature of the information presented on the two Income Statements. The fi rst column represents only 1 month’s operations during the fi rst month, while the second one covers the entire year after the fi rst month. If, however, the length of the time for the two different operations were the same, this approach will provide valuable information on the changes of the amount of individual
items in time. The vertical analysis, which is presented in the following, will provide more meaningful information despite the difference between the lengths of time covered.
The next is the vertical analysis of the Income Statement, which presents the operating effi ciency of each time period by showing the per- centage (%) of individual expenses and profi ts over the revenues. The formula that calculates the percentage of each item is as follows:
The percentage of an expense over revenues = (the amount of an expense/
revenues) × 100
The percentage of a profi t over revenues = (the amount of profi t/revenues)
× 100
Figure 4.5(B) Vertical analysis of the income statements – R&B Grill.
Although the volume of each item presented on the Income Statements are completely different due to the different time period, this approach can yield useful information regarding R&B Grill’s management and
operations that were introduced as the “Operational System” earlier.
The operational system covers many different features. One of the most important features is the capability controlling the costs – individually and overall. The percentage column indicates that the business spent less in its operating expenses in the second term compared with those of the fi rst. The operating expenses in Figure 4.5(B) includes the cost of sales. The management of R&B Grill apparently saved a lot in the oper- ating activities by reducing expenses by 1.8% (the difference between the operating expenses percentages; 96.3%–94.5%), and it increased the EBIT from 3.7% in the previous term by 1.8% to 5.5% in the second term. Although the 1.5% difference may look small, it represents the 1.8% of the revenues ($1,444,195), which is close to $26,000 (=1.8% x
$1,444,195). Thanks to this savings, the Net Income has grown to 2.8%
from the 1.6% of the fi rst term. In conclusion, R&B Grill is enhancing its operational effi ciency by not wasting its resources in its operating expenses. The fi nal result of Net Income may look disappointing but it must be remembered that R&B Grill just started its business. It will have to grow long into the future.