Corporate Finance For Dummies

Two types of comparisons utilize data from both the vertical and horizontal analyses, producing cross comparisons. The horizontal common-size comparison does a lot to help you understand changes in a corporation’s finances over time by comparing financial reports from several consecutive years. Vertical comparisons, by contrast, tell you how efficiently corporate value is being allocated and utilized.

Cross comparisons come in two flavors, the rate-of-change cross comparison and the time-distribution cross comparison.

Rate-of-change cross comparison

Before you can do a rate-of-change cross comparison, you must first do vertical common-size comparisons for several consecutive years. After the vertical comparisons are done, you can measure the amount that each comparison has changed over time.

In other words, you are measure the rate of change of each proportion. If COGS increases from 10 percent of net sales in 2011 to 20 percent of net sales in 2012, you can say that COGS has increased as a proportion of net sales by 100 percent in one year. This would be a very bad thing to happen, certainly, and would be worth knowing.

So, you’re doing a horizontal comparison of several vertical comparisons in this case. The reference year that other years are being compared to is adjusted to 100 percent, and then the following years are a percentage change of the different vertical comparison proportions.

This tells you whether the asset utilization and allocation is improving over time, which is a very important indicator of changes in corporate financial efficiency and trends in corporate financial management. Here’s a short example to illustrate the point.

Income statement Vert. ref Next year vert. Final vert.
Net sales: 100% 101% 102%
COGS: 65% __% __%
Gross margin: 35% __% __%
EBIT: 5% __% __%
Interest & tax: 4% __% __%
Net income: 1% __% __%

Time-distribution cross comparison

This cross comparison is similar to the other cross comparison except in reverse. Start by doing horizontal cross-comparison analyses, but pick only two of them — the one for the first year of the period you’re analyzing and the one for the last year of the period you’re analyzing.

Realistically, you could do them for every year in between as well, but the point is you’re only doing this two years at a time. So, for this example, say you’re doing a horizontal comparison for the years 2011 and 2012. Just two years.

After you finish the horizontal comparisons, you’re left with a series of percentages showing how 2012 changed from 2011. Now it’s time for the vertical analysis.

It’s important to note that, unlike a standard vertical analysis, these percentages don’t add up to 100 percent of net sales. But you’re still setting net sales (or total assets, or total cash flows) to 100 percent and then comparing all other entries in the analysis to that. By doing this, you’re collecting information on the degree to which each changed relative to net sales.

So, if COGS is 101 percent of net sales in your cross comparison, that means that COGS increased by 1 percent more than net sales.

The goal here is to measure how much each entry changes relative to a reference point. This process allows analysts to understand better how allocations are changing over time and whether they’re becoming more or less efficient. Here’s a quick example to show how this analysis looks.

Income Statement Horiz. Change Percentage of Net
Net sales: 100% 100%
COGS: 100% 99%
Gross margin: 100% 101%