Horizontal analysisA simple way to analyze an entity is to follow how an item in its financial statements changes over time. That is what horizontal analysis does.Year 1Year 2Year 3RevenueR$ 350,000R$ 400,000R$ 480,000AssetsR$ 200,000R$ 210,000R$ 240,000Over the three fiscal years, both revenue and total assets grew. Horizontal analysis measures the size of that growth, and there are two ways to calculate it:Fixed base: you choose a base date, usually the first year, and compare every year with it. Revenue in Year 3 is 37.14% higher than in Year 1 (480,000 ÷ 350,000 − 1), and assets are 20% higher (240,000 ÷ 200,000 − 1).Moving base: each year is compared with the previous one. Revenue grew 14.29% from Year 1 to Year 2 (400,000 ÷ 350,000 − 1) and 20% from Year 2 to Year 3 (480,000 ÷ 400,000 − 1).Total assets also grew, but less: 5% and 14.29% on a moving base. This suggests the company is making better use of its assets to generate revenue. Asset turnover (revenue ÷ assets) confirms it: it went from 1.75 in Year 1 to 1.90 in Year 2 and 2.00 in Year 3.A company's revenue was R$ 200,000 in Year 1, R$ 230,000 in Year 2 and R$ 260,000 in Year 3. What was the growth from Year 1 to Year 3 (fixed base)?Answer: 30% — 260,000 ÷ 200,000 − 1 = 30%. The 13% is the growth from Year 2 to Year 3 (moving base).Vertical analysisVertical analysis is a share analysis: it shows how much each item represents of a total. On the balance sheet, the base (100%) is total assets, and you calculate each item's share of it. In the Income Statement, the base is usually net revenue.Year 1Year 2Year 3Current Assets31%32%39%Non-current Assets69%68%61%Current Liabilities18%20%25%Non-current Liabilities20%20%24%Equity62%60%51%From this information, we can see that the share of current assets in total assets increased over time. On the funding side, short-term debt grew in both years, and long-term debt in Year 3, while the share of equity fell from 62% to 51%. In other words, the company is more indebted. Now look at the vertical analysis of the Income Statement accounts, with revenue as 100%:Year 1Year 2Year 3Administrative Expenses24%25%26%Salary Expenses25%27%28%Electricity and Telephone Expenses6%6%6%Supplies Expenses10%10%9%Depreciation Expenses6%7%6%Financial Expenses6%7%7%Other Expenses (including income taxes)9%7%6%Net Profit14%11%12%Total (= revenue)100%100%100%The vertical analysis of the Income Statement shows that net profit fell from 14% to 11% of revenue from Year 1 to Year 2 and rose to 12% in Year 3. The largest accounts, Administrative Expenses and Salaries, increased their share of revenue in both years, which explains the drop in profitability. In Year 3, lower other expenses offset that increase.The two analyses complement each other: horizontal analysis shows where each account is heading, and vertical analysis shows how much each one weighs.In the vertical analysis of the income statement, an expense of R$ 45,000 at a company with net revenue of R$ 300,000 represents:Answer: 15% — 45,000 ÷ 300,000. In the income statement, the 100% base is net revenue.Types of ratiosRatios (or indicators) relate accounts in the financial statements to assess the company's situation. The most widely used groups are:Capital structure and debt: show where the funds come from (equity or third parties), how much the company owes and how much of its equity is tied up in long-term assets.Liquidity: measure the ability to pay debts with assets that turn into cash.Coverage: measure the margin available to meet financial commitments. The most common is interest coverage, operating profit divided by interest expense.Profitability: measure the return on what was invested or sold, for example how much profit each real of equity generated (ROE), or how much of each real of revenue became profit (net margin).Activity (turnover): measure how fast the company turns over its assets: average collection period, payment period, inventory period, asset turnover and operating cycle.Productivity: relate the number of employees or the payroll to revenue.Economy: assess whether resources were used at the lowest possible cost, such as the production cost per unit.Growth: track changes in revenue, costs and output, to see whether the company is growing or shrinking.We will not cover all of them in depth, but we will study the main liquidity, debt and capital structure ratios.Liquidity ratiosLiquidity is about how quickly the company can turn its resources into cash. It is a very important concept, and low liquidity is usually associated with higher risk. That is why liquidity ratios are widely used to predict bankruptcy, grant bank credit and even choose suppliers.They all divide assets that turn into cash by debts. In general, a ratio above 1 indicates that these assets are enough to cover the debts considered; equal to 1, that they match; below 1, that they would not be enough today. Each ratio changes what goes into the numerator and the denominator.Current ratioShows whether short-term assets are larger or smaller than short-term liabilities. Above 1, current assets exceed current liabilities; below 1, short-term obligations exceed short-term assets.\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]Quick ratioIt is similar to the current ratio, but removes the less liquid items from current assets. The form most authors use removes inventories, which still have to be sold (and often collected) to become cash. Some authors also remove prepaid expenses, which never become cash. Here we will use the most common form:\[ \text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventories}}{\text{Current Liabilities}} \]Cash ratioRelates the company's most liquid resources, cash and cash equivalents, to its short-term debts:\[ \text{Cash Ratio} = \frac{\text{Cash and Cash Equivalents}}{\text{Current Liabilities}} \]This ratio tells how much of current liabilities could be paid immediately with the cash available.General liquidity ratioTakes into account not only short-term items but also long-term items that will turn into cash in the future:\[ \text{General Liquidity} = \frac{\text{Current Assets} + \text{Long-term Receivables}}{\text{Current Liabilities} + \text{Non-current Liabilities}} \]To use this formula you need to know where each asset sits on the balance sheet (Brazilian Corporate Law, Law 6,404/76, arts. 178 and 179, as amended by Laws 11,638/07 and 11,941/09):Current assets: cash and rights realized by the end of the following fiscal year (usually 12 months), such as cash, short-term investments, receivables, inventories and prepaid expenses.Non-current assets: everything else, divided into four subgroups: long-term receivables, investments, property, plant and equipment, and intangible assets.Long-term receivables: rights realized after the end of the following fiscal year, and also receivables from affiliates, subsidiaries, partners and directors that do not arise from the company's normal operations, whatever their term. This is the only part of non-current assets included in general liquidity.Investments, property, plant and equipment, and intangible assets: assets the company holds to use or as interests in other companies (machinery, vehicles, land, brands, software), not to turn into cash. That is why they are left out of general liquidity. They roughly correspond to the old "Permanent Assets" group, which ceased to exist with Law 11,638/07.Example with the liquidity ratiosYear 1Year 2Year 3Current Ratio1.721.581.59Quick Ratio1.521.421.45Cash Ratio0.170.210.20General Liquidity0.820.800.80The figures match the vertical analysis we saw above: in Year 1, 31% ÷ 18% = 1.72 current ratio. The current ratio fell, but remains above 1, meaning current assets comfortably cover short-term debts. A low cash ratio (about 0.2) is common: few companies keep enough cash to pay all their current liabilities at once. General liquidity below 1, on the other hand, shows that, adding short and long term together, the company depends on the future results of its operations to pay all its debts.A company has Current Assets of R$ 250,000, inventories of R$ 50,000, prepaid expenses of R$ 22,000 and Current Liabilities of R$ 333,000. What is its quick ratio, in the most common form?Answer: 0.60 — (250,000 − 50,000) ÷ 333,000. The 0.53 would be the version that also removes prepaid expenses, and 0.75 is the current ratio.Debt ratiosWe use these ratios to study the composition of liabilities: the level of debt and the company's sources of funds.Third-party capital to equity (debt-to-equity)Relates third-party capital, that is, current plus non-current liabilities, to equity. It shows how many reais of debt there are for each real of equity:\[ \text{Debt-to-Equity} = \frac{\text{Current Liabilities} + \text{Non-current Liabilities}}{\text{Equity}} \]Debt compositionShows how much of total debt falls due in the short term. The higher it is, the more pressure on cash over the next year:\[ \text{Debt Composition} = \frac{\text{Current Liabilities}}{\text{Current Liabilities} + \text{Non-current Liabilities}} \]Some authors compare short-term directly with long-term debt (current liabilities ÷ non-current liabilities). The reading is similar, but the form above is the most widely used.A company has Current Liabilities of R$ 120 thousand, Non-current Liabilities of R$ 180 thousand and Equity of R$ 200 thousand. What is its debt composition?Answer: 40% — 120 ÷ (120 + 180). The 1.50 is the debt-to-equity ratio (300 ÷ 200), and 66.7% compares short-term directly with long-term debt (120 ÷ 180).Capital structure ratiosBesides the two above, the most common are:\[ \text{Fixed Assets to Equity} = \frac{\text{Non-current Assets} - \text{Long-term Receivables}}{\text{Equity}} \]\[ \text{Fixed Assets to Long-term Funds} = \frac{\text{Non-current Assets} - \text{Long-term Receivables}}{\text{Equity} + \text{Non-current Liabilities}} \]\[ \text{Equity Ratio} = \frac{\text{Equity}}{\text{Total Assets}} \]These "fixed assets" ratios (in Portuguese, índices de imobilização) show how much of the company's own funds (or of its long-term funds) is tied up in investments, property, plant and equipment and intangibles, that is, in assets that will not come back as cash any time soon. In older textbooks, the numerator appears as "Permanent Assets", a name that ceased to exist with Law 11,638/07.Example with the same companyUsing the percentages from the vertical analysis, and assuming, as general liquidity shows, that this company's long-term receivables are practically zero:RatioYear 1Year 2Year 3Debt-to-equity38 ÷ 62 = 0.6140 ÷ 60 = 0.6749 ÷ 51 = 0.96Debt composition18 ÷ 38 = 47%20 ÷ 40 = 50%25 ÷ 49 = 51%Fixed assets to equity69 ÷ 62 = 1.1168 ÷ 60 = 1.1361 ÷ 51 = 1.20Fixed assets to long-term funds69 ÷ 82 = 0.8468 ÷ 80 = 0.8561 ÷ 75 = 0.81Equity ratio62%60%51%Debt rose from 0.61 to 0.96 reais per real of equity, and a larger part of it falls due in the short term. Fixed assets to equity above 1 shows that equity alone is not enough to fund all non-current assets; fixed assets to long-term funds below 1 shows that, once long-term debt is added, these assets are funded with long-term resources, with some left over for working capital.A company has Non-current Assets of R$ 500 thousand, of which R$ 100 thousand are long-term receivables, Equity of R$ 320 thousand and Non-current Liabilities of R$ 180 thousand. What is its fixed assets to long-term funds ratio?Answer: 0.80 — (500 − 100) ÷ (320 + 180) = 400 ÷ 500. The 1.25 is fixed assets to equity (400 ÷ 320), and 1.56 forgets to remove long-term receivables.Exercises1) (FUNDATEC - Prefeitura de Restinga Seca - Accountant - 2022) Economic and financial indicators are tools that enable a detailed analysis of aspects according to the needs of the user of accounting information. In this regard, select the indicator that belongs to the profitability group.A) Current ratio.B) Return on equity.C) Percentage of equity.D) Quick ratio.E) Vertical analysis.2) (IESES - Gas Brasiliano - Junior Economist - 2017) Financial management is strongly concerned with the concepts of liquidity and profitability. The professional most concerned with liquidity is the:A) Shareholder.B) Controller.C) Auditor.D) Treasurer.3) (UFF - UFF - Auditor - 2012) Among management indicators, the one that shows management's attention to the proper use of financial resources, which are by definition scarce, from the suitability of the budget proposal to the targets to be achieved, through consistency with market prices and the development of alternative sources of revenue, to obtaining the lowest costs per product generated, is called:A) economy;B) effectiveness;C) efficacy;D) selectivity;E) essentiality.4) (CESPE/CEBRASPE - ABIN - Intelligence Technical Officer - Accounting - 2010) Judge the following item, regarding general concepts of public sector accounting. The main function of accounting indicators is to enable the automatic recording of accounting events based on a specific numerical code. True or false?5) (CESPE/CEBRASPE - EMBASA - Sanitation Analyst - Administration - 2009) Judge the following item, regarding the Fiscal Responsibility Law (LRF) and financial, economic and asset indicators. To obtain a measure of operating efficiency, the return on investment (ROI) ratio can be used. To interpret the evolution of this indicator, two pieces of information that make up its composition must be obtained: gross profit divided by total investment. True or false?6) (FUNDATEC - 2023 - IF Farroupilha - RS - Accountant) To answer the question, consider the information collected from Instituto WAZ, dated 12/31/2019.AccountBalance (in R$)Current Assets250,000.00Non-current Assets425,000.00Inventories50,000.00Prepaid expenses22,000.00Current Liabilities333,000.00Non-current Liabilities132,000.00Equity210,000.00Net Profit190,000.00Net Sales522,000.00Based on the information from Instituto WAZ, the third-party capital ratio on 12/31/2019 was:A) 0.88.B) 1.00.C) 1.58.D) 2.21.E) 3.11.Solution1) B. Return on equity (ROE) is a profitability ratio; the current and quick ratios are liquidity ratios, and the percentage of equity is a structure ratio.2) D. The treasurer handles cash and payments, which is why they are the one most concerned with liquidity.3) A. Economy means obtaining resources at the lowest cost without losing quality.4) False. Indicators are used to analyze the entity's situation, not to record transactions.5) False. ROI breaks down into margin (profit ÷ revenue) times turnover (revenue ÷ investment), and uses operating or net profit, not gross profit.6) D. Third-party capital ÷ equity = (333,000 + 132,000) ÷ 210,000 = 465,000 ÷ 210,000 = 2.21.
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