In this section, we will look at two types of analysis that we do on profit and loss statement to bring
out insight from the BNL statement.
First is called vertical analysis.
So if you have seen a profit and loss statement, you would know that it shows the total revenue that
you earned, minus all the expenses till you get net profit value from that business.
But in a profit and loss statement, all these values are shown in absolute terms.
That is, if you made one hundred thousand dollars as a revenue, it will be shown as one hundred thousand
dollars.
However, when we want to get inside, we sometimes want to see the contribution of different types
of expenses in percentage terms.
So if I want to know what are my top expenses and how much of these expenses are contributing to the
total expense, I would want to find percentage of all expenses with the total revenue.
That is the concept behind vertical analysis.
In vertical analysis, we simply divide all the expenses with the total revenue earned and we get it
in terms of percentage.
When we have the percentages, we can easily see what are the major expenses and which are those expenses
on which we should focus so that we can reduce our costs and hence increase our profits.
For example, if you see two expenses, one is utilities, which is taking up 33 percent of your total
revenue.
And one is advertising, which is taking only five percent of your total revenue, then it makes more
sense to focus on the utilities expenses and try to reduce it because there is more opportunity to reduce
costs there and hence increase more profit eventually.
So this simple analysis is called vertical analysis.
This is usually done on a panel of a single year, but it can also be done on multiple years.
The other type of analysis is horizontal analysis.
In horizontal analysis, we compared the change in the expenses over two time periods.
So we take personal statements of two consecutive years and we see which expense has increased by what
percentage and which expense has decreased by what percentage.
So we do not find percentage with the total revenue.
We find the percentage change with respect to the last value of that particular expense item or revenue
item.
This type of analysis tells us what went well, that is where did we increase our revenues and where
did we reduce our expenses and what went wrong?
That is which all expense increased and by how much?
You can also use horizontal analysis to compare if any particular kind of activity produced the desired
result.
For example, if you increase your marketing expense in the hopes of increasing your total revenue,
but in your personal statement, you'll notice that the marketing expense has increased, but the total
revenue has not increased proportionately.
So you may deduce that the marketing effort may not be in the right direction.
So let us see how to implement horizontal and vertical analysis in our software to.