What’s horizontal analysis?
In financial statement analysis, horizontal analysis compares historical data across accounting periods, such as ratios or line items. Horizontal analysis can utilize absolute or percentage comparisons, expressing data as a percentage of the baseline year, with the baseline amount considered 100%. They are also known as base-year analyses.
Workings of Horizontal Analysis
Horizontal analysis helps investors and analysts see trends and growth patterns in a company’s financial performance across multiple years. This study lets analysts compare line item changes over time and predict their future. Analyzing the income statement, balance sheet, and cash flow statement over time provides a comprehensive view of a company’s performance, efficiency, and profitability.
Analyzing key business performance metrics like profit margins, inventory turnover, and return on equity can reveal issues and strengths. For instance, higher EPS may be due to decreasing COGS or steady sales growth.
Coverage ratios, such as cash flow-to-debt and interest coverage, indicate a company’s ability to pay debt and increase or decrease liquidity. Horizontal analysis simplifies industry-wide growth and profitability comparisons.
GAAP emphasizes financial statement uniformity and comparability. Consistent accounting concepts like GAAP provide accurate financial statement reviews over time. Comparability allows benchmarking of two or more organizations’ financials.
Methods of Horizontal Analysis
The three main phases constitute a horizontal analysis.
First, gather financial data.
For a horizontal analysis, you must first collect financial data from one business over time. Pull quarterly or annual financial statements or single-account balances for horizontal examination.
Be aware of consistent financial statement gaps. The interval might be month-over-month, year-over-year, etc., but each iterative financial statement should be equivalent in time to other financial data.
Second: Choose Comparison Methods
After gathering financial data, select how to examine it. There are numerous main comparison approaches.
An initial direction comparison compares results from one period to another. The company-wide sales last quarter may have been $75 million, and this quarter maybe $85 million. Most people utilize this comparison to find apparent differences.
Second, variance analysis identifies a general ledger account’s dollar amount and direction of change. Variance analysis measures the company’s financial health by identifying directional changes, the frequency of directions, or how each financial outcome compares to an internal aim (i.e., a budget).
Finally, horizontal analysis can calculate percentage changes between periods. Even when a firm expands in dollars, it gets harder to maintain the same growth rate. This percentage technique is best for spotting long-term changes with considerable departures from the base period to the current period.
Third, find trends and patterns.
It’s time to study the financial statements now that they have computed data. Asking guided questions reveals trends and patterns. Upper management may inquire about effective COGS management by geographical region over the last four quarters. This question suggests horizontal analytic methodologies and trends or patterns to investigate.
Horizontal vs. vertical analysis
Vertical analysis focuses on the correlations between data in one reporting period or instant. Common-size financial statement analysis is also known as vertical analysis.
Vertical analysis restates every income statement figure as a proportion of net sales. If a company’s net sales were $2 million, they’d be 100%. With $2 million in revenue, $1 million in cost of goods sold is 50%.
However, horizontal analysis examines financial statement amounts spanning several years. Horizontal analysis is also known as trend analysis.
Pretend the analysis begins three years prior. For analysis, balance sheets and income statements will use percentages of base-year values. Three-year-old quantities are 100% or 100. Divide recent years’ amounts by base-year amounts.
If the most recent year’s amount were three times the base year’s, it would be $300. It shows patterns in line items, like the cost of goods sold.
Analysis Horizontal
- I used to analyze particular accounting periods’ account balance changes line by line.
- Compares past and present accounting period findings
- Management typically uses it to make strategic decisions.
A vertical analysis
- Used to evaluate a company’s account concentration or connection.
- Returns account balances in percentages.
- Investors and creditors use it to assess business financing and risk.
Horizontal Analysis Criticism
An analyst may make the present period look excellent or terrible, depending on which accounting period they start from and how many they choose. For instance, the current quarter’s profits may look good compared to the prior quarter but dismal compared to last year’s.
To maintain consistency, the footnotes of the financial statement should mention accounting rule changes and one-time events that affect the horizontal analysis.
Horizontal analysis can be problematic because the financial statements’ information aggregation may have changed over time, shifting revenues, expenses, assets, and liabilities between accounts and causing apparent variances in account balances between periods. Companies can alter their segmentation, making horizontal examination of growth and profitability patterns harder to discern. Accounting costs and one-time occurrences might alter the analysis.
Example of Horizontal Analysis
Horizontal analysis usually displays dollar and percentage changes from the base period. Horizontal analysis might explain a 10% sales rise this quarter. Divide the dollar change between the comparison year and the base year by the base year line item value, then multiply by 100 to get the percentage change.
Someone wants to invest in XYZ. Investors may want to know how the firm grew last year. Suppose business XYZ’s base-year net income was $10 million and retained profits were $50 million.
XYZ reported $20 million in net income and $52 million in retained profits in the current year. Thus, its net income and retained profits increased by $10 million and $2 million, respectively.
Net income for firm ABC climbed by 100% (($20 million – $10 million) / $10 million * 100) year over year, while retained profits only grew by 4%.
| Period 1 (Base) | Period 2 (Current Period) | Change | % Change | |
| Net Income | $10 million | $20 million | + $10 million | 100% |
| Retained Earnings | $50 million | $52 million | + $2 million | 4% |
What are the benefits of horizontal analysis?
Horizontal analysis helps analysts evaluate historical performance and the present financial situation or growth. Emerging trends can predict future performance. Horizontal analysis may also compare a corporation to industry rivals.
How Can Investors Use Horizontal Analysis?
Horizontal analysis may show investors a company’s financial patterns and performance to decide whether to invest. Investors should use horizontal, vertical, and other methods to understand a company’s financial health and direction fully.
What is the difference between horizontal and vertical analysis?
Vertical analysis focuses on the correlations between data in one reporting period or instant. Horizontal analysis examines line items, ratios, or variables throughout time to discover changes and trends.
When to Use Horizontal Analysis?
Horizontal analysis works best for established entities with solid record-keeping and verifiable past data that can be used for further analysis. This form of study is more particular for assessing selling or buying value.
The Verdict
Horizontal financial analysis measures a company’s performance over time. A corporation can better identify account balance shift direction and amount by comparing prior-period financial results with more recent financial outcomes.
Conclusion
- Reviews of a company’s financial accounts over various periods employ horizontal analysis.
- Percentage growth above the base-year line item is typical.
- Consumers of financial statements may readily discover trends and growth patterns with horizontal analysis.
- Horizontal analysis compares a company’s growth and finances against those of competitors.
- Choose previous eras of lousy performance to manipulate horizontal analysis to make the current time appear better.
