What Is Horizontal Analysis?
Horizontal analysis is an invaluable tool in financial statement analysis, effectively comparing historical data such as ratios or line items across multiple accounting periods. This form of analysis can leverage either absolute values or percentage comparisons, where each successive period’s figures are expressed as a percentage relative to the baseline year. The baseline year’s figure is set at 100%, serving as a reference point, a method also known as base-year analysis.
Key Takeaways
- Horizontal analysis is pivotal for reviewing a company’s financial statements over varying periods.
- It often illustrates percentage growth against a baseline period.
- This technique helps users detect trends and growth patterns easily.
- It showcases a company’s development and financial stance relative to competitors.
- It can be manipulated if poor performance periods are selectively chosen for comparison.
How Horizontal Analysis Works
Horizontal analysis enables investors and analysts to comprehend the driving factors behind a company’s financial performance over several years, aiding the identification of significant trends and growth patterns. This comprehensive approach involves analyzing the income statement, balance sheet, and cash flow statement across periods to provide a thorough picture of operational results, revealing how efficiently and profitability a company runs.
Key Performance Insights
Studying critical metrics like profit margins, inventory turnover, and return on equity through horizontal analysis can uncover emerging strengths and weaknesses. For instance, an increasing earnings per share (EPS) might be due to declining cost of goods sold (COGS) or steady sales growth.
Coverage ratios, such as the cash flow-to-debt ratio and the interest coverage ratio, indicate how well a company manages its debt and liquidity over time. This method simplifies comparing growth rates and profitability among peers in the same industry.
Adherence to generally accepted accounting principles (GAAP) ensures that financial statements are consistent and comparable over time. This consistent approach allows for an accurate review of financial performance and facilitates benchmarking against other companies.
How to Perform a Horizontal Analysis
Performing a horizontal analysis involves three primary steps:
Step 1: Gather Financial Information
Collect the financial information of a single entity over different periods. This typically includes quarterly or annual financial statements. Ensure a consistent time gap between each financial statement you analyze—be it month-over-month or year-over-year.
Step 2: Determine Comparison Methods
Decide the comparison methods for assessing the collected data. There are three primary methods:
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Direct Comparison: Compare results from one period to another to spot high-level differences. For example, comparing revenue from quarter to quarter.
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Variance Analysis: Assess the direction and dollar amount of changes for a general ledger account. This method also evaluates financial health by identifying directional changes and comparing results against internal targets such as budgets.
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Percentage Changes: Calculate the percentage changes over periods. This method is useful for longer periods, highlighting significant deviations from the base period.
Step 3: Identify Trends and Patterns
Analyze the outcomes by asking guided questions to detect trends and patterns. For example, management may inquire about how different regions performed in managing COGS. These questions help in selecting the appropriate horizontal analysis methods and identifying relevant trends.
Horizontal Analysis vs. Vertical Analysis
Horizontal and vertical analyses serve different purposes. While vertical analysis focuses on the relationship between numbers in a single period (expressing each amount as a percentage of a baseline figure like net sales), horizontal analysis looks at amounts over multiple periods. Vertical analysis can help with cross-sectional comparisons in a single period, whereas horizontal analysis, also known as trend analysis, reveals long-term trends and growth patterns.
With a vertical analysis, each income statement figure may be restated as a percent of net sales. If net sales are $2 million (100%), and the cost of goods sold is $1 million, it will be 50%. Conversely, in horizontal analysis, amounts from multiple periods are expressed as a percentage of a baseline period, illustrating changes over time.
Criticism of Horizontal Analysis
Accuracy can be impacted by chosen periods and starting points, potentially portraying a misleading picture. One-time events or policy changes may also skew results but should be disclosed in financial footnotes. Additionally, changes in financial statement structures over time can confuse comparisons, as can shifting segments, potentially camouflaging true trends.
Example of Horizontal Analysis
Horizontal analysis often presents changes in dollar and percentage terms. For example:
| Period 1 (Base) | Period 2 (Current) | Dollar Change | Percentage Change | |
|---|---|---|---|---|
| Net Income | $10 million | $20 million | + $10 million | 100% |
| Retained Earnings | $50 million | $52 million | + $2 million | 4% |
Example:
An investor examines a company’s growth by comparing current year and base year figures. If the base year’s net income was $10 million and retained earnings were $50 million, but in the current year, net income is $20 million while retained earnings are $52 million, it reflects a 100% growth in net income and 4% in retained earnings.
Benefits of Horizontal Analysis
This analysis is key for evaluating historical performance and current financial health, helping to identify trends and forecast future performance. It also benchmarks performance against competitors in the same industry.
Investor Benefits from Horizontal Analysis
Investors use horizontal analysis to spot trends in performance and financial position across time, aiding their investment decisions. By combining horizontal analysis with other techniques, investors can gain a comprehensive understanding of a company’s financial health.
Difference Between Horizontal and Vertical Analyses
While vertical analysis examines relationships between numbers in a single period, horizontal analysis reviews specific line items over several periods to identify changes and their trends. Both methods complement each other in providing a holistic view of financial performance.
Best Use of Horizontal Analysis
Horizontal analysis shines when used by established entities with robust record-keeping and historical data. It is particularly relevant for evaluating potential investments or strategic decisions related to acquisitions or sales.
The Bottom Line
Horizontal analysis is an essential technique for assessing a company’s performance over time, identifying growth directions, and the magnitude of changes in account balances. It supports strategic decision-making by providing insights into historical and current financial performances.
Related Terms: financial statement analysis, ratio analysis, baseline year, vertical analysis, trend analysis.
References
- U.S. Office of Justice Programs. “Generally Accepted Accounting Principles (GAAP) Guide Sheet”. Page 1.
