Horizontal analysis

What Is Horizontal Analysis?

Horizontal analysis is a technique used in Financial Statement Analysis that involves comparing financial data across multiple reporting periods to identify trends and patterns. This method, sometimes referred to as trend analysis, examines the absolute and percentage changes in specific line items of financial statements, such as the Income Statement, Balance Sheet, or Cash Flow Statement. By performing horizontal analysis, analysts and investors can gain insights into a company's financial performance over time, assessing growth, decline, or stability.²⁰,¹⁹ It provides a dynamic view of how a company's finances have evolved, rather than just a snapshot at a single point.

History and Origin

The practice of comparing financial figures over time to discern performance trends has long been integral to financial analysis. As businesses grew more complex and capital markets developed, the need for standardized and comparable financial reporting became increasingly important. The evolution of accounting standards, such as Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS) globally, has played a crucial role in enabling such comparisons. These standards aim to promote transparency and comparability in financial reports.¹⁸,¹⁷ Efforts towards international convergence of accounting standards, as pursued by bodies like the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), have further enhanced the ability to conduct horizontal analysis across different entities and jurisdictions by making financial data more consistent.¹⁶

Key Takeaways

• Horizontal analysis is a method of financial statement analysis that tracks changes in financial data over successive periods.
• It helps identify trends in Revenue, Expenses, assets, and liabilities, showing growth, decline, or stability.
• Both absolute and Percentage Change are calculated to provide a comprehensive view of performance.
• The insights gained from horizontal analysis are crucial for forecasting future performance and making informed business decisions.¹⁵,¹⁴
• It is particularly useful for assessing a company's Profitability, Liquidity, and Solvency trends.

Formula and Calculation

Horizontal analysis involves calculating the absolute and percentage change for each line item from a base period to a subsequent period.

Absolute Change:
[
\text{Absolute Change} = \text{Current Period Value} - \text{Base Period Value}
]

Percentage Change:
[
\text{Percentage Change} = \left( \frac{\text{Current Period Value} - \text{Base Period Value}}{\text{Base Period Value}} \right) \times 100
]

Where:

• "Current Period Value" refers to the amount of a specific financial line item in the most recent period.
• "Base Period Value" refers to the amount of the same financial line item in the chosen earlier period, which serves as the benchmark for comparison.

These calculations are applied to each line item on the financial statements, such as sales, cost of goods sold, Net Income, total assets, or Shareholder Equity.

Interpreting Horizontal Analysis

Interpreting horizontal analysis involves looking beyond just the numbers to understand the story they tell about a company's performance. A consistent increase in revenue over several periods, for example, might signal strong market demand or effective sales strategies. Conversely, a steady rise in expenses without a corresponding increase in revenue could indicate deteriorating cost control or operational inefficiencies.

When analyzing trends, it is important to consider the context. A significant percentage increase in a small base number might look impressive but have little material impact on overall results. Analysts also look for accelerating or decelerating trends, as these can be more indicative of future performance than a static rate of change. By comparing trends in different line items, such as sales growth versus the growth in cost of goods sold, one can infer changes in Profitability margins. This type of Trend Analysis helps in forecasting and identifying potential issues or opportunities.¹³,¹²

Hypothetical Example

Consider "Tech Innovate Inc.," a fictional software company, and its revenue data for two consecutive years:

To perform horizontal analysis, we calculate the absolute and percentage change for each line item.

For Revenue:

• Absolute Change = $1,200,000 - $1,000,000 = $200,000
• Percentage Change = (($1,200,000 - $1,000,000) / $1,000,000) * 100 = 20%

For Expenses:

• Absolute Change = $750,000 - $650,000 = $100,000
• Percentage Change = (($750,000 - $650,000) / $650,000) * 100 (\approx) 15.38%

For Net Income:

• Absolute Change = $450,000 - $350,000 = $100,000
• Percentage Change = (($450,000 - $350,000) / $350,000) * 100 (\approx) 28.57%

In this example, Tech Innovate Inc. shows a healthy 20% growth in Revenue. Although expenses also increased, their growth rate (15.38%) was lower than that of revenue. This resulted in an even higher percentage increase in Net Income (28.57%), indicating improved profitability. This step-by-step approach demonstrates how horizontal analysis provides a clear picture of performance shifts.

Practical Applications

Horizontal analysis is a widely used tool in various financial contexts, enabling stakeholders to make more informed decisions.

• Investment Analysis: Investors and financial analysts use horizontal analysis to evaluate a company's historical performance, identify growth patterns, and forecast future financial health. This helps them decide whether to buy, hold, or sell securities. Public companies are required to file comprehensive financial reports, such as the Form 10-K, with the U.S. Securities and Exchange Commission (SEC). These filings, accessible through the SEC's EDGAR database, provide the raw data necessary for conducting horizontal analysis.,¹¹ The EDGAR system (Electronic Data Gathering, Analysis, and Retrieval system) provides free public access to corporate information.¹⁰
• Management Decision-Making: Company management employs horizontal analysis to monitor operational efficiency, control costs, and assess the effectiveness of strategic initiatives. By tracking trends in line items like cost of goods sold or operating expenses, management can pinpoint areas requiring attention or celebrate successful improvements.⁹
• Credit Analysis: Lenders and creditors utilize horizontal analysis to assess a borrower's ability to repay debt. Consistent revenue growth and controlled expenses, revealed through horizontal analysis, can indicate a stronger financial position and reduced lending risk.
• Auditing and Compliance: Auditors may use horizontal analysis as part of their analytical procedures to identify unusual fluctuations in accounts that could indicate errors, fraud, or significant business events requiring further investigation.

Limitations and Criticisms

While horizontal analysis is a valuable tool, it has certain limitations and criticisms that users should consider:

• Choice of Base Period: The selection of the base period can significantly influence the results. If a company had an unusually strong or weak performance in the base year, subsequent Percentage Change calculations might be skewed, making current performance appear artificially good or bad.⁸,⁷
• Changes in Accounting Policies: Companies may change their accounting policies or methods over time. Such changes can impair the comparability of financial data across different periods, potentially distorting trends and making horizontal analysis less reliable.⁶
• Inflation: Horizontal analysis typically does not adjust for Inflation. Over longer periods, inflationary pressures can make increases in nominal values appear as real growth, even if the purchasing power has remained constant or declined.⁵
• Lack of Context: While horizontal analysis reveals trends, it doesn't always explain the underlying reasons for those trends. External factors like economic downturns, industry-specific challenges, or changes in market conditions might influence financial figures without being evident from the analysis itself.⁴ For example, a decline in revenue might be industry-wide rather than company-specific.

These limitations highlight the importance of using horizontal analysis in conjunction with other analytical tools and a thorough understanding of the company's business environment.

Horizontal Analysis vs. Vertical Analysis

Horizontal analysis and Vertical Analysis are both essential components of Financial Ratios analysis, but they offer different perspectives on a company's financial health. The primary distinction lies in their comparative approach.

Horizontal analysis, as discussed, examines financial data over multiple periods to identify trends and changes in specific line items over time. It answers questions like, "How much has revenue grown year-over-year?" or "What is the trend in expenses over the past five quarters?" The comparison is "horizontal" across the financial statements, moving from left to right through different reporting periods.

In contrast, vertical analysis (also known as common-size analysis) evaluates financial data within a single reporting period. It expresses each line item as a percentage of a base figure within the same statement. For the income statement, each item is typically expressed as a percentage of total revenue. For the balance sheet, each item is expressed as a percentage of total assets. Vertical analysis helps to understand the proportional relationship of different accounts within a single period, answering questions such as, "What percentage of sales is represented by cost of goods sold?" or "What proportion of assets is inventory?" The comparison is "vertical," moving up and down within a single column of the financial statement.

While horizontal analysis tracks changes over time, vertical analysis focuses on proportional relationships at a specific point in time. Both methods are often used together to provide a comprehensive view of a company's financial performance and structure.

FAQs

What types of financial statements are typically used for horizontal analysis?

Horizontal analysis is most commonly applied to the Income Statement and Balance Sheet, as these statements provide a clear representation of a company's performance and financial position over time. It can also be applied to the Cash Flow Statement, though cash flows tend to fluctuate more, making long-term trends less consistent.³

How many periods should be included in a horizontal analysis?

While horizontal analysis can be performed with just two periods (a current and a base period), including multiple periods (e.g., three to five years or quarters) provides a more robust view of underlying trends. The longer the period, the better the insights into consistent patterns or significant shifts in financial performance.²

Can horizontal analysis be used to compare different companies?

Yes, horizontal analysis can be used to compare the performance trends of different companies, particularly those within the same industry. By comparing their respective revenue growth, expense management, or profit trends, analysts can benchmark a company against its peers and understand its competitive positioning.¹

What is a base period in horizontal analysis?

A base period in horizontal analysis is the earliest period chosen for comparison. All subsequent periods' line items are compared against this base period's corresponding values to calculate the absolute and percentage changes. The selection of an appropriate base period is crucial for accurate analysis.