Horizontal analysis is an approach used to analyze financial statements by comparing specific financial information for a certain accounting period with information from other periods. Analysts use such an approach to analyze historical trends.
Trends or changes are measured by comparing the current year’s values against those of the base year. The goal is to determine any increase or decline in specific values. A percentage or an absolute comparison may be used in horizontal analysis.
Horizontal analysis can also be compared with vertical analysis. Whereas vertical analysis analyzes a particular financial statement using only one base financial statement of the reporting period, horizontal analysis compares a specific financial statement with other periods or the cross-sectional analysis of a company against another company.
Horizontal analysis is the comparison of historical financial information over various reporting periods.
It helps determine a companies’ growth and financial position versus competitors.
The horizontal analysis technique uses a base year and a comparison year to determine a company’s growth.
Horizontal Analysis in Reporting Standards
As outlined in the Generally Accepted Accounting Principles (GAAP), the rules for the preparation of financial statements require financial statements to be consistent and comparable to compare and evaluate companies and their financial performance properly. Consistency constraint here means that the same accounting methods and principles must be used each year since they remain constant over the years.
On the other hand, comparability constraint dictates that a company’s financial statements and other documentation be such that they can be evaluated against other similar companies within the same industry. Horizontal analysis is used to improve and enhance these constraints during financial reporting.
Therefore, analysts and investors can identify factors that drive a company’s financial growth over a period of time. They are also in a position to determine growth patterns and trends, such as seasonality. The method also enables the analysis of relative changes in different product lines and projections into the future.
Key Metrics in Horizontal Analysis
A company’s financial statements – such as the balance sheet, cash flow statement, and income statement – can reveal operational results and give a clear picture of business performance. In the same vein, a company’s emerging problems and strengths can be detected by looking at critical business performance, such as return on equity, inventory turnover, or profit margin.
For example, a company’s management may establish that the robust growth of revenues or the decline of the cost of goods sold as the cause for rising earnings per share. By exploring coverage ratios, interest coverage ratio, and cash flow-to-debt ratio, horizontal analysis can establish whether sufficient liquidity can service a company. Horizontal analysis can also be used to compare growth rates and profitability over a specific period across firms in the same industry.
Example of Horizontal Analysis
In horizontal analysis, the changes in specific financial statement values are expressed as a percentage and in U.S. dollars. To calculate the percentage change, first select the base year and comparison year. Subsequently, calculate the dollar change by subtracting the value in the base year from that in the comparison year and divide by the base year. The result is then multiplied by 100.
To illustrate, consider an investor who wishes to determine Company ABC’s performance over the past year before investing. Assume that ABC reported a net income of $15 million in the base year, and total earnings of $65 million were retained. The company reported a net income of $25 million and retained total earnings of $67 million in the current year.
From the example above, Company ABC increased its net income and retained earnings over the year by $10 million and $2 million, respectively. Therefore, the company’s net income grew by:
[($25 million – $15 million) / $15 million] x 100 = 66%
On the other hand, the company’s retained earnings grew by:
[($67 million – $65 million) / $65 million] x 100 = 3.07%
Drawbacks of Horizontal Analysis
The value of horizontal analysis enables analysts to assess the company’s past performance and current financial position or growth and project the useful insights gained into the future. However, when using the analysis technique, the comparison (current) period can be made to appear uncommonly bad or good. It depends on the choice of the base year and the chosen accounting periods on which the analysis starts.
For example, an analyst may get excellent results when the current period’s income is compared with that of the previous quarter. However, the same results may be below par when the base year is changed to the same quarter for the previous year.
A notable problem with the horizontal analysis is that the compilation of financial information may vary over time. It means that elements of financial statements, such as liabilities, assets, or expenses, may change between different accounting periods, leading to variation when account balances for each accounting period are sequentially compared.
As a result, some companies maneuver the growth and profitability trends reported in their financial horizontal analysis report using a combination of methods to break down business segments. Regardless, accounting changes and one-off events can be used to correct such an anomaly and enhance horizontal analysis accuracy.
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