Horizontal Analysis of Financial Statements

Horizontal analysis of financial statements involves comparison of a financial ratio, a benchmark, or a line item over a number of accounting periods. This method of analysis is also known as trend analysis. Horizontal analysis allows the assessment of relative changes in different items over time. It also indicates the behavior of revenues, expenses, and other line items of financial statements over the course of time. 

The analyzing accounting periods can be two or more than two periods. The accounting period can be a month, a quarter, or a year. It is up to the analyst's discretion to choose the appropriate number of accounting periods. During the investment appraisal, the number of accounting periods for analysis is based on the time horizon under consideration.

Horizontal analysis is a method of financial statement analysis that compares financial data from one period to another. This technique is used to identify trends or changes in a company's financial performance over time and can be applied to various financial statements.  Horizontal analysis of financial statements can be performed on any of the item in the income statement, balance sheet and statement of cash flows. For example, this analysis can be performed on revenues, cost of sales, expenses, assets, cash, equity and liabilities. It can also be performed on ratios such as earnings per share (EPS), price earning ratio, dividend payout, and other similar ratio.

Horizontal analysis can be performed in one of the following two different methods i.e. absolute comparison or percentage comparison.

• Absolute Comparison:

One way to perform a horizontal analysis is to compare the absolute currency amounts of some items over time. For example, the cash balance at the end of one accounting period can be compared to other accounting periods. This method is helpful in identifying the items that are changing the most.

• Percentage Comparison:

The second method of horizontal analysis compares percentage differences in certain line items over a period of time. The absolute currency amounts are converted to percentages for comparison. For example, a change in cash from $5,000 to $5,500 is reported as a 10% increase in cash. It can also be reported as 110%, meaning that the cash is 110% of the cash at the end of the previous accounting period. This method is useful when comparing the performance of two companies of different scope and size.

Horizontal analysis can be used to identify trends or patterns in a company's financial statements that may help analysts and investors better understand its financial health and performance. For example, if a company's revenue has increased steadily over the past three years, but its expenses have increased at a higher rate, it may indicate that the company is struggling to maintain profitability.

Let's take an example of a company that has generated an income statement for the last two years.

Example of Horizontal Analysis

Let's take an example of a company that has generated an income statement for the last two years.

Income Statement

Absolute comparison: By using horizontal analysis, we can compare the income statement from Year 1 to Year 2 and evaluate the changes in both absolute and percentage terms.

Percentage comparison: From the above example, we can see that the company's revenue has increased by 20% from Year 1 to Year 2, while the cost of goods sold has increased by 17.14%. This means that the company's gross profit has increased by 26.67%. We can also see that the company's net income has increased significantly by 42.86%. This indicates that the company's cost-cutting efforts have been successful and the company has been able to improve its profitability over the past year.

As a result, horizontal analysis is a helpful tool for analysts and investors to spot trends in a company's financial performance over time. This method can be applied to assess a company's financial standing and assist investors in making defensible investment choices. Investors can discover potential risks and opportunities that could affect a company's future financial performance by comparing financial data from one period to the next.

Horizontal Analysis vs. Vertical Analysis

Horizontal analysis and vertical analysis are two common methods of analyzing financial statements.

Horizontal analysis, also known as trend analysis, compares financial data over a specific period to identify changes and trends. The analysis compares line items from the same financial statement in different periods to identify whether there have been increases or decreases in the figures. The analysis can be conducted on both the income statement and the balance sheet, comparing the figures for multiple years or quarters.

For example, if a company’s revenue was $1 million in 2019 and $1.2 million in 2020, then the horizontal analysis would show a 20% increase in revenue. This method is useful for identifying trends and changes in a company’s financial performance.

On the other hand, vertical analysis, also known as common size analysis, involves analyzing financial statements by expressing each line item as a percentage of a base figure. The base figure can be either total assets for the balance sheet or total revenue for the income statement. The analysis provides insight into the relative importance of each item in the financial statement.

For example, if a company’s total assets are $10 million and inventory is $1 million, then the vertical analysis of the balance sheet would show inventory as 10% of total assets. This method is useful for comparing the relative importance of line items in the financial statement.

Both horizontal and vertical analysis are useful tools for analyzing financial statements and can be used together to gain a comprehensive understanding of a company’s financial performance. Horizontal analysis provides information on the trend of financial performance over time, while vertical analysis provides information on the relative importance of line items in the financial statement.

Horizontal and vertical analysis are commonly used by financial analysts, investors, and managers to gain insight into a company’s financial performance and to make informed decisions based on the analysis.