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.
Accounting periods can be two or more than two periods. Accounting period can be a month, a quarter or a year. It will depend on the analyst’s discretion when choosing an 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 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 of performing horizontal analysis is comparing the absolute currency amounts of some items over the period of time. For example, cash in hand at the end of an accounting period can be compared to other accounting periods. This method is helpful in identifying the items which are changing the most.
- Percentage Comparison:
In the second method of horizontal analysis, percentage differences in certain items are compared over a period of time. The absolute currency amounts are converted into the percentages for the purpose of comparison. For example, a change in cash from $5,000 to $5,500 will be reported as 10% increase in cash. It can also be reported as 110%, which means that the cash is 110% of the cash at the end of previous accounting period. This method is useful when comparing performance of two companies of different scale and size.