What is Horizontal Analysis?
Horizontal analysis is used in financial statement analysis to compare historical data, such as ratios, or line items, over a number of accounting periods. Horizontal analysis can either use absolute comparisons or percentage comparisons, where the numbers in each succeeding period are expressed as a percentage of the amount in the baseline year, with the baseline amount being listed as 100%. This is also known as base-year analysis.
- Horizontal analysis is used in the review of a company's financial statements over multiple periods.
- It is usually depicted as a percentage growth over the same line item in the base year.
- Horizontal analysis allows financial statement users to easily spot trends and growth patterns.
- It can be manipulated to make the current period look better if specific historical periods of poor performance are chosen as a comparison.
How Horizontal Analysis is Used
Generally accepted accounting principles (GAAP) are based on consistency and comparability of financial statements. Consistency is the ability to accurately review one company's financial statements over a period of time because accounting methods and applications remain constant. Comparability is the ability to review side-by-side two or more different companies' financials. Horizontal analysis not only improves the review of a company's consistency over time directly, but it also improves comparability of growth in a company to that of its competitors as well.
Horizontal analysis allows investors and analysts to see what has been driving a company's financial performance over a number of years, as well as to spot trends and growth patterns such as seasonality. It enables analysts to assess relative changes in different line items over time, and project them into the future. By looking at the income statement, balance sheet, and cash flow statement over time, one can create a complete picture of operational results, and see what has been driving a company’s performance and whether it is operating efficiently and profitably.
The analysis of critical measures of business performance, such as profit margins, inventory turnover, and return on equity, can detect emerging problems and strengths. For example, earnings per share (EPS) may have been rising because the cost of goods sold (COGS) have been falling, or because sales have been growing strongly. And coverage ratios, like the cash flow-to-debt ratio and the interest coverage ratio can reveal whether a company can service its debt through sufficient liquidity. Horizontal analysis also makes it easier to compare growth rates and profitability among multiple companies.
Example of Horizontal Analysis
Horizontal analysis typically shows the changes from the base period in dollar and percentage. For example, when someone says that revenues have increased by 10% this past quarter, that person is using horizontal analysis. The percentage change is calculated by first dividing the dollar change between the comparison year and the base year by the line item value in the base year, then multiplying the quotient by 100.
For example, assume an investor wishes to invest in company XYZ. The investor may wish to determine how the company grew over the past year. Assume that in company XYZ's base year, it reported net income of $10 million and retained earnings of $50 million. In the current year, company XYZ reported net income of $20 million and retained earnings of $52 million. Consequently, it has an increase of $10 million in its net income and $2 million in its retained earnings year over year. Therefore, company ABC's net income grew by 100% (($20 million - $10 million) / $10 million * 100) year over year, while its retained earnings only grew by 4% (($52 million - $50 million) / $50 million * 100).
Criticism of Horizontal Analysis
Depending on which accounting period an analyst starts from and how many accounting periods are chosen, the current period can be made to appear unusually good or bad. For example, the current period's profits may appear excellent when only compared with those of the previous quarter, but are actually quite poor if compared to the results for the same quarter in the preceding year.
A common problem with horizontal analysis is that the aggregation of information in the financial statements may have changed over time, so that revenues, expenses, assets, or liabilities may shift between different accounts and therefore appear to cause variances when comparing account balances from one period to the next. Indeed, sometimes companies change the way they break down their business segments, in order to make the horizontal analysis of growth and profitability trends more difficult to detect. Accurate analysis can be affected by one-off events and accounting charges.
Although a change in accounting policy or the occurrence of a one-time event can impact horizontal analysis, these situations should also be disclosed in the footnotes to the financial statements, in keeping with the principle of consistency.
Vertical Analysis vs. Horizontal Analysis
While horizontal analysis looks changes in the dollar amounts in a company’s financial statements over time, vertical analysis looks at each line item as a percentage of a base figure within the current period. Thus, line items on an income statement can be stated as a percentage of gross sales, while line items on a balance sheet can be stated as a percentage of total assets or liabilities, and vertical analysis of a cash flow statement shows each cash inflow or outflow as a percentage of the total cash inflows. Vertical analysis is also known as common size financial statement analysis. For more, read The Common-Size Analysis of Financial Statements.