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 allows investors and analysts to see what has been driving a company's financial performance over a number of years, as well as spotting trends and growth patterns such as seasonality. It enables analysts to assess relative changes in different line items over time, and project them. By looking at the income statement, balance sheet and cash flow statement at the same 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 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 and has enough liquidity. Horizontal analysis also makes it easier to compare growth rates and profitability among different companies.
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 harder.
Also, accurate analysis can be affected by one-off events and accounting charges.
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 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% YOY, while its retained earnings only grew by 4%.
While horizontal analysis looks at how the dollar amounts in a company’s financial statements have changed over time, vertical analysis looks at each line item as a percentage of a base figure within the statement. 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.