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Horizontal Analysis of Financial Statements
- Analyst Interview
- May 29, 2024
- 4 min read
Introduction
Horizontal analysis, also known as trend analysis, is a fundamental technique in financial analysis that involves comparing financial data over a series of reporting periods. This method is used to identify trends, measure performance, and evaluate the consistency and growth of a company over time. By examining changes in financial statement items across multiple periods, horizontal analysis provides valuable insights into a company's operational effectiveness, financial stability, and strategic direction.\
Definition and Purpose
Horizontal analysis is a method of financial analysis where financial statements are compared across multiple periods. This approach allows analysts, investors, and management to assess relative changes in financial statement items, such as revenue, expenses, and profits. The primary purpose of horizontal analysis is to:
Identify Trends: By looking at financial data over several periods, it becomes easier to spot trends, whether they be positive or negative. For instance, a consistent increase in revenue suggests growing business operations, whereas declining profits over time might signal underlying issues.
Evaluate Performance: Horizontal analysis helps in evaluating the performance of a company by measuring growth rates and profitability. This evaluation helps stakeholders understand whether the company is improving, deteriorating, or maintaining its performance.
Comparative Analysis: It enables comparisons between different periods, which can highlight significant changes or anomalies in the financial statements. Such comparisons are crucial for making informed decisions and strategic planning.
Forecasting and Budgeting: By analyzing historical data, businesses can forecast future financial performance and prepare budgets accordingly. This forward-looking aspect is crucial for planning and resource allocation.
Methodology
Horizontal analysis typically involves two main steps:
Comparative Financial Statements: The first step is to prepare comparative financial statements, where the financial data for multiple periods are presented side by side. These statements could include the balance sheet, income statement, and cash flow statement for, say, three to five years.
Calculating Changes: Next, the changes in financial statement items are calculated in both absolute terms (dollar amount changes) and relative terms (percentage changes). This calculation helps quantify the degree of change and provides a clear picture of financial trends.
Horizontal Analysis Formula
Horizontal analysis, or trend analysis, involves comparing financial data over multiple periods to identify trends and measure performance. The key component of horizontal analysis is calculating the changes in financial statement items over these periods. This is done using two primary formulas: one for the absolute change and one for the percentage change.
Absolute Change Formula
The absolute change measures the difference in the value of a financial statement item between two periods.
Absolute Change = Value in Current Period - Value in Base Period
Percentage Change Formula
The percentage change expresses the absolute change as a percentage of the base period value, providing a relative measure of the change.Percentage Change
= (Absolute Change / Value in Base Period) × 100
Step-by-Step Example
Let's illustrate these formulas with a practical example using revenue data for two consecutive years.
Example Data:
Year 1 Revenue: $500,000
Year 2 Revenue: $600,000
Step 1: Calculate Absolute Change
Absolute Change = $600,000 - $500,000 = $100,000
Step 2: Calculate Percentage Change
Percentage Change = ($100,000 / $500,000) × 100 = 20%Thus, the revenue increased by $100,000 or 20% from Year 1 to Year 2.
Practical Applications
These formulas can be applied to various financial statement items, including revenue, expenses, net income, assets, liabilities, and equity. By systematically calculating the absolute and percentage changes, analysts can derive meaningful insights into the financial trends and performance of a company over time.
Extended Example
To further understand the application, let's consider another example involving net income over three years.
Example Data:
Year 1 Net Income: $50,000
Year 2 Net Income: $70,000
Year 3 Net Income: $90,000
Step-by-Step Calculation:
Year 1 to Year 2:
Absolute Change: $70,000 - $50,000 = $20,000
Percentage Change: (($20,000 / $50,000) × 100 = 40%
Year 2 to Year 3:
Absolute Change: $90,000 - $70,000 = $20,000
Percentage Change: (($20,000 / $70,000) × 100 = 28.57%
Summary of Results:
Year 1 to Year 2:
Net Income increased by $20,000 (40%)
Year 2 to Year 3:
Net Income increased by $20,000 (28.57%)
Through horizontal analysis, we can observe that while the absolute increase in net income remained the same ($20,000), the rate of growth slowed down in the third year compared to the second year.
Comparative Balance Sheets With Horizontal Analysis
Comparative Income Statement With Horizontal Analysis
Horizontal Analysis vs. Vertical Analysis: What is the Difference?
Characteristic | Horizontal Analysis | Vertical Analysis |
Definition | Compares financial data over multiple periods to identify trends and measure performance | Expresses each line item in a financial statement as a percentage of a base figure, such as total assets or total revenue |
Purpose | Understand changes and growth patterns in financial statement items over time | Analyze the internal structure and relationships within a single financial statement |
Focus | Changes and growth rates of individual items | Relative proportions of items within a single period |
Comparison | Intra-firm comparison (comparing a company's own data over time) | Intra-firm and inter-firm comparison (comparing a company's data to industry averages or competitors) |
Representation | Absolute changes and percentage changes | Percentages of a base figure |
Time Orientation | Longitudinal (historical trends over multiple periods) | Cross-sectional (single period) |
Applications | Strategic decision-making, forecasting, and long-term planning | Benchmarking, cost optimization, and operational decisions |
Insights Provided | Identifies growth or decline in financial statement items over time | Reveals the relative importance and composition of financial statement items |
Limitations | Does not provide information about the internal structure of the financial statements | Does not provide information about changes over time |
Examples | Revenue increased by 15% from 2020 to 2021 | Rent expense is 8% of total expenses |
Key Questions Answered | How have the financial statement items changed over time? | What is the relative proportion of each item within the financial statements? |
Download Horizontal Analysis Template
Conclusion
Horizontal analysis is a vital tool in the arsenal of financial analysts, offering a dynamic view of a company's financial health over time. By providing insights into trends, growth rates, and performance metrics, this technique supports more informed and strategic decision-making. While it should be used in conjunction with other analytical methods, horizontal analysis remains a cornerstone of thorough financial analysis.
Frequently Asked Questions (FAQs)
What is the difference between horizontal analysis and vertical analysis?
Horizontal analysis compares financial data over multiple periods, while vertical analysis compares different line items within a single period.
How is horizontal analysis used in forecasting?
Horizontal analysis provides historical trends that can be used as a basis for forecasting future financial performance.
Can horizontal analysis be used for non-financial data?
While horizontal analysis is primarily used for financial data, it can also be applied to non-financial data to identify trends and patterns.
What other financial analysis methods complement horizontal analysis?
Vertical analysis, ratio analysis, and cash flow analysis are commonly used alongside horizontal analysis to gain a comprehensive understanding of a company's financial position.
How often should horizontal analysis be conducted?
Horizontal analysis can be performed annually or over any other relevant period, depending on the specific requirements and objectives of the analysis.
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