Last updated on July 25th, 2024 at 10:24 am
Horizontal analysis is a significant aspect of the world of finance. It is a systematic approach to analysing financial statements by drawing conclusions by comparing financial information for an accounting period while comparing the specific information with other accounting periods. it is usually analysed as the growth in the percentage of a specific item in a year while comparing it with the base year.
Horizontal analysis is important for companies as it helps to easily spot trends and analyse the growth patterns of specific items. Learning horizontal analysis is a must. Acquiring the knowledge of horizontal analysis is a must for individuals who want to build a career in finance.
Read on to understand “what is meant by horizontal analysis?” And how it impacts the finances of an organisation.
What is Meant by Horizontal Analysis?
Horizontal analysis is a key aspect of financial statement analysis which allows users to compare a specific line of item of an accounting period with that of other accounting periods. It is basically done to draw conclusions about the growth or fall of an item.
Horizontal analysis can be used in two ways. One is absolute comparison and another is percentage comparison. Here, the baseline is taken as a hundred percent and a comparison of other accounting periods is drawn accordingly. Hence, this approach is also known as base year analysis.
Horizontal analysis of financial statements is crucial for determining the growth of an organisation when compared to its competitors. It is a way of asserting historical trends which helps organisations to know which part is profitable and which is incurring losses.
Horizontal Analysis in Reporting Standards
As stated in the generally accepted accounting principles (GAAP), financial statements should be projected in such a manner that the information is consistent and comparable in order to evaluate the company's financial performance. Individuals trying to build a career in finance should be well versed in the GAAP principles and draft the financial statements accordingly.
Here, consistency implies that if a company is following a certain method of accounting in the base year, it must follow the same accounting method in the consecutive years. Therefore, the results remain authentic and constant over the accounting periods.
Secondly, by comparability, the standards dictate an organisation to maintain its financial statements and other relevant documents in such a manner that can be evaluated and compared with other companies in the same industry.
Hence, horizontal analysis of financial statements allows the companies to improve the consistency and comparability constraint as outlined by the GAAP.
Key Metrics in Horizontal Analysis
A company's financial performance is reflected by its financial statements which consist of the balance sheet, profit and loss statement and cash flow statement. These financial statements project a clear picture of the organisational performance for that accounting period. At the same time, emerging trends, strengths and weaknesses, critical operational aspects and improvement areas of a company can be ascertained by analysing the various factors such as return on equity, profit margin and inventory turnover ratio.
For instance, an organisation's management may project that the sudden growth of profit or the decline of the cost of goods sold is the reason for the growth per share. After performing horizontal analysis for interest coverage ratio and cash flow to debt ratio the company may conclude whether there has been sufficient liquidity for the accounting year or not. A horizontal balance sheet can also used to compare the growth rate, profitability, losses and overall business performance of various companies and in the same company for various accounting periods.
How Horizontal Analysis Works?
Horizontal analysis of financial statements provides a clear picture to the investors and the shareholders of the company of how the organisation has performed for a particular accounting period. It allows investors to ascertain what has been the driving force of the company and what results it has yielded in their favour. They can easily identify the loopholes and see the growth trend by comparing the relative changes.
For building a career in finance, it’s important to perform a proper analysis of the financial statements of a company such as cash flow statement, income statement and balance sheet. These reveal the company's operating efficiency along with the operational results.
The analysis of critical aspects of a company's finances, such as its return to equity, inventory turnover, and profit margins depends upon horizontal analysis. Coverage ratios show the liquidity capacity of a company and its ability to meet its current debts. With effective horizontal analysis, the growth and profitability of a company can also be evaluated.
To know more about horizontal analysis and its working structure, one may enrol on an insightful financial analysis course. The Postgraduate Financial Analysis Programme by Imarticus is a great pick where you can gain hands-on knowledge about the said topic.
How to Perform a Horizontal Analysis?
The procedure of horizontal analysis is short and crisp. However, it involves three major steps that need to be followed with precision.
The following other steps that one needs to follow to perform horizontal analysis of financial statements:
Step 1: gather financial information
To proceed with the process of horizontal analysis, financial individuals need to gather financial information about a company for various accounting periods. This is generally done by drawing annual financial statements during various accounting years. Thereafter, specific account balances in the balance sheet or cash flow statement are looked upon to uphold a specific line analysis.
Individuals need to ensure that the gap between each financial statement remains consistent. Otherwise, the calculation and conclusion will not be accurate. However, the interval of the accounting period is at the discretion of the organisation, it can be done on a monthly, quarterly or yearly. However, the difference between each iterative accounting period should remain equal and consistent for precise comparison of financial information.
Step 2: determine comparison methods
After successfully gathering the financial information of an entity for various accounting periods, the next step is to decide on the comparison method. There are several primary comparison methods such as direct comparison, variance analysis, horizontal analysis, vertical analysis, and so on.
Here, the chosen approach is horizontal analysis where the comparison is strong by the change in percentage of one accounting period to another. However, all the percentage change is calculated while considering the base year chosen by the organisation. As the company's operation grows, it becomes difficult to maintain the same growth rate.
In order to identify changes over a longer period, the percentage method proves to be very useful. This method also provides indications of significant deviations in the current period when compared to the base year.
Step 3: identify trends and patterns
After the entire calculation process is done, and the financial information is verified, it is time to analyse the outcomes. However, the identification of growth, trends and patterns is characterised by taking into account some specifically guided concerns.
For instance, the management may want to know how well the cost of goods sold for a particular region has been. In that case, the financial analyst needs to provide the result for that specific line of item for various accounting periods. It helps to understand the comparison and also identify the growth rate.
Example of Horizontal Analysis
Horizontal analysis of financial statements is a way to measure the changes in dollars or percentages for various accounting periods by drawing a comparison with the base year. When people having a career in finance state that the revenue has gone up by 10% for the quarter, it means that such individuals are talking about the outcome of horizontal analysis.
The percentage change is calculated by dividing the dollar change between the base year and the year in question by considering the line item. The quotient is then multiplied by 100.
To calculate horizon analysis in percentage the following formula has to be used:
Horizontal analysis (%)= {(amount in comparison year - amount in base year)/ amount in base year} * 100
For example, if an investor wants to invest in ABC company, the investor will want to know how the company has performed over the past years. let’s say that in company ABC, the base year reported the net revenue to be $10 million and retained income of $50 million.
The current year, that is the question of the same company has reported net revenue of $20 million and retained income of $52 million. As a consequence, the net increase has been $10 million, and the earnings retained for that particular particular year is $2 million.
Therefore, the net worth of the company shot up by 100%.
That is,
($20 million -$10 million)/$10 million * 100
Whereas, its retained income only grew by 4%.
That is,
($52 million -$50 million)/ $50 million * 100
| period 1 (base year) | period 2 (current year) | change | % change | |
| Net revenue | $10 million | $20 million | + $10 million | 100% |
| Retained income | $50 million | $52 million | + $2 million | 4% |
Advantages of Horizontal Analysis
Horizontal analysis offers very few disadvantages in financial reporting and financial analysis. The following are the benefits of horizontal analysis:
- It provides a clear picture of the company’s financial performance and health.
- It helps to easily identify growth patterns and trends by comparing financial information of different accounting periods.
- It states whether the company is in a growth stage or facing a decline.
- Horizontal analysis helps the management of a company to make informed decisions.
- It helps to identify the irregularities and anomalies within the company.
- It helps to elevate benchmarking against competitors and industry-standard standards.
- It allows an in-depth examination of the financial information of the company, which leads to a better understanding of the company’s financial health.
- The outcomes of horizontal analysis aid in strategic planning and sustainable business growth.
Criticism of Horizontal Analysis
Horizontal analysis is considered a beneficial approach for companies to ascertain their financial performance, but it is characterised by certain criticism as well. A financial analyst can manipulate the conclusions of horizontal analysis based on the year he chooses as the base year and how many accounting periods he takes into consideration for drawing the comparison.
For instance, the current accounting year’s profit may outshine the ones with which it is compared. On the other hand, it may prove to be relatively poor when compared to the profits of the preceding years which has not been taken into consideration. Hence, it is important for individuals wanting to build a career in finance to know that in such scenarios, leaving a footnote about the financial statement and its consistency is one of the best practices.
Another issue with horizontal analysis of financial statements is that the aggregation of financial information in those statements may have changed over time. It means that the expenses, revenues, assets and liabilities may have changed in different accounting periods. Hence, these changes can cause variations when comparing the account balances of one accounting year to another.
Precise horizontal analysis thus gets affected due to these variations and meticulous selection of the base year and consecutive accounting years for comparison.
Conclusion
Horizontal analysis is an amazing approach to financial analysis that is used to analyse a company’s financial performance over time. It compares previous and current financial performance for various accounting years, which helps to provide a clear picture of how the company is doing. With horizontal analysis, an organisation can spot growth trends and deviations with much accuracy.
If you are a finance professional or you want to step into the field of finance then becoming a financial analyst is a great career option. There are multiple financial analyst courses that you can take to improve your skill set. The Postgraduate Financial Analysis Program by Imarticus is an insightful course that will help you leverage your abilities in the field of finance.
Frequently Asked Questions
- How to do horizontal analysis step-by-step?
There are three major steps involved in the process of horizontal analysis. The first step is to gather financial information, followed by determining the comparison methods. Lastly, identified trends and patterns.
- What is the formula used to complete a horizontal analysis?
For calculating horizontal analysis, the formula is:
Horizontal analysis (%)= {(amount in comparison year - amount in base year)/ amount in base year} * 100
- What is another name for horizontal analysis?
Horizontal analysis is also known as trend analysis where individuals compare the change in the financial statements of one accounting year with another.
- How to calculate the current ratio?
One can calculate the current ratio by dividing a company’s total current assets by its total current liabilities. The current ratio is a resource that can easily be converted into cash and cash equivalents within one year or less than that.
