Horizontal Analysis

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Horizontal Analysis
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Horizontal Analysis focuses on the changes in information from period to period. This type of analysis can tell us whether a company's sales, gross profit, expenses, and net income are increasing or decreasing over time, as well as what the change was for each item for each year. Horizontal analysis also reveals whether cash ( or any other financial statement item) has increased or decreased over a particular period of time. The dollar change from one period to the next in an individual account may not adequately explain a change. The percentage change increases the user's understanding of the significance and nature of the change in that account.

There are two steps involved in performing horizontal analysis[1]:

  • compute the dollar amount of the change from the base year to the year against which you are making the comparison
  • divide the dollar amount of the change by the base year amount

Tools of analysis

We use various tools to evaluate the significance of financial statement data. There commonly used tools are these[2]:

  1. horizontal analysis
  2. vertical analysis
  3. ratio analysis

Difference between horizontal and vertical analysis

There are several differences between horizontal and vertical analysis[3]:

A comparison between horizontal and vertical analysis
Points of comparisons Horizontal Analysis Vertical Analysis
Period It requires comparative financial statements of two or more accounting period. It requires statements of one period only.
Items It deals with the same items of different years or periods. It deals with different items of the same year or period.
Tools Trend analysis is the main tool of horizontal analysis. Common size statements are the main tool of vertical analysis.
Usefulness Horizontal analysis is useful for long-term planning. Vertical analysis is useful for short-term planning.

Problems of horizontal analysis

Horizontal analysis minimizes many of the problems associated with vertical analysis. When you focus on the changes to a ratio reported by one company over time, there is less reason to e concerned about the effect of different accounting methods on the comparisons. Although a company may alter some of its methods from time to time, it is required to report any material changes in those methods. You are therefore better able to tell whether a substantial change in a financial ratio from one year to the next has been caused by a modification in accounting methods or by a change in the ways a company does business.

The major weakness of a strictly horizontal analysis is that it provides you no information about a standard for a given ratio. Suppose you know that a retailer's inventory turns ratio has increased steadily from 8 turns per year to 10 per year over a five-year period. On the face of it, this is a cheery finding: the company has been moving goods through its retail outlets faster and faster over time. But if other, similar retailers average 15 turns per year, then although this company is improving it might not yet be managing its inventory as well as should. A strictly horizontal analysis would not give you this information[4].

Footnotes

  1. F.J. Plewa, G.T. Friedlob 1995, p.214
  2. J.J. Weygandt, P.D. Kimmel, D.E. Kieso 2011, p.645
  3. Accountancy 2016, p.77
  4. C.G. Carlberg 2002, p.154-155

References

Author: Daria Polewka