Horizontal Analysis
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]:
- horizontal analysis
- vertical analysis
- ratio analysis
Difference between horizontal and vertical analysis
There are several differences between horizontal and vertical analysis[3]:
| 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].
Examples of Horizontal Analysis
- Comparing financial statements to determine the change in performance from one year to the next: Horizontal analysis is a useful tool for analyzing a company's financial performance over time. By comparing financial statements from different periods, a business can identify trends in its income, expenses, and other key financial metrics. This information can be used to inform strategic decisions and make more informed decisions about investments and other financial matters.
- Comparing financial statements across industries: Horizontal analysis can be used to compare the financial performance of different companies within the same industry. This can help investors identify which companies are performing better and which ones need to improve their operations. It can also help stakeholders identify which companies are in the best position to capitalize on opportunities, and which ones may need to make changes in order to remain competitive.
- Detecting changes in financial ratios: Horizontal analysis can be used to compare financial ratios across different periods. This can help investors identify trends in how a company is managing its finances and can be used to assess the overall health of a business. For example, a company's current ratio can be compared to the previous year's to see if the company is maintaining or increasing its liquidity. Similarly, a company's debt-to-equity ratio can be compared to the previous year's to see if the company is increasing or decreasing its debt burden.
Advantages of Horizontal Analysis
- Horizontal analysis provides insight into the performance of the company by comparing different accounts over a certain period of time.
- It helps identify trends in the financial performance of a company, allowing for better decision making.
- It allows for comparisons between different companies, providing a basis for comparison.
- It gives the user a better understanding of the financial data, such as the overall financial health of a company.
- It is a simple and easy to understand analysis tool.
- It can help users detect changes in financial performance that may not be apparent when looking at individual financial statement items.
- It can be used to identify any potential problems that a company may be facing, allowing for early intervention and corrective action.
Limitations of Horizontal Analysis
Horizontal Analysis has its limitations, which include:
- It does not provide insight into the cause of changes in accounts, as it does not take into consideration the economic, industry, or company-specific events that could be influencing the changes.
- It is not useful for making comparisons between different companies in the same industry, as different firms may have different accounting methods and practices.
- It is not useful for analyzing changes over long periods of time, as the data will be subject to inflation and economic cycles.
- It may be difficult to draw meaningful conclusions when comparing a company to an industry average, as the industry average may be distorted by outliers.
- It does not provide insight into the sustainability of the changes, as it only focuses on the changes from one period to the next.
Other approaches related to Horizontal Analysis include:
- Vertical Analysis: This approach of analysis is often used to compare the relative size of different accounts on the financial statements by expressing each item as a percentage. It is useful for determining the relative size of different components of the financial statements and analyzing the trends in financial ratios over multiple periods.
- Trend Analysis: This type of analysis is used to compare financial statements from different periods in order to identify trends in a company’s performance. It is used to identify changes in the financial performance of a company over time, allowing for a more in-depth analysis of a company’s performance.
- Cash Flow Analysis: This type of analysis is used to examine the cash inflows and outflows of a company. It is used to identify which areas of a company’s operations are generating cash, and to identify any potential cash flow problems.
- Ratio Analysis: This type of analysis is used to compare different financial ratios to industry averages, or to compare the same ratios over multiple periods. It is used to identify potential problems and opportunities within a company.
In summary, Horizontal Analysis is used to compare different financial statement items over multiple periods, and it is often used in combination with other approaches such as Vertical Analysis, Trend Analysis, Cash Flow Analysis, and Ratio Analysis. This combination of approaches allows for a more in-depth analysis of a company’s financial performance.
Footnotes
| Horizontal Analysis — recommended articles |
| Du Pont analysis — Common-size financial statement — Return on net assets — Comparative statements — Operating cash flow ratio — Accounting ratios — Account Analysis — Aged debt — Burn Rate |
References
- Accountancy, (2016), SBPD Publications, New York.
- Carlberg C.G., (2002), Business Analysis, Que Publishing, Indiana.
- Plewa F.J., Friedlob G.T., (1995), Understanding Cash Flow, John Wiley & Sons, New York.
- Weygandt J.J, Kimmel P.D., Kieso D.E., (2011), Managerial Accounting: Tools for Business Decision Making, John Wiley & Sons, New Jersey.
Author: Daria Polewka
