What Is Horizontal Analysis? How to conduct A Horizontal Analysis and what's the use and importance of such an analysis? Find the answers and an example here.
Businesses closely monitor their financial statements to assess their financial conditions over time. In addition, they analyze their financial statements to gain awareness about their assets and liabilities.
Moreover, businesses analyze their financial statements to monitor their liquidity to know if they can invest or pay off their liabilities.
Analyzing financial statements is very important, and businesses do that in routine, but the real question is how do they do that? The answer to this question is simple. Through horizontal analysis.
The horizontal analysis enables businesses to compare their financial statements of different years to see their financial performance over time.
What Is Horizontal Analysis?
Horizontal analysis, which is also known as trend analysis, is a method used to compare financial data over a series of periods.
It involves comparing financial data, such as balance sheets, income statements, and cash flow statements, for two or more periods side by side to identify trends and changes over time.
Horizontal analysis can be conducted in two ways: using dollar amounts or percentages. In dollar amount analysis, the absolute change in the financial data is compared over the periods. The percentage change in the financial data is calculated over the periods in the percentage analysis.
Horizontal analysis helps businesses and investors identify patterns and trends over time and evaluate the company's revenue, expenses, and profitability performance.
It also provides insights into how the company has grown or declined over time and can be used to forecast future financial performance.
Uses And Importance of Horizontal Analysis
Horizontal analysis is an essential tool used by businesses. There are many ways through which horizontal analysis is beneficial for companies. Let's discuss the uses of horizontal analysis and its importance for businesses.
Identifying Trends
Horizontal analysis compares a company's financial data over time, typically for two or more periods. By comparing data from different periods, a business can identify trends and patterns that may not be apparent when looking at data from a single period.
For example, if a business's revenue increased from $500,000 in 2020 to $600,000 in 2021, this indicates a positive trend. By identifying patterns and trends in financial data using horizontal analysis, businesses can make informed decisions about their operations and investments.
They can identify areas of strength and weakness and adjust their strategies accordingly. This information can also be used to set financial goals and forecast future performance.
Performance Evaluation
By conducting horizontal analysis, businesses can evaluate their financial performance and identify areas where they are doing well and areas where they need to improve.
For example, suppose a business conducts horizontal analysis on its income statement over two years and finds that its revenue has increased by 20%. In that case, it can conclude that its sales strategies have been effective.
However, the analysis reveals that the business's expenses have increased by 30%. In that case, it may indicate that the company needs to focus on cost control measures.
Forecasting Future Performance
Businesses ahead of the curve are more likely to sustain themselves in the market. Therefore, businesses look forward to forecasting their future performances to stay aware of their operations.
Horizontal analysis gives businesses a powerful tool for forecasting future financial performance based on past trends and patterns.
By using this information to set financial goals and objectives, businesses can make informed decisions about future investments and expenditures and ensure long-term financial success.
For example, suppose a business has conducted a horizontal analysis of its income statement over the last five years and found that its revenue grew at 10% yearly. In that case, it can use this information to set a revenue growth target for the future.
Similarly, suppose the analysis reveals that expenses have been increasing at an average rate of 5% per year. In that case, the business can set a cost control target to ensure expenses do not grow faster than revenues.
Benchmarking
Businesses also use horizontal analysis to benchmark their performance against industry standards or competitors.
By comparing their financial data to industry averages or competitors' financial data, businesses can gain insights into how they perform relative to their peers.
This can help them to identify areas of strength and where they lack to make informed decisions about where to focus their efforts to improve financial performance.
For example, suppose a business conducts horizontal analysis and finds its profit margin is lower than the industry average. In that case, it may indicate that the company needs to improve its cost management or adjust its pricing strategy to improve profitability.
Similarly, suppose the analysis reveals that the business's inventory turnover ratio is higher than its competitors. In that case, it may indicate that the company needs to improve its inventory management to optimize cash flow.
Benchmarking through horizontal analysis can also help businesses to identify superior practices and learn from the successes and failures of their peers.
By studying the financial data of industry leaders or successful competitors, businesses can gain insights into what works and what doesn't in their industry and adjust their strategies accordingly.
How To Conduct A Horizontal Analysis?
We have already discussed horizontal analysis and how businesses use it to analyze and forecast their performances. Let's now discuss the process of conducting horizontal analysis.
Choose The Financial Statements
To conduct a horizontal analysis, businesses must select the financial statements they want to analyze. The most common financial statements used for horizontal analysis are the income statement, balance sheet, and cash flow statement.
The income statement shows a company's expenses and revenues over a specific period, usually a year or a quarter.
By analyzing the income statement over multiple periods, businesses can identify revenue growth trends and expense changes, which can help them understand the company's financial performance over time.
The balance sheet paints a complete picture of a company's finances at a specific point in time. It shows the company's assets, liabilities, and equity. By analyzing the balance sheet over multiple periods, businesses assess trends in the company's financial position and changes in its assets, liabilities, and equity.
The cash flow statement displays the outflows and inflows of a company over a specific period. After analyzing the cash flow statement over multiple periods, businesses highlight the trends in cash flow and changes in the company's ability to generate and manage cash.
Collect The Financial Data
To proceed with the horizontal analysis, businesses need to collect the financial data for the selected financial statements for at least two consecutive periods.
This means businesses must gather the financial statements for the same period, such as two or more years, to compare the financial data and identify trends and patterns.
By doing so, businesses can compare each year's revenues, expenses, and net income and identify trends or patterns in the data.
Similarly, if businesses analyze the balance sheet, they should collect the balance sheets for the same period. This allows you to compare each year's assets, liabilities, and equity and identify changes in the company's financial position.
Analyze The Trends
After collecting the financial data for the selected financial statements, the next step in conducting a horizontal analysis is to analyze the changes in the financial data to identify trends and patterns.
This involves looking for areas where there have been significant increases or decreases and considering the reasons behind these changes. For example, companies may notice that their revenues have been growing over the course of a few years while their expenses have been relatively stable.
This may indicate that the company is growing and becoming more profitable. Businesses can also use graphs or charts to visualize the trends in the financial data. This can make it easier for them to identify patterns and trends and to communicate their findings to others.
What Is An Example of Horizontal Analysis?
In the previous section, we discussed the process of conducting horizontal analysis in detail. Let's look at its example to ensure you understand the application of horizontal analysis.
Suppose you are the financial analyst of a company that operates in the retail industry. You have been tasked with conducting a horizontal analysis of the company's income statement for the past two years to identify trends and patterns in its financial performance.
After collecting the financial data for the selected financial statements, you analyze the changes in the financial data to identify trends and patterns. You calculate the percentage change in each item on the income statement between the two years to see how the company's financial performance has changed over time.
You notice that the company's revenues have increased by 15% from the previous year, while its cost of goods sold has increased by only 10%. This indicates that the company has expanded its profit margin, as it has been able to sell its products at a higher price or reduce costs.
You also observe that the company's operating expenses have increased by 20%, which is higher than the increase in revenues. This suggests the company has been spending more on overhead costs such as rent, salaries, and utilities.
Finally, you analyze the company's net income, which has increased by 5%. Although the company's net income has increased, it has not kept pace with the increase in revenues, which could be a cause for concern.
Based on this horizontal analysis, you may recommend that the company focus on reducing operating expenses to improve profitability. Alternatively, the company could increase its prices to maintain its profit margins.
Horizontal Analysis Vs. Vertical Analysis
Horizontal analysis and vertical analysis are two methods of financial analysis used to evaluate a company's performance.
Vertical analysis is a financial analysis technique that compares financial data to a base period or benchmark to determine the relative proportions of each data component. For example, it shows the percentage of each item in relation to a base item in the same period.
Here are some of the differences between horizontal analysis and vertical analysis:
Focus
The horizontal analysis focuses on changes in financial data over time, such as sales revenue or net income changes. It helps in identifying trends, patterns, and changes in performance.
The vertical analysis focuses on the relative proportions of each item in a financial statement. It helps in analyzing the composition of the financial data and identifying any imbalances or trends in the company's financial structure.
Calculation
Horizontal analysis is calculated by dividing the difference between the financial data of two periods by dividing it by the financial data of the earlier period and multiplying it by 100 to get the percentage change.
Vertical analysis is calculated by dividing each item in a financial statement and dividing it by a base item in the same period, then multiplying it by 100 to get the percentage of each item in relation to the base item.
Period
The horizontal analysis involves comparing financial data over several reporting periods, typically several years. This analysis aims to identify trends and changes in performance over time.
For example, a company might use horizontal analysis to compare its revenue from one year to the next to see if it is growing or declining.
In contrast, vertical analysis typically focuses on a single reporting period, such as a single year's financial statements.
This analysis aims to determine the relative proportions of each component of the financial data, such as the percentage of total revenue that comes from each product line or the percentage of total expenses that are related to a particular function.
Horizontal Analysis: Final Word
Businesses rely on financial statements to monitor their financial position, and analyzing them helps businesses identify their assets and liabilities.
Horizontal analysis, also known as trend analysis, is an effective financial analysis method that enables businesses to compare financial data from different periods and identify trends and changes over time.
Horizontal analysis helps businesses identify trends, evaluate, forecast future performance, and benchmark themselves against their peers. To conduct a horizontal analysis, businesses select the financial statements they want to analyze and compare the data for two or more periods.
After discussing the process of conducting the horizontal analysis, we discussed the differences between horizontal and vertical analysis. Both these analyses mainly differ from each other in the calculation, focus, and time period that they both consider assessing the financial analysis.
