Horizontal Analysis of Financial Statements
What is Horizontal Analysis?
Horizontal Analysis is one of the ways of analyzing financial statements. It compares historical data, which includes ratios and line items, over a series of accounting periods. Accounting period can be a month, a quarter or a year. This method of analysis is also known as Trend analysis.
The Horizontal method of analysis is used to see changes in the financial statements over time and assess those changes. A base year is decided as a benchmark in the horizontal analysis. Either the data of the rest of the years is expressed as a percentage of the base year or absolute comparison is done. The base year comparison is known as base year analysis. This method of analysis makes it easy for the user of financial statements to spot changes in trends over the years.
Absolute comparison is when you compare the amount of the same line of the item to its amounts in the other accounting periods. For example, comparing accounts receivables of one year to year before it. Any changes are analyzed then.
In percentage comparison, the increase or decrease in amounts is expressed as a percentage of the amount in the base year. For example, if the base year amount of cash was $100, a 10% increase would make the current accounting period’s amount $110 and a 10% decrease would be $90.
Different ratios, for e.g. Earnings per share or current ratio, of different accounting periods are also compared.
The horizontal analysis focuses on the dollar and percentage changes that have occurred in certain accounts from year to year. The determination of the percentage change in important because it relates the amount of the change to the actual amounts involved. thus, percentage changes are better for comparative purposes with other firms than are actual dollar changes.
For example, a $1 million increase in General Motors’ cash balance is likely to represent a much smaller percentage increase than a corresponding $1 million increase in American Motors’ cash balance.
in order to calculate percentage changes the following formula should be used:
Percentage change = (Amount of dollar change / Base year amount) x 100
The base year is always considered to be the first year in the comparison. For example, Safeway’s total current assets were $1,729,146,000 in 2018 and $1,861,389,000 in 2019. This represents a dollar increase of $132,243,000 and a percentage increase of 7.65% calculated as follows:
Percentage Change = ($1,861,389,000 – $1,729,146,000 / 1,729,149,000) x 100
Horizontal Analysis can be used in conjunction with both the balance sheet and the income statement. As an example below, comparative balance sheets and income statements for Safeway Stores, Inc. showing dollar and percentage change. Several interesting balance sheet changes are apparent. During 2019 Safeway increased its operating of fixed assets. There were increases of more than 12% in all categories of property other than transport equipment. This increase in capital expenditures is also reflected on the liability side of the balance sheet where notes and debentures increased by over 53%. In this discussion and analysis of operations, Safeway’s management notes that this increase is due to a growing trend toward mortgage financing.
Comparative Balance Sheets with Horizontal Analysis
Comparative Income Statements with Horizontal Analysis
Horizontal Analysis of the income statement also provides some interesting information. both sales and cost of sales increased from 2018 to 2019. However, the percentage increase in sales was greater than the percentage increase in the cost of sales. The result is an increase in gross profit from 2018 to 2019. However, operating and administrative expenses increased slightly and interest expense increased over 12%. This resulted in only a slight increase in net income for 2019 over 2018.
The usefulness of Horizontal Analysis:
Consistency and comparability are one of the main and commonly accepted accounting principles (GAAP). Consistency is important when doing horizontal analysis of financial statements. When the same accounting standards are used over the years, the financial statements of the company are easier to compare and trends are easily analyzed. Comparability means that a company’s financial statements can be compared to that of a company in the same industry. The horizontal analysis enables the investors, analysts and other stakeholders in the company to see how well the company is doing financially. A company’s financial performance over the years is assessed and changes in different line items and ratios are analyzed. Bad changes and trends are further investigated. Horizontal analysis also makes it easier to spot when things went sideways. For e.g. if in a particular year a company started generating low profits, expenses can be analyzed. It is easier to spot inefficiency and low performance in particular areas.
Ratios like asset turnover, inventory turn over or receivables turnover are also very important to fully gauge the performance of a business. For example, a low inventory turnover would imply that the sales are low and the company is not selling inventory and there is a surplus. This could also be due to poor marketing or excess inventory due to seasonal demand. Ratios like earnings per share, return on assets or return on equity are also very helpful. They make problems related to the growth and profitability of a company evident and clear. Liquidity ratios are needed to check if the company is liquid enough to settle its debts and pay back any liabilities. Horizontal analysis makes it easy to detect these changes compare growth rates and profitability with other companies in the industry.
Let’s take a look at this simple example before we discuss any further.
Each item in any financial statement is compared to the base year. Here if the management is comparing direct sales of 2007 to 2006 (base year), there is an increase of 3.2%. This would be concerning for the management and they would investigate this if they expected at least a 10% increase.
Another example: An investor is looking to invest and finds company C. Company C’s last year figures are as follows: Net income $2m, retained earnings $10m. Current year details are: net income: $4m and retained earnings: $12m. Net income has grown by 100% and retained earnings have increased by only 20%. The investor will now make the decision of investing by looking at these figures and by comparing other such figures.
Criticism about Horizontal Analysis:
However useful trend analysis can prove to be, there still exists criticism about it. Analysts can choose a base year with poor performance and base the analysis on it. This way the current accounting period (or any other accounting period) can be made to appear relatively better.
Another problem with the horizontal analysis is that some companies change the way they show information in their financial statements. This can cause difficulties in detecting troublesome areas and make it hard to spot changes in trends.
So to conclude, the horizontal analysis should be done but not completely relied upon. Other things should be considered too and only then a decision should be taken.