For example, a company’s management may establish that the robust growth of revenues or the decline of the cost of goods sold as the cause for rising earnings per share. By exploring coverage ratios, interest coverage ratio, and cash flow-to-debt ratio, horizontal analysis can establish whether sufficient liquidity can service a company. Horizontal analysis can also be used to compare growth rates and profitability over a specific period across firms in the same industry. Horizontal analysis is an approach used to analyze financial statements by comparing specific financial information for a certain accounting period with information from other periods.
Horizontal Analysis, like every other accounting process, is only accurate or possible when certain defined steps are followed. Looking to streamline your business financial modeling process with a prebuilt customizable template? Say goodbye to the hassle of building a financial model from scratch and get started right away with one of our premium templates. Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos. For example, a low inventory turnover would imply that sales are low, the company is not selling its inventory, and there is a surplus.
This data can be pulled from your company’s financial statements, such as the balance sheet, income statement, and cash flow statement. To conduct horizontal analysis i.e. evaluate underlying trends, it’s essential to compare financial statements of a company or companies over two or more accounting periods. Horizontal analysis, also known as trend analysis, is a financial analysis technique that compares and evaluates the changes in financial statement data over a specific period. It involves analyzing year-to-year variations in financial metrics to identify trends, patterns, and shifts in a company’s financial performance. By examining the historical data and calculating percentage changes, horizontal analysis helps in understanding the direction and magnitude of changes, enabling informed decision-making and strategic planning.
Calculate Percentage Change
Horizontal analysis can also be used to benchmark a company with competitors in the same industry. For example, the vertical analysis of an income statement results in every income statement amount being restated as a percent of net sales. If a company’s net sales were $2 million, they will be presented as 100% ($2 million divided by $2 million). If the cost of goods sold amount is $1 million, it will be presented as 50% ($1 million divided by sales of $2 million). First, a direction comparison simply looks at the results from one period and comparing it to another.
- Another option is to add as many years as would fit on the page without providing a variance, allowing you to view overall changes by account over time.
- To standardize the output for the sake of comparability, the next step is to divide by the base period.
- Given below is a horizontal analysis in excel of a comparative income statement (i.e. year 1 – base, year 2, and year 3).
- Carrying out horizontal analysis of the income statement and balance sheet helps investors and creditors to determine the current financial position of a company.
Take note of any measurements contained in a company’s loan covenants, as it’s important to keep an eye on changes in these numbers that could lead to a covenant breach. Insert a column to the right of ‘2022’ and click on the cell corresponding to the first revenue line item. Google Sheets offers plenty of Data Analysis features that we can use to make sense of large data sets. From 2021 to 2020, we’ll take the comparison year (2021) and subtract the corresponding amount recorded in the base year (2020).
Why is Horizontal Analysis Important in Financial Analysis?
Ensure the accuracy and completeness of the data, as any inaccuracies can affect the analysis results. For example, if a company starts generating low profits how to hustle in a particular year, expenses can be analyzed for that year. This makes it easier to spot inefficiencies and specific areas of underperformance.
Horizontal Analysis of Financial Statements FAQs
It is typical for an income statement to use revenue (or sales) as the comparison line item. This means revenue will be set at 100% and all other line items within the income statement will represent a percentage of revenue. If we take historical data of the financial statements of a company for year 1 and year 2, then one can compare each item and how it has changed year-over-year. The primary difference between vertical analysis and horizontal analysis is that vertical analysis is focused on the relationships between the numbers in a single reporting period, or one moment in time. Horizontal analysis looks at certain line items, ratios, or factors over several periods to determine the extent of changes and their trends. Horizontal analysis compares amount balances and ratios over a different time period.
Horizontal Analysis: What It Is vs. Vertical Analysis
Another way to see this is where the base period was unusually poor, taking the year 2020 which was greatly affected by the COVID pandemic for example. What this means is that even with good intentions, periods that are rather average or even dangerous may appear to be great periods and a company does not get the most accurate idea of its financial health and environment. For this technique to be used, at least two financial statements (of the same type) need to be in existence. To get a more valid analysis, however, at least three financial statements are used.
Based on trend analysis, however, these expenses are actually declining as a percentage of sales. Initial gross profit ratio calculations seemed to indicate little variation, and thus little effect on income from operations. The increase in cost of goods sold (78% vs. 77% of sales) may warrant further investigation. Horizontal analysis is a financial analysis technique used to evaluate a company’s performance over time.
Calculate the Percentage Change
For example, you can compare your company’s revenue from last year to this year or your company’s net income from last year to this year. You can also compare specific expenses, such as marketing expenses or wages and salaries. By comparing data sets in this way, you can identify trends and patterns in your business performance. Companies may choose to make a period of very poor financial performance the base period and compare all other financial periods with it. This way, companies willfully maneuver and change their growth and profitability trends to their advantage. Horizontal analysis provides insights into a company’s financial performance and health.
Horizontal analysis compares (in absolute or relative form) the main items of the Balance sheet, Profit and loss statement, and Cash flows statement for two or more accounting periods. Simply put, this type of analysis consists of comparing the indicators of the accounting reports with indicators of previous periods. It helps you understand how your company is performing over time to make more informed decisions about allocating your resources. By comparing data sets side-by-side, you can identify upward or downward trends in revenue, expenses, and net sales. This information can be used to make strategic decisions about pricing, budgeting, and product development.