Horizontal or trend analysis is the historic review of the financial statements of a company for a specified period.
Let us discuss what is horizontal analysis, how to perform it, and what are its advantages for the users.
Horizontal Analysis – Definition
Horizontal analysis refers to the historical comparison of financial statement items from one accounting period with another.
It is also known as trend analysis or base year analysis. Using this method, analysts set data from financial statements in one accounting period as a baseline and compare it with the data from other accounting periods.
Horizontal analysis of financial statements can be performed for comparing data across multiple quarters in the same year, quarterly analysis on a year-on-year basis, and yearly comparisons.
This type of analysis is commonly used by internal and external stakeholders of a company including its directors, shareholders, lenders, and investors.
The prime purpose of this analysis is to turn raw data into useful and comparable information for users.
How Does Horizontal Analysis of Financial Statements Work?
Horizontal analysis of financial statements provides an overview of the changing metrics for analysts. It shows how certain numbers in a balance sheet, income statement, or cash flow statement have changed from one accounting cycle to another.
Horizontal analysis requires setting a baseline first. For instance, you take the financial statement results for the second quarter Q2 of the year 2021 as the baseline.
Then, you compare the financial statement results of Q2 for the year 2022. The difference can be recorded in absolute or percentage terms.
Analysts must perform horizontal analysis of all major financial statements as key financial metrics are closely linked for all of them.
Using this type of analysis helps you can determine whether certain financial metrics like gross profit have increased or decreased over time. Then, you can further expand the analysis to evaluate the causes of change.
Similarly, horizontal analysis allows the impact of one financial metric on another. For instance, if a company records a decrease in its sales, the analysis will show its impact on cash flows as well.
Types of Horizontal Analysis and Formulas
Horizontal analysis can be recorded in two ways; absolute and percentage terms.
This method allows you to compare values from different financial statement periods in dollar terms. You can simply subtract figures one from one accounting period to the baseline accounting period.
The formula for absolute comparison is:
Horizontal Analysis Value ($) = Amount in Current Year – Amount in Baseline Year
The results from the absolute comparison can be converted into percentage figures as well. It is useful when analyzing complex figures and for in-depth analysis.
The formula for percentage comparison is:
Horizontal Analysis Value %= [(Amount in Current Year − Amount in Baseline Year)/Amount in Baseline Year] × 100
For simplicity, you can also use variance analysis by recording results as a positive or negative change only. However, this method provides only an overview of the financial health of the business and it is often performed by external stakeholders.
How to Perform Horizontal Analysis?
Once you decide on the type of horizontal analysis, you can conduct it in a few simple steps.
Choose a baseline year or accounting period for the horizontal analysis by gathering relevant financial statements. Then, gather financial statements for the current period or any other period for which you want the comparison.
Select the financial metrics or items that you want to analyze. These items can be from the balance sheet, income statement, or cash flow statement.
Use an appropriate formula for an absolute or percentage comparison as required and put values from both accounting periods into the formula.
You can then dig deeper to evaluate the positive or negative results calculated from the horizontal analysis.
Let’s perform a horizontal analysis of Facebook’s income statement items to understand the concept.
Facebook’s parent company Meta announced a net profit of $ 29,146 million for the year ending 2020. Its net profit grew to $ 39,370 for the next year 2021.
The upwards shift in the net profit was mainly due to increased revenue for Meta. It reported a revenue figure of $ 85,965 million and $ 117,929 million for 2020 and 2021 respectively.
We can calculate the changes in net profit and margin amounts using horizontal analysis ratios.
Change in Revenue $ = $117,929 – $85,965 = $ 31,965 million
Change in Revenue % = [($117,929 – $85,965)/85,965] × 100 = 37.18%
Change in Net Profit $ = $ 39,370 – $ 29,146 = $ 10,224 million
Change in Net Profit % = [($39,370 – $ 29,146)/29,146] × 100 = 35.08%
Similarly, we can perform trend analysis for other metrics in the income statement, balance sheet, and cash flow statement.
Reporting Standards and Horizontal Analysis
The Generally Accepted Accounting Principles (GAAP) require companies to prepare financial statements complying with the comparability and consistency guidelines.
The consistency guidelines mean a company must use the same accounting principles across different accounting periods. If it changes its practice, it must disclose it in its financial statement notes.
The comparability guidelines here mean that financial statement items must be reported to make them easier for comparison across multiple accounting periods. The evaluation and analysis of these items should be fairly easy.
Therefore, when a company complies with these GAAP rules, it makes horizontal analysis easier. The evaluation and comparison through this analysis are in line with GAAP rules as well.
This analysis also helps to evaluate seasonal effects and one-time events like an industry shutdown.
Horizontal Analysis and Stock Investments
Investors can use horizontal analysis as a part of their fundamental analysis for a potential stock investment.
Although this type of analysis is not a comprehensive approach, it can help as a starting point to evaluate a potential investment opportunity. Therefore, trend analysis must not be performed in isolation.
The horizontal analysis will provide an overview of the historic financial performance of the stock for a specified period. An investor can use it to analyze the trend for key financial metrics.
Then, the right approach is to combine it with other types of analysis like forecasting and vertical analysis to get a clearer picture of where the stock is headed.
Advantages of Horizontal Analysis
The horizontal analysis provides several benefits to its users.
- The foremost advantage of horizontal analysis is its simplicity and easy calculations for analysts. It can be calculated and understood by internal and external stakeholders easily.
- This type of analysis is useful in detecting anomalies in the financial statements of a company. It requires basic calculations and if there are any abnormalities, they can be detected easily.
- It is useful in establishing trend analysis. Analysts can quickly establish trends for key financial metrics of a company and evaluate its performance.
- Horizontal analysis or trend analysis is one of the most widely used methods for the performance evaluation of a company. Stakeholders can use this type of analysis as a starting point and dig deeper to comprehensively analyze the performance of a company for a given period.
- Investors and shareholders of a company can use trend analysis to evaluate the potential investment options as well as evaluate historic performances.
- Analysts can use trend analysis as a baseline to forecast the future performance indicators of a company.
Disadvantages of Horizontal Analysis
Despite several advantages, horizontal analysis has some limitations and disadvantages as well.
- The biggest drawback of trend analysis is that it’s not forward-looking as it only evaluates the historic performances of a company.
- The starting and ending accounting periods can be defined by the user of this analysis at will. Therefore, showing favorable results from selective accounting periods is easy.
- Similarly, managers can manipulate accounting practices and adjust profit and other financial indicators for a particular accounting period to show favorable results and horizontal analysis cannot detect it.
- Financial indicators on the financial statements can change even after the completion of the accounting period with auditing and review.
- The horizontal analysis does not provide a comprehensive financial performance overview and requires other types of analysis to complement it.