Horizontal analysis is one approach used in financial statement analysis that helps to compare information over a specific time horizon. The approach is used to assist in identifying trends or patterns in a company’s business cycle. Learning how to perform it is easy and particularly useful for analysts.
In this post, we will cover what horizontal analysis is, how it works, how it is different from vertical analysis, and its limitations.
What Is Horizontal Analysis?
When performing financial statement analysis, it is important to compare performance over time.
The component of “time” in financial statement analysis holds a great deal of weight. This is because businesses go through several stages throughout their lives. One of the overall goals of horizontal analysis is to help users gauge what stage the business is in.
For example, growth businesses might exhibit signs of growing sales with initially low-profit margins. As the business matures over time, horizontal analysis helps to illuminate how well the business is maintaining its growth trajectory and whether management is becoming more effective at managing overhead.
How To Perform Horizontal Analysis
The process of comparing data points over time obviously requires at least two data sets to be available. You can perform horizontal analysis on any financial statement metric, financial ratio, or financial statement line item.
Here are the steps to performing horizontal analysis:
- Identify a line item, ratio, balance, or any other metric you would like to analyze
- Select your beginning time period. This can be a month, quarter, or year. Using this as your beginning value, compare the next period’s value and continue for each subsequent period
- Choose to present the information in terms of absolute changes or in percentages
For example, let us assume that we are interested in comparing gross sales of a business quarter-over-quarter for the last year. Using the financial statements, we could take the gross sales from the first quarter as our beginning period’s value.
Then, we would find the difference between the second quarter’s gross sales and the first. We repeat this process for the third quarter, calculating the difference between this and the second quarter until we have compared all four quarters. The change can be expressed in total value or percentages.
Horizontal Analysis Vs Vertical Analysis
Since horizontal analysis is expressed in percentage change over time, it is often confused with vertical analysis. The two are entirely different with the primary difference between them being that horizontal examines the relationship between numbers across various periods and vertical analysis is only concerned with a single period.
This is because vertical analysis expresses each line in the financial statements as a percentage of a base value, like sales. Using this example, vertical analysis takes the income statement and expresses every line item as a percentage of sales, whereas horizontal analysis is concerned with the percentage change in total sales over a period.
Ideally, the horizontal and vertical analysis are combined to paint a comprehensive picture of a company’s financial performance over time.
Pros And Cons of Horizontal Analysis
The most obvious benefit of horizontal analysis is that helps paint a picture of how a business has performed over time. This has several implications, including the ability to identify trends. Trends are used when projecting future performance and analysts use them to identify where they believe the business is within the business cycle.
Additionally, it is useful in determining how well management is using resources to run the business efficiently. The process of comparing performance over time reveals whether the business is growing, managing expenses, or reinvesting its earnings in research and development.
One of the major criticisms of horizontal analysis is that it can at times produce biased results. This is because the beginning period will determine how the growth and trajectory appear. By selecting a beginning period with particularly inferior performance, analysts can sometimes create the impression that the business is doing better than it is.
Finally, because horizontal analysis relies on the financial statements it is subject to the nuances of accounting policies that might not paint an accurate picture of the business’s actual performance over time.