Horizontal Analysis of Financial Statements – Overview & Examples
Investors, analysts, and even business owners and managers need to track a company's financial performance over the years to spot its growth patterns.
Is the company performing profitably or not? What are the factors driving the company's growth or its decline?
One of the methods used to spot trends and growth patterns in a business over the years is horizontal analysis.
In this article, you will learn everything you need to know about the horizontal analysis of financial statements.
Let's get started.
What is Horizontal Analysis of Financial Statements?
Horizontal Analysis, also known as Trend Analysis, is an analysis technique in accounting used over financial statements such as balance sheets, statements of retained earnings, and income statements, among others.
Trend Analysis is a technique used to identify trends spanning different accounting periods by highlighting the changes in different financial statements when comparing items to each other.
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. The more statements available and used for analysis, the greater the results obtained.
The Horizontal Analysis technique also takes note of the time variance of items contained in statements. The earliest recorded period in the statements is used as a base period with which changes are measured.
These changes are either in the form of dollar amount (variance) and percentage. You can calculate these changes by comparing items in the base accounting period with other items in subsequent periods and financial statements.
A trend is then determined and the level and quality of details you obtain from your financial statements depend on the software or accounting technique you use.
Steps to Perform a Horizontal Analysis
Horizontal Analysis, like every other accounting process, is only accurate or possible when certain defined steps are followed.
Here are the straightforward steps which prove not to be as difficult as some other analytic accounting processes.
1. Make The Statements Available
To start with, the statements over which comparison is intended to be made need to be in existence and available. The more popular financial statements over which Horizontal Analysis is executed are the income statement and balance sheet.
Other financial statements are also considered during Horizontal Analysis but these two statements are generally sufficient enough to provide appropriate insights into a company’s financial health.
Additionally, the financial statements to be provided need to be respective statements for the accounting periods to be compared. At least two of these statements are compared, but having and comparing three or more statements makes horizontal analysis easier, more accurate, and reliable.
2. Decide The Approach You Wish To Take
You can execute your Horizontal Analysis using one or more of the following options:
Direct comparison simply involves directly comparing the results, usually revenue, of two accounting periods.
For instance, Horizontal Analysis through direct comparison involves comparing your $4.5 million 2019 revenue with your 2020 revenue of $6 million. With this method, the difference ($1.5 million) is taken note of and you quickly spot the change between the two periods. You then decide whether those changes are good or not.
Another method of horizontal analysis is calculating the variance between multiple financial items in multiple financial statements and spanning multiple accounting periods.
Positive or negative trends are spotted and this method serves as more reliable when presenting external stakeholders like investors and creditors with your company’s financial health.
For a much deeper analysis, this approach is taken. The percentage change approach is where the full force of the horizontal analysis formula comes in and changes are fully represented in percentage.
In this method, the earliest period is set as the base period and each subsequent period is compared to the base period. The company’s growth is measured through this and the level of growth is always put in comparison with the earliest period on record.
For example, if the revenue generated in 2018 was $1 million and the revenue generated in 2019 was $3 million, the difference between the two periods, called the variance, is $2 million and this would be used to calculate the percentage change using the horizontal analysis formula thus:
Percentage Change = Dollar Change / Amount of the item in base year x 100
Percentage Change = ($2 million / $1 million) x 100
Percentage Change = 200%.
The percentage change is 200%.
Now, let us assume that the revenue generated in 2020 is $1.5 million. Rather than comparing revenues from 2019, Horizontal Analysis still compares the revenues of 2020 to 2018 (the base year).
Dollar Change = Amount of the item in comparison year – Amount of the item in the base year
Dollar Change = $1.5 million – $1 million
Dollar Change = $500,000
The percentage change is then calculated thus:
Percentage Change = Dollar Change / Amount of the item in base year x 100
Percentage Change = ($500,000 / $1 million) x 100
Percentage Change = 50%.
The 50% still represents a positive outcome from 2018 even though it still represents an overall decline in the growth of revenue.
3. Review Your Results
The final step involves you reviewing these changes and making appropriate use of the information you get from your analysis. It is where you determine your company's growth and trend in your financial health.
For more detailed representations of how horizontal analysis really works, here are a few examples with balance sheets, income statements, and retained earnings.
Example of Comparative Balance Sheet with Horizontal Analysis
|Items||2020 ($)||2021 ($)||Increase or (Decrease)Amount ($) | Percentage|
|Preferred 5% stock, $50 par||150,000||150,000||–||–|
|Common Stock, $5 par||500,000||500,000||–||–|
|Total Stakeholder’s Equity||829,500||787,500||(42,000)||(5.3)%|
|Total Liabilities and Stakeholder Equity||1,139,500||1,230,500||91,000||7.4%|
This comparative balance sheet directly compares balances from the balance sheets from the years 2020 and 2021. 2020 serves as the base year, 2021 is the comparison year, and the horizontal analysis takes place over every item taken into account in both balance sheets.
Through horizontal analysis, the different items can be seen to have different increases and decreases, with each item only compared with its corresponding counterpart in the alternate balance sheet.
Example of Comparative Income Statement with Horizontal Analysis
|Items||2020 ($)||2021 ($)||Increase or (Decrease)Amount ($) | Percentage|
|Cost Of Goods Sold||1,000,000||1,200,00||200,000||20%|
|Total Operating Expenses||300,000||370,000||70,000||23.3%|
|Income before income tax||145,000||187,000||42,000||28.9%|
Just like the above comparative balance sheet, these balances obtained from income statements are collected from different periods; 2020 as the base year and 2021 as the comparison year.
Every single item is compared with its counterpart in the alternative income statement. From a general view, it could be seen that the company made considerable growth in its income between the years. The percentage representation makes it easier to determine the level of change between these different periods.
Example of Comparative Retained Earnings Statement with Horizontal Analysis
|Items||2020||2021||Increase or (Decrease)Amount ($) | Percentage|
|Retained earnings, January 1||120,000||164,000||70,000||58.8%|
|Net Income For Year||88,000||102,000||14,000||15.9%|
|On preferred stock||8000||12,000||4,000||50%|
|On common stock||36,000||51,000||15,000||41.6%|
|Retained Earnings, January 1||164,000||229,000||65,000||39.6%|
Above, you are presented a comparative retained earning statement for the years 2020 and 2021. You can see every important item from the retained earnings from the previous year to the net income, dividends, and the retained earnings by the end of the year. Both years are compared with each other and it can be seen generally that there has been a significant increase in earning from all sources.
From the above examples, the horizontal analysis only pushes to present the changes in these different periods and offer companies or businesses easy pointers to the health of their financial growth and situations. However, more than two financial statements need to be compared to obtain more reliable results for proper financial analysis.
More statements are compared with the base year (in this case, 2020). Also, trends are identified to define the actual performance of the company in relation to its first accounting year and how it is predicted to fare as time passes.
Spotting Trends by Using Horizontal Analysis
As business owners, the compilation of financial statements is usually the only measure taken to represent financial health. However, having these statements alone and just looking at the figures does not help you by itself to improve your financial situation.
If anything, they only let you stay in compliance with regulatory standards such as GAAP. You also need to reliably understand how your business is fairing and this is where financial statement analysis comes in.
By analyzing financial statements, your company accurately spots trends over time and identifies the mix of assets and liabilities it has to deal with within a certain period. Financial analysis helps you examine relationships between different financial items and determine efficient operations to manage them.
Financial statement analysis presents you with your firm’s liquidity, debt, and profitability, emerging problems, and strengths. All these are taken into account in relation to identifying your past financial performance and your prospects for the future.
Perhaps, the most important aim of financial analysis is identifying your company prospects through trends for both the near future and long-term periods.
With horizontal analysis, you easily compare the financial position and performance of your company from one period to the next. With your findings, you understand how much change you have in your revenue (increase or decrease) between the two periods in consideration and also spot changes in your COGS and net income.
Using this information, you identify the areas of your business that have seen the most positive changes, what works well for your business, and areas that have experienced negative downturns and need improvement and attention.
Companies and business owners like you make use of financial analysis techniques like horizontal analysis for both internal and external purposes. You examine internal issues such as employee performance, the efficiency of operations, and credit policies as well as external issues such as the feasibility of potential investments and the creditworthiness of borrowers, amongst other factors.
Drawbacks of Using Horizontal Analysis
Even though horizontal analysis does not seem to possess any major disadvantage, there are still certain factors that could hinder its effectiveness or even the possibility of its use. Some of these include:
1. Change In Financial Items
Horizontal analysis is a comparative accounting technique that strictly compares items from different financial statements from different periods. The drawback here is exposed when the financial items contained in these statements are not entirely the same or consistent.
Aggregated information compiled in financial statements may have changed over time, presenting businesses with a problem.
Items such as expenses, current assets, liabilities, among many others may have been added or removed when compared to the base period and, as balances are compared sequentially, this leads to a loophole.
2. The Technique Is Prone To Manipulation
Horizontal analysis may be executed in a manner that makes a company’s financial health look way better than it is. It is mostly done by companies when presenting external stakeholders with information about the business in a bid to deceive them.
As said before, Horizontal analysis is comparative. Companies may choose to make a period of very poor financial performance the base period and compare all other financial periods with it. By this, every comparison presents a better result. This way, companies willfully maneuver and change their growth and profitability trends to their advantage.
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.
Nonetheless, continuous comparisons and the implementation of additional financial analysis techniques help to take care of this drawback.
Horizontal vs Vertical Trend Analysis
Just like horizontal analysis, vertical analysis shows useful information and insights about the health of your finances. Vertical analysis is conducted on financial statements over multiple periods and can be used to identify ratio changes.
With vertical analysis, changes are strictly represented by percentages. It means the changes are shown as a percentage of a base item in the statement and there are no representations for variance. The base item is typically the first line item in the statement.
From this, it is seen that, for instance, with vertical analysis, every item on an income statement is expressed as a percentage of the gross sales. On the other hand, every item on a balance sheet is expressed as a percentage of the total assets held by the firm. Vertical analysis is also known as static analysis.
Compared to horizontal analysis, the changes are not strictly presented as percentages and are also presented as variance (money amount).
Rather than an item in the statement, a whole accounting period is used as the base period and its items are used as the base elements in all comparative statements.
As it is majorly carried out on a single time period, Vertical analysis is also known as static analysis. However, there is an exception. Results from vertical analysis over multiple financial periods can be particularly useful while conducting regression analysis. Accountants see relative changes in company accounts over a given period of time and determine the best strategy to improve the relationship between financial items and variables.
Relating to this, here is how a comparative income statement for vertical analysis looks like:
|Items||2019 Amount ($)||Percentage||2020Amount ($)||Percentage||2021Amount ($)||Percentage|
|Income Before Tax||87,000||43.5%||106,000||48.1%||117,000||54.4%|
As seen from the above example, every ratio is given in relation to the revenue in the case of income statement. For the balance sheet, it is relative to the total assets.
Comparative income statements with vertical analysis can be compared to give a company an idea of its financial health spanning years. For instance, by comparing financial variables over the course of 2019, 2020, and 2021, the company sees that the percentage ratio of its COGS consistently decreases over the years even though sales revenue decreases and operating expenses increase. This could prove to be the main factor enabling the company to attain a consistent increase in net income and, therefore, the main point of focus in maintaining it.
Nonetheless, vertical analysis possesses its own advantages in your company’s accounting operations.
Vertical analysis serves as a more feasible technique compared to horizontal analysis. It is also useful for inter-firm or inter-departmental performance comparisons as one can see relative proportions of account balances, regardless of the size of the business or department.