A Beginner’s Guide to Horizontal Analysis

Consistency constraint here means that the same accounting methods and principles must be used each year since they remain constant over the years. For each line item on this sample income statement, we’ve shown the percentage that it makes up of total revenue. If you just looked at numbers, it might seem like this company did better in 2022 because sales increased from $500,000 to $600,000. However, net income only accounted for 10% of 2022 revenue, whereas net income accounted for more than a quarter of 2021 revenue.

Horizontal analysis allows investors and analysts to see what has been driving a company’s financial performance over several years and to spot trends and growth patterns. This type of analysis enables analysts to assess relative changes in different line items over time and project them into the future. https://marketresearchtelecast.com/financial-planning-for-startups-how-accounting-services-can-help-new-ventures/292538/ Horizontal analysis (also known as trend analysis) looks at trends over time on various financial statement line items. A business will look at one period (usually a year) and compare it to another period. For example, a business may compare sales from their current year to sales from the prior year.

Criticisms of Horizontal Analysis

Aggregated information compiled in financial statements may have changed over time, presenting businesses with a problem. Companies and business owners like you make use of financial analysis techniques like horizontal analysis for both internal and external purposes. Direct comparison simply involves directly comparing the results, usually revenue, of two accounting periods.

The trending of items on these financial statements can give a business valuable information on overall performance and specific areas for improvement. It is most valuable to do horizontal analysis for information over multiple periods to see how change is occurring for each line item. The year being used for comparison purposes is called the base bookkeeping for startups year (usually the prior period). The year of comparison for horizontal analysis is analysed for dollar and percent changes against the base year. The term “Horizontal Analysis” refers to the method of analyzing financial statements where historical data from the income statement, balance sheet, and cash flow statement are subject to comparison.

What is the difference between horizontal and vertical analysis?

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. Investors, analysts, and even business owners and managers need to track a company’s financial performance over the years to spot its growth patterns. Horizontal income statement analysis is typically done in a two-year manner, as shown below, with a variance that shows the difference between the two years for each line item. A financial analyst or investor examines a business’s financial statements and supporting disclosures to determine whether it is worthwhile to invest in or lend money to the company. Exhibit 15.1 and 15.2 present the comparative balance sheet and profit and loss account respec­tively of a company with the amount of increase or decrease and percentage changes shown.

Vertical analysis is more often used by creditors and investors to compare a company’s financial performance to others in the same industry. The level of detail in your financial statements depends heavily on the accounting software you use. If you use entry-level software, you’ll most likely need to use spreadsheets like Excel or Google Sheets to conduct your horizontal analysis. As seen from the above example, every ratio is given in relation to the revenue in the case of income statement. 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.

What is the Horizontal Analysis Formula?

In the same vein, a company’s emerging problems and strengths can be detected by looking at critical business performance, such as return on equity, inventory turnover, or profit margin. For instance, if management establishes the revenue increase or decrease in the cost of goods sold (COGS) is the reason for rising earnings per share, the horizontal analysis can confirm. With metrics like the cash flow to debt ratio, coverage ratios, interest coverage ratio, and other financial ratios, the horizontal analysis can determine whether sufficient liquidity can service the company.

Assume that ABC reported a net income of $15 million in the base year, and total earnings of $65 million were retained. The company reported a net income of $25 million and retained total earnings of $67 million in the current year. Compared with one of its biggest competitors, Microsoft, horizontal analysis shows that Apple’s Revenue growth and gross profit margin were lower than Microsoft’s in both years. Horizontal Analysis is performed by placing multiple years’ worth of data lined up next to each other and then graphing the data points to determine if there is a trend, and where it is going. In the final section, we’ll perform horizontal analysis on our company’s historical balance sheet.

Doing so will help you see at a glance which expenses take up the largest percentage of your revenue. The investor wants to determine how the company grew over the past year, to see if his investment decision should provide solid ROI. Let’s say that in the Company ABC base year, they reported a net income of $5 million and retained earnings of $25 million. This year, Company ABC reports a net income of $10 million and retained earnings of $27 million. As a result, there’s a $5 million increase in net income and $2 million in retained earnings year over year.

• We will also apply this formula to each line item to calculate its percentage change.
• A horizontal analysis is most useful when the underlying financial information is consistently reported, based on the applicable financial reporting framework.
• Let’s say that in the Company ABC base year, they reported a net income of $5 million and retained earnings of $25 million.
• For example, a low inventory turnover would imply that sales are low, the company is not selling its inventory, and there is a surplus.
• Even so, one-off events and accounting changes can be implemented to correct these anomalies to improve the accuracy of the analysis.