Financial analysis is a critical aspect of managing a business, and it helps owners, stakeholders, and investors make informed decisions by analyzing a company’s economic performance. Horizontal analysis, also known as trend one, is a financial tool that compares data from different periods to determine a business’s financial health and stability. This article reveals every crucial aspect of this analysis that you should know. Let’s dive right in.
What is horizontal analysis?
Horizontal analysis is a financial analysis technique that compares data from different periods to evaluate a company’s performance over time. It is performed by comparing financial data from two or more consecutive periods, such as years, quarters, or months. The goal of horizontal analysis is to identify trends and patterns in a firm’s financial performance over time and to provide insight into its future performance.
Horizontal analysis compares financial data such as revenue, expenses, profits, and assets. The comparison is made by calculating the current and prior periods and then converting the difference into a percentage increase or decrease. This allows the analyst to see how the financial data has changed over time and identify any trends and patterns in it.
Horizontal analysis is widely used in financial analysis because it provides a quick and easy way to evaluate a company’s performance over time. It is an essential tool for investors, analysts, and company managers, providing valuable information on a company’s financial health and growth potential.
However, it is vital to remember that horizontal analysis is only one part of a comprehensive financial analysis. It should be used with other financial techniques, such as vertical and ratio analysis.
How it works?
The process of horizontal analysis begins with collecting financial data for the specified period. They must be consistent and comparable.
After collecting the data, the next step is calculating the change in the business’s financial performance over the specified period. The result is a percentage increase or decrease, which helps determine the company’s financial performance trend.
Thus, here are the steps to perform a horizontal analysis:
- Collect Financial Data: The first step in conducting horizontal research is to collect financial data for the specified period.
- Determine the Comparison Period: Decide which financial statement to use and select the comparison period. Comparing the current financial statement with the last one is advisable to identify the trend.
- Calculate the Change: Subtract the current financial statement from the previous one to calculate the change.
- Express the Change as a Percentage: Express the change as a percentage increase or decrease to help identify the company’s financial performance trend.
- Analyze the Results: Identify patterns and trends in financial data and determine if the organization is improving or declining performance.
Horizontal vs. vertical analysis: a comprehensive comparison
Let’s highlight a few basic features by which you can distinguish horizontal analysis from vertical:
- Definition: Horizontal analysis compares financial data over a specified period, while vertical one compares financial data within the same financial statement.
- Period: Horizontal analysis is used to evaluate the change in financial performance over a specified period, while vertical analysis assesses the proportion of different components within the same financial statement.
- Purpose: Horizontal analysis is designed to understand the company’s financial performance trend, while vertical one is used to understand the financial statement’s composition.
- Comparison: Horizontal analysis compares financial data between two or more periods, while vertical analysis compares the different components within the same financial statement.
- Result: Horizontal analysis provides a percentage increase or decrease in financial performance, while vertical one provides the proportion of each component to the total.
- Information: Horizontal analysis gives information on the company’s financial performance trend, while vertical analysis provides insights into the financial statement’s composition.
- Financial Statements: Horizontal analysis can be used on various financial statements, including the balance sheet, income statement, and cash flow statement. Vertical analysis is typically used on the balance sheet and income statement.
- Investment Decisions: Horizontal analysis is used by investors to determine the trend of the company’s financial performance and make informed investment decisions, while vertical analysis is to understand the composition of the financial statement and assess the stability of the business’s financial position.
- Business Operations: Business owners can use a horizontal analysis to understand the company’s financial performance trend and identify areas that need improvement. In contrast, vertical analysis is usually used to understand the composition of the financial statement and make intelligent business decisions.
In conclusion, horizontal and vertical analysis are useful financial tools that provide valuable information. The choice of technique depends on the specific goals and needs of the business or investor.
Criticism of horizontal analysis
While horizontal analysis provides valuable information on a company’s financial performance trend, it has some limitations. Let’s go through the criticism of horizontal analysis:
- Reliance on Historical Data: Horizontal analysis relies heavily on historical data, which may not always represent future performance. Economic conditions, market trends, and company strategy can significantly impact financial performance, making it difficult to predict future trends based on past data.
- Ignores External Factors: Horizontal analysis does not consider external factors that may impact financial performance, such as changes in the economy, competitive landscape, and regulatory environment. This narrow focus on internal data can lead to an incomplete picture of a company’s financial performance.
- Limited Scope: Horizontal analysis only evaluates financial data over a specified period, which may not be sufficient to comprehensively analyze a company’s financial performance. A broader, multi-year analysis may be required to understand the firm’s financial trends and patterns fully.
- Data Selection Bias: Horizontal analysis may be subject to data selection bias, where the data selected for analysis is not representative of the company’s overall financial performance. This can lead to incorrect conclusions and decision-making based on inaccurate information.
- Limited to Comparative Analysis: Horizontal analysis is limited to comparative analysis and does not provide a comprehensive picture of a business’s financial performance. A combination of horizontal and vertical analysis, as well as other techniques, may be required to gain a complete understanding.
- Data Integrity: Horizontal analysis is only as accurate as the data used. If the financial data is incorrect or not up-to-date, the horizontal analysis results will also be false.
Example of horizontal analysis
A retail company has been in business for five years and wants to evaluate its financial performance over that period. The firm has prepared the following income statement:
Year 1: $100,000.
Year 2: $120,000.
Year 3: $130,000.
Year 4: $140,000.
Year 5: $150,000.
To perform a horizontal analysis, the company will calculate the percentage increase or decrease in its revenue from one year to the next. For example, comparing Year 2 to Year 1:
(Revenue in Year 2 – Revenue in Year 1) / Revenue in Year 1 = (120,000 – 100,000) / 100,000 = 0.20 or 20% increase.
The business can then calculate the percentage increase or decrease for each year, resulting in the following:
Year 1 to Year 2: 20% increase.
Year 2 to Year 3: 8.33% increase.
Year 3 to Year 4: 7.69% increase.
Year 4 to Year 5: 7.14% increase.
From this horizontal analysis, the company can see that its revenue has consistently increased, with a slower rate of increase in more recent years. This information can help the business determine if its revenue growth is slowing down and if it needs to take action to improve its financial performance.
To better understand the topic, we have prepared answers to the most frequently asked questions.
What is the horizontal analysis used for?
Horizontal analysis is a financial technique designed to evaluate the change in economic performance over a specified period. Its primary purpose is to understand the company’s financial performance trend by comparing the current and previous financial statements.
How is horizontal analysis calculated?
The first step to calculate the horizontal analysis is to collect financial data for the specified period. The change in economic performance is then calculated by subtracting the current financial statement from the previous one. The result is expressed as a percentage increase or decrease.
What is the difference between horizontal and vertical analysis?
Horizontal and vertical analysis are different techniques used to evaluate a business’s financial performance. The primary difference between them is how the two compare financial data. Horizontal analysis compares it over a specified period, while vertical analysis does it within the same financial statement.
What are the benefits of horizontal analysis?
The benefits of horizontal analysis include clearly understanding the company’s financial performance trend, identifying patterns and trends in economic data, and determining if the business is improving or declining in performance. The analysis can also help identify areas that need improvement and make informed business decisions.
How can an investor use horizontal analysis?
Investors can use horizontal analysis to determine the company’s financial performance trend and make intelligent investment decisions. Horizontal analysis can also help identify potential risks and opportunities and assess the company’s stability.
When can horizontal analysis be used?
It is commonly used to analyze financial statements at the end of the financial year, but it can also be applied to evaluate financial performance throughout the year.
The bottom line
Horizontal analysis is a powerful financial analysis tool that provides valuable insights into an organization’s financial performance. It can help business owners, stakeholders, and investors make informed decisions by comparing data over a specified period and identifying patterns and trends in financial performance. Whether used for investment purposes or to improve business operations, horizontal analysis is essential for understanding a company’s financial health.