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. Horizontal analysis is the evaluation of an organization’s financial performance over many reporting periods. Side by side they do this to determine if the company’s performance is improving or declining.

Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling. This type of analysis in the balance sheet is typically done in a two-year manner, as illustrated bookkeeping for startups below, with a variance indicating the difference between the two years for each line item. It incorporates computations of key ratios or margins, such as the current ratio, interest coverage ratio, gross margin, and/or net profit margin, which can be highly insightful.

Horizontal Analysis Examples

In the current year, company XYZ reported a net income of $20 million and retained earnings of $52 million. Consequently, it has an increase of $10 million in its net income and $2 million in its retained earnings year over year. This type of analysis reveals trends in line items such as cost of goods sold.

These comparisons can be expressed either in terms of absolute dollars or as a percentage change. A horizontal analysis can be performed on any type of financial statement, but is most commonly used on the income statement. To complete a horizontal analysis, the first step is to determine the base year, which is the year that will be used as the starting point for comparisons. The base year is typically the most recent year for which complete financial statements are available. Horizontal analysis is a process used in financial statements such as comparing line items across several years for the purpose of tracking the firms progress and historical performance.

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The year being used for comparison purposes is called the base year (usually the prior period). The year of comparison for https://www.apzomedia.com/bookkeeping-startups-perfect-way-boost-financial-planning/ is analysed for dollar and percent changes against the base year. 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. This results in variations since balances for each period are compared sequentially. You can make your current year (or quarter) look better if you choose historical periods of poor performance as your base comparison year.

• Finally, horizontal analysis does not take into account inflationary effects over time.
• On the other hand, comparability constraint dictates that a company’s financial statements and other documentation be such that they can be evaluated against other similar companies within the same industry.
• For example, comparing the accounts receivables of one year to those of the previous year.
• For example, if the base year amount of cash is $100, a 10% increase would make the current accounting period’s amount $110, whereas a 10% decrease would be $90.
• For example, upper management may ask “how well did each geographical region manage COGS over the past four quarters?”.
• Most importantly, Financial Analysis points to the financial destination of the business in both the near future and to its long-term trends.

For example, a significant increase in sales could be due to strong demand or lower prices, and it would be difficult to determine which without further analysis. 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.

Horizontal Analysis of Balance Sheets and Financial Statements

By comparing prior-period financial results with more current financial results, a company is better able to spot the direction of change in account balances and the magnitude in which that change has occurred. Investors can use horizontal analysis to determine the trends in a company’s financial position and performance over time to determine whether they want to invest in that company. However, investors should combine horizontal analysis with vertical analysis and other techniques to get a true picture of a company’s financial health and trajectory. On the other hand, horizontal analysis looks at amounts from the financial statements over a horizon of many years.

With this approach, you can also analyze relative changes between lines of products to make more accurate predictions for the future. As business owners, we are so busy with the day-to-day operations of running a business that we may forget to take a look at our business as a whole and ignore any company financial statement analysis. 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. For example, growth businesses might exhibit signs of growing sales with initially low-profit margins.

For instance, the increase of $344,000 in total assets represents a 9.5% change in the positive direction. There seems to be a relatively consistent overall increase throughout the key totals on the balance sheet. Even though the percentage increase in the equipment account was 107%, indicating the amount doubled, the nominal (just the number) increase was just $43,000.

For example, a company’s management may establish that the robust growth of revenues or the decline of the cost of goods sold as the cause for rising earnings per share. By exploring coverage ratios, interest coverage ratio, and cash flow-to-debt ratio, horizontal analysis can establish whether sufficient liquidity can service a company. Horizontal analysis can also be used to compare growth rates and profitability over a specific period across firms in the same industry.

You use horizontal analysis to find and monitor trends over a period of time. Instead of creating an income statement or balance sheet for one period, you would also create a comparative balance sheet or income statement to cover quarterly or annual business activities. The business will need to determine which line item they are comparing all items to within that statement and then calculate the percentage makeup. These percentages are considered common-size because they make businesses within industry comparable by taking out fluctuations for size. It is typical for an income statement to use revenue (or sales) as the comparison line item.

• Horizontal analysis is used to improve and enhance these constraints during financial reporting.
• For example, a business may want to know how much inventory contributes to total assets.
• For example, the current period’s profits may appear excellent when only compared with those of the previous quarter but are actually quite poor if compared to the results for the same quarter in the preceding year.
• Horizontal analysis of the income statement is usually in a two-year format, such as the one shown below, with a variance also shown that states the difference between the two years for each line item.
• This type of analysis is useful in identifying trends in the company’s financials, such as an increase or decrease in revenue or expenses.

Cash in the current year is $110,000 and total assets equal $250,000, giving a common-size percentage of 44%. If the company had an expected cash balance of 40% of total assets, they would be exceeding expectations. This may not be enough of a difference to make a change, but if they notice this deviates from industry standards, they may need to make adjustments, such as reducing the amount of cash on hand to reinvest in the business. The figure below shows the common-size calculations on the comparative income statements and comparative balance sheets for Mistborn Trading. The highlighted part of the figure shows the number used as the base to create the common-sizing. A horizontal analysis is used in financial accounting to compare line items in a company’s financial statements over time.