Definition
Horizontal analysis is a method of evaluating and comparing historical data, such as financial statements, over a series of reporting periods. It involves calculating the percentage change between comparable items in two or more sequential periods to identify trends, growth, and problem areas. The analysis is deemed ‘horizontal’ because it spreads across multiple periods horizontally on a financial report.
Key Takeaways
- Horizontal Analysis is a technique in financial analysis where the changes in the value of specific items over time are analyzed. It helps in understanding the growth pattern and trends of a company by comparing its financial statements of different periods.
- This analysis allows investors to check for consistency in growth, profitability and it gives an overview of the performance of a company over several reporting periods.
- Reducing ratios in this type of analysis may indicate potential problems in the future, whereas increasing ratios may indicate strategic growth opportunities. Thus, it is a vital tool for decision making in strategic planning and forecasting.
Importance
Horizontal Analysis is a crucial finance term and tool as it facilitates an in-depth review of a company’s financial statements over a certain period.
It’s important because it allows businesses, investors, and stakeholders to observe trends, observe growth or decline in revenues, and identify any potential areas of concern or opportunity over time.
By comparing financial data side-by-side, it makes it easier to spot trends, both positive and negative, and make strategic decisions accordingly.
It offers more context than a simple snapshot of a single period can provide, giving a broader understanding of a company’s performance and financial health.
Explanation
Horizontal analysis, also known as trend analysis, serves a significant purpose in the financial assessment of a company because it allows stakeholders to compare the performance of a company over a set period. Its primary use is to detect patterns, trends, and significant changes in income statement and balance sheet items.
For instance, it can be used to analyze the growth in revenue, cost of goods sold, operating and non-operating expenses, and net income over several years. Investors, creditors, and management extensively use horizontal analysis as it provides valuable insights into the company’s operations, financial health, and overall performance.
For investors and creditors, it aids in deciding whether to invest or lend to the company based on the trends in its profitability and financial stability. Additionally, the management team uses it to make strategic decisions for the company, such as identifying areas that need improvement or curbing unnecessary expenditures.
Hence, horizontal analysis plays a pivotal role in investment decisions and strategic planning.
Examples of Horizontal Analysis
Apple Inc: Apple as a company is known for its horizontal analysis during its annual and quarterly financial statements review. They compute the percentage change in their income statement items and balance sheet accounts year-over-year. For instance, they would analyze how their net income has grown or reduced compared to the previous year. This allows the company to spot trends in their performance over time and helps them make informed business decisions.
Exxon Mobil: Exxon Mobil, a multinational oil and gas corporation, uses horizontal analysis to compare its financial data over a series of reporting periods. For example, they may compare the cost of producing oil and gas over a series of years to evaluate their production efficiency. If they notice a continual increase in cost over the years, they might decide to investigate what’s causing the increase and take steps to improve efficiency.
Amazon: Amazon also uses horizontal analysis for its financial statements. They compare the surges or falls in their sales, profits, and cost of goods sold over different periods to make strategic decisions. For example, if the cost of goods sold has been increasing significantly over the years, Amazon might opt to negotiate better deals with its suppliers, invest in automation to control its warehouse costs, or reconsider its pricing strategy.These examples illustrate how horizontal analysis can help organizations identify trends, monitor their financial health, and optimize their strategies for better performance.
FAQs on Horizontal Analysis
What is Horizontal Analysis?
Horizontal Analysis, also known as trend analysis, is a financial statement analysis technique that shows changes in the amounts of corresponding financial statement items over a period of time. It is a useful tool to evaluate trend situations.
How is Horizontal Analysis conducted?
Horizontal Analysis is conducted by comparing financial data from a past statement, such as the income statement or balance sheet, with financial data from the current statement. This gives the analysts a clear perspective of how certain operations have improved, deteriorated, or remained constant over the period.
What is the primary purpose of Horizontal Analysis?
The primary purpose of Horizontal Analysis is to incisively and systematically establish financial trends, for the firm, and comparing its progress with that of others in the same industry.
What are the drawbacks of Horizontal Analysis?
One of the main drawbacks of Horizontal Analysis is that it assumes that the monetary value has not changed over the years. Another limitation is that it depends heavily on historical cost accounts that are adjusted for depreciation but not for price level changes.
How does Horizontal Analysis differ from Vertical Analysis?
In Horizontal Analysis comparison is made over a period of time, whereas in Vertical Analysis, no such comparison over time is made. Vertical Analysis is simply the percentage analysis of financial statements, where each item on the statement is listed as a percentage of another.
Related Entrepreneurship Terms
- Base Year
- Trend Analysis
- Financial Statement Comparison
- Percentage Change
- Year on Year Analysis
Sources for More Information
- Investopedia – A comprehensive resource for investing and finance information.
- AccountingCoach – This platform provides extensive accounting knowledge and lessons.
- Corporate Finance Institute – An institute that offers financial analyst training and certifications.
- Khan Academy – A non-profit educational organization with a goal of creating a set of online tools to educate students.
