Understanding horizontal analysis
It is an analytical technique that examines fluctuations in financial data across multiple reporting periods such as quarters or years. By comparing these statements, both investors and analysts can identify positive and negative trends that may impact the company’s future prospects.
The company’s operational results are clarified by balance sheets, income statements, and cash flow statements which tend to provide the clearest picture of performance. In a similar vein, critical metrics such as return on equity, profit margin, and inventory turnover identify a company’s strengths or indeed weaknesses.
Note that horizontal analyses can be absolute comparisons or percentage comparisons. In the latter, the numbers in a succeeding period are expressed as a percentage of a predetermined baseline year. This process is also known as a base-year analysis.
Conducting horizontal analysis
Horizontal analysis can be performed in three core steps.
1 – Select financial statements
However, while there is no stipulation that a specific interval be used, it is important to be consistent. Use month-over-month or year-over-year, but do not combine quarterly or annual statements in the same analysis.
2 – Choose a comparison method and calculate
There are three primary comparison methods to choose from:
- Direct comparison – where the results from one period are compared to another. These are mostly used to spot broad differences that are more obvious than others. For example, company ABC may have revenue of $25 million in Q1 and $33 million in Q2.
- Variance analysis – this determines the direction of change in addition to the dollar amount in a comparison. These are most often used to study the deviation between actual company performance and forecasted or planned performance.
- Percentage change – these are useful in larger companies where it becomes difficult to sustain the same rate of growth. Again, they can be used to determine if there have been significant deviations from forecasted or planned performance.
3 – Identify patterns and trends
The final step is to interpret the results of the horizontal analysis. This involves looking for trends and patterns in the financial data over time and is guided by specific questions such as “How well did each division manage the cost of goods sold (COGS) over the past four quarters?”
For example, if revenue has increased steadily over the past three years, this may be a positive sign for the company’s prospects. On the other hand, if expenses have been increasing at a faster rate than revenue, this may be cause for concern.
It is important to interpret the context of the results by considering external factors such as changes in the market or the company’s strategic decisions.
How are horizontal analyses facilitated?
The Generally Accepted Accounting Principles (GAAP) dictate corporate accounting and financial reporting in the United States.
Developed after the Great Depression, the principles were created to establish a set of standards that would facilitate accurate, transparent, and consistent financial reporting.
In the context of horizontal analysis, these principles ensure that the same accounting and reporting methods are used each year to make them comparable. Other principles dictate that a company’s financial documentation be such that it can be compared with the documentation of other companies in the same industry.
Lastly, GAAP ensure that financial statements are presented in a way that is easier to read and comprehend. This allows investors and other interested parties to identify the factors that drive a company’s growth, determine any trends, and make forecasts.
- Horizontal analysis is a financial review of a company’s performance over a set number of accounting periods.
- Horizontal analysis can be performed in three core steps: select financial statements, choose a comparison method and calculate, and identify patterns and trends.
- The Generally Accepted Accounting Principles (GAAP) dictate and facilitate accurate, transparent, and consistent financial reporting in the United States. This ensures that financial reports can be compared over time and between companies in the same industry.
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