Horizontal analysis of financial statements is a technique used to evaluate trends and growth pattern of financial performance over time by comparing historical data such as line items and financial ratios over a number of accounting period.
It’s also referred to as trend analysis or time series analysis of financial statements.
You can use horizontal analysis to evaluate trends quarter over quarter (QoQ) or year over year (YoY) by computing percentage increase or decrease relative to a base quarter/year.
Why horizontal analysis
Horizontal analysis of income statement and balance sheet highlights structural changes that have taken place in a business. Horizontal analysis provides historical performance and growth data to assist management, investors and analysts in planning and forecasting financial data.
For example, you can compare line items of income statement for the financial year 2018 with the year 2019, to know how each item changed, why it’s changed and whether such change is favorable or unfavorable. You can easily identify whether the company is improving or declining.
Understanding past trends of a company in a less stable environment can help you in assessing trends and capabilities of management to handle economic downturn.
You can use horizontal analysis to forecast financial data when economic and competitive environments is stable or when you are analyzing a mature business. However, past financial data can’t be considered for forecasting when the economic or competitive environment changes.
How to do horizontal Analysis of financial statements
In horizontal analysis, investors take income statement, statement of cash flows and balance sheet of a company for a number of years, lining them up in columns and compare the changes from year to year or quarter to quarter to understand the behavior of revenue, expenses and other financial line items over the course of time.
A decrease in sales could reflect in decrease in number of units sold or a decrease in unit selling price. This decrease can have an adverse impact on profitability.
Cost of goods sold is the largest expenses for a manufacturing unit. If the decrease in cost of goods sold is in proportion to decrease in sales, it indicates that the management is able to manage it effectively.
The balance sheet shows the sources from which the firm has obtained it’s resources and the ways in which those resources are currently employed.
From the basic accounting principles, you can know that the liabilities and owner’s capital are the sources from which the company has obtained it’s capital and the list of assets shows the way in which the company has put those funds to work.
In horizontal analysis of balance sheet, you compute the increase or decrease of each balance sheet item in comparison to prior years. Its shown in percentage terms to highlight the changes.
Example showing you trend analysis of income statement
|Sr. No.||Particulars||Year2||Year1||Changes |
|Change in Percentage|
|B||Cost of Goods Sold||24,00,000||21,00,000||3,00,000||14.29%|
|C||Gross Profit (A-B)||16,00,000||15,00,000||1,00,000||6.67%|
|F||Total Operating Expenses (D+E)||4,10,000||3,72,500||37,500||10.07%|
|G||Operating Income (C-F)||11,90,000||11,27,500||62,500||5.54%|
|I||Profit Before income tax (G-H)||11,25,000||10,65,500||59,500||5.58%|
|K||Net Income (I-J)||8,43,000||7,98,500||44,500||5.57%|
Horizontal analysis formula used in above illustration:
- To calculate changes = Amount in the year 2 – amount in the year 1
- To calculate percentage changes = (changes / year 1 )*100
Similarly you can do horizontal analysis of balance sheet.
In addition to horizontal analysis, you can also use a number of other tools and techniques available in fundamental analysis to analyse financial statements. Here is a list of those other tools and techniques:
One can also use horizontal analysis on financial ratios such as earning per share (EPS), price earning ratios, dividend payouts, profit margins, inventory turnover, return on equity (ROE), interest coverage ratio, debt to equity ratio and other similar financial ratios.