How to Compute Horizontal Analysis on Financial Statements

Horizontal analysis is a fundamental technique used in finance and accounting to evaluate financial data over time. This method primarily involves comparing financial information from different periods to understand how specific items have changed. By focusing on these changes, horizontal analysis helps identify trends and patterns, providing insights into a company’s performance and financial health, whether indicating growth, stability, or decline.

Identifying Necessary Financial Information

Performing horizontal analysis requires financial statements spanning at least two different reporting periods. The primary financial statements used for this analysis include the Income Statement, the Balance Sheet, and the Statement of Cash Flows. These documents provide the comprehensive financial data needed to track changes in various accounts over time.

For accurate comparison, it is essential to define a “base period” and a “comparison period.” The base period is the earlier period against which subsequent periods are measured, serving as the benchmark for calculating changes. The comparison period is the later period whose financial data is being analyzed in relation to the base period. Consistent financial data across all periods is crucial to ensure the validity and reliability of the analysis.

Performing the Calculations

Horizontal analysis involves calculating both the absolute dollar change and the percentage change for each line item across the selected periods. The formula for determining the percentage change is: ((Current Period Value – Base Period Value) / Base Period Value) 100. This calculation transforms raw dollar changes into a standardized percentage, making it easier to compare the magnitude of change across different accounts or even different companies.

For example, if Sales Revenue was $100,000 in the base period and $120,000 in the current period, the calculation would be (($120,000 – $100,000) / $100,000) 100, resulting in a 20% increase. This step is repeated for every line item on the financial statements being analyzed.

Special consideration is needed when the base period value is zero or negative. If the base period value is zero, the percentage change calculation is undefined. When the base period value is negative, the percentage change can be misleading. In these situations, focusing on the absolute dollar change alongside the percentage can provide a clearer picture.

Interpreting the Computed Trends

Once the percentage changes are calculated, the next step involves interpreting these figures to identify meaningful trends. A positive percentage indicates an increase in the financial item from the base period to the comparison period, while a negative percentage signifies a decrease. A zero percentage change suggests stability, meaning the item’s value remained consistent across periods.

The magnitude of the percentage change is just as important as its direction. A small percentage change might indicate minor fluctuations, whereas a large percentage change signals a significant shift that warrants further investigation. Understanding the context behind these changes is crucial for proper interpretation. For example, an increase in revenue is generally positive, but if operating expenses increased at a disproportionately higher rate, it could signal inefficiencies or rising costs of doing business. Analyzing these trends helps in assessing the overall financial performance and identifying areas of strength or potential concern.

Applying Horizontal Analysis to Key Financial Statements

Horizontal analysis can be applied to all primary financial statements, offering unique insights into a company’s performance and financial position. Applying this technique to the Income Statement allows for an examination of revenue growth, cost control, and profitability trends. For example, a consistent increase in revenue over several periods signals business expansion, while a rising cost of goods sold percentage relative to revenue might indicate declining production efficiency or increasing supplier costs. Analyzing changes in operating expenses can highlight how effectively management is controlling costs in areas like marketing, administration, or research and development.

On the Balance Sheet, horizontal analysis reveals shifts in assets, liabilities, and equity over time. An increase in accounts receivable might suggest issues with collecting payments from customers, while a significant rise in inventory could point to slowing sales or overstocking. Analyzing changes in property, plant, and equipment can indicate investment in capital assets, suggesting future growth capacity. Similarly, tracking liabilities like accounts payable or long-term debt helps assess a company’s ability to manage its financial obligations and its reliance on borrowing.

For the Statement of Cash Flows, horizontal analysis reveals a company’s cash generation and usage patterns across operating, investing, and financing activities. An increasing trend in cash flow from operations indicates strong core business performance and self-sufficiency. Conversely, significant increases in cash used for investing activities might reflect strategic acquisitions or capital expenditures, while a rising reliance on cash from financing activities could signal a need for external funding.