Horizontal analysis is the comparison of financial statements and accounting ratios over a number of accounting periods. The objective with horizontal analysis is to spot trends in the financial information such as, for example, whether an expense is increasing or decreasing each year, and for this reason horizontal analysis is also known as trend analysis.
The analysis can be carried out on any of the financial statements but is usually performed on the balance sheet and income statement together with appropriate accounting ratios. While the horizontal analysis can be performed on each statement in isolation, it is always better to analyse both balance sheet and income statements together to avoid drawing the wrong conclusions about the performance of a business.
Obviously financial statements for at least two accounting periods are required, however, using a larger number of accounting periods can make it easier to identify trends within the financial data.
Horizontal Analysis Example
The simplest way to carry out horizontal analysis is to list each accounting periods financial statements side by side. The example below shows the horizontal analysis of an income statement, but it can equally well apply to the horizontal analysis of a balance sheet.
|Cost of sales||1,920||2,880||4,000|
|Research and development||740||1,400||1,000|
|Sales and marketing||500||1,200||2,500|
|General and admin.||200||400||700|
|Income before tax||1,290||1,220||600|
|Income tax expense||320||280||150|
|Gross margin %||60%||62%||58%|
|Net income %||20%||13%||5%|
In this example the business is looking for trends over the three years from 2014 to 2016. By producing the horizontal analysis it is possible to monitor changes in each line item over time. For example, clearly the revenue is growing each year, however, the expenses, particularly the sales and marketing expenses are growing more rapidly, resulting in a reduction in the net income and net income % of the business.
Horizontal Analysis and Variances
In order to improve the horizontal analysis accounting, a variance column could be added for each year showing the change in absolute amount between each year. The horizontal analysis formula in this case for the variance column is shown in the example below for the revenue line item.
Revenue 2014 = 4,800 Revenue 2015 = 7,500 Revenue 2016 = 9,500 Horizontal analysis formula: Variance = Revenue 2015 - Revenue 2014 Variance = 7,500 - 4,800 = 2,700 Variance = Revenue 2016 - Revenue 2015 Variance = 9,500 - 7,500 = 2,000
It is more usual to calculate variances in relation to the previous year as shown above. However, an equally valid alternative would be to calculate the variance in relation to the base year 2014.
Revenue 2014 = 4,800 Revenue 2015 = 7,500 Revenue 2016 = 9,500 Horizontal analysis formula: Variance = Revenue 2015 - Revenue 2014 Variance = 7,500 - 4,800 = 2,700 Variance = Revenue 2016 - Revenue 2014 Variance = 9,500 - 4,800 = 4,700
Although the variance analysis is useful, it is not always easy to spot trends in the financial information.
Horizontal Analysis and % of Base Year
A more useful horizontal analysis can be undertaken by setting one year as the base year, and then calculating each line item for the other years as a percentage of the base year. In this way trends can easily be identified. An example of this type of report is shown below.
|2014 Base||2015 % Base||2016 % Base|
|Cost of sales||1,920||150%||208%|
|Research and development||740||189%||135%|
|Sales and marketing||500||240%||500%|
|General and admin.||200||200%||350%|
|Income before tax||1,290||95%||47%|
|Income tax expense||320||88%||47%|
|Gross margin %||60%||103%||96%|
|Net income %||20%||62%||23%|
In this report, 2014 is identified as the base year, and each line item for the other two years 2015, and 2016 is calculated as a percentage of the same line item for the base year. The horizontal analysis formula used to calculate the % base column is shown in the example below for the revenue line item.
Revenue 2014 = 4,800 Revenue 2015 = 7,500 Revenue 2016 = 9,500 Horizontal analysis formula: % Base 2015 = Revenue 2015 / Revenue 2014 % Base 2015 = 7,500 / 4,800 = 156% % Base 2016 = Revenue 2016 / Revenue 2014 % Base 2016 = 9,500 / 4,800 = 198%
With this type of report it is easier to spot trends in the financial information. For example, while the revenue is increasing each year (156% for 2015 and 198% for 2016), some of the expenses are increasing more rapidly, for example sales and marketing (240% for 2015 and 500% for 2016), this results in a reduction in the net income of the business. For this business, the 2015 net income is 97% of the base year, and the 2016 net income is only 46% of the base year.
Having identified a trend, the next step is to try and understand the reasons behind it by carrying out a more detailed investigation. In the above example, some of the expenses were increasing at a much faster rate than the revenue resulting in a reduction in net income. It might be that this is planned expenditure for future growth, or maybe the revenue expected from the additional expenditure did not materialize, or possibly there has been a re-classification of expenditure between the different years. Either way it is important to identify the reason and correct the problem as necessary.
Horizontal and Vertical Analysis
Horizontal analysis is only one technique which can be used to analyze financial information. As an alternative, vertical analysis can be carried out where each line item is calculated as a percentage of a base line item for each year. For example, in the case of the income statement, each line item might be calculated as a percentage of the revenue line.