Horizontal analysis helps you compare your company's financial performance to your past performance. Suppose your income statement for the year shows you turned a profit. The horizontal income-statement analysis shows how the year looks compared to the previous year or the last three years. It may turn out your income has dropped or, more happily, trended upwards. This approach is also known as trend analysis.
How Horizontal Analysis Works
If your business is brand new, you'll have to wait until you've drawn up financial statements for a couple of different reporting periods, so that you have enough data to work with. Say you've just completed your first fiscal year. To assess trends quarter-by-quarter, you might take the first quarter of the year as a base period. Then you compare the figures from the first quarter's financial statements – your balance sheet, cash-flow statement and income statement – to the rest of the year and mark the changes.
Good horizontal analysis doesn't just eyeball the trends; it crunches the numbers to keep things objective. One way is to look at the dollar change of an item such as total assets or net income. For example, suppose a company's sales in year 1 were $250,000 and in year 2 were $287,500, using year 1 as the base year. The dollar change is an increase of $37,500. If you divide the dollar change by the base-year sales revenue, you get the percentage change, which is 15 percent.
You can apply the formulas to a variety of financial statements and accounts. A typical balance sheet horizontal analysis, for instance, compares one year's balance sheet with the previous year. The analysis looks at multiple sections of the balance sheet such as cash, accounts receivable, fixed assets, accounts payable and retained earnings. A horizontal income statement analysis compares sales, cost of goods sold, different expense categories and net profits from year-to-year.
Interpreting a Horizontal Analysis
Knowing your sales revenue has increased 15 percent since last year is only the first step. It's just a statistical detail until you figure out the significance of the change. What you take away from a horizontal analysis depends on what you want to learn:
- How does the growth in revenue compare to what your business plan predicted? If you expected second-year revenues to go up by 25 percent compared to year one, was the problem your overly optimistic predictions? Did you run into obstacles you didn't anticipate? If so, how can you overcome them?
- How do your horizontals compare to other companies in your field? If the competition's sales revenue has only gone up 7 percent, that's encouraging; if they've gone up 30 percent, however, that makes yours look anemic. One advantage of horizontal analysis is that measuring period-to-period changes gives you a good comparison even if rival businesses are substantially bigger or smaller than your company.
Limitations of Horizontal Analysis
Horizontal analysis is a useful tool, but not a perfect one. Misused, it can lead you astray. A common problem is that the chart of accounts the company uses may have changed over time. The chart lists the various categories for entries, such as petty cash, accounts receivable, fixed assets and inventory. Even if your company follows accepted accounting standards, the system can change, for example, if you start assigning some items to a different category. When you make a horizontal analysis, those changes will affect the outcome, making it look as if the underlying financials have changed more than they actually have.
Another possible problem is looking at individual items or individual financial statements in isolation. The big three financial statements give you an overall picture of your company's financial health:
- The balance sheet shows your total assets and liabilities. Subtracting liabilities from assets gives you the owner's equity in the company or the amount the owners would keep if the company liquidated everything and paid off its debts.
- The income statement measures revenue, including sales you haven't been paid for yet – accounts receivable – and bills you haven't settled, AKA accounts payable. By showing how much income exceeds expenses, it gives you a feel for how profitable your business is.
- The cash-flow statement looks solely at cash transactions. Your business may be profitable, but if cash flowing in is less than cash flowing out, you may have trouble paying employees or covering the mortgage. If you use cash-basis accounting, the income and cash flow statements are identical.
If you perform a horizontal analysis on only one financial statement, that may give you a distorted idea of your performance. Horizontal income-statement analysis may show you income has spiked up this year compared to last year. That's good news. If, however, your balance sheet and cash flow statement show you've also taken on substantially more debt or that your customers are taking longer to pay their bills, the picture is much more mixed.
By carefully selecting which periods you use as the base, you can skew an otherwise sound analysis. For example, an analysis may show a big improvement from last quarter, but much less improvement over the last three quarters. Choosing the same base period every time you make an analysis can avoid this inaccuracy.
The Alternative: Vertical Analysis
Vertical analysis is another way to mine your financial statements for insights. This approach looks at every item on a financial statement as a percentage of another item. The vertical analysis of an income statement, for instance, might report every entry – cost of goods sold, office expense, non-operating revenue and rent – as a percentage of the gross sales income, which is the figure at the top of the statement. A balance sheet vertical analysis usually reports entries as a percentage of total assets.
The vertical analysis formula is simple. Suppose you're interested in a vertical analysis of retained earnings, the profits the company keeps at the end of the year rather than issues to shareholders. For example, say the total assets are $1.2 million, and your retained earnings are $240,000. You would divide earnings by total assets and report the results as a percentage, which is 20 percent in this example. Do the same with other items. If you're interested in a particular section of the balance sheet, such as liabilities, you might use total liabilities as the denominator instead.
Vertical analysis of an income statement can alert you to expenses that are gobbling up a significant share of revenues. They can also show you that some expenses are small enough that it's not worth the effort to lower them further.
You can use vertical analysis to provide a perspective over time, for example, comparing vertical analyses from the past several years. If, say, the cost of goods sold has become a larger percentage of sales revenue over time, that might signify a need to cut costs. On the balance sheet, you might see that your inventory is becoming a larger part of your assets and the cash account a smaller percentage. That might be a sign you're overstocked on the goods you sell. If the long-term debt is a significantly larger percentage than five years ago, that might reflect that you're relying more on debt for financing.
Like horizontal analysis, vertical analysis makes it easier to compare yourself to other companies in the industry regardless of size. Suppose you want to compare your net income to a top company seven times your size. By using vertical analysis on both your income statement and the larger company's statement, you can see what percentage of sales revenue your net incomes are. That makes the comparison a lot easier.