What Does the Horizontal Analysis Tell You?
The approach is illustrated by walking through an example of a horizontal analysis. The potential investor wants to examine the trend in profitability of the Britannia Pudding Corporation and as a first step looks at the trend in sales. From the previous year to the current year the sales have risen from $1.6 million to $2 million, an increase of $400,000.The sales have therefore increased by 25% in the year. The investor will see this as a positive sign but will wish to look further into the company's sales strategy and plans for the future. This analysis is therefore only a first indication of the financial position of the company. It is historic data that may give an indication of future trends but more information would be needed to back this up.
A further valuable piece of data that may be extracted by horizontal analysis is the trend in the company's gross profit percentage. This percentage is computed by dividing the gross profit by sales and expressing the result as a percentage. In the current year the gross profit is $800,000 which is 40% of sales. In the previous year the gross profit was $600,000 or 37.5%. The trend in the gross profit percentage is therefore also upwards. The gross profit itself has increased from $600,000 to $800,000 which is an increase of 33.3% over the two periods.
The investor may then look at the net profit. This has increased from $200,000 to $300,000, an increase of $100,000 or 50%. In the previous year the net profit percentage, obtained by dividing the net profit by sales and expressing the result as a percentage, was 12.5%. In the current year, the net profit percentage is 15%. Again, the trend in profitability is upwards. The investor, however, will require further information to enable a rational decision to be made on investing in the company. For example, the investor must look at why the net profit has increased. This could be entirely due to increased sales, partly due to better control of operating costs or the figure could be influenced by the company's pricing policy.
The investor may notice for example that the operating expenses have increased from $400,000 to $500,000 in the period, an increase of 25%. This may indicate that there is an opportunity for reducing these expenses and thereby increasing the net profit in the future. More detailed analysis of the operating expenses would be required before drawing any firm conclusions. A potential investor looking to take over the Britannia Pudding Corporation and introduce new management strategies may see this as an opportunity.