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Performing a Horizontal Analysis
Horizontal analysis of a company’s financial statements is the comparison of income or expense headings or other items in the accounts over a particular period of time, such as two or more accounting periods.
This analysis is often performed by a potential investor examining the accounts of a company in which an investment is to be made, but could also be performed by other stakeholders such as loan creditors or by competitors.
The task of horizontal analysis is made easier for investors by accounting standards which generally require the disclosure in the financial statements of equivalent figures for previous periods, facilitating comparison between periods. As the purpose of the horizontal analysis is to see the direction or trend of certain figures or ratios over a period of time it is often referred to as trend analysis.
An investor may perform horizontal analysis, not just for one company but for a number of companies in a particular industry, to gain an idea of the performance of the various businesses in that industry. The comparison of figures over two or more periods may take the form of an examination of the increase or decrease in the figures over time or an analysis of the percentage increase or decrease.
The analysis could be applied to individual income or expense headings or could take the form of the comparison of ratios. An analysis may show the result in terms of both dollar and percentage changes.
Although a horizontal analysis could be performed for all the items in a particular financial statement, the investor may be interested in certain items or ratios in particular. The analysis would then be concentrated on these particular figures. The horizontal analysis undertaken must be in line with the objectives and needs of the person or organization performing the analysis.
If the aim of the analysis is to examine the solvency of the target company, the most relevant financial ratios should be examined. If the objective is to analyze the profitability of the enterprise, appropriate figures such as the gross profit ratio or net profit ratio should be the subject of the horizontal analysis.
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A Working Example
The latest financial statements of the Britannia Pudding Corporation show that the company made sales of $2 million, the cost of goods sold was $1.2 million giving a gross profit of $800,000. The operating expenses were $500,000 giving a net profit of $300,000. A food processing company that sees the Britannia Pudding Corporation as a potential takeover target aims to assess its profitability using a horizontal analysis.
The investor, therefore, examines the figures for the previous accounting year which are available as comparative figures on the current financial statements. In the previous accounting period, the Britannia Pudding Corporation made sales of $1.6 million. The cost of goods sold was $1 million giving a gross profit of $600,000. The operating expenses in the previous accounting period were $400,000 resulting in a net profit of $200,000.
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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.
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Points to Note
An investor undertaking financial analysis must be sure that the financial information forming the basis of the analysis is accurate. The data for the analysis should be taken from audited financial statements for the most recent accounting periods. The above example of horizontal analysis shows that it is also important for the investor to analyze the figures that are important for the aims of the analysis.
For example, the trend in the liquidity ratio should be considered to analyze the solvency of the company, while profitability ratios such as the gross profit ratio should be used for examining the trends in profitability. The results of the horizontal analysis should be supplemented by further information about the company such as its sales strategy, future business plans, the climate within the industry and the general economic situation.
Any financial analysis, such as horizontal analysis, is only an indication of the trends within the company and the investor should always be aware that historic information is not necessarily an indication of future developments.