What is horizontal analysis of financial statements?

Examining financial statements horizontally, often referred to as horizontal analysis or trend analysis, involves comparing financial data over multiple reporting periods to identify trends, changes, and patterns in a company's performance and financial position. This analysis helps stakeholders understand how a company's financial performance has evolved over time. Here's how to perform horizontal analysis:

1. Gather Financial Statements:

• Collect the financial statements (income statement, balance sheet, and cash flow statement) for multiple consecutive periods. Typically, you'll want at least three to five years of historical data for meaningful analysis.

2. Organize the Data:

• Create a table or spreadsheet that presents the financial data for each period side by side. This arrangement allows for easy comparison of line items across years.

3. Calculate Dollar and Percentage Changes:

• For each line item in the financial statements, calculate the absolute dollar change (the difference between the current period and the prior period) and the percentage change (the dollar change expressed as a percentage of the prior period's value).

Formula for Percentage Change:

• Percentage Change = [(Current Period Value - Prior Period Value) / Prior Period Value] x 100

4. Identify and Interpret Trends:

• Examine the dollar and percentage changes for each line item to identify trends, patterns, and significant variations over time. Pay attention to the following:

• Revenue Trends: Analyze revenue growth or decline over multiple periods. Identify the factors contributing to changes in revenue.

• Expense Analysis: Look at changes in operating expenses, cost of goods sold, and other expenses. Determine whether there are trends that require attention or further investigation.

• Profitability Trends: Assess profitability metrics such as gross profit margin, operating profit margin, and net profit margin. Identify any consistent improvements or deteriorations.

• Balance Sheet Changes: Examine changes in assets, liabilities, and equity. Identify shifts in the composition of assets or liabilities, such as changes in the ratio of current assets to total assets.

• Cash Flow Patterns: Analyze cash flow from operating, investing, and financing activities. Determine whether there are changes in cash flow trends that impact the company's liquidity and financial stability.

5. Highlight Key Findings:

• Summarize the key findings of the horizontal analysis. Highlight any significant trends, positive or negative, that stand out. Provide context for these trends by considering industry benchmarks, economic conditions, and company-specific factors.

6. Compare to Industry and Peers:

• Compare the company's performance trends to industry averages and peer companies. Assess whether the company is outperforming or underperforming relative to its competitors.

7. Consider Qualitative Factors:

• Combine the quantitative findings from horizontal analysis with qualitative information, such as changes in business strategy, leadership, market dynamics, and industry trends, to gain a comprehensive understanding of the company's financial evolution.

Horizontal analysis is a valuable tool for assessing the direction and magnitude of changes in a company's financial performance and position over time. It provides insights into historical trends, which can inform future projections and strategic decisions. Additionally, it helps stakeholders track the impact of past decisions and events on the company's financial health.