undefined

What is horizontal analysis explain in brief

Horizontal analysis, also known as trend analysis, is a financial analysis method that involves comparing and evaluating financial statement data from different periods. It focuses on identifying and analyzing changes in key financial metrics, such as revenues, expenses, assets, liabilities, and cash flows, over a specified period of time. By calculating the percentage changes in these metrics, horizontal analysis allows analysts to uncover trends, patterns, and shifts in financial performance. This analysis provides valuable insights into the company’s growth, profitability, financial stability, and overall financial health, helping stakeholders make informed decisions and assess the company’s performance relative to previous periods and industry benchmarks.

Methodology

  • Selection of financial statements for analysis: 

The first step in conducting a horizontal analysis is to determine which financial statements will be analyzed. Typically, the income statement, balance sheet, and cash flow statement are chosen as they provide a comprehensive view of a company’s financial performance and position. These statements provide information on revenues, expenses, assets, liabilities, and cash flows, which are essential for evaluating the company’s financial trends and changes over time.

  • Determination of time periods to be compared: 

Once the financial statements are selected, the next step is to decide which time periods will be compared. This can vary depending on the purpose of the analysis and the availability of historical data. Common approaches include comparing consecutive periods (e.g., year-over-year or quarter-over-quarter) or analyzing multiple years to identify long-term trends and patterns. The choice of time periods should align with the objectives of the analysis and provide sufficient data points for meaningful comparisons.

  • Gathering and organizing the data:

After selecting the financial statements and time periods, the relevant financial data needs to be gathered and organized. This involves collecting the financial statements for each period under analysis, ensuring accuracy and completeness. The data can be obtained from internal sources, such as accounting records or financial reporting systems, or external sources, such as publicly available financial statements or databases. It is crucial to ensure the consistency and reliability of the data to facilitate accurate analysis.

  • Calculation of percentage changes: 

The core calculation in horizontal analysis involves determining the percentage changes in the financial statement data. This is done by comparing the values of specific financial metrics between the selected time periods. The percentage change is calculated by subtracting the earlier period’s value from the later period’s value, dividing it by the earlier period’s value, and then multiplying by 100. This calculation allows for a standardized comparison and enables the identification of both positive and negative changes in financial performance. These percentage changes serve as the basis for further analysis and interpretation of the trends and shifts observed in the financial statements.

Horizontal Analysis of Balance Sheet

  • Calculation of percentage changes in assets and liabilities: 

In the horizontal analysis of the balance sheet, the first step is to calculate the percentage changes in assets and liabilities between the selected time periods. This involves comparing the values of specific asset and liability categories (e.g., current assets, non-current assets, current liabilities, long-term liabilities) from one period to another. By subtracting the earlier period’s value from the later period’s value, dividing it by the earlier period’s value, and multiplying by 100, the percentage change for each category can be determined. This calculation helps identify the magnitude and direction of changes in the company’s asset and liability structure over time.

  • Examination of changes in key asset and liability categories: 

Once the percentage changes in assets and liabilities are calculated, the next step is to examine the changes in key categories within the balance sheet. This involves analyzing the variations in specific asset categories, such as cash and cash equivalents, accounts receivable, inventory, property, plant, and equipment, and liabilities categories, such as accounts payable, short-term debt, long-term debt. By assessing these changes, patterns and trends can be identified, indicating shifts in the company’s asset allocation, liquidity position, debt levels, and financial stability. It allows for a deeper understanding of the factors driving the changes in the balance sheet composition.

  • Analysis of changes in financial ratios: 

In addition to examining individual asset and liability categories, horizontal analysis of the balance sheet involves analyzing changes in financial ratios derived from the balance sheet data. Financial ratios, such as current ratio, debt-to-equity ratio, and asset turnover ratio, provide insights into the company’s liquidity, solvency, and efficiency. By comparing these ratios across different periods, analysts can assess the impact of the changes in assets and liabilities on the company’s overall financial performance and health. This analysis helps identify strengths, weaknesses, and potential areas of concern, assisting in making informed decisions and evaluating the company’s financial position over time.

Horizontal Analysis of Cash Flow Statement

  1. Calculation of percentage changes in operating, investing, and financing activities: 

The horizontal analysis of the cash flow statement involves calculating the percentage changes in the cash flows from operating, investing, and financing activities between the chosen time periods. By comparing the cash inflows and outflows in each category, the percentage change can be determined. This calculation helps evaluate the changes in the company’s cash generation, investment activities, and financing sources over time.

After calculating the percentage changes, the next step is to evaluate the cash flow patterns and trends. This includes analyzing the direction and magnitude of the changes in operating cash flows, investing cash flows, and financing cash flows. By assessing the patterns, trends, and fluctuations in these cash flow categories, analysts can gain insights into the company’s cash flow dynamics, such as increasing or decreasing cash flows from operations, changing investment strategies, or alterations in financing activities.

  • Identification of changes in cash flow sources and uses:

Another important aspect of the horizontal analysis of the cash flow statement is to identify changes in cash flow sources and uses. This involves examining the sources of cash inflows and the purposes of cash outflows within each cash flow category. By analyzing these changes, analysts can understand the shifts in the company’s cash generation and allocation. For example, an increase in operating cash flows may indicate improved profitability, while a significant increase in investing cash outflows may suggest higher capital expenditures or acquisitions. This analysis helps identify key drivers of cash flow changes and provides valuable insights into the company’s financial activities and strategies over time.

Interpretation and Conclusion

  • Comparison of the findings from different financial statements: 

In the interpretation stage of a horizontal analysis, it is essential to compare the findings from different financial statements, including the income statement, balance sheet, and cash flow statement. By examining the trends, patterns, and changes in these statements, analysts can identify correlations and connections between various financial metrics. This comparison provides a holistic view of the company’s financial performance and helps identify any inconsistencies or discrepancies that may require further investigation.

  • Assessment of the overall financial performance and health of the company: 

The next step is to assess the overall financial performance and health of the company based on the findings from the horizontal analysis. This assessment involves evaluating the key metrics, ratios, and trends observed in the financial statements. It helps determine whether the company’s performance has improved or declined over time and provides insights into its profitability, liquidity, solvency, and operational efficiency. By considering both positive and negative changes, analysts can form a comprehensive understanding of the company’s financial position.

After analyzing the trends and changes identified through horizontal analysis, it is crucial to draw conclusion regarding their significance. This involves determining the underlying factors driving the observed trends, such as market conditions, operational strategies, or industry dynamics. Additionally, it is important to assess whether the observed changes are temporary or indicative of long-term shifts. By understanding the significance of these trends and changes, stakeholders can make more informed decisions and forecasts about the company’s future performance.

  • Recommendations for future financial management and decision-making: 

Based on the findings and conclusions drawn from the horizontal analysis, recommendations can be provided for future financial management and decision-making. These recommendations may include specific actions to address areas of weakness or capitalize on strengths identified during the analysis. For example, if the analysis reveals declining profitability, recommendations could involve cost-cutting measures or diversifying revenue streams. Similarly, if the analysis highlights improved liquidity, recommendations may focus on optimizing working capital management or exploring investment opportunities. These recommendations provide guidance for management in enhancing financial performance and achieving the company’s strategic objectives.

 

In conclusion, horizontal analysis, a powerful financial analysis technique, enables a comprehensive comparison of financial statement data across different time periods. By calculating percentage changes and analyzing trends in revenues, expenses, assets, liabilities, and cash flows, horizontal analysis provides valuable insights into a company’s financial performance, patterns, and shifts. This analysis facilitates a deeper understanding of growth, profitability, financial stability, liquidity, and efficiency. Through the evaluation of changes in key categories, financial ratios, cash flow patterns, and sources and uses of cash, stakeholders can make informed decisions and strategies. The horizontal analysis of financial statements serves as a critical tool for assessing a company’s past performance, identifying areas of improvement, and guiding future financial management and decision-making.