Horizontal Analysis

Horizontal analysis is a method of reviewing financial statements by comparing the same line items across two or more reporting periods. For each item, such as revenue, cost of goods sold, receivables or long-term debt, the analyst calculates the change in dollars and the change as a percentage of the earlier, or base, period. Reading across the columns of a statement, from left to right, is what gives the technique its name.

Horizontal analysis is one of the most basic tools of financial statement analysis, used by investors, lenders, auditors and managers. It helps answer simple but important questions: is the business growing, are costs rising faster than sales, and are any balances changing in unusual ways? It is usually performed on comparative financial statements, which present two or more periods side by side, and is often paired with vertical analysis, which expresses each item as a percentage of a total within a single period.

The percentage change for each line is:

Here $\text{Current period amount}$ is the figure for the later period and $\text{Base period amount}$ is the figure for the earlier period used for comparison. If the base amount is zero or negative, a percentage change is not meaningful and only the dollar change should be reported.

A furniture retailer's condensed income statement shows the following for two years:

• Net sales rose from $4,000,000 to $4,600,000, an increase of $600,000 or 15 percent.
• Cost of goods sold rose from $2,400,000 to $2,852,000, an increase of $452,000 or about 18.8 percent.
• Gross profit rose from $1,600,000 to $1,748,000, an increase of $148,000 or 9.25 percent.
• Operating expenses rose from $1,100,000 to $1,150,000, an increase of $50,000 or about 4.5 percent.
• Operating income rose from $500,000 to $598,000, an increase of $98,000 or 19.6 percent.

The analysis shows strong sales growth, but cost of goods sold grew faster than sales, so the gross margin fell from 40 percent to 38 percent. Profit still increased because operating expenses were held almost flat. An analyst would want to know why product costs rose so quickly, perhaps due to higher supplier prices, more discounting or a change in product mix, and whether operating expenses can stay flat as the business grows.

When more than two periods are compared, analysts often choose one year as a base and set every item in that year to 100. Each later year's amount is then expressed as a percentage of the base. If revenue was $10 million in the base year and $12.5 million three years later, its index is 125, while an expense index of 140 over the same period would show that the expense grew faster. This version, sometimes called trend percentages, makes multi-year patterns easier to see in a single table.

Horizontal analysis applies to every main statement. On the balance sheet, a jump in receivables or inventory well above sales growth can point to collection problems, slow-moving stock or aggressive revenue recognition. On the cash flow statement, it shows whether operating cash flow is keeping pace with net income. Auditors use it as an analytical procedure to decide which accounts need closer testing.

The method has limits. Percentage changes on small base amounts can look dramatic but mean little, such as a 300 percent rise in an expense from $1,000 to $4,000. Changes in accounting policies, acquisitions, disposals or reclassifications can make periods inconsistent. During periods of high inflation, nominal growth may hide flat or falling real activity. Horizontal analysis also says nothing about whether a figure is good or bad in absolute terms, so it works best alongside ratio analysis, comparison with competitors and a common-size income statement or common-size balance sheet.