Horizontal Analysis of Financial Statements is one of the most important techniques to find out how a company is doing financially. It is used for evaluating trends year over year (YoY) or quarter over quarter (QoQ).
In this article, we will have a closer look at the horizontal analysis of financial statements.
What is Horizontal Analysis?
If you are an investor and thinking about investing in a company, only a year-end balance sheet or income statement wouldn’t be enough for you to judge how a company is doing. You need to look at a couple of years at least to be sure. Better yet if you can see many years of balance sheets and income statements and make a comparison among them.
Through horizontal analysis of financial statements, you would be able to see two actual data for consecutive years and would be able to compare each and every item. And on the basis of that, you can forecast the future and understand the trend.
You don’t need any special financial skill to ascertain the difference between previous year’s data and last year’s data. All you need is diligence, attention to details and a logical mind to decipher why the change happens.
In this GKSR example above, we are able to identify the YoY growth rate using Horizontal Analysis. Horizontal analysis helps us identify potentials areas of growths and concerns.
For example, in GKSR, we note that the provision for tax has increased by 12.6%, however, revenues have increased by only 5.5%. Why provisions increased at a higher rate? Also, there has been a comparatively higher growth of 9.1% in Selling and Admin costs. What could have contributed this increase.
As we see we are able to correctly identify the trends and also come up with relevant areas to target for further analysis.
Horizontal Analysis Formula
Let’s have a look at the horizontal analysis formulas –
First, we need to take the previous year as the base year and last year as the comparison year. For example, let’s say we are comparing between 2015 and 2016; we will take 2015 as the base year and 2016 as the comparison year.
Horizontal Analysis formula = [(Amount in comparison year – Amount in base year)/ Amount in base year] x 100
Horizontal Analysis Example (Basic)
Let us assume that we are provided with the Income Statement data of company ABC. We need to perform horizontal analysis on this company.
|Details||2016 (In US $)||2015 (In US $)||Amount||Percentage|
|Sales||30,00,000||28,00,000||200,000 *||7.14% **|
|(-) Cost of Goods Sold (COGS)||(21,00,000)||(20,00,000)||100,000||5%|
|Total Operating Expenses||(400,000)||(350,000)||50,000||14.29%|
|Profit before Income Tax||450,000||400,000||50,000||12.50%|
This is a basic example, where we have divided our approach into two parts. First we found the absolute difference between the compartive years.
- For example, Change in Sales = (30, 00,000 – 28, 00,000) = 200,000
- We find the percentage change = 200,000/28, 00,000 * 100 = 7.14%
Likewise, we can do the same for all the other entries in the Income Statement.
Colgate Horizontal Analysis Example
Let us now look at the horizontal analysis of Colgate. Here we have the YoY growth rates of Colgate’s Income statement from 2008 until 2015. We calculate the growth rate of each of the line items with respect to the previous year.
For example, to find growth rate of Net Sales of 2015, the formula is (Net Sales 2015 – Net Sales 2014) / Net Sales 2014.
Here are the following observations from Colgate’s Horizontal Analysis.
- The last two years Colgate has seen a dip in Net Sales figures. In 2015, Colgate saw a de-growth of -7.2% in 2015. Why?
- Cost of Sales, however, has decreased (positive from company’s point of view). Why is this so?
- Net Income decreased in the last three years, with as much as 36.5% decline in 2015.
- From income statement and balance sheet, a company may portray pretty good hold on their financial affairs. But as an investor, it’s your responsibility to check each item and understand why there is a difference. Your minute attention to details may help you discover something about the company which the company wanted to hide from all the potential investors.
- Companies can inflate profit or show undervalued statement by changing few things here and there. But if you pay attention to details you would be able to discover what’s actually going on within the company.
- With such analysis you would be able to understand how this company may do in the upcoming years, what they are trying to accomplish over the years and what’s their recent purchase, sales, revenue, net income, fixed assets, current assets, capital structure and every minute data mentioned in the balance sheet and income statement.
- Unlike other ratios, this technique gives investors an overall picture of where a company stands in terms of financial matters, what they are trying to do with the funds and how profitable the company can be in near future.
Horizontal Analysis in Forecasting and Financial Modeling
Horizontal Analysis is very useful for Financial Modeling and Forecasting. The appraoach used here is fairly simple.
- Step 1 – Perform the horizontal analysis on the historical data
- Step 2 – Based on the YoY or QoQ growth rates, you can make an assumption about future growth rates.
Let us now look at Colgate 10K 2013 report. We note that in the income statement, Colgate has not provided segmental information, however, as an additional information, Colgate has provided some details of segments on Page 87 Source – Colgate 2013 – 10K, Page 86
Since, we do not have any further information about the segments, we will project the future sales of Colgate on the basis of this available data. We will use the sales growth approach across segments to derive the forecasts. Please see the below picture. We have calculated the year-over-year growth rate for each segment. Now we can assume a sales growth percentage based on the historical trends and project the revenues under each segment. Total Net sales are the sum total of Oral, Personal & Home Care and Pet Nutrition Segment.
From the above examples, it’s clear that through horizontal analysis of financial statements, you need to look at each and every item in the income statement and balance sheet and you would get a holistic picture of how a company is doing.
So before investing in any company, you should do the horizontal analysis of the company’s financial statements and go ahead and do what seems appropriate to you.
This has been a guide to what is horizontal analysis, its formula along with practical examples of Colgate and how horizontal analysis can be used for forecasting and financial modeling. You may go through the following articles for further readings on financial analysis
- Fiscal Year vs Calendar Year
- Equity Turnover Ratio
- Ratio Analysis Guide (Excel Based)
- Top 20 Accounting Interview Questions
The post Horizontal Analysis of Financial Statements | Formula | Example appeared first on Learn Investment Banking: Financial Modeling Training Online.