What is the Best Procedure for Understanding Horizontal Analysis?
Horizontal analysis is a necessary procedure that is used to compare line items or ratios in the financial statements of a company over a given period. Firms use this trend analysis to help them build models for predicting future financial performances. They will also need this kind of analysis to look and identify any abnormality in the books of accounts and take the corrective actions. Investors would use the trend analysis for 5 years in most cases
Let’s say a company had sales of $ 500,000 in 2018 and 475,000 in 2019. This represents a -5% change from 2018 to 2019. The cost of goods sold was 269,000 and 265,000 in 2019 and 2018, respectively. There was a -1.49 change for the respective years.
For the above, the gross profit would be $231,000 in 2019 and 210,000 in 2018, representing -9.09% changes. Without even going further in the income statement items, one can deduce a few things here. One, we are comparing two years where a difference in each of the line items is shown on the far right.
With the horizontal analysis, you will compute the percentage change in every item in the income statement indicated on the right. Observe the profit and net income. They should give you a hint on what contributes to the decline in the report.
Increases and decreases
Some items will increase while others will decrease by specific percentages. There are items on the list which have more significant impacts on the overall performance. For instance, in the above, a decrease in sales would have a considerable effect on net income.
From the above, we can see that horizontal analysis is essential to the investors because it puts the facts before them, making it easier to analyze the improvements or lack thereof, much easier. The shareholders will consequently understand the percentage of changes in the line items. From the information derived in the statements, all the interested parties will demand an explanation from the management on what they intend to do to fix the problems in the financial statements.