What is Horizontal Analysis?
Horizontal Analysis measures a company’s operating performance by comparing its reported financial statements, i.e. the income statement and balance sheet, to the financial results filed in a base period.
How to Perform Horizontal Analysis (Step-by-Step)
Horizontal analysis, or “time series analysis”, is oriented around identifying trends and patterns in the revenue growth profile, profit margins, and/or cyclicality (or seasonality) over a predetermined period.
The accounting period covered could be one-month, a quarter, or a full fiscal year.
Conceptually, the premise of horizontal analysis is that tracking a company’s financial performance in real time and comparing those figures to its past performance (and that of industry peers) can be very practical.
Performing horizontal analysis can help determine the prevailing industry tailwinds (or headwinds), the forward-looking growth outlook in the market (e.g. the industry’s projected CAGR), and the target customer’s spending patterns, and a more in-depth understanding of the company’s core performance drivers can thus be identified.
Common Size Analysis of Financial Statements
The findings of common size analysis as compiled in the preliminary stages of due diligence are critical.
In particular, the specific metrics and any notable patterns or trends that were identified can be compared across different companies — ideally to close competitors operating in the same industry — in order to evaluate each finding in more detail.
Per usual, the importance of completing sufficient industry research cannot be overstated here. In each industry, market participants attempt to solve different problems and encounter various obstacles, resulting in financial performance that reflects a given industry’s state.
While peer-to-peer comparisons are performed as part of the horizontal analysis process, it is important to consider the external variables that impact operating performance, especially any industry-specific considerations and market conditions.
- Profitability by Industry → Certain industries are comprised of high-growth companies where even publicly traded companies are unprofitable or struggling to turn a profit. In order to evaluate the profitability of companies in a specific industry, an average range must first be determined, as well as the factors that positively (or negatively) impact profit margins.
- Competitive Landscape → Each industry is characterized by its own competitive dynamics and market leaders (i.e. the companies with the most market share). For instance, some industries are under constant threat of technological disruption, whereas others have far less exposure. The generation of long-term, sustainable profits is a function of possessing an “economic moat”, which, to reiterate, is context-specific because no two industries are identical (and neither are the strategies that enabled the market leader to reach its current position).
- Growth Profile → Finding profitable growth opportunities in a market is a challenging task in itself, but capitalizing on the opportunity can be even more difficult. With that said, growth is subjective and the maturity of the company must be considered for comparisons to be useful. For example, a company exhibiting low single-digit growth in revenue yet has a track record of long-lasting profitability (i.e. “cash cow”) might not be appealing to an investor seeking companies at the forefront of disruptive technologies with consistent double-digit revenue growth. However, the goals of a mature, established company is entirely different from that of an early-stage, high-growth company with a future that is contingent on acquiring as many new users as possible and raising capital from venture capital (VC) or growth equity investors.
- Cost Structure → At the end of the day, the reinvestment needs of a company is directly tied to the industry it operates within. For that reason, the amount of capital needed on hand to fund day-to-day working capital needs and capital expenditures (Capex), i.e. the purchase of long-term fixed assets, varies widely across industries. Long story short, the “common size” financial statements are only informative if the companies being compared as similar in nature in terms of the business model, target customer profile, end markets served, etc.
Horizontal Analysis Formula
The formula for conducting horizontal analysis is as follows.
In order to express the decimal amount in percentage form, the final step is to multiply the result by 100.
Comparison Period to Base Period Percentage Change Example
For example, if a company’s current year (2022) revenue is $50 million in 2022 and its revenue in the base period, 2021, was $40 million, the net difference between the two periods is $10 million.
By dividing the net difference by the base figure, the percentage change comes out to 25%.
- Horizontal Analysis (%) = $10 million ÷ $40 million = 0.25, or 25%
The base figure is most often pulled from one of the following sources:
- The earliest period available in a given data set, i.e. the starting point from which progress is tracked.
- The period prior to the current period, i.e. year-over-year (YoY) growth analysis.
- The specific period determined by management to be the most insightful frame of reference against which to compare recent performance.
The latter two tend to go hand-in-hand because the most useful benchmark against which to compare recent performance is most often the preceding period.
In contrast, picking the earliest period for the comparison can show the most positive improvement over time, but the usefulness is somewhat limited considering the extent to how much the company has likely grown and changed given the time elapsed (and selecting a comparison period of underperformance can be misleading in portraying recent performance as better than in actuality).
The priority here should be to identify the company’s areas of strengths and weaknesses to create an actionable plan to drive value creation and implement operating improvements.