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Horizontal Analysis

Guide to Understanding Horizontal Analysis

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Horizontal Analysis

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.

Horizontal Analysis ($ Change) = Comparison Period – Base Period
Horizontal Analysis (% Change) = (Comparison Period – Base Period) ÷ Base Period

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:

  1. The earliest period available in a given data set, i.e. the starting point from which progress is tracked.
  2. The period prior to the current period, i.e. year-over-year (YoY) growth analysis.
  3. 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.

Horizontal Analysis vs. Vertical Analysis

A fundamental part of financial statement analysis is comparing a company’s results to its performance in the past and to the average industry benchmark set by comparable peers in the same (or adjacent) industry.

In particular, there are two forms of financial analysis where a company’s income statement and its balance sheet is adjusted to be “common size”, i.e. the financial data is expressed as percentages of a base figure, which enables comparisons to be closer to “apples to apples”.

  1. Horizontal Analysis → The comparison of a company’s financial data between periods to spot trends (or developments), as well as for peer group benchmarking purposes. Thus, companies of different sizes in terms of total revenue and currently at different stages in their lifecycle can still be compared to obtain useful insights.
  2. Vertical Analysis → In vertical analysis, each line item on the income statement is expressed as a percentage of a base figure, which is usually revenue (or sales). On the balance sheet, the same process is completed, but with the base figure typically being total assets.

Vertical analysis expresses each line item on a company’s financial statements as a percentage of a base figure, whereas horizontal analysis is more about measuring the percentage change over a specified period.

In other words, vertical analysis can technically be completed with one column of data, but performing horizontal analysis is not practical unless there is enough historical data to have a useful point of reference.

In fact, there must be a bare minimum of at least data from two accounting periods for horizontal analysis to even be plausible.

Still, horizontal and vertical analyses are meant to be complementary and used in conjunction with the other, so the user can obtain the most comprehensive understanding of a company’s historical performance and financial state as of the present date.

Horizontal Analysis Calculator — Excel Model Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Step 1. Income Statement and Balance Sheet Assumptions

Suppose we’re tasked with performing horizontal analysis on a company’s financial performance from fiscal years ending 2020 to 2021.

We’ll start by inputting our historical income statement and balance sheet into an Excel spreadsheet.

The two tables below display the financial assumptions we’ll be using here.

Historical Income Statement 2020A 2021A
($ in millions)
Revenue $100 $145
Less: COGS (40) (60)
Gross Profit $60 $85
Less: SG&A (25) (40)
Less: R&D (10) (15)
EBIT $25 $30
Less: Interest Expense (5) (5)
EBT $20 $25
Less: Taxes (30%) (6) (8)
Net Income $14 $18
Historical Balance Sheet 2020A 2021A
($ in millions)
Cash and Equivalents $80 $100
Accounts Receivable 50 65
Inventory 40 45
Prepaid Expenses 10 10
Total Current Assets $180 $220
PP&E, net 200 220
Total Assets $380 $440
Accounts Payable $60 $75
Accrued Expenses 35 40
Total Current Liabilities $95 $115
Long-Term Debt 85 100
Total Liabilities $180 $215
Total Equity $200 $225

Step 2. Horizontal Analysis on Income Statement

Our first task is to evaluate our hypothetical company’s income statement.

The first step to performing horizontal analysis is to calculate the net difference — in dollar terms ($) — between the comparable periods.

  • Base Period → 2020A
  • Comparison Period → 2021A

From 2021 to 2020, we’ll take the comparison year (2021) and subtract the corresponding amount recorded in the base year (2020).

Once repeated for each line item, we are left with the following on the right column:

  • Revenue = +$45 million (45.0%)
  • COGS = –$20 million (50.0%)
  • Gross Profit = +25 million (41.7%)
  • SG&A = –$15 million (60.0%)
  • R&D = –$5 million (50.0%)
  • EBIT = + $5 million (20.0%)
  • Interest Expense = $0 million (0.0%)
  • EBT = +$5 million (25.0%)
  • Taxes = –$2 million (25.0%)
  • Net Income = +$4 million (25.0%)

Horizontal Analysis of Income Statement

Step 3. Horizontal Analysis on Balance Sheet

In the final section, we’ll perform horizontal analysis on our company’s historical balance sheet.

As in the prior step, we must calculate the dollar value of the year-over-year (YoY) variance and then divide the difference by the base year metric.

  • Cash and Equivalents = +$20 million (25.0%)
  • Accounts Receivable = +15 million (30.0%)
  • Inventory = +5 million (12.5%)
  • Prepaid Expenses = $0 million (0.0%)
  • Total Current Assets = +$40 million (22.2%)
  • PP&E, net = +20 million (10.0%)
  • Total Assets = +$60 million (15.8%)
  • Accounts Payable = +$15 million (25.0%)
  • Accrued Expenses = +5 million (14.3%)
  • Total Current Liabilities = +$20 million (21.1%)
  • Long-Term Debt = +15 million (17.6%)
  • Total Liabilities = +$35 million (19.4%)
  • Total Equity = +$25 million (12.5%)

In conclusion, we’re able to compare the year-over-year (YoY) performance of our company from 2020 to 2021.

While the net differential on its own does not provide many practical insights, the fact that the difference is expressed in percentage form facilitates comparisons to the company’s base period and to the performance of that of its comparable peers.

Horizontal Analysis of Balance Sheet

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