Chapter 13: Horizontal Analysis

Horizontal Analysis: Definition and Application Horizontal Analysis involves comparing financial data across time to identify trends and changes in a company’s financial performance. This analysis looks at the same financial items over multiple periods, allowing users to track the progression of revenues, expenses, assets, and liabilities. The analysis is called “horizontal” because it moves from left to right, as one reviews the changes over time. Methods of Horizontal Analysis 1. Comparative Statements: o Comparative financial statements present data in side-by-side columns, making it easier to compare figures across different periods. For example, a company’s income statement or balance sheet might show the current year's figures alongside those from the previous year(s). 2. Dollar Changes: o This method calculates the absolute change in financial statement items from one period to the next. o Formula: Dollar Change=Analysis Period Amount−Base Period Amount o Example: If Apple’s net income in the current year is $50 million and in the prior year it was $45 million, the dollar change is $50 million $45 million = $5 million. 3. Percent Changes: o Percent change indicates the relative change between periods as a percentage of the base period. o Formula: Percent Change=(Analysis Period Amount−Base Period AmountBase Period Amount)×100 o Example: Using the previous example, the percent change in net income is: (5 million45 million)×100=11.1% o Interpretation: This means that Apple's net income grew by 11.1% from the prior year to the current year. Rules for Calculating Percent Changes When performing horizontal analysis, certain situations require special handling: • • Case A & B: When one period has a negative amount and the other has a positive amount, a meaningful percent change cannot be computed. Case C: If the base period amount is zero, no percent change can be calculated since the calculation would involve division by zero. • Case D: If a positive amount exists in the base period and zero in the analysis period, the decrease is considered 100%. However, a 100% increase from zero remains zero. Application of Horizontal Analysis • • Comparative Balance Sheets: o Focus on large dollar and percent changes first. For example, if a company’s long-term investments decline significantly, this might indicate a strategic shift or a need for liquidity. o Example: If Apple’s long-term marketable securities drop by $65 billion (38.3%) in a year while cash increases by 88.5%, it suggests a shift in investment strategy toward more liquid assets. Comparative Income Statements: o Analyze changes in revenues, expenses, and net income. A drop in sales or a rise in expenses could indicate operational challenges. o Example: A 2.0% decline in net sales, coupled with an 11.4% increase in operating expenses, as seen in Apple’s statements, signals unfavorable conditions as expenses are growing faster than revenue. Trend Analysis in Horizontal Analysis • Trend Analysis is an extension of horizontal analysis, focusing on longterm trends rather than just year-over-year changes. o Formula: Trend Percent=(Current Year AmountBase Year Amount)×100 o o The base period is usually set to 100%, and the subsequent years are expressed as a percentage of the base year. Example: If Apple’s net sales were $200 billion four years ago and $260 billion in the current year, the trend percent is: (260,000200,000)×100=130% o o This indicates that sales have increased by 30% compared to the base year. Trend analysis is particularly useful for comparing multiple years, such as analyzing growth in net sales, operating expenses, and profitability over five years. Interpreting Horizontal Analysis The insights gained from horizontal analysis help in making business decisions: • • • Positive trends indicate growth and improvement, such as increasing revenues or a reduction in liabilities. Negative trends might signal potential problems, such as a decline in sales or increasing debt levels. Users should focus on substantial changes first but also consider smaller variations if they diverge from expectations. Example Analysis Consider an analysis of Apple Inc.: • • • Assets: A decrease in long-term securities and an increase in cash suggests a preference for liquidity. Liabilities: A reduction in accounts payable indicates less reliance on credit purchases. Net Income: A decrease of 7.2% may concern investors, but a less significant decrease in earnings per share (0.3%) due to share buybacks could mitigate the impact. In summary, horizontal analysis provides valuable insights into a company’s performance over time, enabling both internal and external users to assess growth trends, financial stability, and the effectiveness of business strategies. It is a fundamental tool for tracking a company’s progress and for making informed financial decisions.