ISL459U-FINANCIAL STATEMENT ANALYSIS
Chapter 4: Horizontal Analysis: Comparative Financial Statement and Trend Analysis
Introduction
Analysis of current financial data provides helpful financial information for decision makers. However, analysis of the current situation will not be enough for the decision makers. Decision makers need an estimate of future financial condition and performance of the companies. They need relevant future information. Creating future information requires a basis that helps to construct the future data. One of the basic tools that is used in constructing future data is the past trend of the related information. Thus horizontal (trend) analysis provides a comparable past trend data has a key role in financial analysis.
Horizontal analysis shows percentage and absolute changes in corresponding financial statement items over a period. It is a very useful tool to gain an understanding and make evaluations on trend situations.
Horizontal analysis does not require complex calculations. However, when interpreting the findings, significant care should be given.
Operating income ratio is a conclusion. Horizontal analysis is useful tool to demonstrate the effects of some factors. As an analyst you should search for the potential factors. Besides, in financial analysis some benchmarks are needed. Those benchmarks could be budgets of the company, or a competitor’s financial results, or industry averages.
What is Horizontal Analysis?
Horizontal analysis is applied for comparing the current financial data with the previous ones. In horizontal analysis the change is compared on the same item (account) basis. On the other hand, if vertical analysis is applied, each item is presented as a percentage of a base figure in the related financial statement.
Comparative Financial Statement Analysis and Trend Analysis
Comparing the past financial data by horizontal analysis can be done in two different ways;
a) Comparative financial statement analysis b) Trend analysis
In comparative financial statement analysis usually financial information of two years are compared. This comparison could be made on a yearly (Year over year, YoY) or on a quarterly (Quarter over quarter, QoQ) basis. In this method, absolute changes and percentage changes are calculated for the comparison.
In comparative financial statement analysis, the analyst lists the several financial statements in a page and tries to observe the variances in each account.
The absolute change is calculated as follows; Absolute Change = Current Year - Previous (Base)Year
After the computation of absolute changes, percentage changes have to be calculated. In percentage calculation absolute change amount is divided to the base year value. Horizontal analysis can be used to compare the financial information over a period. That gives a trend information about a company. In trend analysis usually financial information of 3 to 7 years are compared. Observing the trends over a period carves out valuable information for decision makers. In this analysis a year is fixed as a base year and all financial data on this year is attributed 100% and financial data in succeeding years are expressed as a percentage of the base year.
n trend analysis you can analyze variance of a particular item over a period and easily compare this variance with other related items. This method requires a selection of a base year.
In trend analysis all values in the base year have the same percentage, 100%. In the following years if any number is over 100, that shows an increase according to the base year, any value less than 100 shows a decrease according to the base year. The analysts evaluate the trend of every single item. That is valuable information for forecasting the future and forming reasonable policies.
Why Horizontal Analysis is Used?
Horizontal analysis of financial statements shows significant changes of a company. Those variations provide a basis for financial statement users. The historical trend data makes it easy to forecast the future and make a proper plan. Nevertheless, while making forecasts for the future by using horizontal analysis results, the economic environment should be taken into consideration. If the company operates in a highly unsteady environment, or some structural changes happen in the business, future forecasts must be adjusted accordingly.
Findings in the horizontal analysis may highlight problematic areas to the financial statement users. The objectives of the horizontal analysis users are:
a. To see the trend of financial statement accounts and evaluate the overall performance b. To evaluate the achievement of business goals, and investigate the unexpected variances with using budgets
Implementation of Horizontal Analysis
In order to make an efficient financial analysis we have to check consistency and comparability of financial statements. Consistency is related with the measurement basis. If different measurement bases are applied annually, then it will be hard to make any conclusions from the results. Comparability is related with classification and presentation of the financial information. If different classifications and presentations are applied, it will be impossible to make a financial analysis because all findings will be misleading. Comparability allows analysts
to compare a company’s current financial statements with its historical ones and with other companies.
When a financial statement of a company is compared with a competitor or industry averages, it must be noted that there could be some consistency problems. Therefore, before making any conclusions about the results, effects of consistency issues must be addressed and highlighted.
Comparative Financial Statement Analysis
For implementation of horizontal analysis, initially financial statements must be stated in report format. Financial statements that are included in horizontal analysis should cover the same periods of time.
In the comparison, initially, increases and decreases are calculated for the same accounts.
When all calculations are made and disclosed then these results constitute a basis for conclusions. Later, significant changes should be determined for necessary analysis. Analyzing all changes would not be an efficient way. Focus of the analysis should be given to the related accounts that are relevant for decision making purposes of the financial statement users.
The objective of the financial analyst is not only to select the items, s/he should also determine the effects of these items on financial performance and position. Additionally, influential factors on those changes (sometimes no changes) must be identified. For identifying those factors, the analysts investigate the footnotes and gather some internal and external information about the company.
In non-current assets, there is a significant absolute increase in property, plant and equipment, right of use assets, prepaid expenses, and other non-current assets.
Trend Analysis
Trend analysis provides valuable information about whether company’s accounts are improving or deteriorating. Thus, it provides an important basis for past performance and growth. If sufficient enough data is gathered through trend analysis, financial statement users are able to make more reliable and correct future estimates (Henry et al., 2017). In trend analysis usually a trend of 3 to 7 years is calculated.
Trend analysis does not require complex calculations. You first select a series of financial statements. Then consolidate them in a report format and select the initial year as a base. All the initial year account values will be referred as 100. Then the following year amounts are stated according to the reference year. However, in trend analysis application, care must be given to base year selection and zero or negative values in base year.
Usually the earliest years of the study is selected as a base year. Selected base year should be representative year for the operations of the business. There should not be any unusual values in the financial statements due to some internal and external factors.
Selected base year should be representative year for the operations of the business.
Interpretation of Horizontal Analysis Findings
Interpretation of the findings in any financial analysis depends on the knowledge of the analyst about the company, economic environment, industry and financial statements. Interpretations, therefore, will not be the same. However, even though the interpretations may differ, they must cover some main trends and findings.
The Basis for Interpretation
In horizontal analysis the objective is to find out the trends especially for earnings, assets, and liabilities. In this analysis initially the accounts with large variances should be identified. Those variances should be the subject of a further investigation.
Horizontal analysis results should be evaluated with the following questions: Is change positive or negative? What caused the change?
When using horizontal analysis always look at absolute and percentage change together.
Presentation of Horizontal Analysis in Graphs
Graphs facilitate comparison of performance and financial structure over time, highlighting changes in significant aspects of business operations. In addition, graphs provide the analyst with a visual overview of risk trends in a business (Henry, et al., 2017,345). In general, pie graphs are most useful to communicate the composition of a total value (e.g., assets over a limited amount of time, say one or two periods). Line graphs are useful when the focus is on the change in amount for a limited number of items over a relatively longer time period. When the composition and amounts, as well as their change over time, are all important, a stacked column graph can be useful (Henry, et al., 2017).
Discussion on Horizontal Analysis
Horizontal analysis is suitable for intra firm and inter firm comparisons. Intra firm comparisons provide useful information for understanding the historical trend. Trend information provides a meaningful basis for those who want to make predictions about the future.
While making intra firm horizontal analysis it should be noted that the accounting policies are consistently applied. In inter firm horizontal analysis the accounting policies of the companies before analysis should be compared and the issues that may cause significant differences should be noted. The results of the analysis should be interpreted together with these notes.
One limitation of the horizontal analysis is inflation. In inflationary economies horizontal analysis could be useless. If there is significant inflation, horizontal analysis may require financial information to be adjusted for inflation.