Notes

In this lesson, learn what horizontal analysis is. See how to do a horizontal analysis and a detailed horizontal analysis example. Find out horizontal analysis uses.
What Is Horizontal Analysis?
I am anxious to start working as a financial analyst at Pies Incorporated. Pies, Inc. was voted the best pies in the Southwest and the largest bakery in the state. After orientation with human resources, I have a meeting with my boss and other new hires in the finance department.

My boss, Patty, welcomes the new hires and asks, 'What is horizontal analysis?' We all look around at each other and shrug our shoulders. She said she was a little surprised that no one knew what horizontal analysis was, or maybe we were just shy.

She goes on to say that horizontal analysis is comparing a recent year to a base year and identifying growth trends. 'Hopefully, this explanation sounds familiar, because you'll use this process in your new job function. The analysis can be performed on any of the four financial statements; however, we'll focus on the balance sheet and income statement,' said Patty.

For the rest of the lesson, we'll explore the components of the most commonly used financial statements: the balance sheet and the income statement. You'll also learn how to complete a horizontal analysis and interpret the results.

Balance Sheet
First, let's review what a balance sheet is. The balance sheet shows how much Pies, Inc. is worth. The balance sheet includes three main components: assets, liabilities and equity. An example of an asset for Pies, Inc. would be a building. A liability could be the mortgage on the building, while equity is the total investment in the company. To complete a balance sheet horizontal analysis, let's look at assets:

Horizontal Analysis - Balance Sheet
Year 1 assets are considered our base, which is why we have an index of 100. Now, let's calculate the index for Year 2. We take the actual assets for year 2 and divide by actual assets for year 1 ($15,201/$12,012). We derive at 1.27. We take that amount and multiply by 100 to get 127.

Now we can compare our index in Year 2 to the index in Year 1 (127-100), which equals 27. We can say assets increased from Year 1 to Year 2 by 27%.

After you calculate the results, it's time to determine why the assets increased. You'll need to speak with the accounting department to determine what assets were purchased in Year 2.

Patty looks around the room and says, 'Any questions?' We all say, 'No,' and she says, 'Excellent. Let's move on to the income statement.'

Income Statement
Next, we have the income statement. The income statement shows profit. To calculate profit, you take sales revenue and subtract expenses. Expenses are the cost of doing business. An example of expenses at Pies, Inc. are utilities and auto loan payments. To complete an income statement horizontal analysis, let's look at sales revenue:

Horizontal Analysis - Income Statement
Year 1 sales revenues are considered our base, which is why we have an index of 100. Now let's calculate the index for Year 2. We take the actual revenues for Year 2 and divide by actual revenues for Year 1 ($21,862/$18,627). We derive at 1.17. We take that amount and multiply by 100 to get 117.

Now we can compare our index in Year 2 to the index in Year 1 (117-100), which equals 17. We can say revenue increased from Year 1 to Year 2 by 17%. Again, we need to determine why. Did a competitor go out of business? Did we increase our advertising, which increased sales?

Patty then says, 'Wow, that was a lot to take in, does everyone understand horizontal analysis as it relates to the balance sheet and income statement?' We all said, 'Yes.' She adds, 'Well, good, because for your first assignment, you'll be assigned a financial statement to complete a horizontal analysis.'

Lesson Summary
Horizontal analysis is comparing a recent year to a base year and identifying growth trends. The most widely used financial statements to complete a horizontal analysis are the balance sheet and income statement.

When completing a horizontal analysis, you will have a base year and comparing year with actual numbers. Calculate the comparing year index by taking comparing year/base year. Once you get the calculated index, multiply it by 100 then subtract it by the base year index. After determining if there's an increase or decrease, remember, there's another step after calculating the results: you must find out why, even if the results are positive.

Key Terms
assets
horizontal analysis: comparing a recent year to a base year to identify growth trends

balance sheet: a statement of assets, liabilities, and equity

income statement: a statement that shows profit

Learning Outcomes
Details of this lesson can prepare you to:

Understand the purpose of a horizontal analysis
Name the components of a balance sheet
Calculate profits using an income statement