Horizontal Analysis

Horizontal analysis is the evaluation of an organization's financial performance over many reporting periods. Side by side they do this to determine if the company's performance is improving or declining.

The goal is to find significant changes in the data. Later, this data could be used to conduct a more in-depth examination of financial performance. 

The analysis is usually just a basic grouping of data ordered by period, but the numbers in each consecutive period can also be stated as a percentage of the amount in the baseline year, with the baseline amount indicated as 100%.

Internal corporate management and investors frequently use the analysis. Individuals who wish to invest in a company must decide whether to sell their present shares or purchase more. 

When it comes to management, it determines the actions to do in order to improve the future performance of the firm. In general, the method aids in understanding a company's performance so that educated decisions may be made.

On its own, a horizontal analysis comparison is a helpful tool. However, an extra vertical analysis approach is required for management and innovators to make better-informed judgments.

Now we are going to explain what Financial Analysis is in general, so we can understand more about this specific type of analysis. 

Financial analysis  

Financial analysis is the process of assessing enterprises, projects, budgets, and other financial-related entities in order to identify an organization's stability, solvency, liquidity, and profitability.

Financial analysis is used for evaluating economic trends, creating financial policy, formulating long-term company goals, and designating projects or firms for investment. This type of research can also assist a company in attracting investors. 

It is an important part of any commercial activity since it gives practical insights into the health and future potential of the company. 

Not only does this information give vital data to investors and lenders that may alter stock prices or interest rates, but it also allows firm executives to assess their performance in relation to expectations or industry growth.

Financial analysis can help investors make sense of a company's financial data and compare one organization to another. Investors generally perform extensive studies into a company's financial statements.

Financial research can help evaluate whether a company will:

• Continue or cease its main operation or a portion of its business.
• Make or purchase certain materials for the manufacture of its product.
• To enhance working capital, the company may issue shares or seek a bank loan, and make decisions about investing or lending cash.

Investment Decisions

Investment decisions by Internal and External Investors can be seen as:

1. External Investors

A financial analyst or investor examines a business's financial statements and supporting disclosures to determine whether it is worthwhile to invest in or lend money to the company. 

This usually entails a ratio study to see whether the company is adequately liquid and generates enough cash flow. 

It could also entail merging data from many periods' financial statements to create trend lines that can be used to extrapolate financial performance into the future.

An Investor pays attention to:

a. Net profit: A company's net profit is the money left over after all expenditures have been paid. Profits that aren't sustainable are terrible, but losses might be beneficial if you're on course to profitability as you build up. 

You'll need to know a company's gross profit to calculate this figure. When net profit is negative, it is referred to as a net loss.

b. Sales: You may have an objectively excellent product or service, but the real question is whether or not people will pay for it. Investors will not take the risk of not knowing the answer to that question if you have a track record of sales before seeking financing.

c. Margin: They'll also evaluate your profit margins to industry averages and alternative investment prospects. Investors benefit from higher margins because they get a greater return.

2. Internal Investors

An internal analyst examines the predicted cash flows and other data for a potential investment (usually for a fixed asset). 

The goal is to determine if the project's estimated cash outflows will yield an adequate return on investment. This assessment can also be used to determine whether an asset should be rented, leased, or purchased.

Cash flow: Cash in the bank is viewed by investors as an indication that you can deal with unforeseen issues and seize fresh chances. Free cash flow, or the amount of money left over after you pay your bills each month, is an indication of a company's long-term viability. If you have both, investors won't be concerned that you'll go bankrupt at any moment.

Types of Analysis 

Financial analysts frequently evaluate the following aspects of a company: 

1. Profitability: Refers to a company's ability to generate revenue and grow over time. The income statement, which reports on the company's results of operations, is commonly used to determine a company's level of profitability.

2. Solvency: The majority of the cash required to run a business is not received directly from the proprietors. Companies generally incur debt to operate their businesses, which might take the form of deposits, debentures, or loans. Long-term obligations incurred by the company must be repaid in full, including interest. 

3. Liquidity: Refers to the assessment of an organization's capacity to pay its payments on time. This study is critical for lenders and creditors who wish to get a sense of a borrower's or customer's financial status before extending credit.

4. Stability: Refers to the firm's ability to stay in business over time without suffering significant losses in its operations. The income statement and balance sheet, as well as other financial and non-financial indicators, are used to assess a company's stability.

Evaluation Analysis

Techniques of Evaluation 

1. Past Performance: For the same company, over some time (Approx. 3 to 5 years).

2. Present Performance: Similar businesses are compared. It could be by conducting a financial ratios analysis. 

3. Future Performance: This extrapolation method is the main source of errors in financial analysis because past statistics can be poor predictors of prospects (Ex. Monte Carlo simulation).

Key types of financial analytics

• Client profitability analytics distinguishes between clients who generate revenue for a business and those who do not. CPA helps businesses to assess their consumers and determine how advantageous it is to maintain them.
• Product profitability analytics involves evaluating each product individually rather than determining a company's overall profitability. The money left over at the conclusion of an accounting period after subtracting total costs from total revenue is referred to as a company's overall profit.

Cash-flow analytics uses real-time indicators to anticipate cash flow, such as the working capital ratio and cash conversion cycle, and may incorporate methods like regression analysis.

Financial analytics software programs

Finance analytics solutions, with their multiple capabilities, supply you with accurate and previously undetected important data, reducing any difficulties. It assists you in keeping track of your financial flows, including income and costs, across the board.

1. Oracle Financial Analytics

2. SAP ERP Financial Analytics

3. SAS Business Analytics

4. IBM Cognos Finance

5. NetSuite

6. MATLAB

Other types of financial analysis

The other types are:

1. Vertical analysis: Each line item on a financial statement is expressed as a % of another item. For example, each line item on an income statement is expressed as a percentage of gross sales, but each line item on a balance sheet is expressed as a percentage of total assets. 

This type of analysis allows an analyst to go deeper into a financial statement's structure and gain a better understanding of it. 

2. Multi-company comparison: This entails counting and comparing the major financial ratios of two companies, usually from the same industry sector. The goal is to discover the financial strengths and weaknesses of the companies. 

Direct rivals, such as those in the same or a closely comparable industry/sector, and/or firms of similar size, quality, and even growth characteristics, are typically termed, peers.

3. Industry comparison: Compares the outcomes of a single business to the industry's average results. The goal is to see if there are any outliers when compared to the industry average. (ETF or Indices). 

The underlying forces at work in the industry, the overall attractiveness of the sector, and the important criteria that determine a company's performance within the industry are the three primary aspects of an industry study.

Formulas 

To perform this analysis on the income statement or the balance sheet, we must first compare the financial results, that is, the change in line items from one accounting period to the next, in order to determine whether the change is positive or negative, and how strong the growth or decline is.

In other words, it shows the change in each line item, either in absolute terms or as a percentage change year over year (Y-o-Y). 

Horizontal Analysis= Amount in Comparison Year – Amount in Base Year

This specific analysis (percent change) formula is calculated by dividing the difference between the amount in the comparison year and the amount in the base year in the base year. It is expressed mathematically as:

Horizontal Analysis (%) = [(Amount in Comparison Year – Amount in Base Year) / Amount in Base Year] * 100

These formulas are used to compare trends across time, which might be quarter-to-quarter or year-to-year, depending on the accounting period from which the data is derived. 

To acquire relevant insights into how a firm is operating, it's important to use several years of historical data for this analysis. This can assist in determining what is a definite pattern and what is a one-time occurrence.

How to Use Horizontal Analysis

It's best to do so for all of the financial statements at once so you can understand the full influence of operational outcomes on a company's financial situation across the review period. 

For example, the income statement analysis in the two instances below shows a company having a great second year, but the accompanying balance sheet analysis reveals that it is having problems supporting growth due to a decrease in cash, a rise in accounts payable, and an increase in debt.

It incorporates computations of key ratios or margins, such as the current ratio, interest coverage ratio, gross margin, and/or net profit margin, which can be highly insightful. 

Take note of any measurements contained in a company's loan covenants, as it's important to keep an eye on changes in these numbers that could lead to a covenant breach.

Advantages 

This type of analysis has the advantage of allowing for the visual identification of anomalies from long-term trends. 

• Changes in the data are more easily visible when presented on a comparative basis. 

• The ability to compare trends to those of competitors or industry averages to assess how well an organization's performance compares to that of others.

• Detecting anomalies in a trend needs little talent, whereas determining if the data in a presentation are suggestive of problems may require extensive knowledge.

Disadvantages 

• The aggregation of information in financial statements may have changed over time due to ongoing changes in the chart of accounts, causing revenues, expenses, assets, or liabilities to shift between different accounts and appear to cause variances when comparing account balances from one period to the next.

• This examination can be used to report results that are skewed. This can occur when the analyst alters the number of comparison periods utilized to make the results appear exceptionally excellent or unfavorable. 

• This problem can be mitigated by using comparison periods consistently. Also, any changes in the comparison periods should be reported when an analysis is presented on a repeating basis over numerous reporting periods so that readers are aware of the difference.

How to perform horizontal analysis

It can be performed in the following ways:

1. Gather financial statements: Begin by accumulating financial statements from different quarters or years, as horizontal analysis is performed on financial statements throughout time.

2. Compare the statements: Choose which line items to examine after you've gathered your assertions. To assess how the amounts have changed over time, compare the identical line items from successive statements and represent the changes as percentages or dollar amounts.

3. Patterns and trends in the data should be identified: Analyze the information to determine if there are any difficulties or opportunities for the company. This might aid the company in generating effective projects and planning for the future. You can also provide recommendations to the firm based on your findings.

a. Horizontal Analysis of the Income Statement

Horizontal income statement analysis is typically done in a two-year manner, as shown below, with a variance that shows the difference between the two years for each line item.

Another option is to simply add as many years as would fit on the screen without presenting a variance, allowing you to monitor overall changes by account over time.

b. Horizontal Analysis of the Balance Sheet 

This type of analysis in the balance sheet is typically done in a two-year manner, as illustrated below, with a variance indicating the difference between the two years for each line item.

Another option is to add as many years as would fit on the page without providing a variance, allowing you to view overall changes by account over time. 

For example, if management determines that increased earnings per share are due to an increase in revenue or a drop in the cost of goods sold (COGS), the horizontal analysis can corroborate. 

It can assess whether sufficient liquidity can service the company using indicators such as the cash flow to debt ratio, coverage ratios, interest coverage ratio, and other financial ratios.

Horizontal Analysis vs. Vertical Analysis

The major distinction between horizontal and vertical analysis is that horizontal analysis compares numbers from multiple reporting periods, whereas vertical analysis compares figures from a single reporting period. The more data available, the easier it is to spot trends. 

Horizontal analysis of the cost of insurance, for example, may show the cost on a quarter for the previous few years, but a vertical analysis would just show the cost as a % of sales for the current time.

Creditors and investors use vertical analysis to compare a company's financial performance to that of others in the same industry.

What are the top 3 skills for a financial analyst?

Regardless of education, a successful career as a financial analyst requires:

• Strong quantitative skills  

  A quantitative skill is defined as any skill that includes the use or manipulation of numbers. It's the capacity to think in numbers. Quantitative abilities are essential in statistics, economics, and mathematics, for example, although quantitative techniques are employed across the board.

• Expert problem-solving abilities 

  Problem-solving abilities enable you to determine why something is occurring and how to resolve it. It's one of the most significant skills that employers look for in potential employees. The issue-solving process includes identifying the problem, generating solutions, implementing those solutions, and evaluating their effectiveness.

•  Problem-solving abilities 

  Problem-solving abilities relate to the capacity to solve difficulties in an efficient and timely manner without encountering any hurdles. It comprises recognizing and describing the problem, developing several solutions, assessing and selecting the best option, and implementing the chosen solution.

Researched and authored by Charbel Yammine | LinkedIn

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