Business Valuation
Apr 8, 2023
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This guide explains what horizontal analysis is, why it is used, and it further highlights the benefits of horizontal analysis. Horizontal analysis is important for entrepreneurs and finance professionals trying to understand a company’s performance over a period of time. Here are some quick takeaways about horizontal analysis.
Horizontal analysis is when a company takes financial data from a given time period and compares it to previous time periods. The purpose of horizontal analysis is to analyze trends in company performance. This is valuable because it shows how a company has performed over time. The objective of using horizontal analysis is to try and determine how well the company is growing.
By analyzing historical trends, we’re more capable of projecting future performance. This can be understood by looking at business lifecycle stages.
The image (above) shows how trends can be graphed over time to show us how a company is performing. In the image above, the trend is obvious. The business lifecycle is typically looked at in stages: launch, growth, maturity, and decline. Horizontal analysis can help us better understand which stage a business is in based on historical performance.
Because of this, ideally, horizontal analysis is looked at over a five-year time period. This gives insight into how a company has been managed over time but is made up of recent enough data that it’s still relevant to future predictions.
Horizontal analysis looks to discover trends. Some examples of trends that can be seen are illustrated below.
The idea is to look at the data over several years to identify trends and make assessments about how these trends will project into the future.
It’s important to note that horizontal analysis doesn’t just look at revenue growth. We can use horizontal analysis to learn much more than that. We could use horizontal analysis to compare how well a company is currently able to make interest payments on debt to previous years for example. The key is that it looks at trends over a period of time.
Now that we understand that the purpose of horizontal analysis is to look back over previous time periods so we can see trends in performance, we’ll look at why this is beneficial.
By using horizontal analysis we’re able to discern trends in company performance and we can then use these trends to ask questions. It allows us to narrow in on areas of the business that need further investigation.
For example, we could use horizontal analysis to look at whether a company’s profit margins are growing or declining. After we see this trend, we can analyze it and ask questions to try and determine what is causing margins to rise or fall?
Horizontal analysis helps us make financial information useful for determining what’s really going on with a business.
Now we’ll look at what trends we can observe over time with horizontal analysis. To see this, we first need to understand vertical analysis. Vertical analysis is when we compare data in the same period (months, quarters, years). Gross profit margins are an example of vertical analysis where we determine our gross profit and divide it by our total revenue. This would show us that our gross margins were 70 percent or 20 percent, for example.
Most commonly, vertical analysis is performed before horizontal analysis. We can use horizontal analysis to compare our vertical analysis over a longer period of time.
With horizontal analysis, we’re often looking at the same things as in vertical analysis, but we’re looking at the trends over time. Have they improved or declined?
Horizontal analysis is commonly used to look at the gross profit margins, operating profit margins, net profit margins, efficiency ratios, and interest coverage ratios we determine with vertical analysis—over a longer period of time. To learn more about these margins and ratios, we recommend our guide: Vertical Analysis.
