Horizontal Analysis

Horizontal analysis, also known as trend analysis, includes comparisons made to a selected base year or period. Trend percentages are useful for comparing financial statements over several years because they disclose changes and trends occurring through time, especially compared to the previous year.

Trend percentages, also referred to as index numbers, help you to compare financial information over time to a base year or period. You can calculate trend percentages using the following formula:

  • selecting a base year or period
  • assigning a weight of 100 percent to the amounts appearing on the base-year financial statements
  • expressing the corresponding amounts on the other years’ financial statements as a percentage of base-year or period amounts

Compute the percentages using the equation analysis year amount / base year amount and then multiplying the result by 100 to get a percentage.

The following information for a sample company illustrates the calculation of trend percentages:

(USD millions)

20Y3

20Y4

20Y5

Net sales

$9,105.50

$10,029.80

$10,498.80

Cost of goods sold

$4,696.00

$5,223.70

$5,341.30

Gross profit

$4,409.50

$4,806.10

$5,157.50

Operating expenses

$3,353.60

$4,369.90

$4,012.00

Income before income taxes

$1,055.90

$436.20

$1,145.50

 

We will calculate the trend percentages using 20Y3 as the base year, and everything in 20Y3 will be 100 percent. For net sales in 20Y4, take ($10,029.80 from 20Y4 minus $9,105.50 from 20Y3) / $9,105.50 from 20Y3 and multiply by 100 to get 10.15%. The same process continues for each account using the amount for each account in the base year 20Y3. The trend analysis would look like this (calculations added beside each column):

Trend Analysis with Calculation
 20Y320Y4 20Y5 
Net Sales100.0%10.15%($10,029 − $9,105.50) / $9,105.50115.30%$10,498.80 / $9,105.50
Cost of goods sold100111.2$5,223.70 / $4,696.00117.7$5,341.30 / $4,696.00
Gross profit100109$4,806.10 / $4,409.50117$5,157.50 / $4,409.50
Operating expenses100130.3$4,369.90 / $3,353.60119.6$4,012.00 / $3,353.60
Income before income taxes10041.3$436.20 / $1,055.90108.5$1,145.50 / $1,055.90

These trend percentages indicate the changes taking place in the organization and highlight the direction of these changes. In horizontal analysis, we find the percentage change from one year another one. For instance, the percentage of sales is increasing each year compared to the base year. Cost of goods sold increased at a lower rate than net sales in 20Y3 and 20Y5, causing gross profit to increase at a higher rate than net sales. Operating expenses in 20Y4 increased due to the provision for restructured operations, causing a significant decrease in income before income taxes. Percentages provide clues to an analyst about which items need further investigation or analysis. In reviewing trend percentages, a financial statement user should pay close attention to the trends in related items, such as the cost of goods sold in relation to sales. Trend analysis that shows a constantly declining gross margin (profit) rate may be a signal that future net income will decrease.

As useful as trend percentages are, they have one drawback. Expressing changes as percentages is usually straightforward as long as the amount in the base year or period is positive—that is, not zero or negative. Analysts cannot express a $30,000 increase in notes receivable as a percentage if the increase is from zero last year to $30,000 this year (remember, you cannot divide by zero). Nor can they express an increase from a loss last year of $10,000 to income this year of $20,000 in a realistic percentage term.

Proper analysis does not stop with the calculation of increases and decreases in amounts or percentages over several years. Such changes generally indicate areas worthy of further investigation and are merely clues that may lead to significant findings. Accurate predictions depend on many factors, including economic and political conditions; management’s plans regarding new products, plant expansion, and promotional outlays; and the expected activities of competitors. Considering these factors along with horizontal analysis, vertical analysis, and trend analysis should provide a reasonable basis for predicting future performance.

Check Your Knowledge

Comparative Balance Sheet with Horizontal Analysis
      Increase or Decrease
  2008 ($) 2007($) Amount Percent
Sales
1,498,000
1,200,000
298,000 24.8%
Cost of Goods sold 1,043,000 820,000 223,000 27.2%
Gross profit 455,000 380,000 75,000 19.7%
Selling expenses 191,000 147,000 44,000 29.9%
General expenses 104,000 97,400 6,600 6.8%
Total operating expenses 295,000 244,400 50,600 20.7%
Operating income 160,000 135,600 24,400 18.0%
Other income 8,500 11,000 (2500) (22.7)%
Other expenses 168,500 146,600 21,900 14.9%
  6,000 12,000 (6,000) (50.0)%
Income before income tax 162,500 134,6000 27,900 20.7%
Income tax 71,500 58,100 13,400 23.1%
Net income 91,000 76,500 14,500 19.0%
         
Question 1

In the above example we do horizontal analysis for the year 2008. Percentage changes from one year to another year are horizontal or trend analysis. What is the change in Gross Margin in 2008 in comparison to 2007?

Question 2

What was the total percentage change in gross margin? To determine the percentage change in gross margin, would you examine the change in sales or the change in cost of goods sold?

Licenses and Attributions

Calculating Trend Percentages from Financial Accounting by Lumen Learning is available under a Creative Commons Attribution 4.0 International license. UMGC has modified this work and it is available under the original license.