Horizontal common-size comparisons use only one type of financial statement at a time, but instead of using that statement from just one year, they utilize several consecutive years’ worth of the same type of financial statement.
For example, if a corporation were to do a horizontal analysis on its income statement, it would use the income statements for 2010, 2011, and 2012. Three years of comparisons is pretty much the norm for horizontal analyses, but it’s very common to do extended analyses to measure long-term trends and to search for patterns or cycles in the corporation’s performance.
Remember that each analysis can be used for every one of the major financial statements, but the income statement works particularly well for examples because it’s easy to illustrate and explain.
| Income Statement | Reference Year | Next Year | Last Year |
|---|---|---|---|
| Net sales: | $100,000 | 104% | 110% |
| COGS: | $65,000 | 108% | 115% |
| Gross margin: | $35,000 | 99% | 101% |
| Admin costs: | $30,000 | 113% | 127% |
| EBIT: | $5,000 | 70% | 46% |
| Interest & tax: | $4,000 | 70% | 46% |
| Net income: | $1,000 | 70% | 46% |
The reference year is always considered 100 percent, and the following years are measured as a proportion of that 100 percent value. For a horizontal analysis, you’re not at all worried about how value is being utilized or distributed throughout the organization, only how those values change over time.
So the percentages shown are a percentage of a single reference year. Net sales, for example, were $100,000 in the first year, and then changed in the following two years, both referencing the first year rather than the year before (in other words, the column “Last Year” is measured as a percentage of the “Reference Year” rather than “Next Year”).
This horizontal analysis allows you to track changes in financial management over time to determine whether the corporation’s financial management is getting better or worse, as well as where the changes are being experienced.
In the preceding example, for instance, net sales increased over a 3-year period, meaning that the corporation increased its sales during that period. But that wouldn’t really matter if its costs increased more than its sales did.
In the example, though, the corporation did a very good job because although it increased its sales, it was able to cut its costs of production to a fraction of what they were in the reference year. More sales plus lower costs means the company is utilizing its resources more efficiently.
Still, the horizontal analysis tells you how things are changing only in a nominal sense, which isn’t entirely useful.