In financial analysis, understanding how to create and interpret financial statements is crucial. One effective method for analyzing these statements is through horizontal analysis, which evaluates the percentage changes in account balances from one year to the next. This technique allows investors, creditors, and companies to assess trends and performance over time.
To perform a horizontal analysis, follow a two-step process. First, calculate the dollar amount of the change between the two years. This is done by subtracting the previous year's amount from the current year's amount. The formula for percentage change can be expressed as:
\[\text{Percentage Change} = \frac{\text{Current Year Amount} - \text{Previous Year Amount}}{\text{Previous Year Amount}}\]
Alternatively, this can be simplified to:
\[\text{Percentage Change} = \frac{\text{New} - \text{Old}}{\text{Old}}\]
Next, divide the dollar amount of the change by the previous year's amount to find the percentage change. This method provides a clear view of how much an account has increased or decreased over the specified period.
For example, consider a company with net sales of \$65,455 in 2018 and \$58,081 in 2017. The dollar change is calculated as:
\[65,455 - 58,081 = 7,374\]
To find the percentage change, divide this dollar change by the previous year's amount:
\[\frac{7,374}{58,081} \approx 0.127\]
Converting this to a percentage gives a 12.7% increase in net sales. This information is valuable for stakeholders as it indicates growth in sales.
Next, consider the cost of goods sold (COGS). If COGS was \$54,912 in 2018 and \$45,377 in 2017, the dollar change would be:
\[54,912 - 45,377 = 9,535\]
Calculating the percentage change yields:
\[\frac{9,535}{45,377} \approx 0.198\]
This results in a 21.0% increase in COGS, which is significant as it indicates that costs are rising faster than sales, potentially impacting profitability.
Gross profit, defined as net sales minus COGS, can also be analyzed. For 2018, gross profit is:
\[65,455 - 54,912 = 10,543\]
For 2017, it is:
\[58,081 - 45,377 = 12,704\]
The dollar change in gross profit is:
\[10,543 - 12,704 = -2,161\]
To find the percentage change in gross profit:
\[\frac{-2,161}{12,704} \approx -0.171\]
This results in a -17.0% change, indicating a decrease in gross profit, which is critical information for stakeholders as it suggests declining efficiency or increased costs relative to sales.
Overall, horizontal analysis is a powerful tool that can be applied to various financial statements, including income statements and balance sheets, providing essential insights into a company's financial health over time.
