Financial Accounting: An Integrated Statements Approach, 2nd Edition

HORIZONTAL ANALYSIS

The basic financial statements illustrated in this chapter are a primary source of in-

formation that financial analysts use in evaluating a company’s performance. One

method of analyzing financial performance is to compute percentage increases and

decreases in related items in comparative financial statements. This type of analysis,

calledhorizontal analysis, compares each item on the most recent financial statement

with the related item on one or more earlier statements. The amount of the increase or

decrease in each item is shown along with the percent increase or decrease.

To illustrate, income statements for Hershey Foods Corporationwill be used for

the years ending December 31, 2004 and 2003. For analysis purposes, the income state-

ments have been condensed and adapted to emphasize the operating aspects of

Hershey’s performance. For example, other expenses, interest expense, and income

taxes have been omitted from the income statements. This allows us to focus on the

basic operating aspects of Hershey’s business without being distracted by unusual

items, such as other expenses related to asset impairments. The exclusion of income

taxes helps simplify the analysis and also recognizes that the amount of income taxes

is largely beyond the operating control of the business. Interest expense is omitted,

since it deals more with the financing rather than the operating aspects of the business.

The resulting comparative income statements are shown in Exhibit 10.

The income statements shown in Exhibit 10 report gross profitas sales less the

cost of sales. Gross profit represents the amount that Hershey marked up the cost of

its products in selling them to its customers. Gross profit is a useful performance

measure in analyzing the profitability of the company’s products from one period to

the next.

Did Hershey improve its operations during the year ending December 31, 2004?

Exhibit 10 indicates that Hershey was able to increase its sales by 6.1%, while the cost

of sales increased by a lesser amount, 5.3%. This combination of sales increasing faster

than cost of sales caused gross profit to increase by 7.5%. Selling and administrative

expenses increased only 1.9%, which is probably related to headquarter’s efficiency

efforts. The overall impact on operating income before taxes is an increase of 13.3%.

This would generally be considered a favorable change in operating performance.

However, before arriving at a final conclusion on Hershey’s operating results for 2004,

26 Chapter 1 The Role of Accounting in Business

Describe and illustrate how

horizontal analysis can

be used to analyze and

evaluate a company’s

performance.

6

Exhibit 10

Comparative Income

Statements Using

Horizontal Analysis:

Hershey Foods

Corporation

Hershey Foods Corporation

Income Statements

For the Years Ended December 31, 2004 and 2003 (in millions)

Increase (Decrease)

2004 2003 Amount Percent

Sales $4,429 $4,173 $256 6.1%

Cost of sales 2,679 2,545 134 5.3

Gross profit $1,750 $1,628 $122 7.5

Selling and administrative

expenses 847 831 16 1.9

Operating income

before taxes $ 903 $ 797 $106 13.3

International Perspective

International Accounting

Standards (IASs) are the

accounting rules that deter-

mine the content of certain

international financial state-

ments. Beginning in 2005,

publicly listed companies in

the European Union are

required to use IASs in

preparing their financial

statements.