Horizontal analysis is the term used in the context of analysis of financial statements, horizontal analysis in simple words refers to that analysis where a company compares the accounting data such as ratios and other financial items over different accounting periods to find out the trend or growth of the company over a period of time and hence a useful tool when it comes to investors looking to invest into the company based on past trends and growth rate of the company. In order to get a better idea about this concept one should look at some of the advantages and disadvantages of horizontal analysis –
Advantages of Horizontal Analysis
Helps in the Identification of Trend
The first and foremost advantage of horizontal analysis is that it helps in the identification of a trend in the company’s growth over a period of time. Hence for example if the company’s sales over the past 5 years are increasing year on year then it indicates that the company is growing constantly, on the contrary, if the company’s sales is zigzag over the past few years that is rising in one year and falling in another year than it indicates the inconsistent performance of the company. In simple words by comparing the data over many years of the same company an investor can get a fair idea about the company’s growth rate and its performance.
Identification of Problem Areas
Another benefit of horizontal analysis is that it helps in the identification of problem areas which in turn can be of great help to the company in taking steps to make sure that the problem areas are resolved. Hence for example if the sales of the company have increased 50 percent over the past year but its net profit has increased only 5 percent and its operating costs have increased by 40 percent then the company can attribute the reason for low net profit to a rise in operating costs.
Aids in Decision Making
It helps in decision-making in the sense that once the investor has looked at various financial statements and ratios then he or she can have a better idea about the financial condition of the company but doing horizontal analysis can further enhance the confidence of the investor about the company and he or she can invest into the company with more confidence. In simple words, horizontal analysis acts like extra cheese on pizza just like extra cheese enhances the taste of pizza in the same way horizontal analysis enhance the confidence of investor while deciding about the company.
Disadvantages of Horizontal Analysis
Based on Accounting Data
The biggest disadvantage of horizontal analysis is that it is based on accounting data and if accounting data is incomplete or inaccurate then horizontal analysis is of no use. In simple words, the accuracy of horizontal analysis is dependent on the accuracy of the accounting data and that is the reason why there is always that risk that horizontal analysis may not present the true picture due to window dressing methods adopted by companies while presenting their accounting data.
Ignores other Factors
Another limitation of horizontal analysis is that it does not take into account other factors like competitors analysis, industry trends, government policies, global market, and so on, hence there is always this possibility of horizontal analysis missing important data points which may fall outside the scope of the horizontal analysis. Hence for example according to horizontal analysis, a company may be growing at 10 to 15 percent over the past 10 years but if other companies working in the same industry are growing at 50 to 60 percent then the 10 percent growth rate of the company is not acceptable as competitors are growing at a better rate than the company.
Lacks Forecasting Angle
The limitations of this technique are that it can’t provide any insight into what factors might cause changes in the future, and it can’t provide any predictions about the future of the company’s performance thus it lacks the forecasting angle which is an important aspect of any investment as investors will like to invest into those companies which can give good returns in future and not in those companies which have given good returns in the past.
As one can see from the above that horizontal analysis has pros as well as cons and that is the reason why any individual thinking of doing horizontal analysis should carefully read the above points and then only should take any decision based on the horizontal analysis.