Using Trend Analysis To Assess Financial Performance
Financial statement users often have a need to draw comparisons. Some want to compare their company’s recent performance to prior periods. Others are seeking a meaningful way to compare their financial results to other companies in their market or industry. Investors may want to compare companies to determine which one offers the greatest potential for return on their capital. Rather than relying on instinct or intuition, a more objective approach is to use trend analysis to see how companies have performed over time.
Is a company experiencing growth or is it in decline?
How sensitive is the company’s performance to external factors in the market and the overall economy?
How profitable will the company be in the next three to five years?
By examining financial trends, we can make strong inferences about an entity’s current health and future performance.
Vertical vs. Horizontal Analysis
At a basic level there are two approaches to analyzing trends, vertical and horizontal. To utilize vertical analysis, first identify one accounting item as a benchmark and then track the relationship of other key financial statement items against that standard. For example, by using revenue as your benchmark, you can quickly calculate the percentage relationship of other meaningful financial statement line items, such as cost of goods sold, gross margin, general and administrative expenses, net income and EBITDA as shown below.
By using ratios, you get a better basis for comparison than by using total dollars because they highlight how efficiently a company translates revenue to the bottom line. Vertical analysis gives you a good snapshot of a company at a point in time, but to establish a trend, you will need to examine these metrics over multiple periods.
Horizontal analysis, on the other hand, is the comparison of historical financial information over a series of reporting periods. By looking at trends horizontally, you can quickly identify results that are unusually high or low in comparison to other periods within the range. Identification of such macro-variances may indicate the need for a detailed investigation of the reason for the difference. In a purely horizontal analysis, financial information is sorted by period, with each succeeding period expressed as a percentage of the amount in the baseline period.
In the horizontal example above, the trend from Year 1 to Year 2 are fairly consistent across the balance sheet. However, in Year 3, we see a sharp rise in Total Assets and Total Liabilities while Current Assets and Current Liabilities have remained relatively stable. This could indicate that the company has leveraged itself with long-term debt to purchase fixed assets. If that were the case, the debt to equity ratio would take a hit in the short run, but the company may be increasing capacity in anticipation of growing its market share. Whether this is actually the case or not, if you are considering an investment in this company, it warrants further investigation.
While both vertical and horizontal analysis have their relative merits, it can also be useful to look at them in conjunction with one another. That is, calculating ratios relative to a benchmark and comparing them over time.
From this example, we can draw several conclusions:
The company is growing, as evidenced by the annual increases in revenue.
Costs of production and G&A overhead are increasing at a faster rate than revenues based on the declining gross margin percentage and increasing G&A Expense percentage.
While revenue has increased year over year, the company is relatively less profitable. This could indicate that the company’s pricing strategy has not kept pace with costs, or perhaps the company has seen a decline in efficiency during this period of growth.
For the sake of simplicity, the examples shown above are limited to common financial statement metrics drawn from the balance sheet and income statement. In practice, you can utilize any measurements that are significant within the company or industry. This could include common financial ratios such as debt to equity, return on capital, or working capital. It could also include non-financial metrics like headcount, machine hours, or employee turnover. The key is identifying what drives profitability. By understanding long-term trends, you can often react quickly to internal and external factors affecting financial performance and more accurately forecast future results. For more information on outsource accounting and outsourcing solutions, click on the link below. LUXA Enterprises is an outsourced accounting group offering accounting solutions to small and mid-size businesses in the Tulsa and surrounding areas.