What is Trend Analysis of Financial Statements?
Trend analysis of financial statements helps the users of information to observe the percentage changes over time of the selected data. For example, it helps the users to observe whether the net profit of the enterprise is increasing, decreasing or stable, or there are ups and downs over the number of years.
Horizontal analysis can easily be expanded to include more than a single change from one year to the next. This is called trend analysis. In many cases, it is important to look at changes over a period of time in order to evaluate emerging trends that are likely to have an impact on future years’ performance. The five-year summary of selected financial data which is found in all annual reports is particularly useful in this regard.
When more than two years are involved, index numbers are used instead of percentage changes. Essentially, one year is selected as the base year and is set to 100%. All other years are represented as a percentage of the base year.
Formula to Calculate Index Number
An index number can be calculated by the following formula:
Index number = (Index year dollar amount / Base year dollar amount) x 100
The trend facilitates the user of information to make certain decisions which may be critical. In this analysis, percentage changes are calculated for several years instead of between two years. by looking at the trend in a particular ratio, the user is in a position to identify a problem or observe a sign of good management. Here index numbers are constructed keeping one year as the base year; the value of the item represented in that base year is equal to 100%. The value of the same item for other years are measured in relation to the value of the base year. The base year should be carefully selected because the year o be used for constructing an index number should not suffer from any abnormalities.
A person who is interested to assess the earning capacity of an enterprise may consider sales and earnings comparison for a period of 3, 5 7 years through trend analysis.
To illustrate, Safeway’s sales in 2015, the base year, were $15,102,673,000. Sales in 2019, the index year, were $19,642,201,000 and the index for 2019 was 130.06, calculated as follows:
Index Number = ($19,642,201,000 / $15,102,673,000) x 100
This means that Safeway’s sales in 2019 were 130.06% or 1.30 times 2015 sales. The index numbers for other items are calculated in the same manner.
Index numbers are particularly useful in measuring real growth. For example, in the Safeway illustration sales increased 1.30 times from 2015 to 2019. Does this represent a real growth of sales, the same unit sakes only at higher prices, or a combination of both? One way to answer this question is to compare the index number for sales growth to the rate of inflation for the same period measured by an index such as the consumer price index for all urban consumers, or a specific price index for the industry. If the particular index increased 1.20 times during the same period we can assume that Safeway experienced some real growth in sales during the 5-year period 2015 to 2019.
The sales and net profit of Zenith Company for five years are shown below.
You are required to show the trend keeping 2014-15 as the base year.
Calculation of Trend percentage – Base year 2014-15
The base year is 2014-15. Therefore, sales and net profit of years 2015-16, 2016-17, 2017-18 and 2018-19 are divided by the base year sales and base year profit respectively, and multiplied by 100 to get the trend percentage. For example for year 2015-16 (Base year 2014-15)
For Net Profit
This process goes on for every year keeping 2014-15 as the base year.
Interpretation: The trend of performance in sales and net profit are growth-oriented as there is an increasing trend. However, the net profit percentage growth has outstepped the sales percentage growth. Other things remaining constant this is a company which can be preferred for investment.
Keeping 2014-15 as the base year we can observe that the increase in sales and net profit percentage is as follows:
When we compare the growth of sales and net profit together, we observe the net profit growth is higher than sales growth. In the sense, if sale has increased by 100%, the net profit has increased by 181% in five years time. The yearly increase in sales and net profit vertical comparison indicates that:
For the year 2015-16, if sales have increased by 20%, the net profit has increased by 31%.
For the year 2016-17, if sales have increased by 40%, the net profit has increased by 56%.
For the year 2017-18, if sales have increased by 67%, the net profit has increased by 109%.
For the year 2018-19, if sales have increased by 100%, the net profit has increased by 181%.
This comparative growth clearly indicates that management is very efficient and effective.
Note: Only positive growth is shown in the exhibit, but the growth can be negative also. There can be consistency without positive or negative growth. There can be ups and downs in the growth. Based on the type of the trend, one can interpret the result and make a decision based on the inference.