Trend Analysis-Part I

Trend analysis is a technique for determining the extent of a debtor company's progress, or lack of it by comparison of past and present financial statements. Attention is focused on the year-to-year changes in significant figures and ratios. The value of comparative analysis is that it enables creditors to spot weaknesses in a customer's present financial position.  It also tells creditors  where the customer is strongest, and how that company compares to its competitors. This type of analysis also has at least one serious shortcoming; it fails to indicate the direction in which the customer's business is moving. 

For example, suppose that after a thorough comparative analysis of an applicant's latest financial statements, the credit analyst finds nothing to recommend the company for open account terms. Sales and profits are low; net worth and working capital are both fairly thin. A creditor would be tempted to reject the applicant's request for open account terms.  It would be unwise to do this without some idea of what the applicant's future prospects are, of whether the business appears to be headed up or down financially. It may be that:

• The applicant is plummeting from a formerly strong financial position toward bankruptcy, or 

• Has plodded along in the same marginal way for years, or 

• Has been poorly managed and unprofitable for years, and has no real prospects of doing any better. 

It is possible that the company under review is in the process of recovering from a slump. It may be that the weak position is only temporary, and that the applicant's long term prospects are favorable. In this case, it could be an acceptable credit risk and a source of significant sales volume and profit.

Credit professionals determine the direction a business is headed by using trend analysis. By examining the customer's past financial statements along with the current statement, it is possible to project the direction the debtor company is heading.  Every must be either an improving credit risk, a worsening risk, or an unchanged risk.

How do you get these earlier statements? For a privately held company, the best way is to ask the customer to submit them along with a current financial statement. Request of this type are becoming more and more routine. Creditors might find the information on the credit report obtained from a third party credit bureau. If a creditor company has done business with the customer before, this financial information may be in the credit file.

Try to get successive annual or quarterly statements. If the financial information is not from successive time period, the changes will be more difficult to interpret.  Once a creditor has received past and current financial statements, the investigation may involve either or both of  trend analysis techniques. Creditors can perform ratio trend analysis, comparing the year-to-year changes of various important ratios. Creditors can perform horizontal trend analysis, comparing the year-to-year changes of the actual figures on the statements.

Ratio Trend Analysis

Ratio trend analysis resembles comparative analysis in that creditors calculate many of the same ratios for both. It differs from comparative analysis mainly in the fact that instead of comparing the ratios with the standard ratios for companies in the same line of business, they are compared to the same customer or applicant for different time periods. The goal of this financial analysis is to find signs of improvement or deterioration in the company's financial health and if possible to understand why these changes are taking place.

Figures from two successive annual financial statements of a retail business appear below. With these figures an analyst might make the following calculations in a typical ratio trend analysis: 

The Working Capital Ratio

A rise in current assets coupled with a drop in current liabilities has resulted in a marked increase in the working capital ratio. This is a healthy sign since it indicates growing liquidity. But the change in the working capital ratio alone does not explain the causes of this growth. The reasons for the change, and not the change itself, are of primary importance - especially in the long term outlook of this company. To understand the reasons for the changes, additional ratios must be calculated.

Net Sales to Inventory

The store's inventory turnover rate has also shown a marked increase in the period between the first and second year reporting dates:
A rising turnover rate [which in this case is no doubt a major cause of the firm's increased liquidity] may reflect either improved sales, improved purchasing or improved stock control. Since sales have risen and inventories have dropped, it may well reflect improvements in all three.

A possible reason for increased sales comes to light in the reduced receivables turnover rate:

A rise in this rate always results from a decrease in overall average collection time.  This is considered to be an indication of improved credit policy and collection techniques. For this company, the opposite seems to be the case. The accounts receivable turnover rate has dropped from 11.2 times in the first year to 8.7 times in the second year, but the average collection period has increased from 32 days to 42 days:

This increase has been accompanied by an increase in sales. This is encouraging.  It is possible that in the first year the store's credit policy was too stringent or its collection techniques were too aggressive.  It is possible that in the second year, more enlightened policies were adopted.

Net Sales to Net Worth

In trend analysis, this ratio is interpreted just as it is in comparative analysis. Any reduction is a good sign if it is caused by an increase in net worth; and a bad sign if it is caused by a drop in sales. An increase is troublesome if a reduction in net worth or a poorly capitalized increase in sales is responsible for the increase.  It is a good sign if it results from an adequately capitalized increase in sales.

In view of this store's healthy increase in sales, the modest increase in this ratio from the first year to the second year is a positive factor indicating that net worth is increasing along with sales and that profits are being retained in the business rather than being distributed to shareholders.

Current Liabilities to Net Worth

A decline in this ratio is considered favorable. It indicates that the owner's share in the current financing of the business is increasing compared to the company's creditors. The creditors' margin of protection is increasing. However, the real significance of this ratio relates to the insights it offers about changes in the sales to net worth and the working capital ratios. In this case, it confirms the favorable trend in net worth turnover and the growth in the store's liquidity. Of course, any rise in this ratio would be matched by a decline in the current ratio.

Expenses to Net Sales

An increase in this ratio may be the result of rising costs, or falling sales, or both. Whatever the cause, an increase is one of the most unfavorable findings that trend analysis can reveal - especially if the ratio is well outside of industry norms of expenses to sales in the firm's field of business.

In this case a substantial increase in sales combined with only a small increase in expenses has resulted in a drop in this ratio. This is yet another indication of the upward trend of the business and the strengthening of its credit position.

The Profit Ratios

The dramatic increase shown in the relationship of profits to sales, and profits to net worth serve as the final confirmation of the upward trend of the store's business. But bear in mind that these profit ratios confirm the other ratios. They do not stand by themselves as proof of the store's progress. It is not unusual for a business to magnify its profit reports to attract investors or to adjust the profit figures downward for tax purposes.

A trend is involves changes over time.  Technically, a change does not involve movement from one accounting period to the next. 

Edited by Michael C. Dennis