Trend Analysis - Part II

In trend analysis, there are several different methods of analyzing financial statements. In this essay, we will examine (a)  simple base-year horizontal trend analysis, and (b) progressive base-year horizontal trend analysis.

Assume that companies A and B are wholesaling firms in the same line of business. Company A's sales dropped from $500,000 to $300,000 in one year, while its net worth remained at about $100,000s. Company B's sales were $500,000 in each of these years but its net worth rose from $100,000 to $167,000. Therefore, both companies showed identical drops in their sales to net worth ratios (from 5:1 to 3:1).  Obviously, Company B's financial position is considerably better than Company A's.

To understand the financial condition of these two companies and to understand where financial ratios may at first glance may be misleading, a credit analyst often has to combine ratio trend analysis with a comparison of the actual figures in a series of financial statements. This technique is called horizontal trend analysis. 

In its simplest form, horizontal trend analysis involves tabulation of the year-to-year changes in dollar amounts of the asset and liability. In addition to these simple calculations, most credit analysts that use horizontal trend analysis to calculate the percentage changes that these items undergo. 

There are two basic methods of making these percentage calculations: simple base-year horizontal trend analysis and progressive base-year horizontal trend analysis.

Simple Base-Year Horizontal Trend Analysis

In this analysis, the first step is to establish the a base line.  The base line is the first year for which financial statements are received.  Creditors consider each item in that statement to represent 100 percent. For each succeeding year, you calculate every item as a percentage of the base year figure. Thus, the simple base-year trends for certain key items of the Jones Company, whose statements for three years are shown below, would look like this:

This method shows the relative changes that have occurred since the base year. Unfortunately, except with regard to the changes between the base year and the second year, simple analysis is usually not the best way of presenting this type of information.

As a credit manager, your overriding concern should be with financial changes in the recent past - specifically within the last year. But the percentage changes of these latest items, computed on the basis of an original base year that may have been several years ago, tend to conceal the magnitude and severity of recent developments. These developments stand out more clearly in a progressive base-year analysis.

Progressive Base-Year Horizontal Trend Analysis

In progressive analysis, instead of relating figures reported for each successive year to a single base year, you relate them to the preceding year. Here are the same five items from the Jones Company statements using progressive analysis:

Both simple and progressive analysis makes it clear that Jones Company inventories are rising while its sales are falling, and that current liabilities are increasing while net worth is falling. Progressive analysis makes it more evident that many of these unfavorable developments have become evident in the past year.

The information that third-year inventories have risen to 150 percent of second-year inventories, while third-year sales have dropped to 94 percent of second-year sales, enables a credit analyst to make a quicker appraisal of this vital relationship. This is a much simpler concept than trying to understand the implications of the fact third-year inventories are 225 percent of first-year [the base year] inventories and third-year sales are 141 percent of first-year sales.

In other words, progressive analysis is more helpful than simple analysis in revealing year-to-year developments because year-to-year changes are reflected immediately in each year's percentages.

Progressive analysis does have one important shortcoming; you cannot conveniently associate it with comparative analysis, as you can ratio trend analysis. If you use progressive base-year percentages for your trend analyses, you must go on to make additional calculations to get ratios for comparative analysis, thus doubling your efforts.

Edited by Michael C. Dennis