How to Perform Trend Analysis on Financial Statements

Trend analysis reads several years of the same statements together. Direction becomes visible where a single year shows only a position. Two years give a change and only three begin to give a direction, so three years is the working minimum. The most useful lines are rarely the headline ones: what a business collects, holds and owes, expressed against its revenue, moves before the profit figure does.

The idea underneath is this. One year of accounts is a photograph, and a business is a moving thing. A photograph shows exactly where somebody is standing. The photograph does not show whether they are walking towards the viewer or away, and those two people need completely different responses from anyone lending to them, supplying them or buying into them. A business that has arrived at a position and a business that is passing through it look identical on a single set of statements. Trend analysis exists to separate those two.

Three choices carry the method: how many years to lay side by side, which base to read each line against, and which derived line to build first.

What does looking at several years together give that one year cannot?

Start away from accounts entirely. A child is weighed at a clinic and the scale reads eighteen kilograms. Is that good? The number is a position and the question is about direction, so nobody in the room can answer. Bring the card with the last three visits on it and the same eighteen kilograms becomes a completely different fact depending on whether the previous readings were sixteen and seventeen, or twenty and nineteen. Nothing about the child changed between those two versions. The only thing that changed is how much history was on the table.

Trend analysisReading the same lines from several years of accounts side by side, so that the direction a business is moving in becomes visible rather than just the position it has reached. is the same move applied to a set of statements: the same lines from consecutive years are laid beside each other, and the direction is read rather than the level. The mechanics are almost embarrassingly simple. Nothing exotic is being computed. This year's revenue sits next to last year's, this year's profit next to last year's, and this year's balance sheet next to last year's, and the question put to each is which way it points and how fast.

Laying the years side by side buys a set of questions a single year cannot even pose. Is the business growing, and is the growth speeding up or slowing? Is it holding more stock for every rupee it sells than it used to? Is it taking longer to get paid? Is it leaning on suppliers more heavily each year? Each of those is a comparison, and a comparison needs at least two points. None of them is answerable from a single column of figures, however carefully it is read.

How many years are needed, and why is two not enough?

Two years give a change. Three years begin to give a direction, and the difference between those two things is not a technicality.

Any two points can be joined by a straight line, so two years can never contradict the line they appear to draw. Revenue of Rs 1,95,00,000 set next to revenue of Rs 2,40,00,000 leaves only one reading available: revenue went up. The third year is the first one with the power to say something the first two did not already imply. The third year can say the rise is getting steeper, that it is holding steady, or that it has already begun to reverse. Until that third point lands, all three of those futures are equally consistent with the figures in view.

There is a second reason three is the working minimum, and it is about noise rather than geometry. Businesses have odd years. A large one-off order, a fire, a delayed season, a year in which the monsoon shifted a school term. With two years the odd year is half of everything visible, so an odd year cannot be told from a new normal. With three years the middle year can at least be tested as an outlier or as a turning point. Five years is better still where the years are comparable, and for a business that has been reorganised twice in that time it may be worse, for reasons covered below under comparability.

What is compared, and against what base?

The comparison is of the same line to itself. Comparing a line to itself sounds obvious, and it is where most of the errors live. The same line has to have been prepared on the same basis in every year for the comparison to mean anything. Revenue against revenue, profit against profit, the closing receivables balance against the closing receivables balance, all measured at the same date each year and all counted the same way.

The base compared against is a separate choice from the line compared, and it decides which question is being answered. There are three bases in ordinary use, and each is right for a different question. Against the year immediately before comes year on year growthThe change in a figure from one year to the year immediately after it, usually written as a percentage of the earlier year.. Year on year growth answers whether the business is speeding up or slowing down. Against a fixed base yearOne year chosen as the reference point and set to 100, so that every later year is expressed as a proportion of it and several lines can be compared on one scale. set to 100 gives how far the line has travelled in total, and lets four lines measured in different units sit on the same chart. Against another line in the same year, usually revenue, comes whether the balance sheet is keeping pace with the trade. The third base does most of the work in trend analysis, and the derived line it produces is usually the first line to move.

What does a rising line actually establish?

Less than most readers assume, and it is worth sitting with. A rising line establishes that the level went up. The level says nothing about whether the rise is getting stronger or weaker, and those two are the interesting part.

A line can rise every single year while the business behind it slows down every single year, and the level alone will never show it. Anjani Stationers, an invented supplier of school stationery, billed schools Rs 1,95,00,000 in year zero, Rs 2,40,00,000 in year one and Rs 2,70,00,000 in year two. Read as levels, that is three rising bars and a pleasant story. Read as growth, the first step is Rs 45,00,000 or 23.1 per cent, and the second step is Rs 30,00,000 or 12.5 per cent. The growth rate almost exactly halved. Both statements are true at the same time: revenue is rising, and the rise is running out of momentum. A reader who reports only the first has dropped the more informative half.

Two habits follow from this, and they cost nothing. Always write the growth rate next to the level, never instead of it. And always ask which base the growth is measured against. A large percentage on a small base and a small percentage on a large base are very different facts. Rs 45,00,000 of extra billing on a base of Rs 1,95,00,000 is a real acceleration. The same Rs 45,00,000 added to a base ten times that size would be a rounding difference.

How is the trend that the headline numbers hide found?

By building a derived line. A balance sheet figure is a stock sitting there at one date, and a figure from the statement of profit is a flow across the whole year. The first is divided by the second. The result is not a rupee amount and not a percentage of anything meaningful on its own. It is a pace. And pace is what moves first.

A balance sheet figure expressed against the revenue that produced it measures the plumbing rather than the result, so it will usually turn a year or more before the profit figure does. Think about a household. The salary arrives on the first of every month and the salary has not changed, so the headline is steady. But the cook has started buying the month's provisions on credit from the corner shop and clearing the bill later and later. Nothing in the salary shows it. The corner shop's ledger measures the pace at which money is actually moving rather than the amount that was earned, so the ledger shows it immediately. A business has exactly the same instrument, and it is sitting in its own accounts.

For Anjani Stationers the relevant balance sheet figure is receivablesThe total that customers have been billed for and have not yet paid, sitting on the balance sheet at the year end as an amount the business is owed., the money schools have been billed for and have not yet paid. Read as rupees it went from Rs 30,00,000 to Rs 78,00,000 to Rs 95,00,000, and the rupee figures look like nothing more than a business that is billing more. Read against the revenue that produced it, it is 15.4 per cent, then 32.5 per cent, then 35.2 per cent. Turn those shares into days of sales outstandingRoughly how many days of billing are sitting unpaid at the year end, found by dividing what customers owe by the year's revenue and multiplying by the number of days in the year. by multiplying by 365, and the result is 56.2 days, then 118.6 days, then 128.4 days.

One year worked through keeps the arithmetic from being a black box. In year one, receivables of Rs 78,00,000 divided by revenue of Rs 2,40,00,000 gives 0.325, the 32.5 per cent in the table. Multiplied by 365, 0.325 gives 118.6 days. In year zero, Rs 30,00,000 over Rs 1,95,00,000 is 0.1538, or 56.2 days. In year two, Rs 95,00,000 over Rs 2,70,00,000 is 0.3519, or 128.4 days. Every input to the calculation is printed in the two statements.

The convention matters, and the one used for Anjani Stationers is receivables at the year end divided by the full year's revenue, multiplied by 365. Other conventions exist and give different answers for the same business. Some analysts use average receivables across the year rather than the closing balance, some use credit sales only rather than total revenue, and some use 360 days. None of those is wrong. The other conventions simply produce different numbers, so a figure quoted from another source cannot be set beside these ones until the convention that produced it is known. One more assumption is baked in and worth naming. Dividing by the whole year's revenue treats billing as though it were spread evenly across the year, and for a business selling school notebooks it is not.

A pace converts back into money. Had Anjani Stationers collected in year one at the same 56.2 day pace it managed in year zero, receivables on that revenue would have been about Rs 36,92,000 rather than Rs 78,00,000. In year two they would have been about Rs 41,54,000 rather than Rs 95,00,000. Roughly Rs 41,08,000 and then Rs 53,46,000 of the business's money is sitting with schools purely because the collection pace changed. The cash sitting with schools is not a metaphor. It is the amount a slower pace has quietly absorbed.

Taken one line at a time, the four lines say this. Revenue rose in both years, from Rs 1,95,00,000 to Rs 2,40,00,000 to Rs 2,70,00,000, so the revenue line never turns. Profit rose from Rs 28,00,000 to Rs 38,00,000 and then fell to Rs 30,00,000, so profit turns in year two. Receivables in rupees rose from Rs 30,00,000 to Rs 78,00,000 to Rs 95,00,000 and never turns, and that is exactly why the rupee figure is useless on its own. Receivables in days of sales went from 56.2 days to 118.6 days to 128.4 days, so the collection line turns in year one. Of the four lines, the day count is the first to turn, and it turns a full year before the profit figure does. Set the history control to the end of year one and the point becomes sharp: at that date the collection line had already more than doubled while profit had just risen by Rs 10,00,000, and nothing in the headline gave any hint of the year to come.

What breaks a trend comparison and makes the years not comparable?

Everything above assumes the years can honestly be set beside each other. Four specific things break that assumption, and each one leaves a trace somewhere in the accounts, so none of them has to be guessed at.

Two years stop being comparable the moment the same events would have been measured differently in each of them, and the four ordinary causes are a changed policy, a restated comparative, a period that is not twelve months, and a business bought or sold during the period. Taken in turn: a changed accounting policy means the method itself moved, so part of the difference in view is the method rather than the business. A restated comparative means last year's published figure is not the figure now printed in last year's column, usually because an error was corrected. A period that is not twelve months, usually the result of a shifted year end, cannot be set against a twelve month period without adjusting for the length. And a business bought or sold means the two years describe different collections of businesses, so revenue can jump without a single extra notebook being sold.

Notice that none of these is hidden. A set of statements presents comparative figuresThe previous period's amounts printed alongside the current period's in the same statement, so that a reader can see both years without hunting for last year's report. for the previous period alongside the current one, and where a prior period has been corrected the accounts carry restated figuresA previous year's amounts reissued in corrected form, because an error was found in what was originally published for that year. together with a statement of what was restated and why. The work is finding the note, not deducing the change. A trend analysis is not ruined by the existence of these four events. It is ruined by running the comparison without checking whether any of them happened.

How is a trend told apart from a single unusual year?

Telling the two apart decides the next move, and there is a workable test. Look at whether the derived lines were already moving before the headline moved.

A bad year with the derived lines unchanged is an event, and a bad year that the derived lines were already leading is a trend. In one case a business has one poor year: profit falls sharply, but collection is at the same pace as always, stock is turning as fast as it always did, and suppliers are being paid on the same terms. Nothing was building. Something happened. A fire, a lost tender or a one-off legal cost does not repeat itself by default, so the sensible response is to find out what it was. In another, the same fall in profit arrives after two years in which collection stretched and stock climbed. Nothing happened. Something has been happening, and the profit line is the last of the several instruments in the statements to say so.

What does this look like when somebody actually does it?

The routine is the same whoever is running it, and it takes about twenty minutes for a small business once the figures are typed in. Lay three years of the same statements in three columns. Copy across the handful of lines that matter: revenue, profit, receivables, inventory, payables, borrowings and cash. Under each level line write the growth over the year before. Then, and only then, build the derived lines. Divide each balance sheet figure by the same year's revenue and multiply by 365, and each balance sheet figure becomes a number of days.

A working reader is looking in that grid not for a bad number but for a line that changed direction, and the fastest way to find one is to read across the derived rows rather than down the columns. The question in front of a lending committee is whether the business can repay over years rather than whether it earned this year, so a credit analyst does this before the file goes to committee. An equity analyst does it before building any projection. A projection that starts from a collection pace that has deteriorated for two years is a projection of a business that no longer exists. An owner should do it because it is the cheapest early warning available and it needs nothing except accounts already prepared. And a household can do a smaller version of the same thing: three years of what came in, what went out and what is sitting on the card, and the third row will move before the other two do.

The stopping point matters too. Trend analysis shows where to look. It does not show why. When the collection line stretches from 56 days to 119 in a single year, the analysis has done its job by putting the question on the table, and the answer to that question is never in the statements. The answer is in who the customers are, what was agreed with them, and which of them has stopped paying. Finding out is a conversation, not a calculation.

Anjani Stationers Private Limited, its school customers and the lending branch that financed it are invented.
Educational material. Not advice on any investment, tax, budget or market position.