The claim of profit in the financial statements of a business is not good enough metric for comparing performances with preceding years and with other businesses operating in the same sector.
A trend analysis must be done to have an accurate knowledge of the relative position of the business. This is the most reliable way to know if things are improving or deteriorating.
Trend analysis is used to evaluate business’s performances over time and with those of other businesses of same size in the same industry.
In reviewing trends and comparing businesses, ratio analysis is used to interpret relevant financial statements. The categories of ratios often used, are those which test the solvency, the profitability and the efficiency of businesses.
To analyze the solvency of a business over time and compare that with those of companies within the same sector, the current ratio is used.
The current ratio compares total current assets to total current liabilities.
The analysis of the profitability trend employs:
- gross profit to sales ratio ,
- the net profit after tax to sales ratio,
- the return on capital employed (ROCE) – compares profit earned before interest and tax (PBIT) to funds employed to generate the return and.
- Return on share capital (ROSC) – often compares profit before tax (PBT) to share capital and reserves. The profitability of how shareholders’ investment has been used is directly proportional to the value of the ROSC. The higher the ROSC value the higher the profitability.
The following ratios are used for the efficiency (how assets are used) trend analysis;
- asset turnover measures the effectiveness at which assets are used to generate sales,
- Debtors days – measures a business’s efficiency at handling its debtors,
- Creditors days – measures how short term financing is used to fund business activities and,
- Stock turnover – the number of times stock is replenished within an accounting period..
It is important to understand how the above ratios are calculated and how to use them for trend analysis.
What are their formulae?
- Current ratio (solvency test) = currents assets/current liabilities
- Gross profit to sales ratio (profitability test) = gross profit/sales,
- Net profit after tax to sales ratio (profitability test) = net profit after tax/sales,
- ROCE (profitability test) = profit before interest and tax (PBIT)/Total assets – current liabilities,
- Return on share capital (profitability) = profit before tax (PBT)/share capital + reserves
- Asset turnover (efficiency test) = sales/total assets – current liabilities,
- Debtors days (efficiency test) = debtors/sales x 365,
- Creditors days (efficiency test) = creditors/purchases x 365,
- Stock turnover (efficiency test) = cost of goods sold/average stock.
The table below can be used to carry out the trend analysis of the performances of company A over five years and compare them with those of Companies B, C and D. All companies are of the same size and all operate in the same industry.
|B||gross profit to sales ratio|
|C||Net profit after tax to sales ratio (profitability test)|
|D||ROCE (profitability test)|
You can download the comprehensive trend analysis spreadsheet below.