Financial statement analysis

Financial Statement: Meaning and Limitations

Financial Statements are the collective name given to Income Statement and Positional Statement of an enterprise which show the financial position of business concern in an organized manner. We know that all business transactions are first recorded in the books of original entries and thereafter posted to relevant ledger accounts. For checking the arithmetical accuracy of books of accounts, a Trial Balance is prepared. Trial balance is a statement prepared as a first step before preparing financial statements of an enterprise which record all debit balances in the debit column and all credit balances in credit column. To find out the profit earned or loss sustained by the firm during a given period of time and its financial position at a given point of time is one of the purposes of accounting. For achieving this objective, financial statements are prepared by the business enterprise, which include income statement and positional statement.

These two basic financial statements viz:

(i) Income Statement, i.e., Trading and Profit & Loss Account and

(ii) Positional Statement, i.e., Balance Sheet portrays the operational efficiency and solvency of any business enterprise.

The income statement shows the net result of the business operations during an accounting period and positional statement, a statement of assets and liabilities, shows the final position of the business enterprise on a particular date and time. So, we can also say that the last step of the accounting cycle is the preparation of financial statements.

Income statement is another term used for Trading and Profit & Loss Account. It determines the profit earned or loss sustained by the business enterprise during a period of time. In large business organization, usually one account i.e., Trading and Profit & Loss Account is prepared for knowing gross profit, operating profit and net profit.

On the other hand, in small size organizations, this account is divided into two parts i.e. Trading Account and Profit and Loss Account. To know the gross profit, Trading Account is prepared and to find out the operating profit and net profit, Profit and Loss Account is prepared. Positional statement is another term used for Balance Sheet. The position of assets and liabilities of the business at a particular time is determined by Balance Sheet.

Limitations of Financial Statements:

 Manipulation or Window Dressing:

Some business enterprises resort to manipulate the information contained in the financial statements so as to cover up their bad or weak financial position. Thus, the analysis based on such financial statements may be misleading due to window dressing.

Use of Diverse Procedures:

There may be more than one way of treating a particular item and when two different business enterprises adopt different accounting policies, it becomes very difficult to make a comparison between such enterprises. For example, depreciation can be charged under straight line method or written down value method. However, results provided by comparing the financial statements of such business enterprises would be misleading.

Qualitative Aspect Ignored:

The financial statements incorporate the information which can be expressed in monetary terms. Thus, they fail to assimilate the transactions which cannot be converted into monetary terms. For example, a conflict between the marketing manager and sales manager cannot be recorded in the books of accounts due to its non-monetary nature, but it will certainly affect the functioning of the activities adversely and consequently, the profits may suffer.

Historical:

Financial statements are historical in nature as they record past events and facts. Due to continuous changes in the demand of the product, policies of the firm or government etc, analysis based on past information does not serve any useful purpose and gives only post­mortem report.

Price Level Changes:

Figures contained in financial statements do not show the effects of changes in the price level, i.e. price index in one year may differ from price index in other years. As a result, misleading picture may be obtained by making a comparison of figures of past year with current year figures.

Subjectivity & Personal Bias:

Conclusions drawn from the analysis of figures given in financial statements depend upon the personal ability and knowledge of an analyst. For example, the term ‘Net profit’ may be interpreted by an analyst as net profit before tax, while another analyst may take it as net profit after tax.

Lack of Regular Data/Information:

Analysis of financial statements of a single year has limited uses. The analysis assumes importance only when compared with financial statements, relating to different years or different firm.

No Brief Information

Accounting rules, methods and conventions are applied for preparing financial statements. Sometimes experiences of the accountancy profession is also used for preparation. These lead to detailed information included in the financial statements.

Qualitative Information is Ignored

Only quantitative information are included in the financial statements and are expressed in monetary terms. But, the qualitative information such as efficiency of management executives, goodwill of the company, employee and employer relationship, efficiency of workers, customer satisfaction, loyalty of customers, competitive strength and the like are not expressed in monetary terms.

Hence, these are not included in the financial statements. However, these qualitative information are necessary for understanding the real financial position and the operating results of the business.

Disclose Wrong Financial Position

The financial position of a business concern is affected by several factors such as economic, social and financial. But, the financial statements include only financial factors. Both social and economic factors are not recorded in the financial statements. This type of practice leads to disclosing wrong financial position of the company.

Static Financial Position of the Company

A balance sheet is prepared on a specified date and reflects the financial position on such date. The real financial position of the company may be changing day to day. Hence, there is a possibility of window dressing in the Balance Sheet.

Financial Statements are Dumb

The financial statements cannot speak themselves. They need detailed analysis and interpretation.

Balance Sheet is not a Valuation Statement

Various assets and liabilities are recorded in the balance sheet at their book value. But, the real value is different from the book value. Hence, it is clear that real financial position of the company cannot be judged from the balance sheet.

Real Profit is not disclosed by Profit and Loss Account

Both operating expenses and non-operating expenses are recorded in the Profit and Loss Account. They are recorded only on estimation but not on the basis of actual incurred expenses. Hence, there is a possibility of not showing real profit by the Profit and Loss Account.

No Comparison of Financial Statements

The financial statements are prepared by different companies in different accounting methods. The reason is that there are different accounting policy and size of business concern differs from one company to another. Hence, the financial statements of two companies cannot be compared.

Meaning and concept of financial analysis

Financial analysis refers to an assessment of the viability, stability and profitability of a business, sub-business or project. It can also be defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. It is the examination of a business from a variety of perspectives in order to fully understand the greater financial situation and determine how best to strengthen the business and it also looks at many aspects of a business from its profitability and stability to its solvency and liquidity. It is a process of scanning the Financial Statements for evaluating the relationship between the items as disclosed in them. In other words it can be defined as an analysis which critically examines the relationship between various elements of the Financial Statements with a view to obtain the necessary and effective information from them. According to John N. Myer, ‘Financial Statement Analysis is largely a study of relationships among the various financial factors in a business, as disclosed by a single set of statements, and study of these factors as shown in a series of statements.’ Financial Statement Analysis involves a systematic and critical examination of the information contained in the Financial Statements with a view to provide effective and more meaningful information to its different users. It is an exceptionally powerful tool for a variety of users of financial statements, each having different objectives in learning about the financial circumstances of the entity. Financial analysis is an aspect of the overall business finance function that involves examining historical data to gain information about the current and future financial health of a company. According to Alan S. Donnahoe - "The inability to understand and deal with financial data is a severe handicap in the corporate world"

Financial analysis can be applied in a wide variety of situations to give business managers the information they need to make critical decisions."In a very real sense, finance is the language of business. Goals are set and performance is measured in financial terms. Plants are built, equipment ordered, and new projects undertaken based on clear investment return criteria. Financial analysis is required in every such case." Financial statement analysis is an analysis that highlights the important relationship in the financial statements. Financial statement analysis focuses on the evaluation of past performance of the business firm in terms of liquidity, profitability, operational efficiency and growth potentiality. Financial statements analysis includes the method use in assessing and interpreting the result of past performance and current financial position as they relate to particular factors of interest in investment decisions. Therefore financial statement analysis is an important means of assessing past performance and in forecasting and planning future performance. It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other reports. These reports are usually presented to top management as one of their bases in making business decisions, such as: 

·         Continuing or discontinuing the business

·         Making or purchasing certain materials in the manufacture productØ 

·         Acquire or rent/lease certain machineries and equipment in the production of its goods 

·         Negotiating for a bank loan to increase its working capital and to issue the stocks

·         Making decisions regarding investing or lending capital

·         Allowing management to make an informed selection on various alternatives in the conduct of its business

The analysis of financial statements represents the three major steps:

The first step involves the reorganization and rearrangement of the entire financial data as contained in the financial statements. This calls for the breaking down of individual components of financial statements and regrouping them into few principal elements according to their resemblances and affinities.

Thus, the balance sheet and profit and loss account are completely re-casted and presented in the condensed form entirely different from their original shape. The next step is the establishment of significant relationship between the individual components of balance sheet and profit and loss account. This is done through the application of tools of financial analysis.

Finally, significance of results obtained by means of financial tools is evaluated. This requires establishment of standards against which actual are evaluated.

Types of Financial Analysis:

Two types of analysis undertaken to interpret the position of an enterprise are:

(i) Analysis of relationship as between different individual components and as between these components and their totals for a given period of time. Such an analysis is known as Vertical Analysis. Since this sort of analysis examines relationships as between different components for a given point of time and does not shed light on changing behaviour of the above relationships, it is also regarded as ‘static analysis’.

Comparison of current assets to current liabilities or comparison of debt to equity or comparison of debt to total assets for one point of time is concrete examples of vertical analysis.

(ii) Analysis of changes in different components of the financial statements over different periods with the help of series of the statements is known as ‘Horizontal Analysis’. Such an analysis makes it possible to study periodic fluctuations in different components of the financial statements.

Study of trends in debt or share capital or in their relationship over the past ten-year period or study of profitability trends for a period of five or ten years are examples of horizontal type of analysis. Horizontal analysis is also known as ‘Dynamic Analysis’ since this reflects changes in financial position of firm over a long period of time.

Methods employed to examine the vertical as well as horizontal relationships of different financial variables with a view to studying profitability and financial position of a business firm is called ‘techniques of financial analysis’. A number of techniques are used to undertake financial analysis. Important among these are: common size statement, ratio analysis, trend analysis, funds flow analysis and profit Planning.

Utility of Financial Analysis:

Financial analysis seeks to spotlight the significant facts and relationships concerning managerial performance, corporate efficiency, financial strengths and weaknesses and credit-worthiness of the company. The tools of analysis are used to study accounting data so as to determine the continuity of the operating policies, investment value of the business, credit ratings and testing the efficiency of operations.

A finance manager must equip himself with the different tools of analysis in order to reach rational decisions for the firm. These tools of analysis are immensely helpful to finance manager in carrying out his planning and controlling functions.

While preparing financial plan for the firm, finance manager must know the impact of financial decisions he is taking on financial condition and profitability of the business enterprise.

The techniques of financial analysis can serve as handmaid to the management in determining the effect of his decisions. These techniques are equally useful in the sphere of financial control in as much as they enable the finance manager to make constant reviews of the actual financial operations of the firm as a whole and of various divisions of the firm against the Performa balance sheet and profit and loss statement and to analyse the cause of major deviations which result in corrective action where indicated.

Thus, with the help of tools of financial analysis finance manager can rationalize his decisions and reach the business goal easily.

The utility of tools of financial analysis is limited not only to finance manager they are equally useful to the top management, creditors, investors and labourers. By analysing and interpreting financial statements, the top management can measure the success or otherwise of a company’s operations, determine the relative efficiency of various departments, processes and products, appraise the individual’s performance and evaluate the system of internal control.

The creditor can find out the financial strength and capacity of a borrower, the value of a floating share on the assets held as security and the value of unquoted shares. A lending bank through an analysis of these statements appraises the ability of the company at a particular time to meet its obligation and also judges the probability of its continued ability to meet all its financial obligations.

The long-term lenders examine not only the safety of principal and interest on the indebtedness but also the business. The shareholders or the investors are enabled to evaluate the efficiency of the management and determine if there is a need for change. In a large company the shareholders’ interest is limited to decide whether to buy, sell or hold the shares.

The labour unions analyse the financial statement with a view to determining the business costs and benefits before and after the taxes, the financial benefits received by the various groups interested in the enterprise, the company’s financial and operating experience compared with that of the other enterprises and likely future business course.

The unions thus assess whether the company is earning a fair rate of return on invested capital, whether it can presently afford a wage increase, whether a decrease may be necessary, whether it can absorb a wage increase through increased productivity or by raising prices.

The economists analyse the financial statement with a view to studying the prevailing business and economic conditions. The government agencies analyse them for the purpose of price regulations, rate setting and similar other purposes.

It is not necessary to employ all the techniques for analytical purposes. The choice of a particular tool would depend, by and large, on the purpose in hand. A technique that is used frequently by an analyst may not prove useful to other analyst because of difference in the particular interests of the analysis.

Tools of Analysis of Financial Statements

The most commonly used techniques of financial analysis are as follows:

1. Comparative Statements: These are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form to give an idea about the position of two or more periods. It usually applies to the two important financial statements, namely, balance sheet and statement of profit and loss prepared in a comparative form. The financial data will be comparative only when same accounting principles are used in preparing these statements. If this is not the case, the deviation in the use of accounting principles should be mentioned as a footnote. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as ‘horizontal analysis’. From practical point of view, generally, two financial statements (balance sheet and income statement) are prepared in comparative form for financial analysis purposes. Not only the comparison of the figures of two periods but also be relationship between balance sheet and income statement enables an in depth study of financial position and operative results.

The comparative statement may show:

(i) Absolute figures (rupee amounts).

(ii) Changes in absolute figures i.e., increase or decrease in absolute figures.

(iii) Absolute data in terms of percentages.

(iv) Increase or decrease in terms of percentages.

The analyst is able to draw useful conclusions when figures are given in a comparative position. The figures of sales for a quarter, half -year or one year may tell only the present position of sales efforts. When sales figures of previous periods are given along with the figures of current periods then the analyst will be able to study the trends of sales over different periods of time. Similarly, comparative figures will indicate the trend and direction of financial position and operating results.

The financial data will be comparative only when same accounting principles are used in preparing these statements. In case of any deviation in the use of accounting principles this fact must be mentioned at the foot of financial statements and the analyst should be careful in using these statements.

Types of Comparative Statements:

The two comparative statements are

(i) Balance sheet, and

(ii) Income statement.

(i) Comparative Balance Sheet:

The comparative balance sheet analysis is the study of the trend of the same items, group of items and computed items in two or more balance sheets of the same business enterprise on different dates.’ The changes in periodic balance sheet items reflect the conduct of a business.

The changes can be observed by comparison of the balance sheet at the beginning and at the end of a period and these changes can help in forming an opinion about the progress of an enterprise. The comparative balance sheet has two columns for the data of original balance sheets. A third column is used to show increases in figures. The fourth column may be added for giving percentages of increases or decreases.

While interpreting Comparative Balance Sheet the interpreter is expected to study the following aspects:

(1) Current financial position and liquidity position.

(2) Long -term financial position.

(3) Profitability of the concern.

(1) For studying current financial position or short -term financial position of a concern, one should see the working capital in both the years. The excess of current assets over current liabilities will give the figures of working capital. The increase in working capital will mean improvement in the current financial position of the business.

An increase in current assets is accompanied by the increase in current liabilities of the same amount will not show any improvement in the short-term financial position. A student should study the increase or decrease in current assets and current liabilities and this will enable him to analyze the current financial position.

The second aspect which should be studied in current financial position is the liquidity position of the concern. If liquid assets like cash in hand, cash at bank, bills receivables, debtors, etc. show an increase in the second year over the first year, this will improve the liquidity position of the concern.

The increase in inventory can be on account of accumulation of stocks for want of customers, decrease in demand or inadequate sales promotion efforts. An increase in inventory may increase working capital of the business but it will not be good for the business.

(2) The long -term financial position of the concern can be analyzed by studying the changes in fixed assets, long-term liabilities and capital .The proper financial policy of concern will be to finance fixed assets by the issue of either long-term securities such as debentures, bonds, loans from financial institutions or issue of fresh share capital.

An increase in fixed assets should be compared to the increase in long-term loans and capital. If the increase in fixed assets is more than the increase in long term securities then part of fixed assets has been financed from the working capital. On the other hand, if the increase in long-term securities is more than the increase in fixed assets then fixed assets have not only been financed from long-term sources but part of working capital has also been financed from long-term sources. A wise policy will be to finance fixed assets by raising long-term funds.

The nature of assets which have increased or decreased should also be studied to form an opinion about the future production possibilities. The increase in plant and machinery will increase production capacity of the concern. On the liabilities side, the increase in loaned funds will mean an increase in interest liability whereas an increase in share capital will not increase any liability for paying interest. An opinion about the long-term financial position should be formed after taking into consideration above-mentioned aspects.

(3) The next aspect to be studied in a comparative balance sheet question is the profitability of the concern. The study of increase or decrease in retained earnings, various resources and surpluses, etc. will enable the interpreter to see whether the profitability has improved or not. An increase in the balance of Profit and Loss Account and other resources created from profits will mean an increase in profitability to the concern. The decrease in such accounts may mean issue of dividend, issue of bonus shares or deterioration in profitability of the concern.

(4) After studying various assets and liabilities an opinion should be formed about the financial position of the concern. One cannot say if short-term financial position is good then long-term financial position will also be good or vice-versa. A concluding word about the overall financial position must be given at the end.

(ii) Comparative Income Statement:

The Income statement gives the results of the operations of a business. The comparative income statement gives an idea of the progress of a business over a period of time. The changes in absolute data in money values and percentages can be determined to analyze the profitability of the business. Like comparative balance sheet, income statement also has four columns. First two columns give figures of various items for two years. Third and fourth columns are used to show increase or decrease in figures in absolute amounts and percentages respectively.

Guidelines for Interpretation of Income Statements:

The analysis and interpretation of income statement will involve the following steps:

(1) The increase or decrease in sales should be compared with the increase or decrease in cost of goods sold. An increase in sales will not always mean an increase in profit. The profitability will improve if increase in sales is more than the increase in cost of goods sold. The amount of gross profit should be studied in the first step.

(2) The second step of analysis should be the study of operational profits. The operating expenses such as office and administrative expenses, selling and distribution expenses should be deducted from gross profit to find out operating profits.

An increase in operating profit will result from the increase in sales position and control of operating expenses. A decrease in operating profit may be due to an increase in operating expenses or decrease in sales. The change in individual expenses should also be studied. Some expenses may increase due to the expansion of business activities while others may go up due to managerial inefficiency.

(3) The increase or decrease in net profit will give an idea about the overall profitability of the concern. Non-operating expenses such as interest paid, losses from sale of assets, writing off of deferred expenses, payment of tax, etc. decrease the figure of operating profit. When all non-operating expenses are deducted from operational profit, we get a figure of net profit. Some non-operating incomes may also be there which will increase net profit. An increase in net profit will gave us an idea about the progress of the concern.

(4) An opinion should be formed about profitability of the concern and it should be given at the end. It should be mentioned whether the overall profitability is good or not.

2. Common Size Statements:

 These are the statements which indicate the relationship of different items of a financial statement with a common item by expressing each item as a percentage of that common item. The percentage thus calculated can be easily compared with the results of corresponding percentages of the previous year or of some other firms, as the numbers are brought to common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. Thus, common size statements are useful, both, in intra-firm comparisons over different years and also in making inter-firm comparisons for the same year or for several years. This analysis is also known as ‘Vertical analysis’.

Advantages of Common-Size Statement:

The advantages of Common-Size Statement are:

(a) Easy to Understand:

Common-size Statement helps the users of financial statement to make clear about the ratio or percentage of each individual item to total assets/liabilities of a firm. For example, if an analyst wants to know the working capital position he may ascertain the percentage of each individual component of current assets against total assets of a firm and also the percentage share of each individual component of current liabilities.

(b) Helpful for Time Series Analysis:

A Common-Size Statement helps an analyst to find out a trend relating to percentage share of each asset in total assets and percentage share of each liability in total liabilities.

(c) Comparison at a Glance:

An analyst can compare the financial performances at a glance since percentage of increase or decrease of each individual component of cost, assets, liabilities etc. are available and he can easily ascertain his required ratio.

(d) Helpful in analysing Structural Composition:

A Common-Size Statement helps the analyst to ascertain the structural relations of various components of cost/expenses/assets/liabilities etc. to the required total of assets/liabilities and capital.

Limitations of Common-Size Statement:

Common-Size Statement is not free from snags.

Some of them are:

(a) Standard Ratio:

Common-Size Statement does not help to take decisions since there is no standard ratio/percentage regarding the change of percentage in the various component of assets, liabilities, sales etc.

(b) Change in Price-level:

Common-Size statement does riot recognise the change in price level i.e. inflationary effect. So, it supplies misleading information’s since it is based on historical cost.

(c) Following Consistency:

If consistency in the accounting principle, concepts, conventions is not maintained then Common Size Statement becomes useless.

(d) Seasonal Fluctuation:

Common-Size Statement fails to convey proper records during seasonal fluctuations in various components of sales, assets liabilities etc. e.g. sales and closing stock significantly vary. Thus, the statement fails to supply the real information to the users of financial statements.

(e) Window Dressing:

Effect of window dressing in financial statements cannot be ignored and Common-Size Statements fail to supply the real positions of sales, assets, liabilities etc. due to the evil effects of window dressing appearing in the financial statements.

(f) Qualitative Element:

Common-Size Statement fails to recognise the qualitative elements, e.g. quality of works, customer relations etc. while measuring the performance of a firm although the same should not be ignored.

(g) Liquidity and Solvency Position:

Liquidity and solvency position cannot be measured by Common-Size Statement. It considers the percentage of increase or decrease in various components of sales, assets, liabilities etc. In other words it does not help to ascertain the Current Ratio, Liquid Ratio, Debt Equity Capital Ratio, Capital Gearing Ratio etc. which are applied in testing liquidity and solvency position of a firm.

The common-size statements may be prepared in the following way:

(1) The totals of assets or liabilities are taken as 100.

(2) The individual assets are expressed as a percentage of total assets, i.e., 100 and different liabilities are calculated in relation to total liabilities. For example, if total assets are Rs 5 lakhs and inventory value is Rs 50,000, then it will be 10% of total assets (50,000×100/5,00,000)

Types of Common-Size Statements:

(i) Common-Size Balance Sheet:

A statement in which balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability is expressed as a ratio of total liabilities is called common-size balance sheet.

For example, following assets are shown in a common-size balance sheet:

The total figure of assets Rs 2,00,000, is taken as 100 and all other assets are expressed as a percentage of total assets. The relation of each asset to total assets is expressed in the statement. The relation of each liability to total liabilities is similarly expressed.

The common-size balance sheet can be used to compare companies of differing size. The comparison of figures in different periods is not useful because total figures may be affected by a number of factors. It is not possible to establish standard norms for various assets. The trends of figures from year to year may not be studied and even they may not give proper results.

(ii) Common Size Income Statement:

The items in income statement can be shown as percentages of sales to show the relation of each item to sales. A significant relationship can be established between items of income statement and volume of sales. The increase in sales will certainly increase selling expenses and not administrative or financial expenses.

In case the volume of sales increases to a considerable extent, administrative and financial expenses may go up. In case the sales are declining, the selling expenses should be reduced at once. So, a relationship is established between sales and other items in income statement and this relationship is helpful in evaluating operational activities of the enterprise.

3. Trend Analysis:

It is a technique of studying the operational results and financial position over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. The trend percentage is the percentage relationship, in which each item of different years bear to the same item in the base year. Trend analysis is important because, with its long run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of good or poor management is detected.

The financial statements may be analyzed by computing trends of series of information. This method determines the direction upwards or downwards and involves the computation of the percentage relationship that each statement item bears to the same item in base year.

The information for a number of years is taken up and one year, generally the first year, is taken as a base year. The figures of the base year are taken as 100 and trend ratios for other years are calculated on the basis of base year. The analyst is able to see the trend of figures, whether upward or downward. For example, if sales figures for the year 2006 to 2011 are to be studied, then sales of 2006 will be taken as 100 and the percentage of sales for all other years will be calculated in relation to the base year, i.e., 2006

Suppose the following trends are determined.

The trends of sales show that sales have been more in all the years since 2006. The sales have shown an upward trend except in 2008 when sales were less than the previous year i.e., 2004. A minute study of trends shows that rate of increase in sales is less in the years 2007 and 2008.

The increase in sales is 15% in 2006 as compared to 2007 and increase is 10% in 2007 as compared to 2006 and 5% in 2008 as compared to 2007. Though the sales are more as compared to the base year but still the rate of increase has not been constant and requires a study by comparing these trends to other items like cost of production, etc.

Procedure for Calculating Trends:

(1) One year is taken as a base year. Generally, the first or the last is taken as base year.

(2) The figures of base year are taken as 100.

(3) Trend percentages are calculated in relation to base year. If a figure in other year is less than the figure in base year the trend percentage will be less than 100 and it will be more than 100 if figure is more than base year figure. Each year’s figure is divided by the base year’s figure.

The interpretation of trend analysis involves a cautious study. The mere increase or decrease in trend percentage may give misleading results if studied in isolation. An increase of 20% in current assets may be treated favorable. If this increase in current assets is accompanied by an equivalent increase in current liabilities, then this increase will be unsatisfactory. The increase in sales may not increase profits if the cost of production has also gone up.

The base period should be carefully selected. The base period should be a normal period. The price level changes in subsequent years may reduce the utility of trend ratios. If the figure of the base period is very small, then the ratios calculated on this basis may not give a true idea about the financial data. The accounting procedures and conventions used for collecting data and preparation of financial statements should be similar otherwise the figures will not be comparable.

Advantages of Trend Analysis:

(a) Possibility of making Inter-firm Comparison:

Trend analysis helps the analyst to make a proper comparison between the two or more firms over a period of time. It can also be compared with industry average. That is, it helps to understand the strength or weakness of a particular firm in comparison with other related firm in the industry.

(b) Usefulness:

Trend analysis (in terms of percentage) is found to be more effective in comparison with the absolutes figures/data on the basis of which the management can take the decisions.

(c) Useful for Comparative Analysis:

Trend analyses is very useful for comparative analysis of date in order to measure the financial performances of firm over a period of time and which helps the management to take decisions for the future i.e. it helps to predict the future.

(d) Measuring Liquidity and Solvency:

Trend analysis helps the analyst/and the management to understand the short-term liquidity position as well as the long-term solvency position of a firm over the years with the help of related financial Trend ratios.

(e) Measuring Profitability Position:

Trend analysis also helps to measure the profitability positions of an enterprise or a firm over the years with the help of some related financial trend ratios (e.g. Operating Ratio, Net Profit Ratio, Gross Profit Ratio etc.).

Disadvantages of Trend Analysis:

The trend analysis is not free from snags.

Some of them are:

(a) Selection of Base Year:

It is not so easy to select the base year. Usually, a normal year is taken as the base year. But it is very difficult to select such a base year for the propose of ascertaining the trend. Otherwise, comparison or trend analyses will be of no value.

(b) Consistency:

It is also very difficult to follow a consistent accounting principle and policy particularly when the trends of business accounting are constantly changing.

(c) Useless in Inflationary Situations:

Analysis of trend percentage is useless at the time of price-level change (i.e. in inflation). Trends of data which are taken for comparison will present a misleading result.