Why Is Trend Analysis Important When Examining Financial Statements?

Personal-finance experts advise clients to periodically check their assets and liabilities, so they can spot instances of high indebtedness or the possibility of financial trouble down the road. This time-honored counsel also applies to the business environment, and financial analysts regularly gauge performance trends when reviewing the financial statements of businesses and nonprofits.

Trend analysis helps the public make sense of what goes on behind a company's closed doors, historically speaking. By reviewing the organization's financial statements, investors not only see whether the business made money during the year under review, but also whether it has been generating cash over a longer period -- such as three, five or 10 years. A full set of financial reports includes a balance sheet, an income statement, a cash-flows statement and a statement of retained earnings.

Trend analysis is important when examining a firm's financial statements, because financial analysts can see how company assets have grown over time. In the competitive landscape, the topic of asset growth is often preeminent, especially in industries requiring substantial upfront investments -- such as oil and gas, mining and the military. By evaluating performance trends, corporate analysts also can tell whether an organization is adeptly managing its money and investing it wisely. There are primary methods to analyze trends while sifting through financial statements. These are ratio analysis, vertical analysis and horizontal analysis.

Ratio analysis calls for the use of performance metrics, such as net profit margin and return on equity, to evaluate a company's operating trends. These run the gamut from efficiency and safety signals to solvency and liquidity patterns. Net profit margin equals net income divided by sales revenue and indicates profitability over a period. Return on equity, or ROE, gauges how well a company uses its equity to generate returns. ROE equals income before taxes divided by net worth.

In vertical analysis, financial managers set one accounting item as the benchmark and compare other items with the numerical standard. For example, a company's revenues, expenses and net income are $10 million, $6 million and $4 million, respectively. Revenues are the benchmark. Accordingly, a vertical analysis of the firm's income statement shows the following: revenues 100 percent ($10 million divided by $10 million times 100); expenses 60 percent ($6 million divided by $10 million times 100); and net income 40 percent ($4 million divided by $10 million times 100).

Horizontal analysis is the study of performance trends over time. For example, investors can review a company's five-year balance sheet to determine how corporate assets and liabilities moved from Year 1 through Year 5.